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2024 Curriculum CFA Program Level III Portfolio Management and Wealth Planning
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This reading provides a broad overview of passive equity investing, including indexselection, portfolio management techniques, and the analysis of investment results.
Although they mean different things, passive equity investing and indexing have becomenearly synonymous in the investment industry. Indexing refers to strategies intendedto replicate the performance of benchmark indexes, such as the S&P 500 Index, theTopix 100, the FTSE 100, and the MSCI All-Country World Index. The main advantagesof indexing include low costs, broad diversification, and tax efficiency. Indexingis the purest form of a more general idea: passive investing. Passive investing refersto any rules-based, transparent, and investable strategy that does not involve identifyingmispriced individual securities. Unlike indexing, however, passive investing can includeinvesting in a changing set of market segments that are selected by the portfoliomanager.
Studies over the years have reported support for passive investing. Renshaw and Feldstein (1960) observe that the returns of professionally managed portfolios trailed the returnson the principal index of that time, the Dow Jones Industrial Average. They also concludethat the index would be a good basis for what they termed an “unmanaged investmentcompany.” French (2008) indicates that the cost of passive investing is lower than the cost of active management.
Further motivation for passive investing comes from studies that examine the returnand risk consequences of stock selection, which involves identifying mispriced securities.This differs from asset allocation, which involves selecting asset class investmentsthat are, themselves, essentially passive indexed-based portfolios. Brinson, Hood, and Beebower (1986) find a dominant role for asset allocation rather than security selection in explainingreturn variability. With passive investing, portfolio managers eschew the idea ofsecurity selection, concluding that the benefits do not justify the costs.
The efficient market hypothesis gave credence to investors’ interest in indexes bytheorizing that stock prices incorporate all relevant information—implying that aftercosts, the majority of active investors could not consistently outperform the market.With this backdrop, investment managers began to offer strategies to replicate thereturns of stock market indexes as early as 1971.
In comparison with passive investing strategies, active management of an investmentportfolio requires a substantial commitment of personnel, technological resources,and time spent on analysis and management that can involve significant costs. Consequently,passive portfolio fees charged to investors are generally much lower than fees chargedby their active managers. This fee differential represents the most significant andenduring advantage of passive management.
Another advantage is that passive managers seeking to track an index can generallyachieve their objective. Passive managers model their clients’ portfolios to the benchmark’sconstituent securities and weights as reported by the index provider, thereby replicatingthe benchmark. The skill of a passive manager is apparent in the ability to trade,report, and explain the performance of a client’s portfolio. Gross-of-fees performanceamong passive managers tends to be similar, so much of the industry views passivemanagers as undifferentiated apart from their scope of offerings and client-servicingcapabilities.
Investors of passively managed funds may seek market return, otherwise known as betaexposure, and do not seek outperformance, known as alpha. A focus on beta is basedon a single-factor model: the capital asset pricing model.
Since the turn of the millennium, passive factor-based strategies, which are basedon more than a single factor, have become more prevalent as investors gain a differentunderstanding of what drives investment returns. These strategies maintain the low-costadvantage of index funds and provide a different expected return stream based on exposureto such factors as style, capitalization, volatility, and quality.
This reading contains the following sections. Section 2 focuses on how to choose apassive benchmark, including weighting considerations. Section 3 looks at how to gainexposure to the desired index, whether through a pooled investment, a derivatives-basedapproach, or a separately managed account. Section 4 describes passive portfolio constructiontechniques. Section 5 discusses how a portfolio manager can control tracking erroragainst the benchmark, including the sources of tracking error. Section 6 introducesmethods a portfolio manager can use to attribute the sources of return in the portfolio,including country returns, currency returns, sector returns, and security returns.This section also describes sources of portfolio risk. A summary of key points concludesthe reading.
Learning Outcomes
The member should be able to:
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discuss considerations in choosing a benchmark for a passively managed equity portfolio;
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compare passive factor-based strategies to market-capitalization-weighted indexing;
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compare different approaches to passive equity investing;
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compare the full replication, stratified sampling, and optimization approaches for the construction of passively managed equity portfolios;
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discuss potential causes of tracking error and methods to control tracking error for passively managed equity portfolios;
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explain sources of return and risk to a passively managed equity portfolio.
Summary
This reading explains the rationale for passive investing as well as the construction of equity market indexes and the various methods by which investors can track the indexes. Passive portfolio managers must understand benchmark index construction and the advantages and disadvantages of the various methods used to track index performance.
Among the key points made in this reading are the following:
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Active equity portfolio managers who focus on individual security selection have long been unsuccessful at beating benchmarks and have charged high management fees to their end investors. Consequently, passive investing has increased in popularity.
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Passive equity investors seek to track the return of benchmark indexes and construct their portfolios to reflect the characteristics of the chosen benchmarks.
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Selection of a benchmark is driven by the equity investor’s objectives and constraints as presented in the investment policy statement. The benchmark index must be rules-based, transparent, and investable. Specific important characteristics include the domestic or foreign market covered, the market capitalization of the constituent stocks, where the index falls in the value–growth spectrum, and other risk factors.
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The equity benchmark index weighting scheme is another important consideration for investors. Weighting methods include market-cap weighting, price weighting, equal weighting, and fundamental weighting. Market cap-weighting has several advantages, including the fact that weights adjust automatically.
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Index rebalancing and reconstitution policies are important features. Rebalancing involves adjusting the portfolio’s constituent weights after price changes, mergers, or other corporate events have caused those weights to deviate from the benchmark index. Reconstitution involves deleting names that are no longer in the index and adding names that have been approved as new index members.
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Increasingly, passive investors use index-based strategies to gain exposure to individual risk factors. Examples of known equity risk factors include Capitalization, Style, Yield, Momentum, Volatility, and Quality.
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For passive investors, portfolio tracking error is the standard deviation of the portfolio return net of the benchmark return.
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Indexing involves the goal of minimizing tracking error subject to realistic portfolio constraints.
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Methods of pursuing passive investing include the use of such pooled investments as mutual funds and exchange-traded funds (ETFs), a do-it-yourself approach of building the portfolio stock-by-stock, and using derivatives to obtain exposure.
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Conventional open-end index mutual funds generally maintain low fees. Their expense ratios are slightly higher than for ETFs, but a brokerage fee is usually required for investor purchases and sales of ETF shares.
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Index exposure can also be obtained through the use of derivatives, such as futures and swaps.
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Building a passive portfolio by full replication, meaning to hold all the index constituents, requires a large-scale portfolio and high-quality information about the constituent characteristics. Most equity index portfolios are managed using either a full replication strategy to keep tracking error low, are sampled to keep trading costs low, or use optimization techniques to match as closely as possible the characteristics and performance of the underlying index.
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The principal sources of passive portfolio tracking error are fees, trading costs, and cash drag. Cash drag refers to the dilution of the return on the equity assets because of cash held. Cash drag can be exacerbated by the receipt of dividends from constituent stocks and the delay in getting them converted into shares.
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Portfolio managers control tracking error by minimizing trading costs, netting investor cash inflows and redemptions, and using equitization tools like derivatives to compensate for cash drag.
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Many index fund managers offer the constituent securities held in their portfolios for lending to short sellers and other market participants. The income earned from lending those securities helps offset portfolio management costs, often resulting in lower net fees to investors.
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Investor activism is engagement with portfolio companies and recognizing the primacy of end investors. Forms of activism can include expressing views to company boards or management on executive compensation, operational risk, board governance, and other value-relevant matters.
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Successful passive equity investment requires an understanding of the investor’s needs, benchmark index construction, and methods available to track the index.
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