Index-Based Equity Strategies

Index funds now hold a large share of listed equities, and running one well is a craft: the manager must pick a sensible index, decide how fully to replicate it, keep costs and tracking error low, and earn what it can from securities lending without taking hidden risks. This module covers index design and weighting, replication methods and vehicles, the causes and control of tracking error, and the sources of return and risk in a passive equity portfolio.

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What you will learn

1. Compare market-capitalization weighting with price, equal, fundamental and factor-based weighting, and explain how capping, rebalancing and reconstitution rules shape an index.

Float-adjusted cap weighting is self-rebalancing, has low turnover and high capacity, but concentrates in the largest stocks.
Price weighting lets high-priced shares dominate; equal weighting tilts to small caps and needs regular, contrarian rebalancing.
Fundamental weighting tilts to value; factor indexes target value, size, momentum, quality or low volatility.
Any non-cap-weighted index carries active risk relative to the cap-weighted market and can underperform for long periods.
Capping, buffering and reconstitution rules change both the index's risk and the trading its trackers must do.

2. Contrast full replication, stratified sampling and optimization for building an index portfolio, and compare pooled funds, separate accounts, futures and swaps as ways to obtain index exposure.

Full replication: lowest tracking error, best for indexes with relatively few liquid constituents.
Stratified sampling: match cell weights (country, sector, size, style) with a few stocks per cell; no risk model needed.
Optimization: minimize expected tracking error with a factor risk model under constraints; exposed to model error and needs re-optimization.
Blended: replicate the liquid core, sample or optimize the illiquid tail.
Futures are cheap and liquid but need rolling and margin; total return swaps add counterparty risk; ETFs isolate trading costs through in-kind flows.

3. Explain the sources of tracking error and tracking difference in an index portfolio and the techniques used to keep them small.

Tracking difference = cumulative return gap (mostly costs); tracking error = annualized standard deviation of active returns (unpredictability).
Causes: fees, trading costs, cash drag, sampling, timing and tax differences, and untradeable constituents.
Cash drag is roughly cash weight x (index return - cash return).
Trade index changes at the close on the effective date and equitize cash with futures to control tracking error.
Trading ahead of an index change can lower cost but adds tracking risk: a deliberate trade-off.

4. Identify the sources of return and risk in an index-based equity portfolio, including securities lending, stewardship and the attribution of tracking difference.

Index fund return = index return - fees - trading costs - cash drag + securities lending income +/- sampling residual.
Non-cash collateral: income = value on loan x lending fee; cash collateral: income = collateral x (reinvestment rate - rebate rate).
Lending risks: borrower default, collateral reinvestment and operational risk; loaned shares cannot be voted until recalled.
Index-design risks such as concentration are borne in full by the passive investor.
Index managers cannot sell, so engagement and proxy voting are their stewardship tools.

Module at a glance

Cap weighting is self-rebalancing and high-capacity but concentrated; equal, fundamental and factor weightings need rebalancing and carry active risk against the market.
Full replication suits few, liquid constituents; stratified sampling matches cell weights; optimization minimizes expected tracking error with a risk model.
Tracking difference is the average return gap (mostly costs); tracking error is its annualized volatility.
Cash drag is about cash weight x (index return - cash return); equitize cash with N = (beta_T / beta_f) x V / (F x multiplier).
Trade index changes at the effective-date close; trading early lowers impact but adds tracking risk.
Securities lending income offsets costs, but cash collateral brings reinvestment risk and loaned shares cannot be voted.
Passive managers cannot sell, so stewardship works through engagement and proxy voting.

This free module has 4 lessons, 16 practice questions with full explanations and 1 essay case with a model answer.

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