Title LM4 Passive Equity Investing IFT Notes.pdf ✅

LM4 Passive Equity Investing 2024 Level III Notes © IFT. All rights reserved 2 1. Choosing a Benchmark: Indexes as a Basis for Investment This reading gives a broad overview of passive equity investing. In the investment industry, the terms ‘passive equity investing’ and ‘indexing’ have become synonymous. However, they mean different things. Indexing refers to strategies where a portfolio is created to replicate the performance of an index, such as the S&P 500. Passive equity investing is a broader term that refers to any investment strategy that is rules-based, transparent, and investable. Indexing is a subset of passive equity investing. This reading has six sections. Sections 1-3 describe how to choose an appropriate benchmark for a passive strategy. Sections 4 and 5 discuss different approaches to passive equity investing. Section 6 discusses how to construct passive portfolios. Section 7 describes tracking error management. Finally, Section 8 describes sources of return and risk in passive equity portfolios. Choosing a Benchmark Indexes as a Basis for Investment To become the basis for an investment strategy, an index must meet three requirements. It must be: 1. Rules-based: For example, selection of constituent securities should be based on well-defined rules. 2. Transparent: Index providers should disclose their rules and passive investors should be able to understand these rules easily. 3. Investable: Passive investors should be able to buy the constituent securities easily. For example, the FTSE 100 is an investable index because its constituent securities are liquid. On the other hand, most hedge fund indexes are non-investable, because the constituent hedge funds are illiquid. Index providers can use the following techniques to make their indexes more investable: 1. Free-float adjustment: Only shares that are available for trade to the public are counted. Shares held by founders, governments, or other companies are excluded. For example, consider a company with 100 million shares outstanding, of which 90 million shares are held by the founding family and 10 million shares are available for trading. A market cap index that uses a free-float adjustment will only consider the 10 million shares and not the total 100 million shares while calculating the index weight for this company. Many stock indexes have a requirement that the float and average shares traded should be above a certain percentage for the share to be included in the index. 2. Buffering: This involves setting up ranges around breakpoints that define a stock’s inclusion in one index or another. Consider two indexes based on market cap – a large-cap index that has the 300 largest companies by market cap and a mid-cap
LM4 Passive Equity Investing 2024 Level III Notes © IFT. All rights reserved 3 index that has the remaining companies i.e. the 301st company and so on. Because market cap changes every day, there will be a lot of flux at the border of these indexes. To deal with this problem, index providers can use the buffering technique, where a range is established around the breakpoint. In our example, the breakpoint is 300, let’s say that a buffering range of 200 to 450 is established. As long as stocks remain in this buffer zone, they are kept in their current index. They are reclassified only when they cross this range. A large-cap company will be reclassified as a mid- cap company when its market cap shrinks and it becomes the 451st largest company. Similarly, a mid-cap company will be reclassified as a large-cap company, when its market cap rises and it becomes the 200th largest company. Buffering ensures that the movement between the two indexes is significantly reduced and the indexes are easy to replicate. 3. Packeting: This involves splitting stock positions into multiple parts. Continuing with our large-cap and mid-cap index example, consider a company that is currently in the mid-cap index. If its capitalization increases and it breaches the breakpoint of 300, then a portion of its total holding will be transferred to the large-cap index but the rest will be retained in the mid-cap index. On the next reconstitution date, if the stock meets all criteria of the large-cap index, the remaining shares will be moved from the mid-cap index to the large-cap index. Considerations When Choosing a Benchmark Index The first consideration when choosing a benchmark index is the ‘desired market exposure’ which is driven by the investor’s IPS. Choices to be made include broad indexes versus sector indexes and domestic indexes versus international indexes. For example, let’s say that for a US investor, it is appropriate to invest in the broad U.S. equity market, then the desired market exposure is broad and from a geographic perspective the focus is on domestic US equities. Another investor may be interested in investing in the telecom sector in different parts of the world and will therefore have a different benchmark index. Besides desired market exposure, another consideration when choosing a benchmark index is ‘risk-factor exposure’. One or more of the following risk factors can be considered: • Size • Style • Momentum • Liquidity • Quality For example, small-cap stocks tend to be riskier and provide a higher return than large-cap stocks. This return difference is considered a risk factor. If a benchmark’s return is correlated with this risk factor, the benchmark has exposure to the ‘size’ factor. Similarly, the ‘value’ factor is calculated as the return on value stocks less the return on growth stocks.
LM4 Passive Equity Investing 2024 Level III Notes © IFT. All rights reserved 4 Instructor’s Note: Risk factor exposures are covered in more detail later. Exhibit 1 of the curriculum shows the number of available total-return equity indexes worldwide in various classifications. Equity indexes 9,165 Broad market indexes 5,658 Sector indexes 3,479 Not classified 28 Of the 5,658 broad market indexes: Developed markets 2,903 Emerging markets 1,701 Developed & emerging markets 1,050 Not classified 4 Of the 5,658 broad market indexes: All-cap stocks 1,892 Large-cap stocks 121 Large-cap and mid-cap stocks 2,100 Mid-cap stocks 657 Mid- and small-cap stocks 39 Small-cap stocks 846 Not classified 3 2. Choosing a Benchmark: Index Construction Methodologies Passive portfolios are created based on a benchmark index. Therefore, to construct passive portfolios, it is important to understand how the index was constructed. Two major factors have to be considered to understand index construction methodologies: • Stock inclusion methods • Weighting scheme of constituent securities Stock inclusion methods: This can either be exhaustive or selective. The exhaustive method includes all constituents of a universe. Whereas, the selective method includes securities with certain characteristics. For example, consider a population of 1,000 large-cap stocks. An index based on this population that uses the exhaustive method will include all 1,000 stocks. On the other hand, an index that uses the selective approach may only include 100 stocks that are selected based on certain characteristics such as reflecting the various sectors of the population. A classic example of a selective index is the S&P 500. It has 500 stocks that are selected from the population of all large-cap US stocks. Weighting scheme of constituent securities: The following table summarizes the four commonly used weighting schemes in index construction.