In 1989, to celebrate its 150th anniversary, Swiss watchmaker Patek Philippe created a pocket watch, Caliber 89, which to this day remains one of the most complicated portable timepieces ever made. The watch comprises 1,728 parts, including two dials, eight disks, 61 bridges, 129 jewels, 184 wheels, 332 screws, 415 pins, and 429 mechanical components; it took five years of research and development, and another four years to bring it into physical existence.1
Managing and implementing efficiently index portfolios is analogous to the level of complexity (but thankfully not the cost!) of Caliber 89: a portfolio benchmarked to an equity index could typically comprise c. 3,000 index constituents from c. 50 countries and c. 25 industries and be exposed to multiple risk premia and/or sustainable factors. Using sophisticated systems and processes, each index constituent has to be analyzed carefully and index changes have to be implemented optimally as they occur; a process, involving timely, detailed, precise and pragmatic consideration of liquidity, turnover, cost, corporate events and valuation metrics.
Trading for index changes: the ‘mainspring’ in the index portfolio management process
Trading for index changes: the ‘mainspring’ in the index portfolio management process
Our experience over many years is that when stocks are added to or deleted from major indices, prices can be distorted by market trading at the impact point due to aggregate market demand. Thus, adjusting the timing of purchases and sales by a short period in a risk controlled manner can often add value without significant risk to the performance of the portfolio. These small but incrementally significant gains could be a major source of added value for index equity strategies. Attention to detail of stock price formation patterns could allow index clients to capture added-value from pricing inefficiencies at the impact point of index changes with minimal impact on tracking accuracy. The degree of value that could be added depends on a number of aspects, including the amount of assets tracking particular index, the size of basket of additions/deletions, liquidity, stock specific events, accuracy of predictions, and so on.
Corporate events: the ‘wheels’ that make the index tick
Corporate events: the ‘wheels’ that make the index tick
Specific rules apply to corporate actions treatment in different index types, for example between market capitalization weighted and non-market capitalization weighted (for example factor indices, sustainable indices, etc.) indices. When corporate actions affecting index constituents are announced, we have to decide how to trade and implement them in our clients' portfolios.
Due to the nuances and intricacies, often the treatment of the same stock impacted by the same event would differ between our market cap and non-market cap portfolios. Corporate activity in market cap indices is largely self-rebalancing. This might not be the case with non-market cap indices. The main difference in the treatment between market cap and non-market cap indices is in the case of corporate events such as spin-offs, mergers, takeovers and rights issues. While these events require little or no actions in market cap weighted indices, they may result in far more significant trading in risk premia factor and sustainable indices. When events are treated on a ‘case-by-case’ basis, we analyze carefully the treatment of the event in question in different indices, and, if necessary, we seek further clarity from the index providers, in order to determine our trading and implementation strategy for our clients' portfolios.
Valuation metrics: the ‘hands’ of the index ‘clock’ measuring the spirit of time
Valuation metrics: the ‘hands’ of the index ‘clock’ measuring the spirit of time
Similar to the way active equity portfolio manager review stocks’ valuation metrics, as part of our index analysis we examine a range of fundamental valuation metrics indices, especially on non-market cap weighted indices such as factor indices, and compare these to the valuation levels of market cap indices. Such analysis provides us with an indication of the valuation levels of factors indices, relative to their long-term historic trading levels and to the underlying market cap index.
In Exhibit 1 we show the valuation levels of different factor indices capturing some of the key equity return factors, namely value, size, low volatility, quality. It is hard to accurately time entry and exit points into a particular factor strategy, and we would not suggest using index valuation levels as a tool to ‘time’ entry and exit points, but as a broad indication and a ‘common sense’ check of the trading levels of alternative beta indices. If we observe that certain indices trade outside their long-term historic levels we investigate the causes of the valuation patterns.
For example, if a factor index trades at high multiples you could conclude stocks capturing this factor are overvalued. But further valuation analysis of the index might reveal a different story: some alternative indices tend to be more concentrated, consequently addition/deletion or large weight change of just several major index constituents could impact the overall index valuation metrics. However, this does not necessarily mean that all stocks capturing the factor in question are overvalued.
Exhibit 1: Factor indices relative valuation vs. market
Implementing index portfolios efficiently: staying ahead of time
Implementing index portfolios efficiently: staying ahead of time
In summary, index portfolio implementation is an elaborate process requiring skill and dedication, just like Swiss watchmaking. Our approach involves in-depth, timely and precise analysis of index changes, liquidity, turnover, cost, corporate events and valuation metrics – but with experience and expertise these processes can run like clockwork.
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