Archive for the 'Passive Management' Category

A Completeness Fund for Equity Management

When several managers are selected within an asset class, each may bring specific risk exposures relative to the overall benchmark, but the group of managers may have aggregate characteristics that do not match the benchmark. In such cases, a completeness fund can be used to adjust the overall risk exposures to align with those of the benchmark.

The completeness fund can be managed passively or semi-actively, but must periodically be re-estimated to reflect the changes in actively managed portfolios.

The purpose of a completeness fund is to eliminate misfit risk. However, it may be desirable to retain some misfit risk that results from manager skill in going outside the benchmark.

Posted on 25th January 2008
Under: Active Management, Asset Allocation, Institutional Investing, Passive Management, Portfolio Management | No Comments »

Enhanced Indexing Strategies for Fixed Income Portfolios

Enhanced indexing strategies typically seek to minimize tracking error relative to a benchmark index while generating sufficient excess return to cover fund expenses. There are a number of approaches to enhanced indexing with regard to fixed-income (bond) portfolios.

Matching Primary Risk Factors

This strategy uses a sampling approach, with the goal of matching primary index risk factors (such as duration, level of interest rates, yield curve and credit spreads). Compared to pure indexing in a bond portfolio, the sampling method reduces construction and maintenance costs, which generally more than offsets the additional tracking error.

The portfolio should have a similar reaction as the benchmark when exposed to macro factors, and the manager can attempt to add value by finding undervalued bonds.

Small Risk Factor Mismatches

This strategy typically attempts to match only the portfolio duration relative to that of the benchmark index. Managers can attempt to add value by tilting the portfolio in favor of any other risk factor. The mismatches, however, will typically be small in order to minimize tracking risk. The primary goal is to earn sufficient excess return to offset the administrative costs.

Posted on 23rd January 2008
Under: Active Management, Fixed income investments, Investing in bonds, Passive Management, Portfolio Management | No Comments »

Calculating Returns in a Portfolio

One would think that determining the return in a portfolio would be simple: divide the change in value by the beginning value. In the most simple of cases, this can be true. But external cash flows (cash flows in and out of a portfolio, rather than those generated by the investments themselves) can make things more difficult.

Whenever there is an external cash flow such as a deposit to or withdrawal from the portfolio, the return should be measured. Then, each period between cash flows (or ending at specified dates such as year-end) can be linked together in a process called chain-linking. This process is used to determine the time weighted rate of return (TWR).

Consider the following exhibit, which shows the change in portfolio value before and after cash flows.


The portfolio starts the year at $100,000 and ends at $118,000 – so its return is 18%, right? Not so fast! All during the year (for simplicity it is assumed to be on the last day of the month after the ending value is calculated) there are deposits and withdrawals. The 118,000 reflects not only the investment return, but these external cash flows as well.

The proper way to calculate return in this case is to take the change in value from the beginning to the end of each month (before the cash flow). So, in the first month the return is (110,000 – 100,000)/100,000 = 10%.

Next, the cash flow is added or subtracted from the ending value to arrive at the following month’s beginning value, and that month’s return is calculated the same way.

Returns can be linked geometrically. To do this, 1 is added to each return and they are multiplied together. At the end, 1 is subtracted from the final product. So the linked return for the three months ending in March are (1.10 X 1.043 X 0.965)  – 1 = 10.7% (which is slightly off from the 10.8% in the exhibit due to rounding).

Posted on 6th January 2008
Under: Active Management, Investment Returns, Passive Management, Portfolio Management, Valuation | 3 Comments »

Using Futures to Minimize Transaction Costs

Trading illiquid stocks or baskets of stocks can take time, resulting in an opportunity cost while the trade is being executed. Some of this opportunity cost can be reduced by executing a futures trade while the stock trades are being processed. For example, an investor with a global portfolio that wants to reduce exposure to Japan could sell futures on the Japanese index rather than selling the stocks in the portfolio. If the stocks are subsequently sold, the futures position could be reduced by a similar amount.

The risk to this strategy is that the stocks in the portfolio are not strongly correlated to the corresponding index. If the stock declines and the index advances, the portfolio would lose on both ends of the trade. The strategy is most suitable for passive investors or for active managers willing to accept that risk.

Posted on 4th January 2008
Under: Active Management, Investing in Stocks, Passive Management, Portfolio Management | No Comments »

Core-Satellite Approach to Equity Manager Selection

The core-satellite approach typically anchors the overall portfolio using a core portfolio that is typically either indexed or an enhanced index portfolio linked to the overall asset class benchmark.

Around this core portfolio, the investor selects satellite managers for portions of the fund based on the manager’s expertise. The satellite portfolios may have the same benchmark, or constitute specific styles within the benchmark.

Posted on 25th December 2007
Under: Active Management, Asset Allocation, Institutional Investing, Investing in Stocks, Passive Management, Portfolio Management | No Comments »

Pure Indexing in a Fixed Income Portfolio

In a pure indexing strategy, the goal is to produce a portfolio that perfectly matches the benchmark. All bonds would be owned in the same proportion as their weight in the index.

Full replication is more commonly practiced in equity portfolios, as equities tend to be far more liquid than bonds. Bonds’ illiquidity makes the strategy difficult to implement. The difficulty, inefficiency and high costs of implementation result in this strategy being attempted only rarely.

Posted on 23rd December 2007
Under: Fixed income investments, Investing in bonds, Passive Management, Portfolio Management | No Comments »

Quality Tests for Portfolio Benchmarks

Ideally, the benchmark for a portfolio should reflect the manager’s style and the investor’s objectives and constraints. There are several ways to tell whether this is the case.

Systematic biases are factors that should be persistent across all relevant securities. The relationship to interest rates and general economic conditions will affect many securities the same way. The portfolio should have a beta relative to its benchmark of approximately 1.0 over a reasonable historical period. Furthermore, there should be little correlation between the manager’s active return and style returns.

Tracking error is a given for actively managed portfolios. However, the volatility of active returns should be closer to that of the chosen benchmark than to alternative benchmarks or the market index.

Exposure to different sources of systematic risk (i.e. sector weights, interest rate exposure) should be similar to those of the benchmark over time.

The portfolio should be “covered” by the benchmark, meaning that a high percentage of the securities in the portfolio should also be in the benchmark.

Benchmark turnover should be monitored, and particularly the need for new purchases when the portfolio is rebalanced (especially when new names added are larger than the names being deleted, which can cause flow-through effects on the weight of every security in the benchmark.) If the rebalancing causes significant shifts in weight it calls into question whether the benchmark is truly an investable alternative.

The benchmark should contain securities of the type the manager would want to own. Too many zero-weight positions can indicate that the benchmark is not reflective of the manager’s style.

Posted on 7th December 2007
Under: Active Management, Investment Returns, Passive Management, Performance Measurement, Portfolio Management, Risk Management | No Comments »

Indications of Interest

An indication of interest is a way of seeking parties willing to take the opposite side of a transaction, particularly for baskets of securities. Polling dealers for indications of interest can help a manager find a suitable counterparty for a trade. In doing so, transaction costs can be minimized.

A disadvantage is that the polling process indicates an interest in itself, and that indication may result in a market impact on the share price. Active managers typically don’t want to “give away” their interest in a company while trying to build a position, so the technique is typically used by passive managers.

Posted on 4th December 2007
Under: Active Management, Investing in Stocks, Passive Management, Portfolio Management | No Comments »

The Role of Capital Market Expectations in Portfolio Management

When developing an investment strategy, one key element is to develop capital market expectations – forecasts of the long-term risk and return characteristics for various asset classes. These forecasts will be used to select asset allocations that minimize risk for a given level of return or maximize return for a given level of risk.

The capital market expectations influence asset allocation strategy and the frequency at which portfolios will need to be rebalanced. Even in a passive strategy (passive strategies do not react to changing capital market expectations) an initial forecast of long-term expectations is crucial.

Posted on 30th November 2007
Under: Active Management, Asset Allocation, Fundamental Analysis, Investment Returns, Passive Management, Portfolio Management | 1 Comment »