Mark Stephenson, Senior Portfolio Manager in BGI’s index equity team, explains the differences in fully replicating and optimised ETFs as well as the risk model used. …
For professional investors only
1. iShares uses both full replication and optimisation techniques to manage the equity funds – can you briefly explain the different techniques and when you would use optimisation or sampling in a fund?
On the one hand full replication or simply replication describes tracking the performance of an index by buying all index securities in exactly the same weight as the index. That also means that we rebalance the portfolio whenever the index rebalances and mirror other index changes, such as corporate actions. This approach is typically used for indices with liquid constituents, for small indices and whenever we have sufficient assets under management to fully replicate.
Classical examples for this type of index tracking are the iShares FTSE 100 and the iShares DJ Euro STOXX 50.
Alternatively we have the option to optimise the ETF portfolio to track an index which is too broad to fully replicate with the given assets under management or the index includes illiquid securities. Often full replication of these types of indices would be very costly or simply not possible (because of restricted access to securities for example in some emerging markets).
So we use an approach described as optimisation (or sampling), where we only hold a representative subset of index securities. A good example for this approach is the iShares MSCI World, which tracks an index of more than 1600 stocks.
2. Can you explain optimisation in more detail and the impact it may have on a fund?
At BGI we currently use the MSCI Barra optimisation system. The system is an integrated suite of equity investment analytics modules designed to manage equity risk and also enables the construction of optimised portfolios. A typical optimisation will include constraints such as a limit on the number of stocks in the portfolio or a minimum threshold size to avoid small uneconomic trades. The optimiser will also take into account a number of other in-built risk factors such as size, liquidity and volatility. Different portfolio managers will have different goals which dictate the shape of the final portfolio given the expected level of net return and risk. The basic aim of an indexed ETF is to minimise the overall risk relative to a particular benchmark.
Optimised portfolios generally have a higher expected tracking error than a replicating fund. For example the MSCI World had an expected tracking error (also called ex ante) of 47 basis points. The realised (also called ex post) tracking difference achieved over the 12 months to 31 August 2009 was +63 basis points.
3. This sounds a lot like active management – can you explain why this is still indexing?
I can see it sounds like active management if we outperform the index after costs. However it is not. The ex-ante tracking error measures the expected return difference over the next year with a 68% level of confidence. Active approaches generate active returns or “alpha” by having greater deviations away from the benchmark than a passive portfolio.
Passive approaches have an expected portfolio return equal to the benchmark’s expected return (beta) with an expected active return at or close to zero. For iShares our primary objective is to find a balance between tracking error and costs that is most beneficial for the investor.
The ex ante (expected) tracking error should not be confused with the ex post (realised) tracking error. Expected tracking error figures also do not take into account costs associated with index rebalancing, annual fees, withholding taxes, smart trading or securities lending. All of these factors combined would have attributed to the performance of the MSCI World fund over the period.
For professional investors only
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Source: ETFWorld – BGI