Approaches to Passive Equity Investing

Pooled Investments

Pooled investments include open-end mutual funds and ETFs. Pooled investments are the most convenient approach for the average investor because they are easy to purchase, hold, and sell. 

The advantages of open-end mutual funds are the low costs and the convenience of the fund structure.

The advantages of ETFs are that they trade intraday (not just at market close each day) and they do not have to sell stocks in response to shareholder redemption requests. This eliminates taxable gains from portfolio stock sales that shareholders are exposed to with open-end mutual funds.

Disadvantages of the ETF structure include the need to buy at the offer and sell at the bid price, commission costs, and the risk of an illiquid market when the investor needs to buy or sell the actual ETF shares.

Derivatives Based Strategies

Derivatives based strategies use derivatives (options, futures and swap contracts) to recreate the risk/return performance of an index.

Derivative strategies are advantageous in that they can be low cost, easy to implement, and provide leverage. However, they also present a new set of risks, including counterparty default risk for derivatives that are not traded on exchanges or cleared through a clearing house. Derivatives can also be relatively difficult to access for individual investors.

Derivative positions used to adjust the existing portfolio risk and return exposures may be called overlay positions, reflecting that they are used to modify the underlying portfolio positions. 

Completion overlays can move the portfolio back to the risk exposure of the index, for example, by adjusting the portfolio’s beta to match the index beta. 

Rebalancing overlays can efficiently and cheaply match the reconstitution of the index as securities are added and dropped. 

Currency overlays adjust the foreign exchange risk of portfolio holdings denominated in a foreign currency.

Advantages of using equity index derivatives (options, futures, and swaps) over cash-based portfolio construction techniques are that derivatives:

  • Can be used to quickly adjust a portfolio’s factor exposures at low cost.
  • Trade in liquid markets.
  • Make it easy to leverage the portfolio.

Disadvantages include:

  • Derivative positions have finite expirations, so they must be rolled over at or near expiration.
  • Some contracts have position limits.
  • Specialty portfolio needs might not be met by the existing offerings of exchange-traded derivative contracts.
  • OTC derivatives introduce counterparty risk.
  • Basis risk can increase tracking error.

Separately Managed Portfolios

Separately managed equity index-based portfolios hold all the constituent stocks in the index or a representative sample. They require regularly updated data on the index, sophisticated trading and accounting systems; well-established broker relationships to facilitate program trading and lower trading commissions; and compliance systems to ensure compliance with laws, regulations, and internal company policies.

Building an index-based equity portfolio as a separately managed portfolio requires a certain set of capabilities and tools. An equity investor who builds an indexed portfolio will need to subscribe to certain data on the index and its constituents. The investor also requires a robust trading and accounting system to manage the portfolio, broker relationships to trade efficiently and cheaply, and compliance systems to meet applicable laws and regulations.

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