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BFF5270 Funds Management Tutorial

Week 4 – Active vs Passive

Funds Management

Tutorial Question (to be completed in-class)


Q1. Tracking Error

Explain what is meant by ‘tracking error’ and discuss the importance of tracking error for passive, semi-active, and active funds.

· Difference between a portfolio’s return and the index that the portfolio is benchmarked against

· Calculation: standard deviation of the time-series of returns between the portfolio and the index (standard deviation of excess returns)

· Passive investors: seek to minimize tracking error / track an index as closely as possible

· Active investors: increase tracking error to generate excess returns (alpha)

- Value-add measured in terms of Information Ratio (IR) … ratio of alpha to the tracking error

- Example: An active equity manager has 2% XS and t/e of 4%. Hence, IR = 0.5

- Clients may impose constraints that limit tracking error

· Semi-active investors: attempt to outperform a benchmark while carefully managing their portfolio’s risk exposures

- T/E will increase slightly (vs passive) in hope that the incremental returns will compensate for the small increase in risk

- Tend to have lower tracking error vs active managers and superior IR’s

Q2. Active v Passive investment vehicles

Which form of portfolio management is better – active or passive? The debate has raged for years. Discuss some of the evidence and arguments for and against each approach.

· Active management = art of stock picking and market timing to generate alpha

· Passive management = buy-and-hold approach to money management

· Ongoing debate about active vs. passive management

· Literature suggests its challenging for active managers to consistently outperform net of fees and taxes

· That said, index managers will underperform net of fees (albeit these tend to be quite low)

· The key to the debate is (i) are markets efficient and if not, are active managers better positioned to capitalise, and (ii) what are hit-rates of active managers – is there consistency, and ways to identify quality managers

· Much of the empirical research is dated – so is it still relevant, what are the assumptions?

·  Blake, Elton and Gruber – bond market analysis.

- Examined >360 bond funds for the period starting in 1977

- Compared various active funds to simple index strategy alternatives

- On average active funds underperformed their index equivalents by 85bps pa.

- Between 65-80% of active funds underperform

· Elton, Gruber, Hlavka and Das - equity mutual funds

- Examine 143 active funds that existed for the period of 1965-1984

- These funds are compared to the set of index funds —big stocks, small stocks, and fixed income

- The result: on average these funds underperformed by ~159 bps pa.

- Not one active fund generated positive performance that was statistically significant

· Carhart (1997) studied a total of 1,892 funds that existed any time between 1961 and 1993

- After adjusting for the common factors in returns, an equal-weighted portfolio of active funds underperformed by 1.8% per year

But … Jim Atkinson survey of 2018 of 12,000 funds over a 10-year period showed that active managers did far better than passive (with 85% of these underperforming)

What is your view??

Q3. Approaches to Active Management

Discuss the three key approaches to active management.

Style-based investing – approach to investment is aligned with philosophical beliefs (ie. Value, growth, size, momentum). In constructing a portfolio, will overweight securities with a particular style that the manager believes has attractive investment properties.

Top-down (macro-centric) – fund manager takes into consideration macroeconomic variables of investment themes which guide security selection / portfolio construction. Consideration on how various themes impact sectors, industries, countries etc. Q. What impact will the war between Ukraine and Russia have on markets?

Bottom-up (fundamental analysis) – focus is on company-specific factors and deep dive due diligence. Focus on sustainability of earnings, solvency levels to identify mispriced securities.

Q4. Methods of Indexation

Explain the three approaches to constructing an index portfolio and discuss the circumstances under which each approach would be adopted.

· Full replication: every index security is held in approximately the same weight in the fund as in the index

- Best for indices comprised of highly liquid securities

- Approach used by Vanguard

· Stratified sampling: samples from the index’s securities are organized into representative cells (ie. duration, curve, spread)

- When full replication is not feasible (ie. thousands of securities) or cost effective

- Approach used by BlackRock. Note Global aggregate size constraint (i.e $US$200m)

· Optimization: chooses a portfolio of securities that minimizes expected tracking error relative to the index based on a multifactor model of index risk exposures

- Seek to replicate benchmark characteristics

- When full replication is not feasible (ie. thousands of securities) or cost effective

Q5. Index Calculations

Assume that a market comprises four stocks: Monash, Deakin, La Trobe, and Flinders. Current information about each of these stocks is provided in the table below:

 

Monash

Deakin

La Trobe

Flinders

Price at time t

$20

$12

$8

$6

Number of Shares on Issue (mill)

1500

800

600

400

Market Capitalisation ($ mill)

$30,000

$9,600

$4,800

$2,400

Price at time t+1

$21

$13

$6

$6

You are developing a new index fund with $2 million to invest.

a) Calculate the number of stocks you would need to buy for each company to construct the following indices:

· Value-weighted

· Equal-weighted

· Price-weighted

 

Q6. To optimise or not?

Toni Cruz has been asked to internally manage a FTSE 100 index fund. Because the index’s 10 largest stocks make up more than 50% of its weight, Cruz is considering using optimization to build the portfolio using fewer than the 100 stocks. All 100 stocks in the index are considered liquid. Is optimizing the best approach?

· Full replication would be superior

- Components of the FTSE 100 are very liquid, so full replication can be accomplished easily / inexpensively

- Full replication minimises tracking risk

- Self-rebalancing portfolio in the case of a value-weighted (or float-weighted index) à the portfolio moves in line with the index without any need for trading

- Trading only required to reinvest dividends and to reflect changes in index composition 

· An optimized portfolio will hold fewer than 100 stocks

- periodic trading required to realign the portfolio’s characteristics with those of the index à Over time, the trading-related costs will drag down performance

** An example of using the excel solver to optimise an index portfolio is provided on Moodle. This is for information purposes only and will not be tested.

Q7. Stock-based or synthetic-enhanced index

Tammy Hall is responsible for the U.S. equity portion of a superannuation fund. She is thinking about trying to boost the overall alpha in U.S. equities by using an enhanced index fund to replace her existing index fund holding.

A. The U.S. equity portion of the pension plan currently consists of three managers (one index, one value, and one growth) and is expected to produce a target annual alpha of 2.0% with a tracking risk of 2.75%. By replacing the index manager with an enhanced indexer, the target alpha changes to 2.3% with a tracking risk of 2.9%. Does this change represent an improvement?  Why?

Existing Portfolio = 2.0% XS, 2.75% t/e. Proposed Portfolio = 2.3% XS, 2.9% t/e

· Proposed portfolio will be a superior outcome as IR is higher

· Current IR = 0.73 (2.0%/2.75%). Proposed IR = 0.79 (2.3%/2.9%).

Stock-based enhanced indexing manager

· Over/underweight individual stocks based on PM’s return expectations for those stocks

· Resembles targeted benchmark but seeks to add some alpha on a consistent basis

· Advantage: greater breadth of opportunities to add XS vs synthetic approach

· Disadvantage: consistency in stock selection can be hard

 

 

Self-Revision Questions (answers on Moodle)

Question 1.

Describe the three major approaches to investing: passive, active and semi-active.

The major passive approach is indexing, which is based on the rationale that after costs, the return on the average actively managed dollar should be less than the return on the average passively managed dollar.

Active management is historically the dominant approach to investment and is based on the rationale that markets offer opportunities to beat a given benchmark.

Semiactive or (enhanced indexing) is a growing discipline based on the rationale that markets offer opportunities to achieve a positive information ratio with limited risk relative to a benchmark.

Question 2.

Provide reasons why active fund managers can find it difficult to consistently outperform.

• Transactions Costs: The costs of collecting and processing information and trading on stocks can be meaningful – puts additional pressure on managers to find winners and avoid losers.

• Taxes: Trading exposes investors to higher tax liabilities

• Market timing risks: Activity, by itself, can be damaging as investors often sell when they should not and buy when they should not.

• Failure to stay fully invested in equities: tend to retain a cash buffer for redemptions, opportunities, distributions which can drag on performance (consider QE)!

• Behavioral factors: analysts can ‘fall in love’ with companies they are analysing and have impaired judgement

Question 3.

Describe the three ways that securities can be weighted in an index and discuss the limitations of each.

• Price weighted. In a price-weighted index, each stock in the index is weighted according to its absolute share price.

• Value weighted (or market-capitalization weighted). In a value-weighted index, each stock in the index is weighted according to its market capitalization (share price multiplied   by the number of shares outstanding). A subset of the value-weighted method is the float-weighted method, which adjusts value weights for the floating supply of shares (the fraction of shares outstanding that is actually available to investors).

• Equal weighted. In an equal-weighted index, each stock in the index is weighted equally.

A price-weighted index is biased toward shares with the highest price, and a value- or float-weighted index is biased toward the largest market cap companies, which may reflect positive valuation errors. An equal-weighted index is biased toward smaller-cap companies.

Question 4.

Li Zhu is an analyst who is in the process of constructing an index portfolio using the stratified sampling technique. She has decided to adopt the stratified sampling technique given many of the stocks in the index that she is attempting to track are highly illiquid. She has decided to stratify across 12 industries and has collected the following data regarding the total market cap of firms (in $ mill) across industries as at December 2017.

 

NoDur

Durbl

Manuf

Enrgy

Chems

BusEq

Market Cap

1535123

373180.2

1911675.92

1306142

778123.1

6573134

 

 

 

 

 

 

 

 

Telcm

Utils

Shops

Hlth

Money

Other

Market Cap

1294887

969081.2

2646627

2828001

4775728

3043658

A. Calculate the portfolio weighting in each industry based on the above data.

 

NoDur

Durbl

Manuf

Enrgy

Chems

BusEq

Weighting

5.48%

1.33%

6.82%

4.66%

2.78%

23.45%

 

 

 

 

 

 

 

 

Telcm

Utils

Shops

Hlth

Money

Other

Weighting

4.62%

3.46%

9.44%

10.09%

17.03%

10.86%

B. Discuss a limitation with the approach to stratified sampling identified above.

The data is only stratified on one dimension: industry. This approach assumes that firms are highly homogenous within an industry, however that is often not the case. For example, there may be significant differences between small and large firms within a particular industry and therefore it might be advisable to also stratify on size.

Question 5.

Discuss the rules-based and committee-determined approaches for Index construction

§ Rule-based: Constituents are determined by an algorithm.

• E.g. Russell 3000 are the 3000 largest stocks in the U.S. by market capitalisation as at last trading day in May (reconstituted annually).

• S&P equity indices are reconstituted quarterly.

§ Committee-determined: Constituents are determined by a governing body / committee-based

• E.g. Dow Jones Index comprises 30 large, mature blue-chip stocks chosen by Wall Street Journal editors.

• Tend to have lower turnover than those reconstituted regularly leading to lower transaction costs and taxes

• May not be representative of other mainstream/comparable indices where they do not adjust for emerging market segments (ie. Emerging IT sector) due to infrequent reconstitution.