Passive Equity Investing (Brief)

by David M. Smith, PhD, CFA and Kevin K. Yousif, CFA

David M. Smith, PhD, CFA, is at the University at Albany, New York (USA). Kevin K. Yousif, CFA, is at LSIA Wealth & Institutional (USA).

LEARNING OUTCOMES

The candidate should be able to:

• discuss considerations in choosing a benchmark for a passively managed equity portfolio

• compare passive factor-based strategies to market-capitalization-weighted indexing

• compare different approaches to passive equity investing

• compare the full replication, stratified sampling, and optimization approaches for the construction of passively managed equity portfolios

• discuss potential causes of tracking error and methods to control tracking error for passively managed equity portfolios

• explain sources of return and risk to a passively managed equity portfolio

SUMMARY

This reading explains the rationale for passive investing as well as the construction of equity market indexes and the various methods by which investors can track the indexes. Passive portfolio managers must understand benchmark index construction and the advantages and disadvantages of the various methods used to track index performance.

Among the key points made in this reading are the following:

• Active equity portfolio managers who focus on individual security selection have long been unsuccessful at beating benchmarks and have charged high management fees to their end investors. Consequently, passive investing has increased in popularity.

• Passive equity investors seek to track the return of benchmark indexes and construct their portfolios to reflect the characteristics of the chosen benchmarks.

• Selection of a benchmark is driven by the equity investor’s objectives and constraints as presented in the investment policy statement. The benchmark index must be rules-based, transparent, and investable. Specific important characteristics include the domestic or foreign market covered, the market capitalization of the constituent stocks, where the index falls in the value–growth spectrum, and other risk factors.

• The equity benchmark index weighting scheme is another important consideration for investors. Weighting methods include market-cap weighting, price weighting, equal weighting, and fundamental weighting. Market cap-weighting has several advantages, including the fact that weights adjust automatically.

• Index rebalancing and reconstitution policies are important features. Rebalancing involves adjusting the portfolio’s constituent weights after price changes, mergers, or other corporate events have caused those weights to deviate from the benchmark index. Reconstitution involves deleting names that are no longer in the index and adding names that have been approved as new index members.

• Increasingly, passive investors use index-based strategies to gain exposure to individual risk factors. Examples of known equity risk factors include Capitalization, Style, Yield, Momentum, Volatility, and Quality.

• For passive investors, portfolio tracking error is the standard deviation of the portfolio return net of the benchmark return.

• Indexing involves the goal of minimizing tracking error subject to realistic portfolio constraints.

• Methods of pursuing passive investing include the use of such pooled investments as mutual funds and exchange-traded funds (ETFs), a do-it-yourself approach of building the portfolio stock-by-stock, and using derivatives to obtain exposure.

• Conventional open-end index mutual funds generally maintain low fees. Their expense ratios are slightly higher than for ETFs, but a brokerage fee is usually required for investor purchases and sales of ETF shares.

• Index exposure can also be obtained through the use of derivatives, such as futures and swaps.

• Building a passive portfolio by full replication, meaning to hold all the index constituents, requires a large-scale portfolio and high-quality information about the constituent characteristics. Most equity index portfolios are managed using either a full replication strategy to keep tracking error low, are sampled to keep trading costs low, or use optimization techniques to match as closely as possible the characteristics and performance of the underlying index.

• The principal sources of passive portfolio tracking error are fees, trading costs, and cash drag. Cash drag refers to the dilution of the return on the equity assets because of cash held. Cash drag can be exacerbated by the receipt of dividends from constituent stocks and the delay in getting them converted into shares.

• Portfolio managers control tracking error by minimizing trading costs, netting investor cash inflows and redemptions, and using equitization tools like derivatives to compensate for cash drag.

• Many index fund managers offer the constituent securities held in their portfolios for lending to short sellers and other market participants. The income earned from lending those securities helps offset portfolio management costs, often resulting in lower net fees to investors.

• Investor activism is engagement with portfolio companies and recognizing the primacy of end investors. Forms of activism can include expressing views to company boards or management on executive compensation, operational risk, board governance, and other value-relevant matters.

• Successful passive equity investment requires an understanding of the investor’s needs, benchmark index construction, and methods available to track the index.