Managing index funds is not as easy as it is made out to be
There's a widely held notion that index-investing is only slightly less exciting than watching grass grow. Let's face it. Index fund managers don't get much respect. In contrast to the 'exciting' world of active management, index fund managers are perceived as a pretty boring lot who require little talent or information in running their passive fund. One index fund manager listened to a prospective investor say over the phone that 'a monkey could run that fund'.
In fact, it takes a special kind of talent to run an index fund. But the challenges and goals of index managers are radically different from those of active managers.
Managing an index fund is a basis-point game. Unlike active equity managers, who try to beat the benchmark and their peers, index fund managers try to match the returns of their benchmark index, not to outperform them. Of significantly more importance is by how many basis points (one basis point equals 0.01%) their fund underperforms or outperforms its benchmark.
This is known as tracking an error. Each basis point is critical, as it will determine the fund's correlation with its benchmark. Since the success of an index fund is measured by its correlation to the performance of the benchmark, successful index fund management requires a detail-oriented, micromanaging, perfectionist personality. Let's analyse the factors that pose a massive challenge for an index fund manager in discharging his duties effectively.
Benchmark selection: "Passive" management is in some ways a misnomer because initially an index fund manager has to make the "active" decision of benchmark selection. Benchmark selection is further complicated by the myriad choices available.
Today, stock market indices can be differentiated on the basis of market coverage, sector-focus and calculation methodology -- free-float being the new buzzword in India. Once a benchmark is selected, the next challenge for an index fund manager is to make a choice between "full-replication" and "sampling" technique to generate index returns.
Cash management: This is one of the most significant challenges confronted by index fund managers as the amount of funds kept in cash assets will not be available for generating index returns. The higher the cash assets maintained by the fund, the higher will be the tracking error. In an open-ended index fund, subscription and redemption is an ongoing activity necessitating maintenance of sufficient cash.
The amount of cash required will depend on both the size of the fund (lower the size of fund, higher is the cash required) and the average daily net cash flow resulting from the subscription and redemption activity.
In order to mitigate any detrimental tracking error resulting from holding cash assets, a fund manager is well advised to utilise the leverage available in the derivatives market.
Choice of tools: Index fund managers have three basic tools to replicate benchmarks: futures, ETFs and slices. The types and combinations of securities a manager uses may vary. Futures contracts may be used to equitise cash when there isn't sufficient cash available to buy a stock.
ETFs, like futures, are generally very liquid investments, which help provide efficient index replication without a significant cash outlay. A slice is a basket of stocks that is weighted identically to the benchmark. This is created by computer models that calculate exactly how many shares are necessary to replicate that particular index.
Re-balancing index basket: An index is frequently adjusted for activities such as additional issue of capital, mergers, spin-offs, replacement of scrips in index etc. An index fund manager has to reconcile his asset composition with the index composition virtually on a daily basis to ensure perfect congruence.
Of particular challenge is the course of action to be adopted subsequent to the announcement of a scrip replacement in the benchmark index. Any scrip replacement in the Sensex is announced six weeks in advance of the effective date.
Ideally an index fund manager would reduce tracking error by replacing stocks at the market close price on the effective date. In order to protect oneself from the price rise generally associated with the "index-effect" during the intervening six-week period, an index fund manager has to take a call on the appropriate time within this six weeks, to churn the portfolio accordingly.
I recall an index fund manager at the World Cup of Indexing Conference in Barcelona last year sharing his firm's policy of buying and selling such replacement stock three days in advance of the effective date. Finally, the exact timing at which the trades are executed becomes a valuable skill. The capital gains accruing at the time of such replacements coupled with the higher transaction cost poses another challenge. A similar challenge of timing also arises on a daily basis when the index fund manager has to time the buying and selling of index baskets depending on subscription or redemption.
Minimising tracking error: An index fund theoretically should provide the benchmark return, less the expense ratio of the fund. To illustrate, if the sensex is up 10 per cent and the fund's expense ratio is 0.50 per cent, then perfect tracking would imply an index fund return of 9.50 per cent. In reality, very few funds have been capable of performing perfectly and the tracking varies.
Apart from the given factors, one major source of tracking error is the dividend adjustment. The sensex, as it is quoted daily, is a plain vanilla index that is not adjusted for dividends.
However, in real life, an index fund manager receives dividend on the Sensex stocks held in its portfolio. Since the annual average dividend yield on Sensex stocks is around 2 per cent, an index fund manager tracking his performance vis-
