Reading 23: Passive Equity Investing Flashcards
Sample Size
Adding to the sample size with liquid stocks first reduces tracking error when replicating a benchmark. But as less liquid stocks are added the costs and tracking error increase.
Cash Drag
Refers to cash in the passive portfolio that reduces return in upswings vice versa. The index represents theoretically fully invested performance.
Security Lending
Used to generate income by lending securities, which offsets portfolio expense and reduces tracking error. The stock lender faces counterparty risk (returning the security) and collateral market risk.
Overlay Positions
Using derivatives to adjust existing portfolio risk and return. Completion overlays move portfolio back to risk exposure of index. Rebalancing overlays efficiently matches reconstitutions.
Free Float Adjustment
Indicates true liquidity. Excluding shares held by founders, governments, of other companies. Market cap weighted indexes are based on free float.
Basis Risk
Using a hedging instrument that is imperfectly matched to the investment being held, can arise when the underlying pays dividend (the futures contract does not).
Price Weighted Index
The weight of each stock is its price per share divided by the sum of all prices in the index. The portfolio is composed of one share for each constituent security. Equal number of shares in each index stock. Change in response to stock splits and stock dividends.
Index Rules
Must be rules based, transparent, and investable.
Equal Weighted
Is factor indifferent, and randomises factor mispricing. It is more volatile due to is small cap bias than market cap weighted. Market based should be rebalanced with new issuance of shares or significant repurchase of shares.
Effective Number
Effective number of stocks is related to the HHI. If the effective number is less than the actual number in the index it indicates that the index has a disproportionate effect to large cap stocks.
Buffering & Packeting
Both make the index more investable and relate to rebalancing. Buffering needs to reach a specific level before rebalanced and packaging does half now then the other half if the trend is persistent.
Fama & French
Identify five risk factors to explain variation in returns. Market risk, firm size, B/M, operating profitability (operating income over beginning shareholders equity), investment intensity (growth rate of total assets).
Factor Weighted
Increase exposure to a certain risk factor. Typically structured as an ETF. Lower operating costs than traditionally active (because they are still considered passive although a somewhat active view is taken on the factor), but higher costs than large cap weighted index funds.
Return Orientated Strategies
Include momentum based indexes, dividend yield strategies, and fundamental weighted strategies.
Risk Orientated Strategies
Include volatility weighting and minimum variance testing. Portfolio is selected to minimise portfolio variance. Based on past return data but are simple and easy to implement.
Diversification Orientated Strategies
Include equally weighted portfolios and maximum diversification strategies.
Pooled Investments
Include open ended funds and ETFs. Opened ended have low transaction costs and convenient structure. ETFs trade intra day and do not need to sell stocks for investor redemptions eliminating taxable gains (unlike open ended). ETFs can have higher transaction costs from commissions and bid-ask spread as well as possible illiquidity.
Derivative Based
Can quickly adjust factor exposure at low cost, trade in liquid markets, easy to leverage portfolio. But must be rolled over at expiration, can have position limits, may not match the portfolios needs, OTC have counterparty risk, basis risk increases tracking error.
Separately Managed Equity Index Based Portfolios
Hold all constituent stocks or a representative sample. Need sophisticated trading systems and need to be updated regularly.
Replication Strategies
Full replication: includes all stocks, costly with large indexes.
Stratified sampling: takes a stock from each strata (mutually exclusive and exhaustive sub sets) to replicate factor exposure. Less costly but can have higher tracking error. Simple approach.
Optimisation: More complex, uses mean variance analysis to minimise tracking error, considers correlations between securities. Based on historic data and can result in portfolios that are not mean variance efficient.
Causes of Tracking Error
Management fees, commissions on trades, sampling (compared to full replication), intraday trading (index returns based on close price), cash drag.
Attribution Analyses
Manager understanding the sources of index returns to replicate that index. Helps identify sources of tracking error and reduces them.
