Reading 14 - Passive Equity

Question 1

Considerations in choosing a benchmark for passively managed equity portfolio

Answer 1

It should be

1. Rules-based
2. Transparent
3. Investable

The rules for including and excluding stocks in the portfolio, weighting scheme, rebalancing frequency must be consistent, objective, and predictable so investors can replicate the investment performance of the index

Question 2

Buffering

Answer 2

to make Indexes more investable by limiting stock migration problems and keep trading costs low

Buffering refers to the practice of establishing a threshold level for the change in a firm’s capitalization rank that must be met before moving it from one index to another on a reconstitution date

Size rankings may change almost every day with market price movements, so buffering makes index transitions a more gradual and orderly process.

Question 3

Packeting

Answer 3

With packeting, when a mid-cap company’s capitalization increases so that it qualifies as large-cap stock, half of the portfolio position is moved to the large-cap index on the reconstitution date. If the stock still meets the criteria for inclusion in the large-cap index at the next reconstitution date, the remainder of the position is moved from the mid cap to the large-cap index.

A policy of packeting can keep portfolio turnover and trading costs low

Question 4

Risk Factor exposure

Answer 4

Expected sensitivity of portfolio returns to various risk factors. Recall that a Multifactor model of returns uses multiple risk factors, while the CAPM is based on a single-factor market risk. Examples of risk factors used in portfolio construction include market risk (beta), firm size, style (e.g., growth vs. value), and prior returns (momentum).

Other factors considered include Liquidity, Volatility, and Firm “Quality.”

Question 5

Methods of Index-weighting

Answer 5

(1) market-cap weighting,
(2) price weighting, (DJIA)
(3) equal weighting, and
(4) fundamental weighting

Question 6

Equal Weighting

Answer 6

Equal weighting refers to investing equal amounts in each portfolio stock. Equally weighted indexes produce the least-concentrated portfolios.
Equal weighting also reduces changes in sector
exposures as market prices change compared to market-cap weighting.
Equal weighting is factor-indifferent;
it randomizes factor mispricing
small-cap bias relative to market-cap weighting, leads to more volatile returns

• require regular rebalancing due change in market prices
• limited investment capacity due to illiquid small-cap stocks

natural advantage over cap-weighted portfolios. not too much money is invested in overvalued stocks nor too less is invested in undervalued

Question 7

Fundamental Weighting

Answer 7

Fundamental weighting refers to weighting index stocks by their proportions of the total index value of a Fundamental Factor, such as Sales, Income, or Dividends. For example, a stock of a firm that pays 3% of all the dividends paid by index companies will have a 3% weight in a dividend-weighted index.

Question 8

Stock Concentration & HHI

Answer 8

Stock concentration is a key concern in the selection of the appropriate index.
Concentration can be captured using the concept of “effective number of stocks,” which can be measured using the Herfindahl-Hirschman index (HHI). HHI is the sum of the squared weights of the individual stocks in the portfolio and ‘effective no. of stocks’ is 1 / HHI

Question 9

Rebalancing Portfolio

Answer 9

Rebalancing is the process of adjusting portfolio weights as index weightings change.
For an equal weighted index, portfolio weights are no longer equal as soon as prices change.
Price-weighted index weights change in response to stock splits and stock dividends.
Market-cap-weighted portfolio weights require rebalancing when index firms issue new shares or repurchase shares in a significant amount.
Rebalancing incurs trading costs (and possibly tax costs) and will decrease returns.

Question 10

Reconstitution

Answer 10

Reconstitution is the process of removing and replacing stocks that no longer fit the desired market exposure of an index.

When reconstitution occurs, index-tracking portfolios, mutual funds, and ETFs will want to hold the newly included names and sell the deleted names. The demand created by investors seeking
to track an index can push up the stock prices of added companies while depressing the prices of the deleted ones.

The smallest-cap stocks in the Russell 1000 Large-Cap Index have a low weight in that cap-weighted index. After any of those stocks are demoted to the Russell 2000 Small-Cap Index, they are likely to have some of the highest weights.

Petajisto (2010) shows that the process of moving in that direction tends to be associated with increases in stock prices, while movements into the large-cap index tend to have negative effects. He also concludes that transparency in reconstitution is a virtue rather than a drawback.

Question 11

ETFs

Answer 11

Available indexes with greater or less exposure to a factor than broad-based index funds are typically structured as exchange-traded funds (ETFs).

Question 12

Fama French Factor Multi-Factor Model

Answer 12

five factors are:

1) Market risk (based on beta, standardized covariance of returns with the return on the market)

2) Firm size (market value of equity)

3) Book-to-market value (shareholders’ equity divided by market value of equity)

4) Operating Profitability (operating income (prev yr GP - expenses) divided by beginning BV of equity)

5) Investment Intensity (growth rate of total assets)

Question 13

Factor Weighted Portfolio

Answer 13

Factor-weighted portfolios are rules-based
- lower operating costs than actively managed funds - higher costs than large-cap weighted index funds

Factor-based index funds themselves are considered passive, as they are rules-based and typically transparent and replicable.
However, emphasizing some factors and de-emphasizing others relative to the overall market portfolio is a form of active portfolio management.

Question 14

Passive Factor based strategies

Answer 14

(1) Return oriented (dividend yield strategies, momentum strategies, and fundamentally weighted strategies)

(2) Risk oriented (Volatility weighting and Minimum variance)

(3) Diversification oriented (equally weighted indexes and maximum-diversification strategies)

• transparent in terms of factor selection, weighting, and rebalancing.

Possible risks -
- ease of replication by other investors, which can produce overcrowding and reduce the realized advantages of a strategy.
- compared to passive cap weighted index mgt fee and trading commissions are higher
- higher tracking error as often use multiple benchmarks, including both factor-based and market-cap-weighted indexes,

Advantage -
less costly than active management but still allows for different factor exposures

Question 15

Approaches to Passive Equity investing

Answer 15

(1) Pooled investments (open-end MFs, ETFs)
(2) Derivatives-based strategies, and
(3) Separately Managed Index based portfolios

Question 16

Derivatives-based strategies - overlay

Answer 16

Use of derivatives to manage pre-existing
portfolios (i.e. money already invested in stocks)

• Completion overlay (move the portfolio back to the risk exposure of the index)
• Rebalancing overlay (match the reconstitution of the index OR change security mix or allocation between equity and bond)
• Currency overlay

Question 17

Derivatives-based strategies - pros & cons

Answer 17

Advantage:
- Can be used to quickly adjust a portfolio’s factor exposures at low cost
- Trade in liquid markets
- Make it easy to leverage the portfolio

Disadvantages
1) options expire but stocks do not
2) are subject to position limits but not stocks
3) use may not be allowed by regulators and/or IPS in some cases
4) not available (particularly exchange traded futures contract) on desired index to be tracked
5) OTC derivatives introduce counterparty risk
6) Basis risk can increase tracking error

Question 18

Separately Managed Equity Index-based portfolios

Answer 18

hold all the constituent stocks in the index or a representative sample.
- require regularly updated data on the index;
- sophisticated trading and accounting systems;
- well-established broker relationships to facilitate program trading and lower trading commissions;
- compliance systems to ensure compliance with laws, regulations, and internal company policies.

Question 19

Tracking error

Answer 19

the degree to which the portfolio performance deviates from the index.

In Full replication -
As the portfolio manager moves to the least liquid stocks in the index, transaction costs begin to dominate and tracking error increases again

High tracking error -
- large number of constituents in index
- high expense ratio

Question 20

Program trading

Answer 20

a strategy of buying or selling many stocks simultaneously.

Question 21

Approaches to construction of passively managed equity portfolios

Answer 21

1) Full Replication (preferred for indexes with small numbers of similar liquid stocks)

2) Stratified Sampling (indexes with many heterogeneous, thinly traded, small-cap stocks)

3) Optimisation (indexes with many heterogeneous, thinly traded, small-cap stocks)

4) Blended approach

Blended - Full replication approach for the largest-cap section of an indexed portfolio or liquid securities and stratified sampling or optimization approach for the smallest-cap section or less liquid securities.

Question 22

price-weighted index

Answer 22

weight of each stock is its price per share divided by the sum of all the share prices in the index. As a result, a price-weighted index can be interpreted as a portfolio composed of one share of each constituent security.