1 INTRODUCTION Passive investing is a simple rule-based investment strategy that does not engage in stock selection Indexing, a pure form of passive investing, tends to mimic the performance of benchmark indexes Indexing is a low cost, diversifying and tax-efficient strategy Passive investment managers believe that the cost of security selection is higher than the cost of passive investing The efficient market hypothesis asserts that all stocks are perfectly priced therefore it would not be possible for active investors to consistently outperform the market CHOOSING A BENCHMARK Originally benchmark indexes were used to assess performances of active portfolio managers but now they are also used to establish investment strategies the stock stays in the buffer zone Buffer zones reduce frequent reconstitution and make index transitions gradual and well-ordered Choosing a suitable benchmark is essential for investors Benchmark’s past performance and creation method are important in its selection Packeting methodology splits stock positions into multiple parts Once a stock moves out of the transition band, only a portion of the total holding is shifted from one index to another In the following reconstitution date, the remainder of the parts are transferred if the security stays beyond the threshold level 2.1 Indexes as a Basis for Investment Indexes (when are used as a basis for investment) must meet three initial requirements They must be rule-based, transparent and investable Indexes follow rule-based methodologies with regards to rebalancing frequency, inclusion of constituent securities etc An index is investable when investors can track and replicate its performance by buying its constituent securities easily Certain characters of individual securities that make them investable as index securities include: • • high free-float (no of shares available for trade by the public) high trading volume which in turn means high liquidity and low trading costs Index providers try to mitigate ‘stock migration issue’ to keep trading costs low and to make the index more investable Stock migration takes place when an individual stock migrates from one index to another For example, when market capitalization of a stock increases overtime, its status might move from small-cap to mid-cap or mid-cap to large-cap ‘Buffering’ and ‘Packeting’ are two of many policies index practitioners defined to reduce stock migration issues These policies lower portfolio turnover and trading costs Index providers define a buffer zone between adjacent indexes A stock remains in its current index as long as 2.2 Constitutions When Choosing a Benchmark Index Selection of a benchmark is guided by the investor’s investment policy statement (IPS) ‘Market segment’, ‘Equity capitalization (the size factor)’ and ‘Style of benchmark’ are key considerations when choosing a benchmark Market segment (such as broad versus sectors, domestic versus international, developed versus emerging/frontier) are based on investor’s perspective including his domicile, risk tolerance, liquidity needs, legal considerations etc Risk Factor (such as Size, Style, momentum and liquidity) exposure is an important determinant of realized risk and return Benchmarks with defined size ranges (holdings’ market capitalization) offer investors opportunity to get market exposure to size risk factor Empirical studies have shown that small-cap stocks are riskier and provide a higher long-term return compared to large-cap stocks The choice of the size factor involves the investor’s preferences for exposure on the capitalization spectrum (small-cap, mid-cap, large-cap) Some investors contemplate that small-cap stocks are suitable for alpha generation through active management and large-cap stocks are suitable for low-cost passive management Investors who require a broad universe of equities may prefer all-cap index Such indexes include stocks from various size ranges –––––––––––––––––––––––––––––––––––––– Copyright © FinQuiz.com.All rights reserved –––––––––––––––––––––––––––––––––––––– FinQuiz Notes Passive Equity Investing Reading 27 Passive Equity Investing Reading 27 Another decision element is the style of the benchmark that determines where the index falls in the value-growth scale Ø Ø 2.3 Growth stocks exhibit features such as high price momentum, high P/E ratio, and high growth Value stocks exhibit features such as high dividend yields, low P/E and low P/BV ratios Index Construction Methodologies Stocks inclusion methodologies range from exhaustive to selective Exhaustive approach selects all securities Selective approaches choose securities based on selective features Performance of an index is affected by the weighting method used to construct the index Market-cap weighting is one of the most common weighting methods A security’s market-cap is calculated as (price × no of shares outstanding) Each stock’s weight in the "#$%&’" )*+&,# %*index is calculated as #$#* )*+&,# %*- $/ * "#$%&" Cap weighted indexes are reasonable proxy for market portfolios and are investable because of higher liquidity Free-float adjusted weighting is a common market-cap weighting where market capitalization is calculated as (price × no of shares freely available in the market) Free-float weighting adjusts number of shares outstanding for closely held shares unavailable for public Finding number of shares available for free-float requires analytical judgement and company’s information available for public The reported number may vary slightly depending on methodologies used In Price-weighted index, the weight of each stock is -+0%, -,+ "1*+, calculated as: "2) $/ * "1*+, -+0%," 03 #1, 034,5 Shares are weighted in proportion to their price per share Price-weighted indexes are adjusted for stock splits Another problem is that price -weighted index includes equal number of shares for each security This investment approach is followed by very few participants Equal-weighted index gives equal weights to all stocks in the index Each stock weights 3, where n represents the total number of stocks in the index (also called naïve strategy) Benefits of equally weighted index include ‘lower single stock concentration’ and ‘slow changing sector exposures’ Equal weighting indexes are factor-indifferent Because of randomness, there is no (or very little) factor mispricing in equal weighted indexes FinQuiz.com Unlike market capitalization weighted indexes, equal weighted indexes not give too much weight to any single factor or sector (e.g technology) This protects investors from losses occurring because of, for example, tech bubble or mortgage finance bubble etc Equal-weighted indexes are more volatile than marketcap weighted indexes because of presence of large number of small-cap stocks Equal weighted indexes are very different than market weighted large-cap indexes as difference in weights of constituent stocks is enormous (e.g allocation to Apple or Microsoft will be much higher in market weighted large-cap index) This is difference is not much when we compare equal weighted indexes with mid-cap market weighted indexes Equally-weighted indexes require regular rebalancing as change in market prices cause individual stock investment values to change One challenge for equally weighted indexes is their limited investment capacity as they allocate equal weights to all stocks including small-caps, which are generally less liquid Equal weighted indexes exhibit a natural advantage over cap-weighted portfolios This is because not too much money is invested in overvalued stocks nor too less is invested in undervalued stocks As prices of overvalued stocks fall, cap-weighted portfolios suffer much more losses than equal weighted portfolios Similarly, when undervalued stocks prices rise, more gains accrue to equal weighted portfolios as amount invested in them were not small Fundamental weighted indexes are based on stock’s fundamental characteristics such as sales, income, dividends The reasoning behind fundamental weighting is that the stock’s market value may change overtime to reflect the stock’s fundamental attributes Market-cap weighted indexes versus fundamentally weighted indexes Similarities low cost, rules-based index structure, transparency, investability Differences Philosophy of • market cap weighted index is based on efficient market hypothesis • fundamentally weighted index is based on stock’s attributes and to exploit inefficiencies in market pricing Another concern in benchmark selection is the effective number of stocks in the index The Herfindahl-Hirschman Index (HHI) is a commonly used measure of stockconcentration risk in a portfolio The HHI is calculated as: Passive Equity Investing Reading 27 HHI = ∑30;6 𝑤0: where 𝑤0 is the weight of stock i in the portfolio The value of HHI can range from to 1, where, n = no of securities The value of HHI in equally weighted portfolio would be The value of HHI can be used to estimate the effective number of stocks Effective no of stocks = ∑? > =@A