Financial Market Investing.

Investing in the financial market is a complex process that requires a deep understanding of various factors that influence the performance of a portfolio. One such factor is the concept of index-based portfolios. Initially, these portfolios were designed to mirror the performance of the market. Some investors, without any critical evaluation, accept the returns of these portfolios.

Attribution Analysis

Attribution analysis is a sophisticated technique employed by investors to gain a deeper understanding of their investment portfolio’s performance. This method involves breaking down asset classes into smaller categories, such as stocks, bonds, and other assets. These categories are then further divided based on specific criteria like countries, market-cap sizes, investment styles, and weighting methods. For instance, the return on an indexed portfolio can be derived from any of these criteria. To illustrate, consider a global investment portfolio. The attribution analysis would involve breaking down the portfolio into asset classes like equities, bonds, and commodities. These would then be further divided based on the countries they are invested in, their market capitalization, and other factors.

Ex-Post Return Analysis and Sources

Return analyses are typically conducted ex-post, meaning the returns of the portfolio are studied after they have been experienced. The sources of return for an equity index replication portfolio are the same as for any actively managed fund and include company-specific returns, sector returns, country returns, and currency returns. For example, if a portfolio manager invested in Apple Inc., the return from this investment would be a combination of the company-specific return (how well Apple Inc. performed), the sector return (how well the technology sector performed), the country return (how well the US market performed), and the currency return (how the USD performed against the investor’s home currency).

Alternative Grouping Methods for Indexed Portfolios

Beyond the traditional methods of grouping the risk and returns of the indexed portfolio, portfolio managers can group their indexed portfolios according to the stated portfolio objective. For instance, a high dividend yield indexed portfolio may be grouped against the broad market benchmark by dividend yield. Similarly, a low volatility portfolio could be grouped by volatility buckets to show how the lowest volatility stocks performed in the indexed portfolio as well as the broad market. This means that if a portfolio manager has a portfolio focused on high dividend yield stocks, they could compare the performance of their portfolio against a broad market index like the S&P 500 based on the dividend yield of the stocks in the portfolio.

Role of Portfolio Attribution System for Index Fund Managers

Most portfolio managers rely on their portfolio attribution system to help them understand the sources of return. Index fund managers who track a broad market index need to understand what factors are driving the returns of that portfolio and its underlying index. Index fund managers of factor-based strategies should understand both the sources of return for their indexed portfolios and how those returns relate to the broad market index from which the constituents were chosen. In this way, factor-based strategies are similar to actively managed funds in the sense that they are actively chosen. For example, a portfolio manager who manages a value-based index fund would need to understand how the returns of their fund are related to the returns of the broad market index and how the returns of the individual stocks in their fund contribute to the overall return.

Securities lending

Securities lending is a common practice in the financial world where investors who hold long equity positions lend their shares to investors who wish to sell short. This process can generate additional income for the long portfolio managers, which can enhance portfolio returns or offset management costs. In some cases, such as low-cost indexed portfolios, securities lending income can even result in net expenses becoming negative, leading to returns exceeding the benchmark index.

Securities Lending: Utilizing Lending Agents

Investors who wish to lend securities often employ a lending agent. Institutional investors, such as mutual funds, pension funds, and hedge funds, frequently use their custodian, typically a custody bank, for this purpose. Sometimes, the asset management firm itself offers securities lending services. Two legal documents are usually established: a securities lending authorization agreement between the lender and the agent, and a master securities lending agreement between the agent and borrowers.

Roles and Processes in Securities Lending

The lending agent identifies a borrower who posts collateral, usually 102–105% of the value of the securities. If the collateral is in securities form, the lending agent holds them as a guarantee.

• The lending agent evaluates the collateral daily to ensure sufficiency.
• If the collateral is cash, the lending agent invests it in money market instruments and earns interest income.
• In this case, the borrower may receive a rebate that partially offsets its lost interest income.
• Regardless, the borrower pays a fee to the lender when borrowing the securities.
• The lender typically shares a portion of this fee with the lending agent.

Risks and Considerations in Securities Lending

Securities lending carries risks that can offset the benefits. The main risks are the credit quality of the borrower (credit risk) and the value of the posted collateral (market risk). Additional considerations include liquidity risk and operational risk. Lenders can sell loaned securities at any time under the normal course of the portfolio management mandate, and the borrowed shares must be returned in time for normal settlement of that sale. However, there is no guarantee that the borrower can deliver on a timely basis. If a lender chooses to invest cash held as collateral in long-term or risky securities, the collateral value is at risk of erosion. As long as the cash is invested in low-risk securities, risk is kept low.

Roles and Costs for Borrowers in Securities Lending

Borrowers take formal legal title to the securities, receive all cash flows and voting rights, and pay an annualized cost of borrowing, typically 2–10%. The borrowing cost depends on the borrower’s credit quality and the difficulty of borrowing the security in question. Some securities are widely recognized as “easy to borrow” (ETB).

Securities Lending Impact on Investment

Let’s consider an example to illustrate how securities lending revenue can benefit investment beneficiaries. Take the iShares Russell 2000 ETF (IWM). As of 31 March 2021, IWM had lent USD5.97 billion in securities to various counterparties, 100% collateralized with cash. The securities lending agent, BlackRock Institutional Trust Company, received 4 basis points of collateral investment fees annually. IWM’s net securities lending income for the year was slightly above USD63 million, which nearly offset the approximately USD90.7 million in investment advisory fees charged by the portfolio managers.

Investor Activism and Engagement by Index-Based Fund

Investor activism and engagement by index-based funds is a significant aspect of the financial market. It involves the active participation of investors in the management and decision-making processes of the companies they invest in. This is done with the aim of influencing the company’s policies, corporate governance, or operations for the betterment of the company and, ultimately, the return on investment. This concept is crucial in understanding the dynamics of the financial market and the role of investors in shaping the direction of the companies they invest in.

Key Aspects of Investor Activism

Investor activism is a proactive approach where investors use their equity stakes in a company to influence its management and operations. For instance, a real-world example could be the case of Carl Icahn, a renowned activist investor, who has used his significant holdings in companies like Apple and eBay to push for changes in their corporate strategies.

Investor activism is often carried out by large institutional investors, such as index-based funds, who have significant holdings in a company. These investors have the financial clout and influence to effect changes in the companies they invest in.

Investor activism can take various forms, including proxy fights, shareholder proposals, and negotiations with management. For example, in a proxy fight, an investor may try to convince other shareholders to vote against a proposed action by the company’s management.

The ultimate goal of investor activism is to improve corporate performance and increase shareholder value. This is achieved by advocating for changes that will enhance the company’s profitability and growth prospects.

Engagement by Index-Based Funds

Index-based funds, such as exchange-traded funds (ETFs) and index mutual funds, are significant players in investor activism. These funds typically hold a broad range of securities, giving them substantial influence over the companies in their portfolios. For example, BlackRock, the world’s largest asset manager, has been known to use its influence to push for changes in the companies it invests in.

Engagement by index-based funds can involve voting on shareholder proposals, engaging in dialogue with management, and advocating for changes in corporate governance or business practices. This active engagement can lead to improved corporate performance and higher returns for the fund’s investors.

Such engagement can lead to improved corporate performance and higher returns for the fund’s investors. This is because the changes advocated by these funds are often aimed at enhancing the company’s long-term growth prospects.

Institutional Investors and Corporate Influence

Institutional investors, such as index fund managers, often hold significant shares in numerous companies. Their voting shares can have a substantial impact on corporate elections and the outcomes of the proxy process. As large shareholders, these investors often have the privilege of private meetings with corporate management to discuss their concerns and preferences regarding various corporate policies. These policies may include board structure and composition, management compensation, operational risk management, the integrity of accounting statements, and other matters. For instance, BlackRock, a global investment management corporation, is known to be a significant shareholder in many companies and has a significant influence on corporate policies.

Expanded Scope of Investor Engagement

Over the years, the scope of investor engagement has broadened, covering more topics that are not principally financial. Governance policies, executive compensation, and social, environmental, and strategy issues are now dominant. Institutional investors, who are required to act in a fiduciary capacity, have a key responsibility to carry out their duties as voting shareholders. For example, Vanguard, a well-known institutional investor, has been actively involved in promoting good governance policies and executive compensation practices.

Activism in Corporate Governance

Many hedge funds and other large investors specialize in activism to align governance in their invested companies with shareholder interests. Activist investors are usually associated with active portfolio management. If their activism efforts do not produce the desired result, they can express their dissatisfaction by selling their shares. For instance, Pershing Square Capital Management, a hedge fund led by Bill Ackman, is known for its activist approach in companies like Chipotle and Starbucks.

Role of Index-Based Investors in Corporate Governance

Index-based investors, on the other hand, do not have the same flexibility to sell. However, both types of investors usually have the opportunity to vote their shares and participate in governance improvements. Corporate governance improvements aim to improve the effectiveness of the operations, management, and board oversight of the business. If these improvements result in higher returns to index-constituent stocks, the index performance rises, and so does the performance of an index-tracking portfolio. For example, the S&P 500 index performance is directly influenced by the governance improvements in its constituent companies.

• Index-based investors may even have a higher duty than more-transient active managers to use their influence to improve governance. As long as a stock has membership in the benchmark index, index-based managers can be considered permanent shareholders.
• Such investors might benefit from engaging with company management and boards, even outside the usual proxy season. For instance, BlackRock, as a significant index-based investor, often engages with company management to improve governance.

Most index-based managers have a fiduciary duty to their clients that includes the obligation to vote proxy ballots on behalf of investors. Although shareholder return can be enhanced by engagement, the costs of these measures must also be considered. These costs include staff resources required to become familiar with key issues and to engage management, regulators, and other investors.

Researching and voting thousands of proxy ballots becomes problematic for many managers. They frequently hire a proxy voting service, such as Institutional Shareholder Services or Broadridge Financial Services, to achieve their goal of voting the proxy ballots in their clients’ favor.

Potential conflicts of interest may limit investors’ propensity to challenge company management. For instance, a large financial firm that earns substantial fees from its business of administering corporate retirement plans, including the pension plan of a company whose stock is one of many index constituents, may have incentives structured to support that company’s management on any controversial issue.

Management of the company targeted by activist investors is likely to see active portfolio managers as skillful and willing users of the proxy process to effect changes and accordingly will respond seriously. In contrast, index-based investors hold the company’s shares to fulfill their tracking mandate (without the flexibility to sell or take a short position), so management may take these investors’ activist activities less seriously.

Practice Questions

Question 1: An investor has been passively managing his index-based portfolio, accepting the returns without any critical evaluation. Recently, he has noticed a significant difference in the performance of his portfolio compared to the market benchmark. To understand the reasons behind this difference and make informed decisions about his investments, he decides to use a specific method. What method is the investor likely to use to understand the sources of return in his portfolio?

1. Market trend analysis
2. Attribution analysis
3. Financial statement analysis

Answer: Choice B is correct.

The investor is likely to use Attribution Analysis to understand the sources of return in his portfolio. Attribution analysis is a quantitative method for analyzing a fund manager’s performance based on investment style, stock selection, and market timing. It breaks down the performance results to explain the impact of the manager’s investment decisions. This method helps to identify the sources of return in a portfolio and understand whether the portfolio’s performance is due to the manager’s skill or luck. It can also help to identify the strengths and weaknesses of the portfolio’s strategy and make informed decisions about future investments. Attribution analysis is particularly useful for passively managed portfolios, where the goal is to replicate the performance of a benchmark index. If the portfolio’s performance deviates significantly from the benchmark, attribution analysis can help to identify the reasons for this difference.

Choice A is incorrect. Market trend analysis is a method of technical analysis that involves studying past market data to identify potential trends and patterns. While it can be useful for making investment decisions, it does not specifically help to identify the sources of return in a portfolio.

Choice C is incorrect. Financial statement analysis involves analyzing a company’s financial statements to assess its financial health and make investment decisions. While it can provide valuable insights into a company’s performance, it does not specifically help to identify the sources of return in a portfolio.

Question 2: A portfolio manager is keen on understanding the effectiveness of her investment strategies. She wants to identify the components contributing to the performance difference between her portfolio and the benchmark. What method should the portfolio manager use to break down the performance difference into components and understand the sources of return?

1. Quantitative analysis
2. Attribution analysis
3. Risk analysis

Answer: Choice B is correct.

Attribution analysis is the method that the portfolio manager should use to break down the performance difference into components and understand the sources of return. Attribution analysis is a quantitative method for analyzing a fund manager’s performance based on investment style, stock selection, and market timing. It helps to identify the sources of return in a portfolio and the manager’s skill in selecting securities and sectors. It breaks down the difference in returns between the portfolio and the benchmark into components such as sector allocation, security selection, and interaction effect. This analysis can provide valuable insights into the effectiveness of the manager’s investment strategies and help in making necessary adjustments to improve the portfolio’s performance. Attribution analysis is a critical tool for portfolio managers, investors, and analysts as it provides a deeper understanding of the drivers of portfolio performance.

Choice A is incorrect. Quantitative analysis is a broad term that refers to the use of mathematical and statistical methods to evaluate investment or business opportunities and make decisions. While it can be used in the process of attribution analysis, it is not the specific method used to break down the performance difference into components and understand the sources of return.

Choice C is incorrect. Risk analysis is the process of identifying and assessing potential losses related to strategies, actions, and operations. It is a part of the overall risk management process and is used to make decisions about whether certain risks need to be mitigated, transferred, or accepted. While risk analysis is important in portfolio management, it does not specifically break down the performance difference into components and understand the sources of return.

Glossary:

• Index-based portfolios: Portfolios designed to match or track the components of a market index.
• Attribution analysis: Identifying reasons for the difference in performance between a portfolio and its benchmark.
• Benchmark: A standard for measuring the performance of investments.
• Securities lending: Loaning stocks or other securities to investors or firms.
• Ex-post: Analysis or measurement based on actual results.
• Equity index replication portfolio: Aims to mimic the performance of a specified equity index.
• Factor-based strategies: Selecting securities for higher returns based on specific attributes.
• Long equity positions: Buying securities with the expectation of a price increase.
• Short selling: Selling borrowed securities, hoping to buy them back at a lower price.
• Custodian: Institutions that hold securities for safekeeping.
• Collateral: Assets pledged as security for loan repayment.
• Credit risk: The risk of a borrower’s failure to make required payments.
• Market risk: The risk of loss due to movements in market prices.
• Liquidity risk: The risk of being unable to convert assets to cash quickly.
• Operational risk: Risk of loss from failed internal processes, people, and systems.

Portfolio Management Pathway Volume 1: Learning Module 1: Index-Based Equity Strategies; LOS 1(f): Explain sources of return and risk to an index-based equity portfolio