Passive equity fund management
Investors who believe the markets are efficient will pursue passive strategies. a zero-sum game in aggregate and investors as a group can only earn the market return.
Average performance of active FM matches passive before costs and taxes, underperforms after costs and taxes.
Advantages of indexing: superior long-term performance; (ii) predictable performance relative to the benchmark; (iii) tax and transaction cost :low turnover.(4)advantage in
illiquid and inefficient markets :transaction costs are significantly higher because of greater custodial fees and costs of acquiring infor.
Numerous benchmarks measure performance. Each index is created with different criteria. even for two indexes that measure the performance of the same segment of the
market, they will not perform exactly the same. The difference in performance should be considered as noise unless it is systematic.
Differences in construction of each index and trade-off associated with the selection of any index. S&P are determined by a committee and for liquidity so the indexes can be
fully replicated. The turnover is controlled. However, may suffer subjectivity of the committee and a liquidity bias.
Three basic ways to construct a passive index portfolio: Full replication: very small TE. higher transaction costs due to buying and selling many securities & dividend
reinvestment which may increase the TE. Stratified sampling: industry and capitalization deciles to create a matrix. sampling of stocks selected randomly. TE may be
larger as a result of not purchasing all of the securities in the index, lower transaction costs (buy and reinvest less) reduce the TE. Quadratic optimization: use historical
data to create an optimized portfolio that has same risk and return characteristics with the index within the sample. Zero TE within the sample, frequent rebalancing is
required to avoid increase in TE as a result of changes in prices and correlations over time. To improve tracking, the largest stocks in the index may be fully replicated to
ensure nearly perfect tracking of a significant portion of the index.
Replicate or sampling for small and mid caps depend on (i) the liquidity of the index: large-cap indexes fully replicated; (ii) the size of the fund: sampling approach
appropriate for start-up fund; (iii) the nature of the cash flows into the fund: large interim cash flow should invest in a liquid sampled subset of the index to gain immediate
market exposure, and slowly add to thinly traded stocks to lower transaction costs; (iv) the benefits of producing tighter tracking: sampling good for fund have very long
investment horizon and are less sensitive to short-term TE than higher costs of full replication.
Higher trading cost for small and mid caps: wide bid/ask spread; price impact and opportunity costs higher with large order.
based on a ‘paper’ portfolio, not subject to the same market frictions with actual index funds, reasons for TE arising(i) transaction cost; (ii) higher volatility of BM, higher
TE; (iii) cash flow, new funds and dividend, reinvestments; (iv) Index changes by corporate restructuring or index reconstitution.
TE negatively correlated with size of sample, time and expense required to create and maintain the portfolio.
‘Front-running’ is a form of arbitrage where index changes are pre-empted. Index funds should not rebalance the portfolios till the day the change becomes effective due to
TE concerns. This allows arbitrageurs to make profit by selling the stock at a premium to index funds. However, the goal of the index fund manager will always be, regardless
of arbitrage opportunities available to them, to minimize the tracking error.
Are index fund B+H? cap-weighted indexes is because it buy assets based on index and hold it, and invest dividend and CFs back to the same asset. For fully replicated,
only the cap-weighted index do not need rebalancing.
Criticisms about cap-weighted indexes are: (1) when fully replicated, the cap-weighted strategy forces investors to invest more in over-valued stocks and less in under-
valued stocks; (2) index displays autocorrelation of returns in same industry; (3) represents the collection of active fund managers’ interest.(4) large caps more researched.
Main benefits of cap-weighted: lower cost(automatically rebalance);preserves capacity(larger cap larger opportunity), liquidity(reduce price impact cost), diversification and
broad market participation. Why create cap: mimic the market portfolio; B+H, lower cost. Fundamental index give higher allocation to companies with higher cash flows,
dividends, sales and book value.
Fundamental indexes: active strategy; exploit price inefficiencies by tilting towards value stocks, fundamental indexing outperform cap indexing when the market is
inefficient. fundamental indexes underperform in bubble environment due to extreme momentum exhibited in the markets. Doesn’t work when pricing error across stocks are
not correlated, and has momentum effect
Indexing: alpha, TE and information ratio close to zero; Active management: greater alpha and TE, but lower IR ; enhanced indexing: lower alpha and TE, but highest IR
Two types of enhanced strategies: Stock-based strategy: belief that value can be added through stock selection. Risk controlled by limits of under/overweighting, exposure
to risk factors and industry sector concentration. Approaches: Fama –Freanch model give all the titls. main issues: high turnover/transaction costs, shrinking alpha as a result
of increasing exploitation of model or anomaly, and model risk due to changes in historical factors. Synthetic strategy: belief that gain efficient price return from index, but
using external mispricing to gain additional alphas. Risk is controlled by limits to exposure and use of stop loss orders. three strategies: index arbitrage-related strategies,
index futures enhanced cash management, and volatility-based strategies. Use derivatives. Investing most money to create index exposure, and use the borrowing money to
play for alphas. Main issues (i) derivatives may not be fairly priced at all time; (ii) rollover risks; and (iii) use swaps which might be less liquid and subject to credit risk.
Since the alphas of stock-based and synthetic strategies are uncorrelated, superior strategy :combine. alpha = average, TE significantly lower due to greater
diversification. When choosing Enhanced index: when the investors care about IR & large FM Passive FM don’t care about IR; Active FM depend: hedge FM don’t
care; FM that are large, only equity, don’t want to leverage and shorting, either by their own or market risk constraints, they care about IR. Large FM invest in EI because
have no choice, because of the diminishing of the economic scale, and they do not want to destroy the name of the market, then so take lower and lower risks. As the risk
level decease from the FM’s part, the availability of alphas decease from the market. Don’t take higher risk
Active equity strategies:
Effective trading requires following steps: Determine the motivation of the trade: trading motivations: (i) Value trades: trade due to different perception of the price of
assets. price sensitive. Delay trade to reduce the trading costs; (ii) Information trades: trade to reflect new information and changes in expectations. Information value erodes
rapidly, time sensitive; (iii) Cash flow trades: trade without consider prospects of the stocks. Examples include liquidity trade, index trade and target beta-rebalancing trade.
Assess market conditions and liquidity: to determine the expected cost of liquidity for the required trading size by looking at factors: current trading volume, trading
frequency indicated by bid-ask spread and whether the trade is supplying or demanding liquidity. Establish initial trading strategy to assess supply and demand: buy-side
trader (i) principal trade: buy stock from a broker directly, able to completely trade very quickly and efficiently without letting other people know; (ii) working trade: slowly
accumulate stock during the normal flow of the day. Looking for liquidity and information; Adapt strategy to changing market conditions; Appraise effectiveness when
trading is completed. Implementation shortfall approach: compares the information return on a zero-cost basis to the realized return on a full-costed basis is used.
Trading costs: commissions; price impact; trader timing; opportunity cost: the cost of failing to complete the trade. no opportunity cost for passive index fund, because
manager will always buy the asset regardless the price(alphas), otherwise, creat TE
The most important factor affecting price impact cost is whether the trade is supplying liquidity to or demanding liquidity from the market. Gain from supplying liquidity
and costs associated with demanding liquidity is non-symmetrical.
Liquidity definition & dimensions( when, how much): when trade take place, price of asset should not change in response to that trade; there is the availability of the
liquidity of the market to trade.
Buy-and-hold strategy: (i)portfolio value is linearly with stock market with slop= euity/t-bill; (ii) upside potential is unlimited; (iii) maintain a floor. outperform if there is a
major move in one direction. Constant-mix strategy (CM): contrarian strategy; performs better in a flat but volatile market and worse in a strong bull or bear markets.
Equity value= m (assets – floor): B+H: m= 1; floor= bills; CM: m= 0 -1; floor= 0; CPPI: m > 1; floor=maximum downside portfolio value.
What happens when market drop suddenly and quickly: in CPPI, when the market drops very quickly, it will have negative asset, even though there is a floor. That is
when the market goes up, sell floor and borrow money to invest in equity, so as the market suddenly and quickly goes down, you have to pay back borrowings. And because
market suddenly drop and exposure too much, get negative return. So, momentum strategy have immediate cost. Does contrarian better than momentum? Net really, it is
not always the case the contrarian strategy has a floor, eg. When the market keeps dropping, you keep selling floor to put money in equity, at some point, there is little floor
left, and when the market move down further, lose all the money.
Why put more money to fund, return decrease: 1>cost of ownership: put more money, more impact cost, alphas decrease; 2>alphas has to be distributed to large investor
