An index is investable when investors can track and replicate its performance by buying its constituent securities easily.. Another problem is that price -weighted index includes equal n
Trang 1Reading 27 Passive Equity Investing
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Passive investing is a simple rule-based investment
strategy that does not engage in stock selection
Indexing, a pure form of passive investing, tends to
mimic the performance of benchmark indexes Indexing
is a low cost, diversifying and tax-efficient strategy
Passive investment managers believe that the cost of
security selection is higher than the cost of passive investing
The efficient market hypothesis asserts that all stocks are
perfectly priced therefore it would not be possible for active investors to consistently outperform the market
Originally benchmark indexes were used to assess
performances of active portfolio managers but now they
are also used to establish investment strategies
Choosing a suitable benchmark is essential for investors
Benchmark’s past performance and creation method
are important in its selection
2.1 Indexes as a Basis for Investment
Indexes (when are used as a basis for investment) must
meet three initial requirements They must be rule-based,
transparent and investable
Indexes follow rule-based methodologies with regards to
rebalancing frequency, inclusion of constituent securities
etc
An index is investable when investors can track and
replicate its performance by buying its constituent
securities easily
Certain characters of individual securities that make
them investable as index securities include:
• high free-float (no of shares available for trade
by the public)
• high trading volume which in turn means high
liquidity and low trading costs
Index providers try to mitigate ‘stock migration issue’ to
keep trading costs low and to make the index more
investable Stock migration takes place when an
individual stock migrates from one index to another For
example, when market capitalization of a stock
increases overtime, its status might move from small-cap
to mid-cap or mid-cap to large-cap
‘Buffering’ and ‘Packeting’ are two of many policies
index practitioners defined to reduce stock migration
issues These policies lower portfolio turnover and trading
costs
Index providers define a buffer zone between adjacent
indexes A stock remains in its current index as long as
the stock stays in the buffer zone Buffer zones reduce frequent reconstitution and make index transitions gradual and well-ordered
Packeting methodology splits stock positions into
multiple parts Once a stock moves out of the transition band, only a portion of the total holding is shifted from one index to another In the following reconstitution date, the remainder of the parts are transferred if the security stays beyond the threshold level
2.2 Constitutions When Choosing a Benchmark Index
Selection of a benchmark is guided by the investor’s investment policy statement (IPS) ‘Market segment’,
‘Equity capitalization (the size factor)’ and ‘Style of benchmark’ are key considerations when choosing a benchmark
Market segment (such as broad versus sectors, domestic
versus international, developed versus emerging/frontier) are based on investor’s perspective including his
domicile, risk tolerance, liquidity needs, legal considerations etc
Risk Factor (such as Size, Style, momentum and liquidity) exposure is an important determinant of realized risk and return
Benchmarks with defined size ranges (holdings’ market
capitalization) offer investors opportunity to get market exposure to size risk factor Empirical studies have shown that small-cap stocks are riskier and provide a higher long-term return compared to large-cap stocks
The choice of the size factor involves the investor’s preferences for exposure on the capitalization spectrum (small-cap, mid-cap, large-cap) Some investors
contemplate that small-cap stocks are suitable for alpha generation through active management and large-cap stocks are suitable for low-cost passive management
Investors who require a broad universe of equities may prefer all-cap index Such indexes include stocks from various size ranges
Trang 2Another decision element is the style of the benchmark
that determines where the index falls in the value-growth
scale
Ø Growth stocks exhibit features such as high
price momentum, high P/E ratio, and high
growth
Ø Value stocks exhibit features such as high
dividend yields, low P/E and low P/BV ratios
2.3 Index Construction Methodologies
Stocks inclusion methodologies range from exhaustive to
selective Exhaustive approach selects all securities
Selective approaches choose securities based on
selective features
Performance of an index is affected by the weighting
method used to construct the index Market-cap
weighting is one of the most common weighting
methods A security’s market-cap is calculated as (price
× no of shares outstanding) Each stock’s weight in the
index is calculated as #$#* )*+&,# %*- $/ * "#$%&"
"#$%&’" )*+&,# %*-Cap weighted indexes are reasonable proxy for market
portfolios and are investable because of higher liquidity
Free-float adjusted weighting is a common market-cap
weighting where market capitalization is calculated as
(price × no of shares freely available in the market)
Free-float weighting adjusts number of shares
outstanding for closely held shares unavailable for
public
Finding number of shares available for free-float requires
analytical judgement and company’s information
available for public The reported number may vary
slightly depending on methodologies used
In Price-weighted index, the weight of each stock is
calculated as: "2) $/ * "1*+, -+0%," 03 #1, 034,5-+0%, -,+ "1*+, Shares are
weighted in proportion to their price per share
Price-weighted indexes are adjusted for stock splits
Another problem is that price -weighted index includes
equal number of shares for each security This investment
approach is followed by very few participants
Equal-weighted index gives equal weights to all stocks in
the index Each stock weights 63, where n represents the
total number of stocks in the index (also called nạve
strategy) Benefits of equally weighted index include
‘lower single stock concentration’ and ‘slow changing
sector exposures’
Equal weighting indexes are factor-indifferent Because
of randomness, there is no (or very little) factor mispricing
in equal weighted indexes
Unlike market capitalization weighted indexes, equal weighted indexes do not give too much weight to any single factor or sector (e.g technology) This protects investors from losses occurring because of, for example, tech bubble or mortgage finance bubble etc
Equal-weighted indexes are more volatile than market-cap weighted indexes because of presence of large number of small-cap stocks
Equal weighted indexes are very different than market weighted large-cap indexes as difference in weights of constituent stocks is enormous (e.g allocation to Apple
or Microsoft will be much higher in market weighted large-cap index) This is difference is not much when we compare equal weighted indexes with mid-cap market weighted indexes
Equally-weighted indexes require regular rebalancing as change in market prices cause individual stock
investment values to change
One challenge for equally weighted indexes is their limited investment capacity as they allocate equal weights to all stocks including small-caps, which are generally less liquid
Equal weighted indexes exhibit a natural advantage over cap-weighted portfolios This is because not too much money is invested in overvalued stocks nor too less
is invested in undervalued stocks As prices of overvalued stocks fall, cap-weighted portfolios suffer much more losses than equal weighted portfolios Similarly, when undervalued stocks prices rise, more gains accrue to equal weighted portfolios as amount invested in them were not small
Fundamental weighted indexes are based on stock’s fundamental characteristics such as sales, income, dividends The reasoning behind fundamental weighting
is that the stock’s market value may change overtime to reflect the stock’s fundamental attributes
Market-cap weighted indexes versus fundamentally weighted indexes
structure, transparency, investability
Differences Philosophy of
• market cap weighted index is
based on efficient market hypothesis
• fundamentally weighted
index is based on stock’s attributes and to exploit inefficiencies in market pricing
Another concern in benchmark selection is the effective number of stocks in the index The Herfindahl-Hirschman Index (HHI) is a commonly used measure of stock-concentration risk in a portfolio The HHI is calculated as:
Trang 3HHI = ∑3 𝑤0:
0;6 where 𝑤0 is the weight of stock i in the
portfolio The value of HHI can range from 63 to 1, where,
n = no of securities The value of HHI in equally weighted
portfolio would be 63
The value of HHI can be used to estimate the effective
number of stocks
Effective no of stocks = ∑ 6<
=>
?
=@A = BBC6 After recent financial crises, investors started noticing
strategies that were defensive or volatility reducing (for
example weights based on higher dividend yields or
lower volatility)
Another consideration of index construction is its:
• reconstitution schedule which involves
adding/deleting the constituent securities in
the index
• rebalancing frequency, which involves
periodic adjustment of the weights of the
constituent securities in the index
The index reconstitution may affect the stock prices The
prices of stocks rise(fall) that are going to be added in
(removed from) the index due to increase (decrease) in
demand
The reconstitution effect on stock prices varies
depending on the reconstitution method used Investors
can easily guess and front-run the trades when there is a
precise method or objective criteria for reconstitution
When a committee vote for addition/deletion of stocks
or there are subjective criteria for reconstitution, it
becomes difficult for investors to anticipate stocks
beforehand
Effective indexes are ones that are investable Indexes
are investable when their constituent securities are liquid
and readily available to public for trading
2.4 Factor-Based Strategies
The returns of some benchmarks are determined by
certain risk factors such as size, value, quality,
momentum, volatility Such benchmarks contain
securities that are exposed to one or more specific risk
factors
Fama and French (2015) research demonstrates that U.S
equity market returns incorporate five major risk factors,
which are market risk premium, company’s size,
book-to-market (value or growth categories), operating
profitability and investment intensity
Operating profitability is measured as:
-+,D0$2" E,*+’" F+$"" -+$/0#G ,5-,3",".
I,F03303F I$$& D*.2, $/ ,J20#E
Investment intensity is measured as: growth rate in total assets in the previous year
Passive-factor-based strategies also known as
‘smart-beta’ are growing in popularity There are many passive investment vehicles and indexes that allow exposures to common equity risk factors such as value, size,
momentum, volatility, yield, quality etc Investors apply factor tilts and deviate their portfolios by over or under weighting certain risk factors to incorporate their opinions regarding capital market conditions
Passive factor investing apply passive rules but involve frequent active decision-making, which is usually upfront, on matters e.g timing, degree of factor exposure Passive factor-based strategies that are highly concentrated on certain risk factors may significantly underperform during unfavorable market conditions To circumvent this issue, many investors use multi-factor approaches
Passive factor-based investing is transparent in factor selection, weightings and rebalancing However, transparency may bring ease of replication, which in turn cause overcrowding and reduce realized returns The objective of factor-based approaches is to enhance portfolio’s risk or return performance as compared to market-cap-weighted strategy Factor-based strategies can be:
i) return-oriented ii) risk-oriented iii) diversification-oriented
Return-oriented factor-based strategies include
dividend-yield strategies, momentum strategies, and fundamentally weighted strategies
Dividend yield strategies can incorporate dividend growth and absolute dividend yield Dividend yield strategies are gaining investors’ attention following the recent crises
Momentum strategies weight stocks in the index, based
on the stocks’ recent performance relative to the market over a stated period
Risk-oriented strategies mainly reduce overall portfolio
risk For example, volatility weighting strategy weights index securities based on the inverse of their relative price volatility Commonly, price volatility is determined
by standard-deviation of price returns for the past 252 trading days or the last 156 weeks etc
Minimum variance investing is another volatility weighting strategy that minimizes the volatility of the portfolio’s returns based on historical price returns depending on certain limitations regarding index
Practice: Example 1,Volume 4
Reading 27, Curriculum
Trang 4construction e.g single-stock selection, country
selection, sector over/under weights
Risk-weighting strategies are simple to interpret but are
based on historical return data
Diversification-strategies include ‘equally-weighted
indexes’ (63 weighting structure) and
‘maximum-diversification strategies A ‘maximum-diversification ratio is
calculated as <,0F1#,4 *D,+*F, D$.*#0.0#,"-$+#/$.0$ D$.*#0.0#E
Factor-based investment portfolios are usually evaluated
through multiple benchmarks including factor-based
index and broad-market-cap-weighted index This
mismatch in benchmarks can lead to portfolio tracking
error, which is measured as the standard deviation of the
difference between a portfolio’s returns and its benchmark returns
Compared to market-cap-weighted strategies, passive factor-based strategies usually have higher
management fees and higher trading commissions which may lead to lower net portfolio performance Passive factor-based approaches are suitable for investors who seek pure exposure to specific risk-factors
or market segments Rules-based strategies do not require constant monitoring and therefore are less costly Investors may choose to shift exposures and risk factors
as market conditions change This is called factor rotation
3 APPROACHES TO PASSIVE EQUITY INVESTING
Passive equity investing approaches include:
• Pooled investments (e.g mutual funds,
exchange-traded funds)
• Derivatives-based portfolios (using options,
futures, swaps contracts)
• Direct investments in the stocks underlying the
strategy
Pooled investments are easy to purchase, hold or sell
Pooled investment approaches covered under this
section are open-end-mutual funds and
exchange-traded funds (EFTs)
Mutual Funds
Like active investing, in passively managed mutual funds,
managers identify investor’s risk and return objectives as
well as investment constraints to form suitable mutual
fund-based strategy
Mutual fund shares can be purchased through:
• the fund manager, who manages investments
• fund marketplace, which is a brokerage
company that offers funds from different
providers in a single account
• individual financial adviser, who provides
guidance to identify the strategy and the
low-cost shares while keeping the single
account to house the fund shares
Passive investing strategies involve tasks such as
1) dividends re-investment
2) buy and sell stocks to match addition/deletion of
stocks in index (reconstitution)
3) how to handle corporate actions (e.g mergers)
4) voting proxies
5) reporting performance (e.g for tax)
Investor has to take care of all such tasks in direct investments (purchase of shares by the investor); in contrast, the fund manager is responsible for all such activities in passively managed funds; though, additional costs [like audit, registration etc.] are involved in indirect investments [i.e through a fund manager]
Ownership and purchase price records are maintained
by fund’s record keepers (accountants) They also ensure proper titles and custody of shares
Investment Company Act of 1940 and UCITS are followed by mutual funds in US and EU respectively ETFs (a special type of pooled investments) trade on stock market like stocks and track the return of an index [index can be a broad or a focused one (e.g value index)] Investors can get some extra benefits by
investing in ETFs instead of investing in open-end passive
funds These include: all day trading of ETFs (open-end funds can be redeemed/bought only at day-end); low fees (even lower than passive open-end funds and definitely much lower than active funds); tax efficiency; purchase on margin; taking a short position
Role of authorized participant {AP} (most likely a broker): When an investor wants to purchase shares of ETF – he goes to AP and give him the money AP delivers basket
of shares to ETF manager and gets shares of ETF, which
he transfers to the investor [Note: AP may also purchase shares of ETF with his own money and sell it to investors as demand rises.] AP works as a retailer
Reverse of the above happens when investors want redemption [ i.e investor brings shares of ETF to AP who demands basket of shares back from the ETF manager,
Trang 5which is transferred to the investor (or sold in the market
for cash on behalf of the investor)]
Investor also has the option to sell shares of ETF directly to
other investors (via stock markets)
In-kind redemption provides tax benefits to ETF investors
No capital gain tax arises, and stocks are delivered to
investors in lieu of their shares of ETF
Purchase at ask and sell at the bid price, commissions
and illiquid market in shares of ETF are some of the
disadvantages of ETF investing
ETFs enable investors to take exposure to selected
market segments (e.g energy, tech, emerging markets
etc.) Except for large investors, ETFS are very attractive
for small to medium-size investors looking for index
tracking New ETFs are being introduced on a regular
basis but there are still many indexes with no ETF tracking
them
Factor-based ETFs provide exposure to a single factor
(e.g size, value); while multi-factors ETFs track many
factors in the same fund (i.e no need to invest in
separate ETFs for size, value, momentum etc.; you get
multiple factor exposure in one ETF)
Open-end mutual fund vs ETFs: ETFs track much higher
number of equity indexes and have slightly lower
expense ratio, compared to open-end funds Though,
investors opting for frequent trading in ETFs incur
significant brokerage fees
3.2 Derivatives-Based Approaches
There are three methods to access index returns (i.e
invest passively):
1 Pooled investments (i.e Open-end funds and
ETFs)
2 Direct investments (i.e buying and selling
stocks directly)
3 Derivatives
There are three advantages of using derivatives:
1 low cost
2 easy to execute
3 leverage
Default risk can be a significant issue for non-traded
derivatives Individual investors cannot easily access
some derivatives (e.g index swaps)
Traded derivatives (options and futures) are default-risk
free
Derivatives allow leverage as initial investment required
(option cost or future margin) is much less than the
notional value
Expiry of contracts is an issue for ‘derivatives investors’ and not for ‘stocks investors’ Options expiry results in the loss of premium paid Futures and swaps are generally rolled forward
Like brokers are needed for stock trading, futures commission merchants (FCM) enable futures trading for investors Investing in the futures contracts require efforts
to manage daily cash flows (Due to daily settlement feature in futures market)
Overlay: Use of derivatives to manage pre-existing portfolios (i.e money already invested in stocks)
There are three types of overlay:
Completion overlay:
Sometimes cash builds up in the portfolio (i.e cash coming in from dividends and from investors cannot (only temporarily) be used for purchase of shares for a variety of reasons)
This causes the average beta of the portfolio to go down (Let’s say portfolio is 80% invested in stocks with a beta of 1.0 and 20% cash with a beta of zero – thus average portfolio beta is only 0.8) creating a tracking error One solution to this problem is ‘Completion Overlay’ The portfolio manager may enter into derivatives to increase portfolio beta to 1.0
Rebalancing overlay:
When a fund manager wants to change equity vs bond investment allocation (e.g from 60%Bonds-40%Stocks to 30%Bonds-70%Stocks), derivatives can be helpful (for the earlier example – sell bond index futures and purchase equity index futures)
Currency overlay:
Use of derivatives to hedge currency risk of investments
in foreign stocks
Derivatives enable portfolio managers to make tactical adjustments by entering into a single transaction (e.g index future contract instead of buying a high number of index stocks) Advantage: quick execution at low cost
In contrast, cash instruments (i.e buying stocks) is better for long-term changes because derivatives:
1) expire but stocks do not
2) are subject to position limits but not stocks 3) use may not be allowed by regulators and/or IPS in some cases
4) are not available (particularly exchange traded futures contract) on desired index to
be tracked
Equity index futures contracts are cash-settled instead of delivery settled
Buyer of index future contract gains when the index rises General formula for gain calculation is: {Multiplier x (new
Trang 6index - old index)} For example, multiplier for S&P500
index is 250 Thus, every one-point change in the index
results in a gain (increase in value) of $250 for the index
future buyer (and loss for index future seller)
Advantages of futures:
1) Small amount of margin allows investors to get
leverage in futures
2) Additionally, many investors with short-sale
restrictions find selling of futures contracts (to create
short exposure) permissible
3) One final benefit is low transaction costs because
of high liquidity
Disadvantages of futures:
Futures prices may change differently than spot prices
[basis risk] (this will negate the idea of using future
contracts as an alternative of buying stocks) Basis risk
can arise because of dividends which are included in
the return of stocks investors but not for futures investors
One solution to this problem is investment in interest
paying securities along with future contracts
3.3 Separately Managed Equity Index-Based Portfolios
Passive fund managers are the largest shareholders of
many companies This enables managers to meet
privately with companies’ management (CEOs, CFOs
etc.) and discuss corporate governance and other
topics (including non-financial issues)
Recent research shows that engagement of passive
fund managers with management can increase funds’
returns
Active investors (i.e fund managers who actively engage with management to improve corporate performance) are generally ‘active funds’ managers These managers can sell shares if management does not agree with their feedback Such option is not available for passive investors
Passive fund managers can vote their shares and try to improve corporate governance
Passive fund managers’ active involvement (by vote and meetings with the management) can be beneficial (higher returns) if this helps in improving overall corporate governance quality of index-constituent stocks
Passive investors do not have the choice to sell shares of any company as long as it is part of an index Returns can be improved by engaging with management of companies on matters such as corporate governance Fund managers are responsible for voting proxy ballots
as representative of investors Many fund managers hire
a proxy voting service to save on costs
Conflict of interest issues can arise in some situations, particularly when the fund manager’s organization has a corporate relationship with the company included in index
Because passive fund managers have to hold shares in index-constituent companies, management of such companies may not take fund managers suggestions seriously as there is no fear of manager selling position
Three main approaches to construct a passive-indexed
portfolio are:
1 Full replication
2 Stratified sampling
3 Optimization
Full replication refers to reconstructing the index exactly
i.e holding all securities in the index and in the same
proportion (or %) as in the index
Full replication approach is easy to follow and closely
matches the index performance
This approach is suitable when constituent securities are
highly liquid, and manager has a large amount to invest
A portfolio manager who closely tracks the index may
have lower tracking error, however, adding relatively
illiquid stocks may increase average trading costs For
indices that include relatively illiquid securities, there is a U-shaped relationship between tracking error and transactions costs versus number of constituent securities held i.e as the number of securities held increases, tracking error decreases but trading cost increases due
to inclusion of illiquid stocks
Trang 74.2 Stratified Sampling
Stratified sampling refers to dividing the securities in
multi-dimensional cells or groups according their style,
market cap, industry, country etc Then a sample from
each group/cell is selected according to its weight in
the index
The notion behind stratified sampling is to construct a
portfolio by matching the basic characteristics of the
index without buying all the securities in the index to
reduce costs (such as rebalancing/trading cost, bid-ask
spread, brokerage fees etc.)
Stratified sampling is largely used when the index
constitutes are large in number or investment amount is
low
Optimization refers to portfolio construction that involves
maximizing(minimizing) the favorable(unfavorable)
characteristics subject to certain constraints
Index portfolio optimization may involve minimizing
tracking risk subject to certain constraints e.g
non-negative weights or limiting the number of security
holdings Other common constraints include
diversification requirements, market-capitalization above
a certain level, restricting trades to round lots, mimicking
style characteristics
An optimized index portfolio that minimizes tracking risk
may be mean-variance inefficient Managers try to
resolve this issue by constructing a portfolio whose total
volatility is equal to the benchmark index
Passive managers usually include all stocks in the index in
mean-variance optimization In the next step, managers
remove the lowest-weighted stocks following the
optimization This enables them to reduce portfolio cost
with little effect on diversification
Optimization can be applied alone or with stratified sampling Optimization demands considerable knowledge of optimization software, algorithms and other technical intricacies
Advantages:
• Optimization attains lower tracking error than stratified sampling
• It considers the covariances between securities from diverse sectors
Disadvantages:
• Optimization is based on historical data and is not reliable to predict future when securities weights and sensitivities change over time
• It requires frequent rebalancing and portfolio adjustments due to the need of matching risk sensitivities over time
It is preferred to use a combination of full replication and stratified sampling/ optimization approaches i.e using full replication approach for the largest-cap section of
an indexed portfolio or liquid securities and stratified sampling or optimization approach for the smallest-cap section or less liquid securities
Full replication approach is suitable when indexes have few securities or when the securities are homogenous
5.1 Tracking Error and Excess Return
The performance of passive portfolio managers is usually
measured by excess return and tracking error
Excess return measures the difference between portfolio
return and benchmark return and evaluates how a
manager performs relative to the index
Excess returnp = R p - R b
where Rp = portfolio return and Rb = benchmark return
Tracking error evaluates a manager’s ability to closely
track the benchmark return overtime
Tracking errorp = K𝑉𝑎𝑟𝑖𝑎𝑛𝑐𝑒STUGTVW
Tracking error is a non-negative number Tracking error varies depending on data frequency, number of securities or time span
Practice: Example 3,Volume 4 Reading 27, Curriculum
Trang 85.2 Potential Causes of tracking Error and Excess Return
Main causes of tracking error in an indexed equity fund
include:
• Fees charged: Higher the fees, lower the excess
return and higher the tracking error
• Number of securities: Tracking error arises when
funds are not fully replicated i.e no of stocks
in the portfolio are lower compared to the
benchmark securities
• Intra-day trading of stocks: The effect of
intra-day trading on portfolio return may be
positive or negative and may cause tracking
error
• Commission costs: trading commission to brokers
lowers portfolio excess return and cause
tracking error One solution to this problem is
to buy and sell at day-end price or close to
day-end price
• Cash holding of the portfolio: Any cash holding
of the portfolio creates tracking error for the
index fund manager Cash accumulation in a
portfolio may result for a variety of reasons
such as cash dividends, sale proceeds,
investor contributions, other sources of
income etc
Ø Tracking portfolios generally have
some uninvested cash balance which
creates tracking error known as
cash-drag Cash drag reduces(boosts) portfolio value when the market is rising (falling) The effects of cash drag (due to uninvested cash and accrued dividends) can be minimized by equitizing a portfolio using futures contracts, ETFs etc
5.3 Controlling Tracking Error
Managers have to consider the trade-off between the benefits (of investing in high number of securities with weights equal to the benchmark) and costs (trading expenses and other fees) to control tracking error
To minimize tracking error, managers try to invest cash flows with target beta 1.0 and other risk factors matched with the index (though ideal would be to purchase all stocks at exact same prices as the benchmark, but this may not be possible sometimes)
6 SOURCES OF RETURN AND RISK IN PASSIVE EQUITY PORTFOLIOS
In passive equity investment process, attribution analysis
is a valuable step to analyze positive and negative
sources of return
6.1 Attribution Analysis
Investors first choose within various asset classes such as
bonds, stocks, other assets and each of these can be
further broken into different sub-categories For example,
equity class may be sub-divided into countries,
market-cap sizes, investment style And another issue is how to
apply weightings
Return on an indexed portfolio depends on portfolio
composition and the return analysis of the portfolio is
conducted at the end of the period (ex-post)
Sources of return may include company-specific returns,
sector returns, country returns, currency returns Indexed
portfolio managers can group their portfolios according
to the conventional risk and return methods or
according to stated objectives e.g grouping against
broad-market index by high dividend yield or low
volatility
A refined portfolio attribution system facilitates index fund managers who follow the broad market index in recognizing the factors that drive returns of their portfolio and the index Additionally, attribution analysis also assists passive fund managers following factor-based strategies to understand how the returns of their portfolio relate to broad market index
Long portfolio managers enhance their portfolio returns
by lending shares to short sellers, known as securities lending As a result, low-cost indexed portfolios may earn
a return above the index return Securities lending process engages a lending agent Sometimes the custodians of institutional investors provide this service The asset management firms also offer securities lending services Two important documents in securities lending procedure include:
a) Securities lending authorization agreement - between the lender and the agent
b) Master securities lending agreement -
Trang 9between the agent and the borrowers
The lending agent finds a borrower who provides
collateral typically (102-105% of the borrowed security)
The collateral may be in the form of securities or cash
• When securities are used as collateral, lending
agent mark-to-market securities value on a
daily basis to determine if the borrower needs
to provide additional collateral
• When cash is used as collateral, the lending
agent invests cash in highly liquid assets and
receives interest income, a portion of this
income is received by the borrower (a.k.a a
rebate)
Major risks associated with security lending are credit risk
and market risk Other risks may include liquidity risk and
operational risk Borrowers may not be able to return the
shares when needed by the lender Collateral
reinvestment risk may arise when lender invest cash
received as collateral in long-term or risky securities
When securities are loaned, legal title is transferred to
the borrower Therefore, borrower receives future cash
flows and voting rights on that security Annualized cost
of borrowing typically ranges from 2-10% depending on
the borrower’s credit quality Easy-to-borrow (ETB)
securities are ones that are readily available for
borrowing for short selling
Institutional investors such as mutual funds, pension funds
and ETFs are preferred lenders and generate revenues
for their investment beneficiaries
6.3 Investor Activism and Engagement by Passive Managers
Passive fund managers are largest shareholders of many
companies This enables managers to meet privately
with companies’ management (CEOs, CFOs etc.) and
discuss corporate governance and other topics
(including non-financial issues)
Recent research shows that engagement of passive
fund managers with management can increase funds’
returns
Active investors (i.e fund managers who actively
engage with management to improve corporate
performance) are generally ‘active funds’ managers
These managers can sell shares if management does not
agree with their feedback Such option is not available
for passive investors
Passive fund managers can vote their shares and try to
improve corporate governance
Passive fund managers active involvement (by vote and
meetings with the management) can be beneficial
(higher returns) if this helps in improving overall corporate governance quality of index-constituent stocks
Passive investors do not have the choice to sell shares of any company as long as it is part of index Returns can
be improved by engaging with management of companies on matters such as corporate governance Fund managers are responsible for voting proxy ballots
as representative of investors Many fund managers hire
a proxy voting service to save on costs
Conflict of interest issues can arise in some situations, particularly when fund manager’s organization has corporate relationship with the company included in index
Because of the fact that passive fund managers have to hold shares in index-constituent companies,
management of such companies may not take fund managers suggestions seriously as there is no fear of manager selling position
Practice: End of chapter Questions Reading 27, Curriculum
Practice FinQuiz Questions and Item-sets