Once the decision has been taken to index part or all of an equity portfolio, the next question is how. How do you set up and maintain the portfolio, what issues and costs are involved, and finally, can and should this be outsourced?
Index management is operationally intensive given the breadth of the portfolios under supervision and the related transactional requirements. So it is important to review your organisation’s ability to cope.
In particular, a thorough review of the current custodian relationship is necessary to determine the custodian’s capacity to deal with portfolios of hundreds of securities. The issues include global clearing capabilities; stock lending capacity, which can be either an additional source of income or an added cost if not properly supervised; cost structure by market, particularly focusing on a per-trade basis and bulk discounts; timeliness of fail reconciliation, including issues of contractual settlement, and dividend collection and monitoring of corporate actions.
The cost structure and lending capacity of global custodians is clearly an advantage to index portfolio managers over regional or local custodians, which do not possess the breadth of market coverage or economies of scale. However, sometimes even the largest global custodians fail to serve their clients’ needs adequately when it comes to monitoring and advising on the handling of corporate actions. Ongoing corporate mergers, acquisitions and restructuring activities, particularly those that are cross-border in nature, have heightened attention as to the impact of such events on equity indices. Recent studies have estimated that such corporate events can impact portfolio performance by 2–3% a year – a big difference when most indexers try to achieve the index performance within a 50 basis point annual tracking error.
Selecting an appropriate benchmark to track is an essential consideration. You must be alert to the qualitative as well as quantitative factors involved, including market or segment representation, tradeability, reconstitution frequency and index policy visibility.
When an appropriate benchmark has been selected, the challenge is to construct a portfolio that closely mimics the desired index performance. The seemingly easy task of full replication of an index is complicated by practical considerations, such as operational capacity or manageability of the portfolio, transaction costs and stock-ownership constraints. Back-office and front-office staffing considerations required to process transactions, monitor settlements and oversee index inclusion or corporate events are closely related to the number of stocks in a manager’s portfolio. This is particularly true when investing in the European markets, for example, where transaction settlement is a fairly manual process and where corporate activity is prevalent. Transaction costs, such as brokerage fees or exchange fees, have a meaningful effect on the performance of an index portfolio, hence the importance in minimising turnover. Constraints in regard to stock ownership are another vital consideration. These can arise due to fund policies that may restrict, for example, ownership of tobacco stocks or have a bias toward environmentally friendly companies. The challenge is to construct an index-proxy portfolio that takes into account the various criteria mentioned and simultaneously minimises risk, or tracking error, to the selected benchmark.
There are two readily accepted approaches to constructing an index proxy: portfolio optimisation and portfolio sampling. Portfolio optimisation is used to find the optimal portfolio that minimises the tracking error to the selected benchmark given some initial criteria such as the universe of stocks and transaction cost or liquidity constraints. To make the task easier, the optimal solution to the problem in question can be derived by using commercially available or internally developed software, which prompts the user for the necessary inputs. For example, a portfolio manager can start with the S&P 500 as the universe of stocks to select from and omit those names that do not fit the investment philosophy, such as alcohol or tobacco stocks. The manager can then specify other constraints, such as number of stocks desired in the portfolio, liquidity constraints or targeted risk tolerance levels. The final step is to specify the target benchmark, like the S&P 500 or the Russell 1000. The optimiser then proceeds to construct the minimum-variance portfolio, based upon a historical or projected covariance matrix, given the specified inputs. It is fairly straightforward, for example, to construct a 100-name portfolio to track the S&P 500 with an expected tracking error of 50bps, thus significantly reducing the number of stocks to be held in the portfolio.
Portfolio sampling can be a simpler process than optimisation as the portfolio manager need not bother with calculating historical or estimating projected covariance figures. Sampling uses statistical selection techniques to construct a representative portfolio in terms of overall index composition either by looking at market capitalisation or industry distribution. A sampling routine can be programmed or followed manually by taking a starting universe of stocks and dividing the universe into market capitalisation deciles and industry or sector groups. The process then follows to select, for example, the top five stocks in each capitalisation decile or industry group and then to select every Nth stock until the total selected capitalisation equals some targeted percentage of the total index capitalisation.
The initial implementation and regular maintenance of an index portfolio can be one of the most costly aspects of the indexing process. Trading costs such as brokerage fees, market impact or benchmark slippage can quickly erode portfolio performance relative to the index benchmark. Dividend reinvestment and regular rebalancings due to corporate events and relative stock movements can either add to or subtract from portfolio performance and thus must be actively managed.
The initial funding process of any portfolio should be closely scrutinised, but this is particularly true with index portfolios, as it is very easy to incur substantial trading costs that can create significant performance slippage even before the portfolio is up and running. Slippage of 50–100bps due to trading costs is not unheard of. One of the best ways to control these costs is by combining index futures with portfolio trading techniques.
Futures can also help in the regular maintenance of the fund by readily investing accrued dividend income or fund contributions. Also, a fund manager can employ a strategy involving purchasing optimal complementary portfolios to invest portfolio income in a staged fashion, building up to the desired target portfolio. This strategy can be used for almost any size of income accrual. Corporate actions, as previously mentioned, can have a material impact on fund performance and must be carefully analysed to determine the appropriate portfolio rebalancing strategy. Many index portfolio managers will try to rebalance close to the time when the index change in light of the corporate event takes effect, if not exactly on the date, to minimise performance slippage. Alternatively, some managers will take trade in advance or subsequent to the effective date of the index to avoid the unusual volatility that commonly develops at that specific time. Still other fund managers will look at this as an opportunity to add outperformance to the portfolio by determining which company, the acquiror or the acquiree, is best to hold on a relative value basis.
Whichever trading strategy one chooses, either during the initial set-up or subsequent maintenance phase of index portfolio management, impact cost or trading cost measurement and performance slippage monitoring are clearly important elements in the process.
After all that is required in setting up and running an index portfolio, you may think that perhaps it is best to outsource these responsibilities to a specialist manager. In making this decision, a number of factors should be considered, such as cost advantages, staffing/technology constraints and the desire to maintain oversight over the portfolio process.
But the cost is frequently the primary determining factor for institutions contemplating this decision. Specialist managers, particularly the largest, have a clear cost advantage when it comes to regular maintenance costs, such as custodial charges or brokerage fees. Another advantage of the largest specialist managers is an active stock-lending programme that can provide performance enhancement to the portfolio. In particular, a specialist manager can run smaller index portfolios more cost-effectively than plan sponsors. However, some of these cost advantages become obscured when it comes to running larger index portfolios where it seems that both a specialist manager and, for example, a plan sponsor may be able to achieve the same result. The consideration for the plan sponsor in this scenario is management capacity. The lack of the appropriately skilled staff and technology infrastructure may lead to the decision to outsource the index mandate.
Whatever the decision taken, whether to manage an index portfolio oneself or to outsource to a specialist, the essential ingredients remain the same. The index community as a whole has helped drive the technological and quantitative evolutionary process and at the same time increase the focus on cost-control and operational efficiency. This will continue to evolve as more and more assets are indexed and as new methods for indexing are explored like enhanced indexing or synthetic indexing techniques.
Emad Morrar is a director and head of portfolio advisory at Lehman Brothers International in London