Topic 1 - Term 2: Passive & Active Equity Portfolio Management

Question 1

Active investment:
In essence, aim to ? the market by ?-picking
Key benefits: potential for ?
Key risks: high ?? & more ?

Answer 1

Active investment:
In essence, aim to beat the market by stock-picking
Key benefits: potential for outperformance
Key risks: high transaction costs & more volatile

Question 2

Passive investment:
In essence, ? an ?
Techniques: ?/ ?
Key benefits: low ?& low ?? 
Key risks: ?? risks & ? constraints

Answer 2

Passive investment:
In essence, track an index
Techniques: replication/ sampling
Key benefits: low research & low transaction fees
Key risks: Total market risks & performance constraints

Question 3

ETF stands for?

Answer 3

ETFs = exchange-traded funds

Question 4

1st technique of Passive investment:

??: buy ? securities in the index in proportion to their ? in the index.

Answer 4

1st technique of Passive investment:

Full Replication: buy all securities in the index in proportion to their weight in the index.

Question 5

Full Replication - Costs:
Transactions costs from buying all the shares in the index.
Transactions costs from re-balancing the portfolio to reflect changes in the underlying index.
Transactions costs from re-investing cash flows, e.g. dividends
Management costs: the costs of the fund manager in managing and administering the fund - effectively, an administrative overhead.
Taxes also need to be paid on capital gains and dividends.
These costs are not included in the actual index therefore, even with full replication, it is practically impossible for a tracker to exactly match the index.

Answer 5

Full Replication - Costs:
Transactions costs from buying all the shares in the index.
Transactions costs from re-balancing the portfolio to reflect changes in the underlying index.
Transactions costs from re-investing cash flows, e.g. dividends
Management costs: the costs of the fund manager in managing and administering the fund - effectively, an administrative overhead.
Taxes also need to be paid on capital gains and dividends.
These costs are not included in the actual index therefore, even with full replication, it is practically impossible for a tracker to exactly match the index.

Question 6

2nd technique of Passive investment:
?:
Managers of equity index funds use sampling when the target index is so large that it’s too expensive and inefficient to buy all of the shares.
Instead, they buy a ?? of securities from the target index, according to their ? in the index.
Fewer stocks means lower transaction cost and reinvestment of dividends is less difficult.
As well as reducing costs, sampling may also be sometimes necessary for legal reasons i.e. a fund may be restricted to holding a set maximum percentage of assets in a particular security.

Answer 6

2nd technique of Passive investment:
SAMPLING:
Managers of equity index funds use sampling when the target index is so large that it’s too expensive and inefficient to buy all of the shares.
Instead, they buy a representative sample of securities from the target index, according to their weight in the index.
Fewer stocks means lower transaction cost and reinvestment of dividends is less difficult.
As well as reducing costs, sampling may also be sometimes necessary for legal reasons i.e. a fund may be restricted to holding a set maximum percentage of assets in a particular security.

Question 7

Sampling - Costs:
While sampling saves on costs, it does come with risks:
Will not track the index as closely as full replication, so there will be some ??.
Tracking error is usually not that significant for stock index funds.
However, in other asset classes where liquidity is not as high e.g. corporate bonds, tracking error can be significant.

Answer 7

Sampling - Costs:
While sampling saves on costs, it does come with risks.
Will not track the index as closely as full replication, so there will be some tracking error.
Tracking error is usually not that significant for stock index funds.
However, in other asset classes where liquidity is not as high e.g. corporate bonds, tracking error can be significant.

Question 8

Ammann and Zimmermann (2001) define Tracking Error as the extent to which ? fluctuations in the managed portfolio are not ? with ? fluctuations in the ?.

Answer 8

Ammann and Zimmermann (2001) define Tracking Error as the extent to which ? fluctuations in the managed portfolio are not ? with ? fluctuations in the ?.

Question 9

The art of being a manager of a passive equity portfolio lies in balancing the ? (???) and the benefits (?management, ? trading commissions) of using ?samples.

Answer 9

The art of being a manager of a passive equity portfolio lies in balancing the costs (larger tracking error) and the benefits (easier management, lower trading commissions) of using smaller samples.

Question 10

Evaluating ? tracking error of a passive portfolio manager may provide insight into how closely they will get to the benchmark return in the future.

Answer 10

Evaluating a past tracking error of a passive portfolio manager may provide insight into how closely they will get to the benchmark return in the future.

Question 11

Tracking error can also be used as an indicator of how actively a fund is managed and its corresponding risk level.
Alford, Jones and Winkelmann (2003) show that tracking error can be a useful way to categorise a fund’s investment style:
– TE < 1% => Passive
TE > 3% => Active.

Answer 11

Tracking error can also be used as an indicator of how actively a fund is managed and its corresponding risk level.
Alford, Jones and Winkelmann (2003) show that tracking error can be a useful way to categorise a fund’s investment style:
– TE < 1% => Passive
TE > 3% => Active.

Question 12

With synthetic replication, the fund manager does not try to buy the underlying members of the index being tracked in physical form: instead, a ? based on the underlying index is bought.
Index futures or index options (as well as swaps) can be used.
This means that there are no issues of having to buy and sell lots of different company shares every time the index is rebalanced.
Also, there is no need to buy or sell the physical assets and hence there are lower transaction costs

Answer 12

With synthetic replication, the fund manager does not try to buy the underlying members of the index being tracked in physical form: instead, a derivative based on the underlying index is bought.
Index futures or index options (as well as swaps) can be used.
This means that there are no issues of having to buy and sell lots of different company shares every time the index is rebalanced.
Also, there is no need to buy or sell the physical assets and hence there are lower transaction costs

Question 13

Synthetic replication can act as a wayfor investors togain ? in markets that are hard to access.
In some asset classes like commodities, there is often no choice but to use synthetic replication, as there is no underlying physical asset that you can reasonably buy.
For example, oil (huge storage costs to hold physically).
Synthetic replication generally ? costs and tracking error issues (although if the investment horizon differs from the time to maturity of the derivative, tracking error will occur) but it increases risk for investors.
Specifically, synthetic replication introduces ? risk (risk that the other party defaults)

Answer 13

Synthetic replication can act as a wayfor investors togain exposure in markets that are hard to access.
In some asset classes like commodities, there is often no choice but to use synthetic replication, as there is no underlying physical asset that you can reasonably buy.
For example, oil (huge storage costs to hold physically).
Synthetic replication generally reduces costs and tracking error issues (although if the investment horizon differs from the time to maturity of the derivative, tracking error will occur) but it increases risk for investors.
Specifically, synthetic replication introduces counterparty risk (risk that the other party defaults)

Question 14

Although investors can construct their own passive investment portfolios by attempting to replicate a particular index (as described previously), there are at least two easily accessible investment vehicles available that are typically more convenient and less expensive.
These are buying shares in:
An ??? or
An ??? (ETF)

Answer 14

Although investors can construct their own passive investment portfolios by attempting to replicate a particular index (as described previously), there are at least two easily accessible investment vehicles available that are typically more convenient and less expensive.
These are buying shares in:
An index mutual fund or
An exchange-traded fund (ETF)

Question 15

A??is a type of financial vehicle made up of a pool of money (hence the term mutual) collected from many investors to invest in securities.
The investment (portfolio) is managed by a ? investment company/manager who is responsible for deciding how the fund is managed

Answer 15

Amutual fundis a type of financial vehicle made up of a pool of money (hence the term mutual) collected from many investors to invest in securities.
The investment (portfolio) is managed by a professional investment company/manager who is responsible for deciding how the fund is managed

Question 16

In the case of an index mutual fund, the management style will be ? (rather than active) and the fund manager will typically attempt to construct the portfolio to ? the composition of a particular ? exactly, meaning that he or she will buy the exact securities comprising the index in their exact weights and then alter those positions anytime the composition of the index itself is changed.
Since changes to most equity indexes occur sporadically, index funds tend to generate ? trading and management expense ratios.
A prominent example of an index mutual fund is Vanguard 500 Index Fund Admiral Shares (VFIAX), which is designed to mimic the S&P 500 index.

Answer 16

In the case of an index mutual fund, the management style will be passive (rather than active) and the fund manager will typically attempt to construct the portfolio to replicate the composition of a particular index exactly, meaning that he or she will buy the exact securities comprising the index in their exact weights and then alter those positions anytime the composition of the index itself is changed.
Since changes to most equity indexes occur sporadically, index funds tend to generate low trading and management expense ratios.
A prominent example of an index mutual fund is Vanguard 500 Index Fund Admiral Shares (VFIAX), which is designed to mimic the S&P 500 index.

Question 17

The advantage of index mutual funds is that they provide an ? way for investors to acquire a ? portfolio that emphasises the desired market they wish to track within the context of a traditional money management product.

Answer 17

The advantage of index mutual funds is that they provide an inexpensive way for investors to acquire a diversified portfolio that emphasises the desired market they wish to track within the context of a traditional money management product.

Question 18

As with any mutual fund, however, the disadvantages are that investors can only liquidate their positions at the ? of the trading day i.e. no intraday trading.
Also, you cannot usually ?? mutual funds and, you may end up with unwanted ? repercussions if the fund has an unforeseen need to sell a portion of its holdings (realising capital gains).

Answer 18

As with any mutual fund, however, the disadvantages are that investors can only liquidate their positions at the end of the trading day i.e. no intraday trading.
Also, you cannot usually short sell mutual funds and, you may end up with unwanted tax repercussions if the fund has an unforeseen need to sell a portion of its holdings (realising capital gains).

Question 19

An ETF, or exchange-traded fund, is a??that tracks an index, a commodity, bonds, or a basket of assets like an index fund.
Unlike mutual funds, an ETF trades like a ?? on a stock exchange.
ETFs experience price changes throughout the day as they are bought and sold.
ETFs typically have higher daily? and lower ? than mutual fund shares, making them an attractive alternative for individual investors.
Because it trades like a stock, an ETF does not have itsnet asset value(NAV) calculated once at the end of every day like a mutual fund does.

Answer 19

An ETF, or exchange-traded fund, is amarketable securitythat tracks an index, a commodity, bonds, or a basket of assets like an index fund.
Unlike mutual funds, an ETF trades like a common stock on a stock exchange.
ETFs experience price changes throughout the day as they are bought and sold.
ETFs typically have higher dailyliquidityand lower fees than mutual fund shares, making them an attractive alternative for individual investors.
Because it trades like a stock, an ETF does not have itsnet asset value(NAV) calculated once at the end of every day like a mutual fund does.

Question 20

?by ?, the largest provider ofexchange-traded-funds(ETFs) in the world.

Answer 20

iSharesby BlackRock, the largest provider ofexchange-traded-funds(ETFs) in the world.

Question 21

You will also frequently see ETFs that track MSCI Indices.
MSCI is an acronym for ????.
It is an investment research firm that providesstock indexes, portfolioriskand performance analytics, and governance tools to institutional investors.
However, best known for its stock indexes - more than 160,000, which focus on different geographic areas and stock types such as small-caps, mid-caps, and large-caps. They track the performance of the stocks that are included in them and act as a base forexchange-traded funds(ETFs).

Answer 21

You will also frequently see ETFs that track MSCI Indices.
What does that mean?
MSCI is an acronym for Morgan Stanley Capital International.
It is an investment research firm that providesstock indexes, portfolioriskand performance analytics, and governance tools to institutional investors.
However, best known for its stock indexes - more than 160,000, which focus on different geographic areas and stock types such as small-caps, mid-caps, and large-caps. They track the performance of the stocks that are included in them and act as a base forexchange-traded funds(ETFs).

Question 22

A significant advantage of ETFs over index mutual funds is that they can be bought and sold (and short sold) like common stock through an organised exchange or in an over-the-counter market.
Can also apply ? order types such as market orders, limit orders, stop orders etc.
Further, they are backed by a ? organisation.
Other advantages relative to index funds include an often smaller management fee, the ability for continuous trading while markets are open and the ability to time capital gain tax realisations.

Answer 22

A significant advantage of ETFs over index mutual funds is that they can be bought and sold (and short sold) like common stock through an organised exchange or in an over-the-counter market.
Can also apply normal order types such as market orders, limit orders, stop orders etc.
Further, they are backed by a sponsoring organisation.
Other advantages relative to index funds include an often smaller management fee, the ability for continuous trading while markets are open and the ability to time capital gain tax realisations.

Question 23

ETF disadvantages include the ?? and the inability to reinvest dividends, except on a quarterly basis.
Agapova (2011) provides a good summary and comparison of ETFs and conventional funds, showing that “conventional funds and ETFs are substitutes, but not perfect substitutes.”

Answer 23

ETF disadvantages include the brokerage commission and the inability to reinvest dividends, except on a quarterly basis.
Agapova (2011) provides a good summary and comparison of ETFs and conventional funds, showing that “conventional funds and ETFs are substitutes, but not perfect substitutes.”

Question 24

Extensions to Passive Management & Indexing:
Index ? and ?:
-Buying futures and options on a particular index can be equivalent to an index fund.
For example, buy a futures contract on the S&P.
- However, this assumes that futures contract is priced at its ? value.
- Derivatives mature: needs ? .
- Options are ? assets. More difficult to replicate the index.

Answer 24

Extensions to Passive Management & Indexing:
Index futures and options:
-Buying futures and options on a particular index can be equivalent to an index fund.
For example, buy a futures contract on the S&P.
- However, this assumes that futures contract is priced at its arbitrage value.
- Derivatives mature: needs reinvestment.
- Options are nonlinear assets. More difficult to replicate the index.

Question 25

One issue for individual/small investors with using futures for indexing is scale of investment.
On today’s level e.g. S&P500 futures contract notional value would be approx. $950,000.
The margin requirement on this is beyond the reach of most retail investors.

Answer 25

One issue for individual/small investors with using futures for indexing is scale of investment.
On today’s level e.g. S&P500 futures contract notional value would be approx. $950,000.
The margin requirement on this is beyond the reach of most retail investors.

Question 26

Chicago Mercantile Exchange (CME) decided to launch a smaller, bite- sized, more retail-friendly version of the S&P 500: the E-mini S&P 500 in 1997.
Designed to be one-fifth the size of standard S&P 500 futures.
The E-mini S&P 500 went on to become the most liquid stock index futures contract in the world.
E-minis are predominantly traded on the CME and contracts have expanded to include many other indexes, commodities, and currencies.

Answer 26

Chicago Mercantile Exchange (CME) decided to launch a smaller, bite- sized, more retail-friendly version of the S&P 500: the E-mini S&P 500 in 1997.
Designed to be one-fifth the size of standard S&P 500 futures.
The E-mini S&P 500 went on to become the most liquid stock index futures contract in the world.
E-minis are predominantly traded on the CME and contracts have expanded to include many other indexes, commodities, and currencies.

Question 27

Some advantages of futures over ETFs are that futures have no annual ??, trading takes place nearly 24 hours a day, six days a week (although this is more important for investors using ETFs for active investing) and futures, particularly on certain markets have greater liquidity.

Answer 27

Some advantages of futures over ETFs are that futures have no annual management fees, trading takes place nearly 24 hours a day, six days a week (although this is more important for investors using ETFs for active investing) and futures, particularly on certain markets have greater liquidity.

Question 28

Factor Investing & Smart beta:
So called “Enhanced” Index Funds claim to offer the benefits of vanilla index funds but in addition delivering some of the excess returns of ? managed funds.

Damodaran states that enhanced index funds are an oxymoron (nghịch lí) - you can be an index or actively managed fund - but not both.

Enhanced indexing, sometimes called smart beta, factor investing or alternatively weighted index investing, is predominantly a ??? strategy, either through a tracker fund or an ETF with an added element of active management.

Answer 28

Factor Investing & Smart beta:
So called “Enhanced” Index Funds claim to offer the benefits of vanilla index funds but in addition delivering some of the excess returns of ACTIVELY managed funds.

Damodaran states that enhanced index funds are an oxymoron (nghịch lí) - you can be an index or actively managed fund - but not both.

Enhanced indexing, sometimes called smart beta, factor investing or alternatively weighted index investing, is predominantly a PASSIVE INDEX TRACKING strategy, either through a tracker fund or an ETF with an added element of active management.

Question 29

Factor Investing & Smart Beta:
The active portion is generally in the form of altering the ? to stocks in an index, for example instead of being market cap weighted, it could be allocated according to dividend yield, volatility or fundamental aspects such as earnings.
The goal of enhanced indexing is to generate modest alpha in a ?- and ?-efficient manner..
Whilst apparently attractive, it seems that many of these funds are just ? managed funds but with significant ? on activity.

Answer 29

Factor Investing & Smart Beta:
The active portion is generally in the form of altering the weightings to stocks in an index, for example instead of being market cap weighted, it could be allocated according to dividend yield, volatility or fundamental aspects such as earnings.
The goal of enhanced indexing is to generate modest alpha in a cost- and risk-efficient manner..
Whilst apparently attractive, it seems that many of these funds are just actively managed funds but with significant constraints on activity.

Question 30

Factor investing is astrategythatchooses securities on attributes that are associated with ??.
There are two main types of factors that have driven returns of stocks, bonds, and other factors: ? factors and ? factors.
The former captures broad risks across asset classes while the latter aims to explain returns and risks within asset classes.
Some common macroeconomic factors include credit, inflation, and liquidity whereas style factors embrace style, value, and momentum, just to name a few.

Answer 30

Factor investing is astrategythatchooses securities on attributes that are associated with higher returns.
There are two main types of factors that have driven returns of stocks, bonds, and other factors; macroeconomic factors and style factors.
The former captures broad risks across asset classes while the latter aims to explain returns and risks within asset classes.
Some common macroeconomic factors include credit, inflation, and liquidity whereas style factors embrace style, value, and momentum, just to name a few.

Question 31

But these smart beta funds haven’t generated the returns they’ve promised => fall out of favour!

Answer 31

But these smart beta funds haven’t generated the returns they’ve promised => fall out of favour!

Question 32

PASSIVE VS ACTIVE DEBATE:
A lot of what we choose to do as investors will come back to our own ?? and what we believe about ??.
So the start of any debate on whether passive or active is better begins with our thoughts on ? and whether we believe we can ? the market (?) or not.
If we believe that it is not possible to beat the market then we “simply” invest in the ?. But passive investors still need to do due diligence, research before investing!

Answer 32

PASSIVE VS ACTIVE DEBATE:
A lot of what we choose to do as investors will come back to our own investment philosophy and what we believe about market efficiency.
So the start of any debate on whether passive or active is better begins with our thoughts on EMH and whether we believe we can beat the market (consistently) or not.
If we believe that it is not possible to beat the market then we “simply” invest in the index.
But passive investors still need to do due diligence, research before investing!