Enhanced indexation is for risk-averse institutions that require the comfort of performance that is consistently close to a benchmark. Many such institutions will opt, or have opted, for entirely passive indexation for some part of their funds. An enhanced approach provides much of the same comfort but seeks a return which is modestly better than that provided by plain vanilla indexers.
Enhanced portfolios don’t include any views on the selection of individual stocks, individual markets or currencies. In this respect, the approach is as passive as any indexer. Like an indexer, enhancers seek a broad diversification of investments, which match the benchmark as closely as possible. Unlike a standard indexer, however, the enhancer recognises it is possible to gain exposure to the relevant stocks and markets.
Derivative markets now exist in every major financial centre. Instruments such as futures and options provide many different means of gaining exposure to equities. By being aware of these methods, and by carefully evaluating the different choices available, it is often possible to find an alternative which is better, even if only slightly, than dealing in the underlying shares themselves. The derivatives markets do not, of course, always offer an advantageous alternative to buying and holding physical stocks and where they do not, the portfolio can simply hold stock and await opportunities.
Futures contracts based on local indices are traded in all major equity markets. Such contracts are designed to allow investors to gain exposure, either positive or negative, to the performance of an indexed basket of stocks. Purchasing the future and holding local cash equivalent to the value of the exposure can closely mirror the performance of a physical stock portfolio.
In a simplified world the futures contracts would always trade at a level at which the returns available from a futures and cash portfolio equalled those from a physical stock portfolio. In the real world they do not. While arbitrage ensures that the futures do trade at levels that are close to fair value (the theoretical level at which returns are equalised), practical issues always intervene. As in any market, the pressures of short-term supply and demand result in fluctuating prices. Large or hurried buyers or sellers of a futures contract will tend to push the price away from theoretical value. Unequal tax rates mean that different classes of investor will have different theoretical fair values.
Since futures contracts exist only for defined periods, a policy of holding futures contracts in place of physical stock involves continuous rolling from one contract to the next. Broadly speaking, if the manager is able to roll futures contracts at points that indicate cheapness, an enhancement of the portfolio return is achieved.
Like futures, options provide an alternative means of obtaining exposure to the movements in equities. While more complex than futures, options have a major advantage as a potential source of enhancement: there are lots of them – call options and put options; options on most major stocks as well as on indices; many different exercise prices, with many different expiry dates. For every major equity market there are thousands of individual contracts available.
The points made about pricing futures apply equally to the pricing of options, but the expected volatility of the underlying equity or equity index also plays a part. An option’s price is described in terms of that implied volatility. The higher the implied volatility, the more expensive is the option. Since future volatility is unknown, taking advantage of apparently mispriced options is more difficult than exploiting advantageously priced futures contracts. However, for this reason it is difficult for arbitrageurs to eliminate any mispricings, the existence of which makes options a good source of enhancement.
The manager’s task is to search the broad universe of options to find good value. Given that there are many more instruments, the possibility of finding that value is proportionately greater.
Although analysing costs is considered dull by many, it is a vital part of the management of an enhanced index fund. The numbers are larger than many investors appreciate.
Since the benchmark is the performance of an index fund based purely on holding physical stocks, it is interesting to calculate the costs an indexed stock portfolio can expect to incur. It is then interesting to compare these costs with those incurred by a portfolio, which gains its exposure synthetically by means of futures or options.
This comparison will vary considerably by market, and will vary with time, but there are some general principles which always apply. Physical portfolios suffer from the costs of withholding taxes, custodial charges, stamp duties, stock spreads and stock brokerage commission. Synthetic portfolios do not. All but the first of these costs will increase proportionately with the degree of change necessitated by turnover within the index- often quite considerable, and the need to reinvest income, capital distributions and the proceeds of cash takeovers. Synthetic portfolios suffer some brokerage costs, and modest spread costs, but avoid the others.
This comparison is quite critical when evaluating alternative means of investing. Even if a synthetic means of investing looks technically worse than purchasing and holding physical stock in a zero cost environment, the very real commercial effect of costs can make a synthetic alternative advantageous in reality.
Because derivatives are often used as a means of gearing or hedging a portfolio it is important to emphasise that they are not used here for either of these purposes. As with a standard index fund, the goal is 100% exposure to the market at all times. Enhanced index portfolios of this type are therefore no more or less likely to outperform in a rising market than they are in a falling market.
By avoiding any market or currency mismatches, and by minimising any mismatches in individual stocks, an enhancer can track benchmarks closely. Tracking error is marginally greater than that of a standard index fund, but is by design much closer to that of an index fund than to an actively managed portfolio.
The additional tracking error comes from three sources:
q enhancements are not perfect. The pattern of relative gains and losses naturally shows a degree of variability.
q the derivatives used will not always be based upon perfect subsets of the benchmark. For an MSCI Europe benchmark, for example, the enhancer may choose to exploit an opportunity in a Dow Jones derivative even though that does not perfectly reflect the constituents of the MSCI index. Holding a mixture of derivatives and stock to avoid any unacceptable degree of tracking error can control this risk.
q the prices of derivatives can to a degree fluctuate independently of the prices of the underlying assets. This produces opportunities that can be exploited. It does, however, lead to some modest tracking error as the derivatives held in the portfolio move around slightly relative to the relevant portions of the benchmark.
This slight extra degree of tracking error is taken in exchange for the potential enhancement that is available.
Phillip Ainsworth is a director of First Quadrant in London