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READING 27: PASSIVE EQUITY INVESTING (MODULE 27.1 BENCHMARKS :railway…
READING 27: PASSIVE EQUITY INVESTING
MODULE 27.1 BENCHMARKS :railway_track:
Requirements of benchmark index :check:
Rules based :straight_ruler:
incl. and excl. stocks in the portfolio,
the weighting scheme,
the rebalancing frequency
Predictable :control_knobs:
Transparent :sunny:
public,
clearly stated
and understandable to investors :copyright:
Investible :package:
can replicate the return and risk performance of the
index :silhouettes:
Considerations in choosing a benchmark :thinking_face:
Determining the
Desired
Market Exposure :swimmer:
market segment: broad market/ focus sector/ local- intl / Developed-EM
Size :scales:
Growth (high multiple) :car: vs. value (low multiple) :elephant:
Other risks factor: momentum , liquidity , volatility , and quality factor.
Identifying the
Methods
Used in Constructing
and Maintaining the Index
maket-cap weghting, or liquidity-weighted or free-float weighted
Price weighting
Equal weighting
Fundamental weighting
Stock concentration
:
key concern
in the selection of the appropriate index :worried: :!:
The effective number of stocks is the reciprocal of the HHI = 1/HHI
It can be interpreted as the effective number of stocks in an equally-weighted portfolio that mimics the concentration of the index.
passive factor-based
strategies
(smart beta)
vs.
market-cap weighted indexing :scales:
The goal of the strategy is to
improve on the risk/return performance
of the marketcap-weighted strategy by more than enough to offset the higher costs.
to
replicate
the return/risk characteristics of an index is to create a portfolio
with the same exposures
to a set of risk factors as the index
A passive market-capitali]ation-weighted investment strategy involves creating a portfolio that tracks the benchmark index as closely as possible at a low cost by investing in
all or a subset of the index stocks
most common equity risk factors: Growth, value, size, Yield, Momentum, Quality, volatility
frequently involve an element of active decision-making by altering the degree of factor exposure
03 Types of passive factor-based strategies
risk oriented
volatility weighting (where the weights
are the inverse of price volatility), minimum-variance investing.
Diversification oriented
equally-weighted portfolios, maximum diversification strategies
(achieved by maximi]ing the ratio of the weighted average volatility of the individual stocks to the portfolio volatility)
return oriented
dividend yield, momentum and
fundamentally-weighted strategies
Pros & cons
Increase tracking errors
less costly than active management,
relative to passive capweighted investing, management fees and trading commissions are higher.
MODULE 27.2 APPROACHES TO PASSIVE INVESTING
:shinto_shrine:
LOS 27.c: Different approaches
Pooled investments
include open-end mutual funds and exchange traded funds (ETFs)
Low cost & convenient fund structure
handle shareholder redemptions cheaply
derivatives-based strategies
use derivatives (options, futures and swap contracts) to recreate the risk/return performance of an index
overlay positions
: Derivative positions used to adjust the existing portfolio
risk and return
exposures
Completion overlays
: move the portf.
back to the risk exposure
of the index by adjusting portf. beta.
Currency overlays:
adjust the foreign exchange risk of portfolio holdings denominated in a foreign currency
Rebalancing overlays:
can efficiently and cheaply match the reconstitution of the index as securities are added and dropped
separately-managed index-based portfolios.
hold all of the constituent stocks in the index or a representative sample.
LOS 27.d: Construction of passively managed equity portfolios
Full replication
: hold all of the securities in the index
Stratified sampling
: holds a subset of the constituent stocks by allocating across multiple dimensions.
Optimization
approaches: uses tools of modern portfolio theory. (-) it is based on historical relationships and those can change / costly to maintain the optimization / are not mean-variance efficient
MODULE 27.3 TRACKING ERROR, RETURN AND RISK
:!?:
LOS 27.e: Potential causes of tracking error and method to control
:scales: The sample size increases ( as liquid stocks added -> tracking error decreases), then less liquid stocks added => tracking errors increase.
:man::skin-tone-4: Management fees charged to manage the fund
:rose:Paying commissions (or bid-asked spread) to execute trades.
The use of intra-day trading to manage the portfolio while performance of the benchmark index is based on close of day pricing
:money_with_wings:: Cash drag in the portfolio while indexes are computed as the return of a fully invested
portfolio with no cash drag
:control_knobs:
Controlling the tracking error:
requires trade-offs between the benefits of larger sample size versus the increase in costs / derivatives can be used to minimize cash drag.
LOS 27.f Explain sources of return and risk
Attribution analysis
Securities Lending
Investor Activism