Passive Management

Question 1

Buy and Hold

Answer 1

Involves buying and holding a portfolio of securities indefinitely. In the interim, only minor and infrequent adjustments are made to the portfolio.

Question 2

Full Replication

Answer 2

Involves an investor
holding all constituents of an index, weighted according to their relevant market
proportions.

Question 3

Stratified Sampling

Answer 3

Involves holding a
sample of securities from each sector within
an index, which is representative of the
characteristics of that index.

Question 4

Factor Matching

Answer 4

Selects securities based
on specifically chosen factors or risk
characteristics (eg, firm size).

Question 5

Optimization

Answer 5

Uses sophisticated
computer modelling to build a portfolio, by finding holdings that broadly mimic the
characteristics of the index.

Question 6

Synthetic

Answer 6

Involves the investor entering into swap agreements to track the return of a benchmark index.

Question 7

Rebalancing

Answer 7

Calendar rebalancing, the weights are adjusted regularly (eg, quarterly).

Contingent rebalancing, when the weights change by a predetermined
percentage.

Question 8

Cash Flow Matching

Answer 8

Simply purchases
bonds whose redemption proceeds will meet a liability as they fall due.

Question 9

Immunisation

Answer 9

An investor buys a portfolio of
bonds with a duration (not maturity) equal
to any liabilities.

Question 10

Laddering

Answer 10

Involves buying bonds with a range of different maturities, thus reducing
sensitivity to interest rate risk. As each
bond matures, funds become available for
withdrawal, or can be reinvested in bonds
with later maturities.

Question 11

Bullet Portfolios

Answer 11

Invest in bonds with
durations close to that of the liabilities, eg, an investor with a liability due in ten years could construct a bullet portfolio of 9 and 11 year duration bonds in equal proportions.

Question 12

Barbell Portfolios

Answer 12

Involves investing in a
portfolio of both short- and long-dated bonds, eg, 1 and 30 year bonds.

Question 13

Combination Matching

Answer 13

A hybrid strategy that involves matching
early liabilities with cash flows, and later
liabilities with immunisation strategies.

Question 14

Passive Fund Fees

Answer 14

A passive fund incurs dealing costs when a security enters or leaves the index, or when weightings
change (eg, due to takeovers, mergers or rights issues). These costs are not reflected in the calculation of the index itself.

Question 15

Index Funds & The Efficient Frontier

Answer 15

The index will not lie at the efficient frontier, since the constitution of the portfolio usually depends on market capitalisation (ie, size) for equity passive funds or maturity for bond passive funds. It does not take into account risk covariance.