Active vs.

Passive Investment
Strategies
Case: BEA Associates: Enhanced
Equity Index Funds
 Active vs. Passive Investments

Active Passive
• Buy undervalues or sell • Buy or sell an index fund
overvalued securities or based on market outlook
index funds driven by • Buy-and-hold an index fund
perceived market timing or
security-specific
inefficiencies
• Selectively buy undervalued
or sell overvalued securities
with no regard to
diversification

90% of return – asset allocation policy

 Choices on Passive Investing
Once you decide that
active investing is not going
to pay off for you, you have
chosen the path of passive
investing
The choices on passive
investing have grown over
time and here are a few:
• Classic Index Funds
• Enhanced Index Funds
• Exchange traded funds
 Index Funds
Fully Indexed Fund
• An index fund attempts to replicate a market index
• It is relatively simple to create, once the index to be replicated has been identified
• Identify the index to be replicated
•
•
•
Example: S & P 500
Estimate the total market values of equity of all firms in that index
Create a market-value weighted portfolio of stocks in the index
• This fund will replicate the index and is self correcting
• It will need to be adjusted only if stocks enter or leave the index

Sampled Index Fund • Here, you sample an index because the index contains too many stocks like the Wilshire 5000 or it is too expensive to index the assets in a fund

Exchange Traded Funds provide

investors with a way of replicating the
index at low cost, while preserving
liquidity

Index Futures and Options

Enhanced Index Funds that attempt to

deliver the low costs of index funds with
slightly higher returns
 Passive Equity Portfolio Investments
All securities in the index
Long-term buy-and-hold strategy are purchased in
Usually tracks an index over time Full
proportion to weights in
the index
Replication
Designed to match market performance Ensure close tracking
Manager is judged on how well they track the
Increases transaction
target index costs, particularly with
dividend reinvestment
Replicate the performance of an index
May slightly underperform the target index due
to fees and commissions
Weight based
Costs of active management (1 to 2 percent) Sampling
are hard to overcome in risk-adjusted Techniques
performance
Many different market indexes are used for Representative sample of
tracking portfolios stocks in the benchmark
index according to their
Investment Mode – Index Funds and ETFs weights in the index
Fewer stocks means lower
Stratified commissions
Quadratic Sampling Reinvestment of dividends is
Historical information on price changes and correlations between
optimization less difficult
securities are input into a computer program that determines the
or Will not track the index as
composition of a portfolio that will minimize tracking error with the programming closely, so there will be
benchmark
some tracking error
This relies on historical correlations, which may change over time,
leading to failure to track the index
Passive Approach to Equity Management

Portfolio Rebalancing Requirements

Best suited for investors who believe
markets are relatively efficient
Mergers and
Changes to the
Attempts to match the performance of Acquisitions:
a benchmark index composition of the
Companies disappear
index
from the market.
Mainly concerned with tracking risk
(measured by tracking error)

Stock splits and

Aims for lowest tracking risk New stock issues
dividend payments

No “active” return relative to the

benchmark index

Index fund + Risk free return can create Stock repurchases

Portable alpha strategy (any beta exposure)
 Expected Tracking Error
Expected Tracking Error
(Percent) Index fund should lag the underling
index by the sum of

4.0 Cost of management

Transaction costs
related to index
and administration
composition changes

3.0
Transaction costs for
Drag on
investing cash flows,
performance from
e.g., reinvesting
2.0 dividends
any cash position

Inevitable Tracking Errors

1.0 Replication implies irregular lots
Composition of securities in the index may change
Modification of the index: entry and exit of securities,
merges, defaults, etc.

But revenues from securities lending can

500 400 300 200 100 0 offset some of these costs

Number of Stocks
Minimize the expected tracking error by optimizing over - Number of securities in the portfolio and Securities to include in the portfolio
Number of securities used in the replication determines a tradeoff between transaction costs and tracking errors.
 Active Equity Portfolio Investments
Goal is to earn a portfolio return that exceeds the return of a passive benchmark portfolio, net of transaction costs, on
a risk-adjusted basis

Practical difficulties of active manager

Transactions costs must be offset
Risk can exceed passive benchmark

Top-down FA
Versus
Bottom-up
Approaches
Position a portfolio to take
advantage of the market’s next
Asset and move
Earnings Screening can be based on
Sector
Attributes momentum various stock characteristics –
Rotation
Strategy Value, Growth, P/E,
Strategies Capitalization, Sensitivity to
Strategies economic variables

Price Contrarian
Momentum Investment TA
TA
Strategy Strategy
Why Active Money Managers Fail
High Transactions • The costs of collecting and processing information and
Costs trading on stocks is larger than the benefits from the same

High Taxes • Trading exposes investors to much larger tax burdens

• Activity, by itself, can be damaging as investors often sell

Too much Activity when they should not and buy when they should not

Failure to Stay Fully • Since mutual fund managers are not great market timers,
Invested in Equities failing to stay fully invested hurts more than it helps

• All of the behavioral problems that we see with individual

Behavioral Factors investors apply in spades with institutional investors
 Behavioral Factors

Lack of • Brown and Van Harlow examined several thousand mutual funds from 1991 to 2000 and
categorized them based upon style consistency
• They noted that funds that switch styles had much higher expense ratios and much lower

Consistency returns than funds that maintain more consistent styles

Herd • One of the striking aspects of institutional investing is the degree to which institutions
tend to buy or sell the same investments at the same time

Behavior

Window • It is a well documented fact that portfolio managers try to rearrange their portfolios just
prior to reporting dates, selling their losers and buying winners (after the fact)
• O’Neal, in a paper in 2001, presents evidence that window dressing is most prevalent in

Dressing December and that it does impose a significant cost on mutual funds
 Enhanced Index Funds
Synthetic • Build on the derivatives strategies
• Using the whole range of derivatives – futures, options and
Enhancement swaps- that may be available at any time on an index, you look
for mispricing that you can use to replicate the index and
Strategies generate additional returns

Stock-Based
• Adopt a more conventional active strategy using either stock
Enhancement selection or allocation to generate the excess returns

Strategies

Quantitative • Use the mean- variance framework that is the foundation of

Enhancement modern portfolio theory to determine the optimal portfolio in
terms of the trade-off between risk and return
Strategies
Investment Style
Equity Style Box
Large
2 1 13

3 17 60 Mid

0 1 3
Small
Value Core Growth 50
 Enhanced Index Funds can be more Profitable
than Regular Index Funds by..

Positioning the Investing only in

portfolio to a Timing the market specific securities in
particular sector the index

Avoiding certain
securities in the index Keeping up to date
Using leverage
that are expected to with market trends
underperform
 Volatility

Momentum Liquidity

Alternative
Weighting
Schemes for
Getting
Smart Beta

Size Quality

Value
 Amihud ratio – median ratio of absolute
Liquidity daily return to daily traded value over the
previous year

Momentum Residual Sharpe ratio

Composite of profitability (return on assets),

Quality efficiency (change in asset turnover),
earnings quality (accruals) & leverage
Common factor based smart
beta types revolve around
six ideas for Optimization

Size Full market capitalization

Composite of trailing cash-flow yield,

Value earnings yield and country relative sales to
price ratio

Standard deviation of 5 years of weekly

Volatility (wed/wed) local total returns
 Enhanced Indexing Strategies
• Enhanced cash managers use futures to replicate the index then they take
the roughly 95% of the capital left after buying futures (with their inherent
20 to 1 leverage) and purchase fixed income securities
Enhanced Cash • The key to performance in these strategies is that the yield on the fixed
income strategies is greater than the yield that is priced into the futures
contracts (for the leverage)

Index • Instead of relying on external indexes created by third parties like S&P or
Construction Dow Jones, enhanced indexes often use proprietary indexes
• Alternatively, they use dynamic rather than static indexes

Enhancements

• By using additional filters, some enhanced indexes eliminate securities

Exclusion Rules likely to reduce performance that would be otherwise included in

traditional indices (e.g. companies with excessive debt or those in
bankruptcy)
 Enhanced Indexing Strategies
• Utilizing intelligent trading algorithms, some
Trading enhanced index funds create value through trading
(e.g. by buying illiquid positions at a discount or by
Enhancements selling more patiently than traditional index funds)

Portfolio • Enhanced index funds sometimes implement hold

ranges that reduce portfolio turnover by allowing
Construction funds to hold positions during buffer periods even
Enhancements after traditional sell signals are triggered

• Among the newest enhancements, tax-managed

Tax-Managed index funds manage buys and sells to minimize taxes
• These tax-managed index funds can be superior to
Strategies variable annuities for tax-efficient wealth creation