ETFWorld.co.uk

Interview with Mark Stephenson, Senior Portfolio Manager in BGI’s index equity team

CALCOLATRICE1

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
Regulatory Information

Barclays Global Investors Limited (‘BGIL’), which is authorised and regulated by the Financial Services Authority (‘FSA’) and is regulated by the Dubai Financial Services Authority (‘DFSA’), has issued this document for access by Professional Clients in Austria, France, Germany, Italy, Luxembourg, Switzerland, the Dubai International Financial Centre (DIFC), the Netherlands and the UK only and no other person should rely upon the information contained within it. iShares plc, iShares II plc and iShares III plc (together ‘the Companies’) are open-ended investment companies with variable capital having segregated liability between their funds organised under the laws of Ireland and authorised by the Financial Regulator.

Restricted Investors
This document is not, and under no circumstances is to be construed as, an advertisement, or any other step in furtherance of a public offering of shares in the United States or Canada. This document is not aimed at persons who are resident in the United States, Canada or any province or territory thereof, where the Companies are not authorised or registered for distribution and where no prospectus for the Companies has been filed with any securities
commission or regulatory authority. The Companies may not be acquired or owned by, or acquired with the assets of, an ERISA Plan.

Risk Warnings
Shares in the Companies may or may not be suitable for all investors. Barclays Global Investors Limited does not guarantee the performance of the shares or funds. The price of the investments (which may trade in limited markets) may go up or down and the investor may not get back the amount invested. Your income is not fixed and may fluctuate. Past performance is not a reliable indicator of future results. The value of the investment involving exposure to foreign currencies can be affected by exchange rate movements. We remind you that the levels and bases of, and reliefs from, taxation can change.
Affiliated companies of Barclays Global Investors Limited may make markets in the securities mentioned in this document. Further, Barclays Global Investors Limited and/or its affiliated companies and/or their employees from time to time may hold shares or holdings in the underlying shares of, or options on, any security included in this document and may as principal or agent buy or sell securities.

Index Disclaimers
‘Dow Jones’, ‘STOXX’, ‘Dow Jones EURO STOXX ® 50 Index’ are proprietary and copyrighted material and trade marks and/or service marks of Dow Jones & Company, Inc. and/or STOXX Limited and have been licensed for use for certain purposes by Barclays Global Investors Limited and iShares II plc. iShares DJ Euro STOXX 50 is not sponsored, endorsed, sold or promoted by Dow Jones or STOXX, and neither Dow Jones nor STOXX makes any
representation regarding the advisability of investing in such a fund. ‘FTSE®’ is a trade mark jointly owned by the London Stock Exchange plc and the Financial Times Limited (the ‘FT’) and is used by FTSE International Limited (‘FTSE’) under licence. The FTSE 100 Index is calculated by or on behalf of FTSE International Limited (‘FTSE’). None of the Exchange, the FT nor FTSE sponsors, endorses or promotes iShares FTSE 100 nor is in any way connected to the fund or accepts any liability in relation to its issue, operation and trading. All copyright and database rights within the index values and constituent list vest in FTSE. Barclays Global Investors has obtained full licence from FTSE to use such copyright and database rights in the creation of this product. iShares’ is a registered trademark of Barclays Global Investors, N.A. All other trademarks, servicemarks or registered trademarks are the property of their respective owners. © 2009 Barclays Global Investors Limited. Registered Company No. 00796793. All rights reserved. Calls may be monitored or recorded.

Source: ETFWorld – BGI

 

 

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