Enhanced Indexing

Enhanced indexing (Semi active management)

Stock based:

If a manager has no opinion on a stock, he holds the same weight as in the index. (In full blown active management, no opinion results in no holding)

Higher IR.

Derivatives-based:

To gain exposure to equity: Use cash + long futures (equitized cash)

The fundamental law of active management

IR = ICsqrt(IB)

IR: Information Ratio

IC: Information Coefficient (knowledge of individual securities)

IB: Investor Breadth (number of independent investment decision)

IC: measured by comparing the forecast and outcome

Investors are more risk averse when facing active risk than total risk:

1. Need to believe there is +ve active return and can pick the right manager for +ve active return
2. Need to proof +ve alpha if really taking active risk
3. Becomes less diversified if putting most of the money in high active return managers

Target active risk and active return and use optimization process to find the best mix of equity mangers. (Assume no covariance)

Core-Satellite Approach:

Invest core portion in passive or semiactive managers

Invest the rest (Satellite) in different active managers

Completeness Fund Approach

The aggregation of several managers’ fund may not have the characteristic to match that in the index. A completeness fund can be used to make the overall risk the same as the benchmark

True Active Return = return – manager’s normal return

Misfit Active Return = manager’s normal return – benchmark return

True IR = true active return/ true active risk

Alpha and Beta Separation

Invest in large cap for Beta and then avoid market risk by doing long-short in small cap for alpha.

Can change the Beta by going to other index – portable alpha

Selecting investment managers:

1. History: consistency and good history
2. Questionnaires + interview
1. Staff and organization
2. Investment philosophy and procedures
3. Resources and research
4. Performance
5. Fee

Fees:

Ad valorem (according to the value): charged according to Asset Under

Management (AUM) .e.g 0.4% – straight forward, known ahead, not aligned with investor’s interest

Performance-based fee: base fee + alpha: aligned interest, symmetric but more complicated and hurt organization at low time

There is fee cap and high water mark also

Fee cap is to prevent manager from taking too high a risk

Top-down approach vs. bottom up approach

Sell-side analysts (available to outside, help to promote stocks) vs Buy-side analyst