R23: Passive Equity Investing Flashcards
Key characteristics of a benchmark
- Rules-based
- Transparent
- Investable
Index construction methods and issues with each
- Price-weighted: highest price stock dominates. Need to adjust divisor for stock splits.
- Market-weighted: large cap bias. Diversification issue.
- Equal-weighted: small cap bias. Need to rebalance frequently.
Ways to reduce transaction costs
- Buffering (ranges around breakpoints for migration)
- Packeting (split stock position if cap changes and breaches breakpoint)
What are the issues with factor-based investing?
- Higher management fee vs passive
- Issues identifying the most appropriate benchmark which would affect the tracking error
What’s Smart Beta
Slightly vary the factor sensitivities to earn a small active return
Pros and cons of investing with ETFs vs mutual funds
- Trade continuously
- Can be bought in margin
- Preferable tax treatment
- Exposed to market risk and trading commissions
- No streamlined record-keeping
Pros and cons of using derivatives
Pros:
- Low cost
- Leverage opportunities
- Gain or reduce exposure over short-term
Cons:
- OTC e.g. equity swaps have default (counterparty), liquidity risk and tax policy risk
- Maintening long-term exposure difficult (position limits) and expensive (roll costs)
- Futures have basis risk and need to post margin
Portfolio construction methods for passive
- Full replication
- Stratified sampling
- Optimisation
Causes of tracking error
- Fees and trading costs
- Sampling approach (fall first then increase due to TC)
- Time of trade
- Cash drag
What’s a completion overlay?
If indexed portfolio has diverged from exposure, e.g. surplus cash, equities with derivatives to increase beta
What’s investment intensity?
Rate of growth in firm’s total assets
Cons of securities lending
- Credit risk (credit quality of the borrower)
- Market risk (change in value of collateral)
- Reinvestment risk (if collateral is cash)
What are the approaches to passive investing?
ETFs/mutual funds
Derivatives
SMA
