CFA Level 3 | Index-Based Equity Strategies

CFA Level 3 | Portfolio Management Pathway | Learning Module 1

Introduction

Index-based equity investing seeks to replicate the performance of an index rather than identify mispriced securities.
Indexes can be broad market (e.g., S&P 500) or factor-based (e.g., Russell 1000 Growth).
The main advantages of index-based investing are low costs, diversification, and tax efficiency.

Factor-Based Strategies

Factor-based strategies aim for returns based on exposure to specific factors beyond market beta, maintaining the low-cost advantage of index funds.
These strategies can be based on single factors (other than beta) or multiple factors.
Common equity risk factors include Value, Size, Momentum, Volatility, Quality, Yield, and Growth.
Factor investing (“smart beta“) has seen increased adoption, allowing investors to apply factor tilts based on market views.
Fundamental factor indexing weights companies based on fundamental data (e.g., book value, cash flow) rather than market capitalization, with the rationale that market prices can deviate from intrinsic value, especially for larger-cap stocks.
Fundamental indexes have historically outperformed cap-weighted indexes but may provide heightened exposure to Value and Size factors.
Factor-based strategies can be return-oriented (e.g., dividend yield, momentum, fundamentally weighted), risk-oriented (e.g., volatility weighting, minimum variance), or diversification-oriented (e.g., equally weighted, maximum diversification).
Factor-based strategies often involve active decision-making upfront regarding factor exposure and timing, unlike continuous active management.
They can concentrate risk exposures and may experience periods of underperformance for chosen factors, leading to multi-factor approaches.
Transparency is a key feature, but risks include ease of replication and potential overcrowding.
Portfolio managers may use multiple benchmarks for factor-based strategies, leading to tracking error relative to a broad market-cap-weighted index.
Factor-based strategies can have higher management fees and trading commissions than broad-market indexing.
Factor rotation involves actively changing exposures to specific risk factors based on market conditions using index-based vehicles.

Pooled Investments

Index-based strategies can be implemented through pooled investments (mutual funds, ETFs), derivatives, or direct investment.
Pooled investments (mutual funds and ETFs) are convenient for the average investor.
Index-based mutual funds offer ease of investing and record-keeping.
Investors need to conduct a needs analysis to align their objectives with available index mutual fund strategies.
Investment managers handle rebalancing and reconstitution for index mutual funds, but these funds also bear costs like registration and custodial fees.
Exchange-Traded Funds (ETFs) are registered funds traded like stocks, offering advantages such as ease of trading, low management fees, and tax efficiency.
ETFs have a unique creation/redemption process involving authorized participants who act as market makers.
ETFs generally have greater tax efficiency than mutual funds due to in-kind redemptions.
Disadvantages of ETFs include bid-ask spreads, commission costs, and potential illiquidity.
Factor-based ETFs represent a significant portion of the ETF market.
The choice between mutual funds and ETFs often depends on cost and flexibility, with ETFs generally having lower expense ratios but potentially higher transaction costs for frequent trading.

Derivatives-Based Approaches and Index-Based Portfolios

Derivatives (options, swaps, futures) can provide low-cost, easy-to-implement, and leveraged access to index performance.
Risks include counterparty default risk for over-the-counter derivatives (like swaps). Exchange-traded options and futures are cleared, mitigating this risk.
Derivatives allow for leverage through their notional value.
While stocks can be held indefinitely, derivatives expire and may need to be rolled forward.
Futures require a futures commission merchant (FCM) and management of daily margin requirements.
Derivatives are typically used to adjust existing portfolios (overlays) rather than for long-term synthetic replication.
Common overlay strategies include completion overlays (addressing deviations like cash drag), rebalancing overlays, and currency overlays.
Derivatives offer efficient tactical adjustments to portfolio exposure due to liquidity and low transaction costs.
Strategic long-term changes are usually better implemented with cash instruments due to indefinite expiration and potential position limits in derivatives.
Equity index futures are cash-settled and require margin.
Equity index swaps are agreements to exchange returns, offering customization but carrying counterparty, liquidity, interest rate, and tax policy risks.

Separately Managed Equity Index-Based Portfolios

Building a direct index portfolio requires index data, trading/accounting systems, broker relationships, and compliance systems.
Index data includes constituent information, weights, dividends, and corporate actions, often requiring a license for replication strategies.
Trading systems facilitate portfolio comparison to benchmarks, electronic communication with brokers, and compliance checks.
Accounting systems report performance and track transactions.
Negotiating better commission rates with brokers is advantageous.
Robust compliance tools and teams are essential to adhere to regulations and client agreements.
Portfolio managers must regularly review holdings and weightings against the index.
Portfolio establishment involves creating and transmitting trading files for program trading, often using Order Management Systems (OMS) and communication protocols like FIX and SWIFT.
Most index-based trades are executed at the market-on-close (MOC) price to match the benchmark pricing.
Ongoing maintenance includes trading index changes (adds/deletes, rebalances) and reinvesting dividends.

Portfolio Construction

Principal approaches for building indexed portfolios with individual securities are full replication, stratified sampling, and optimization.
Full replication involves holding all index constituents in their index weights, suitable for sufficiently large, liquid mandates with readily available constituents.
Advantages of full replication include close tracking and ease of understanding.
As the number of held securities increases, tracking error tends to decrease, but trading costs increase, creating a U-shaped relationship between tracking error (gross of trading costs) and the number of holdings for indexes with illiquid constituents.
Portfolio creation in full replication involves importing index data into an OMS to generate required trades.
Stratified sampling involves holding a representative sample of the index constituents, matching key characteristics (e.g., industry, style) of the index.
It is used for indexes with many constituents or with lower assets under management to reduce trading costs.
Portfolio holdings in stratified sampling are typically weighted proportionately to each stratum’s weight in the index.
Optimization aims to maximize a desirable characteristic or minimize an undesirable one (e.g., tracking error), subject to constraints (e.g., number of holdings, market cap limits).
Optimized portfolios can be mean-variance inefficient relative to the benchmark, so constraints on total portfolio volatility are often added.
Post-optimization, low-weighted stocks might be deleted due to transaction costs.
Optimization can be used with stratified sampling or alone, requiring sophisticated technical skills and understanding of the output.
Advantages include lower tracking error than stratified sampling and explicit consideration of covariances.
A limitation is that optimization is based on historical data that may not predict future relationships, requiring frequent re-running and adjustments.
A blended approach uses full replication for more liquid, large-cap constituents and sampling or optimization for less liquid, smaller-cap parts of broad market indexes.

Tracking Error Management

Tracking error is the standard deviation of the difference between portfolio and benchmark returns, measuring the manager’s ability to replicate the benchmark.
Excess return is the difference between portfolio and benchmark returns.
Low tracking error and non-negative excess returns are generally desired for index funds.
Tracking error tends to be higher for indexes with a large number of constituents.

Potential causes of tracking error include:

Fees: Directly reduce excess returns and increase tracking error.
Number of securities held: Sampling leads to higher tracking error than full replication.
Intra-day trading: Trading at prices different from the closing index prices contributes to tracking error.
Trading commissions: Make excess returns more negative and affect tracking error.
Cash holding (cash drag): Equity indexes have no cash allocation, so cash balances dilute returns when the market rises.

Methods to control tracking error:

Minimizing cash held.
Investing cash flows at valuations close to the benchmark provider’s.
Maintaining a beta of 1.0 and similar risk factor exposures to the benchmark.
Using equitization tools like futures and ETFs to offset cash drag, including hedging dividend drag.
Balancing the costs and benefits of maintaining close alignment with the benchmark.

Sources of Return and Risk in Index-Based Equity Strategies

Understanding return sources through attribution analysis is important even for index portfolios.
Sources of return for an equity index replication portfolio include company-specific returns, sector returns, country returns, and currency returns.
Attribution analysis can be grouped by various criteria, including the stated portfolio objective (e.g., dividend yield, volatility).
Index fund managers need to understand the factors driving returns for both broad market and factor-based strategies.
Securities lending income can be a valuable addition to portfolio returns, potentially offsetting management costs.
Securities lending involves lending shares to short sellers in exchange for collateral, typically managed by a lending agent (often the custodian).
Risks of securities lending include credit risk of the borrower and market risk of the collateral. Collateral investment risk arises if cash collateral is invested in risky securities.
Investor activism and engagement by index fund managers, as large shareholders, can influence corporate governance on issues like board structure, executive compensation, and risk management.
While traditionally associated with active management, governance improvements in index constituents can enhance index performance.
Index-based investors may have a long-term duty to engage with companies due to their “permanent” shareholder status.
Costs of activism include staff resources for research and engagement; proxy voting services are often used.
Potential conflicts of interest may limit an index manager’s willingness to challenge company management if there are other business relationships.
The effectiveness of activism by index-based investors might be questioned by company management compared to active investors who can sell their shares.