How can we construct an index portfolio? Well, there are many ways to construct an index portfolio. And the most obvious way is to purchase the same Securities that make up the index in the same weights as the index. This is referred to as full replication and has the advantage of reducing the risk of the portfolio not performing in line with the index, which is a primary concern for an investor who wishes to earn the return of the index the risk of not tracking the performance of the index is referred to as tracking error and this risk will be lower under full replication. However, an investor may not be able to earn the same return as the index due to various costs which are not taken into account within the calculation of the index value these costs include management fees which are present in all portfolio construction methods as well as transaction fees that is fees pay to a stop broker for the execution of the initial trades and all subsequent trades made to Meridian decks as it changes over time. There is however the additional benefit that the investor will know exactly what is held by the portfolio at any time under full replication optimization is an alternative approach to indexing which attempt Dress barriers to full replication like Market restrictions optimization involves the portfolio engineer investing in a sample of Securities from within the index taking into account the total risk, which includes Market risk and investment risk as well as transaction costs in an attempt to match the performance of the index. Sample can be identified through testing the historic performance of different combinations of assets against the historic performance of the index to find the best fits or by matching the exposure of key risk factors within the sample portfolio to those of the index. For example, if an equity index has a beta of one the sample portfolio should also have a beta of one or for a fixed income index the duration of the portfolio should be matched to the duration of the index optimization can also be more appropriate than full replication for indexes which contain low liquidity Securities where it may not be possible to purchase the underlying Securities in sufficient volume at a fair price. The sampling approach can reduce transaction fees since fewer Securities are usually held however, there is the risk that the sample of Securities may not track the performance of the index resulting in higher tracking error. The final way to construct an index portfolio is to do so synthetically which involves using derivatives. The main benefit of this approach is that the performance of the derivatives will be driven by the performance of the index resulting in low tracking error. However, it may not always be clear which derivatives are being used and who the counterparties of the derivatives are these reduces transparency for the investor. And in addition there is the risk that the counterparties of the derivatives may not honor their obligations which may result in the fund not receiving payments as their due. This is referred to as counterparty risk and is not a problem for the full replication or optimization approaches since the Securities are owned by the fun. These three approaches are not mutually exclusive and an index fund may use a combination of these approaches or change approach over time.