Pooled Investments

Pooled investments encompass mutual funds and ETFs, topics extensively covered in other parts of the curriculum. Both open-ended and closed mutual funds, along with ETFs, provide various avenues for mirroring index performance.

Derivatives-based Strategies

Derivatives, such as futures, forwards, options, and swap contracts, can be used to tailor portfolio exposure. For instance, using options contracts on the S&P 500 index allows altering portfolio beta through call options.

Derivatives can stand alone in a portfolio or complement underlying equity holdings as overlays. Different types of overlays include:

• Completion overlay: Adjusts a portfolio back to its original index exposure.
• Rebalancing overlay: Adapts a portfolio after changes in index composition, like new stocks added to the S&P 500.
• Currency overlay: Tweaks foreign currency exposure in a portfolio.

Derivatives' advantages comprise:

• Liquidity in markets allows swift, cost-effective exposure adjustment.
• Facilitates easy portfolio leverage adjustments.

Disadvantages encompass:

• Rolling positions required due to expiration.
• Potential limits on positions or daily movement.
• Exchange-traded options might not align with specific portfolio requirements.
• Counterparty risk possibility.
• Tracking error.

Separately Managed Equity Index-based Portfolios

These portfolios contain all or a representative sample of the stocks in an index. While this replicates index performance, it requires expertise and technology for efficiency. This involves trading systems, broker relationships, accounting, and compliance staff. Hence, it suits managers with existing financial services.

Question

Which of the following is not a disadvantage of using derivatives to gain passive equity exposure?

1. Position expirations.
2. Market liquidity.
3. Tracking error.

Solution

The correct answer is B.

Market liquidity is not a disadvantage of using derivatives to gain passive equity exposure. In fact, derivatives markets, especially those related to major equity indices, are often highly liquid. Liquidity is the ease with which an asset can be bought or sold without significantly affecting its price. Liquid markets generally have tight bid-ask spreads and a high volume of trading activity, making it easy for investors to enter and exit positions in derivatives without incurring substantial transaction costs.

A is incorrect. Derivatives contracts often have expiration dates, and this can be considered a disadvantage if not managed properly. When a derivative contract expires, you may need to roll over your position by entering into a new contract, which can incur additional transaction costs. However, position expirations are a common feature of derivatives trading, and experienced investors typically plan for these expirations.

C is incorrect. Tracking error is the difference between the performance of a derivative-based investment (e.g., an ETF or index fund) and the performance of the underlying index it aims to replicate. A low tracking error is generally a desirable feature, indicating that the investment closely tracks the index. While derivatives can introduce some tracking error due to factors like dividend adjustments and interest rate changes, this is not a unique disadvantage of using derivatives. Other passive equity exposure methods, such as traditional index funds or ETFs, can also experience tracking error.

Reading 24: Passive Equity Investing

Los 24 (c) Compare different approaches to passive equity investing