Equity Strategies.

Equity investment strategies, particularly those based on indexes, are a crucial part of the financial landscape. These strategies can be implemented using a variety of approaches, from the individual investor buying stocks on their own to hiring a professional subadviser to create and maintain the investment strategy. Essentially, any internal or external portfolio manager equipped with the necessary index data, trading tools, and skills can replicate these strategies. This is a stark contrast to actively managed funds, where the investment strategy is unique and developed by the active portfolio manager.

There are several ways to gain access to the desired performance stream of an investment strategy. These include pooled investments such as mutual funds and exchange-traded funds (ETFs), derivatives-based portfolios using financial instruments like options, futures, and swaps contracts, and direct investment in the stocks underlying the strategy. For instance, an investor might choose to invest in a mutual fund that tracks the S&P 500, or they might buy options contracts to hedge against potential losses. Some index-based investments are managed with a specific target beta in mind, and the performance of the managers is evaluated based on how closely they meet this target.

Portfolio managers often use futures and open-end mutual funds to transform a position, for example, converting cash into equity exposure. This process is known as equitizing . The choice of which method to use is largely determined by the financing costs of rolling the futures contracts over time. For instance, if the costs of rolling futures contracts are high, a manager might opt for open-end mutual funds instead. In the case of multinational indexes, it can be more efficient to buy a set of complementary exchange-traded funds to replicate market returns for the various countries. For example, an investor might buy ETFs that track the performance of markets in the US, Europe, and Asia to gain exposure to global equity markets.

Pooled Investments

Pooled investments are a popular choice for average investors due to their ease of purchase, holding, and selling. This category includes open-end mutual funds and exchange-traded funds (ETFs). These investment vehicles allow investors to pool their money together to invest in a portfolio of assets, providing diversification and professional management.

Open-End Mutual Funds

Open-end mutual funds are a type of pooled investment vehicle that allows investors to buy and sell shares directly from the fund at the net asset value (NAV) price. The fund continuously issues and redeems shares, hence the term “open-end”. The Qualidex Fund, started in 1970, was the first open-end index mutual fund available to retail investors. It was designed to track the Dow Jones Industrial Average. An example of this would be the SPDR Dow Jones Industrial Average ETF (DIA), which also tracks the Dow Jones Industrial Average. The Vanguard S&P 500 Index Fund, started in 1975, was the first retail fund to attract investors on a large scale. This fund is similar to the iShares Core S&P 500 ETF (IVV), which also tracks the S&P 500 index.

Mutual Fund Investments

Mutual funds offer an efficient way to invest, monitor investments, and keep records. They are especially beneficial for those investing in index-based mutual funds. Investors need to analyze their return and risk objectives, investment constraints, and develop a matching strategy. Understanding financial goals, risk tolerance, and investment horizon is crucial.

Options for Purchasing Mutual Funds and Available Support

Investors can buy mutual funds directly from the fund adviser, through a fund marketplace, or with a financial adviser’s help. The investment companies provide extensive support via websites and call centers for easier transactions and information access. A fund marketplace offers a streamlined process to invest in multiple funds from various providers under one account. This consolidation enhances the ease of record keeping and investment tracking.

Benefits of Index-Based Mutual Funds

Index-based mutual funds are cost-effective and offer structural convenience. These funds enable affordable access to broad market indices. Managing these funds involves rebalancing, reconstitution, and adjustments to mirror the benchmark index closely. Portfolio managers have duties including trading securities, managing cash, handling corporate actions, proxy voting, and reporting performance. While index-based funds are cost-efficient, they still incur expenses for registration, custodial services, and auditing, similar to actively managed funds.

Comprehensive Record Keeping and Regulatory Oversight

The operational integrity of mutual funds is upheld through rigorous record keeping, ensuring accurate documentation of share ownership, transaction histories, and pricing. Close collaboration between record keepers, custodians, and mutual fund sponsors guarantees the secure and precise handling of fund assets. Regulatory frameworks, such as the Investment Company Act of 1940 in the United States and the UCITS directive in the European Union, provide a structured and protective environment for mutual fund operations, safeguarding investor interests and promoting market stability.

Exchange-Traded Funds (ETFs)

Exchange Traded Funds (ETFs) are a type of investment fund and exchange-traded product, first introduced in the United States in 1993. The first ETF was launched in the Canadian market in 1990 to track the return of 35 large stocks listed on the Toronto Stock Exchange. A real-world example of this would be the iShares S&P/TSX 60 Index ETF (XIU), which tracks the S&P/TSX 60 index of large-cap Canadian stocks. They are designed to track the performance of a specific index, sector, commodity, or asset class. They can be bought and sold on a stock exchange, much like individual stocks, offering the flexibility of intraday trading. ETFs have gained popularity due to their ease of trading, low management fees, tax efficiency, and the ability to provide exposure to a wide array of indexes.

Structure of ETFs

The structure of an ETF involves two primary entities: the fund manager and the authorized participant.

The fund manager oversees the ETF’s management, including asset allocation and index tracking. The authorized participant, usually a significant financial institution, serves as a market maker, crucial in the ETF shares’ creation and redemption process. Authorized participants help to stabilize supply and demand by creating or redeeming ETF shares as needed.

Tax Efficiency of ETFs

ETFs are known for their tax efficiency, making them an attractive investment option in regions where capital gains are taxable. The unique creation/redemption mechanism, often involving an in-kind exchange, minimizes the occurrence of taxable events. This process reduces the likelihood of realizing capital gains, thereby lowering the tax impact on investors compared to mutual funds.

Disadvantages of ETFs

ETFs have some disadvantages, including the bid-ask spread, which affects the buying and selling price of shares. Commission costs can accumulate with frequent trading, impacting overall investment returns. Market liquidity can pose a risk, potentially making it challenging to execute trades at desired prices or times.

Use of ETFs

ETFs have become a popular tool among financial advisers and large investors. They are often used to gain targeted exposure to specific sectors or asset classes. For example, a financial adviser might recommend a technology ETF to a client who wants to increase their exposure to the tech sector. Large investors, on the other hand, may find it more cost-effective to build their own portfolios using ETFs through strategies such as replication, stratified sampling, and optimization.

Limitations of ETFs

Despite their versatility, ETFs do have some limitations. One of these is that the number of benchmark indexes far exceeds the number of ETFs, meaning not all indexes have an ETF that tracks them. However, the ETF market is continually evolving, with new ETFs being created regularly. For instance, factor-based ETFs have emerged, providing exposure to specific factors such as Size, Value, Momentum, Quality, Volatility, and Yield.

Market Share of ETFs

As of the end of 2022, ETFs accounted for only 9% of equity assets across the United States, Europe, and Asia Pacific. The market share for fixed-income ETFs is even lower. These figures include index ETFs as well as factor-based and other types of ETFs.

Choosing between ETFs and Mutual Funds

The decision between investing in a conventional open-end mutual fund and an ETF often comes down to factors such as cost and flexibility. Long-term investors may benefit from the slightly lower expense ratios of ETFs compared to equivalent mutual funds. However, the brokerage fees associated with frequent trading of ETF shares can offset the advantage of lower expense ratios, making ETFs less economical for active traders.

Practice Questions

Question 1: A portfolio manager is looking to implement an index-based equity investment strategy. They have access to the index data, trading tools, and necessary skills to replicate the strategy. They are considering different approaches to gain access to the investment strategy’s desired performance stream. Which of the following methods could the portfolio manager use to implement this strategy and gain the desired equity exposure?

1. Investing in pooled investments such as mutual funds and exchange-traded funds, derivatives-based portfolios using options, futures, and swaps contracts, and direct investment in the stocks underlying the strategy.
2. Investing only in actively managed funds.
3. Investing only in the stocks underlying the strategy.

Answer: Choice A is correct.

The portfolio manager can implement an index-based equity investment strategy and gain the desired equity exposure by investing in pooled investments such as mutual funds and exchange-traded funds, derivatives-based portfolios using options, futures, and swaps contracts, and direct investment in the stocks underlying the strategy. This approach provides the portfolio manager with a diversified exposure to the equity market, which can help to reduce risk. Mutual funds and ETFs are designed to replicate the performance of a specific index, making them suitable for an index-based strategy. Derivatives can be used to gain exposure to the equity market without having to invest directly in the underlying stocks, which can be beneficial in terms of cost and efficiency. Direct investment in the stocks underlying the strategy allows the portfolio manager to have full control over the portfolio and to adjust the holdings as necessary to match the index.

Choice B is incorrect. Investing only in actively managed funds would not be an effective way to implement an index-based equity investment strategy. Actively managed funds aim to outperform the market, not to replicate the performance of a specific index. Therefore, they may not provide the desired equity exposure. Furthermore, actively managed funds typically have higher fees than index funds or ETFs, which could reduce the net return on the investment.

Choice C is incorrect. Investing only in the stocks underlying the strategy could be a way to implement an index-based equity investment strategy, but it would not be the most efficient or cost-effective method. It would require the portfolio manager to buy and sell individual stocks to replicate the index, which could be time-consuming and costly due to transaction fees. Furthermore, it would not provide the benefits of diversification that can be achieved through pooled investments or derivatives.

Question 2: A portfolio manager is considering using futures and open-end mutual funds to transform a cash position and obtain the desired equity exposure, a process known as “equitizing”. What factor would largely determine the choice of method to use in this scenario?

1. The unique investment strategy developed by the active portfolio manager.
2. The financing costs of rolling the futures contracts over time.
3. The target beta established for the index-based investments.

Answer: Choice B is correct.

The factor that would largely determine the choice of method to use in this scenario is the financing costs of rolling the futures contracts over time. When a portfolio manager decides to equitize a cash position, they are essentially trying to gain exposure to the equity market without actually buying the underlying equities. This can be done using futures contracts or open-end mutual funds. However, futures contracts have an expiration date and need to be rolled over to maintain the equity exposure. This rollover process involves costs, including the bid-ask spread and any difference between the futures price and the spot price of the underlying asset. These costs can add up over time and can significantly impact the overall return of the portfolio. Therefore, the financing costs of rolling the futures contracts over time would be a key factor in deciding whether to use futures or mutual funds for equitizing the cash position.

Choice A is incorrect. While the unique investment strategy developed by the active portfolio manager could influence the choice of method to use, it would not be the primary determinant. The choice between futures and mutual funds for equitizing a cash position is more a matter of cost and convenience, rather than investment strategy.

Choice C is incorrect. The target beta established for the index-based investments could influence the choice of method to use, but it would not be the primary determinant. The target beta is a measure of the portfolio’s sensitivity to market movements and could be achieved using either futures or mutual funds. However, the costs associated with each method would be a more important factor in the decision.

Glossary

• Pooled investments: Investment vehicles that pool together money from multiple investors to invest in a portfolio of assets.
• Open-end mutual funds: A type of pooled investment vehicle that allows investors to buy and sell shares directly from the fund at the net asset value (NAV) price.
• Net asset value (NAV): The per-share value of a mutual fund or ETF, calculated by dividing the total value of all the securities in the portfolio by the number of fund shares outstanding.
• Index-based mutual funds: Mutual funds that aim to replicate the performance of a specific market index.
• Rebalancing: The process of realigning the weightings of a portfolio to maintain its original or desired balance of asset classes.
• Reconstitution: The process of changing the securities in a fund’s portfolio to reflect changes in the index it tracks.
• Investment Company Act of 1940: A U.S. federal law that regulates mutual funds and other companies that engage in the investment business.
• Undertakings for Collective Investment in Transferable Securities (UCITS): An agreement among countries in the European Union that governs the management and sale of collective investment funds across European borders.
• Index-based equity investment strategies: Investment strategies that aim to replicate the performance of a specific index.
• Subadviser: A professional investment manager hired to help oversee a portfolio.
• Actively managed funds: Investment funds where the portfolio manager makes specific investments with the goal of outperforming an investment benchmark index.
• Derivatives-based portfolios: Portfolios that include financial instruments like options, futures, and swaps, which derive their value from underlying assets.
• Target beta: A benchmark measure of a portfolio’s or security’s risk in relation to the market.
• Equitizing: The process of transforming a cash position into equity exposure.
• Rolling futures contracts: The process of extending the expiration or maturity of options or futures contracts by closing the initial contract and opening a new longer-term contract for the same underlying asset at the current market price.
• Multinational indexes: Indexes that track the performance of stocks across multiple countries.
• Exchange Traded Funds (ETFs): A type of investment fund and exchange-traded product, designed to track the performance of a specific index, sector, commodity, or asset class.
• Authorized Participant: A large financial institution that plays a crucial role in the creation and redemption process of ETF shares.
• Replication: A strategy used by ETFs to track a particular index by buying all the assets in that index.
• Stratified Sampling: A strategy used by ETFs to track an index by buying a representative sample of the assets in that index.
• Factor-based ETFs: ETFs that aim to outperform market-cap-weighted indexes by selecting stocks based on factors such as size, value, momentum, quality, volatility, and yield.

Portfolio Management Pathway Volume 1: Learning Module 1: Index-Based Equity Strategies; LOS 1(b): Compare different approaches to index-based equity strategies