From the strategist - 2007



rebalancing funds under management

Something happens to the ASX200 and SPI200 at 11:00 am, 2:20 pm, and 2:30 pm. The SPI often achieves (or re-achieves) its high (or low) at these times. Usually seen as an upsurge in BHP transactions. During daylight saving the Nikkei opens at 11:00am and 2:30pm. However the surges still occur at these times during non-daylight saving.

About $5 billion is done on the ASX each day. While some can be attributed to fund managers rebalancing index funds, most is proprietary-trading by prime-brokers and their associated hedge-funds. Highly leveraged complex derivative combinations, are constantly "rebalanced" in the same way as "index funds". As discussed below, the SPI200 can be used as insurance, or hedge, or cost effective means of re-balancing a portfolio.

During the 1990's a colleague operated a substantial bonds and bills "book". Due to its size, it was kept hedged (insured) at all times. The "hedge" was re-balanced every hour on the hour.


portfolio rebalance

To the strategist.
I need to pick your brain re Index Funds
I have a general idea what they are and how they work. What I would like to find out is how they are managed. How and when are funds re-indexed or re-balanced. Is it done intra-day, twice daily, daily, weekly, when?. Do you have any info on this side of the industry. Any links you can direct me to?. I want to prepare a paper explaining how its done, and when, and the implications for the ASX200.

Generally 80% of ALL managed funds are indexed funds. Trustees outsource the daily management to a Fund Manager.

A single fund manager can represent (manage) 30+ funds (portfolios). Fund managers use a model which the TRUSTEES of the funds rely on in selecting a manager. Models are revised quarterly. Portfolios must adhere to the model. A model may include BHP as 20% of the model. If the price of BHP rises, and becomes 25% of the portfolio, the manager has to sell BHP and buy stocks in the model which have become under-weight as a result of BHP becoming over-weight. The question is how and when they do it.


index funds

4 Types

From the strategist.
Full Replication - purchase all securities comprising the given index in the same proportion as that used in the calculation of the index. This is harder than you think as some stocks (even in the ASX200) are illiquid so its expensive in terms of time and costs (both commission and cost of opportunity as you tend to move prices as you try to "get in"). State Street ETF (Code STW) uses this method. It will only rebalance when a stock comes in or out of the index. (http://www.streettracks.com.au/)

Partial Replication - tries to stratify the index into factors such as industry group, yield and beta size. This method is a compromise between illiquidity constraints and tracking error. Usually used for Fixed Income

Optimised Sampling - determines the optimal portfolio by specifying a trade-off between the transaction costs of revising an existing portfolio and the expected tracking error.You use quantities techniques to work out the optimum sample of stocks and quantities to give you the required tracking error. Vanguard Index funds use this method for equities
Vanguard's site says: (http://www.vanguard.com.au/Financial_Advisers/FATopNav/FAQ/index.aspx) Optimisation-based processes seek to determine the appropriate number of securities to hold to deliver the full market return while taking into account the structure of the index (distribution of marketcap weight; which markets; the number of securities), and the nature (the size and frequency) of portfolio capital flow activity. Enhanced indexing is really low-risk active management. A better way to describe it is as structured quantitative processes designed to capture a factor, or characteristic, the portfolio manager believes will outperform over time. These processes still run the risk of underperforming their benchmark and shouldn't be considered as an "index plus" strategy.

Enhanced indexing processes may also have reduced after-tax returns compared with an optimised approach, simply because of increased portfolio activity. Enhanced indexing turnover averages around 20% to 50% pa compared to typical benchmark turnover of 5 to 10%. Vanguard's funds' average turnover is currently around 2 to 5%. This is due to the reduced number of securities held and positive cashflow, which avoid the need for the fund to sell existing assets to acquire new index assets. So Optimised Sampling has low turnover Ref: http://www.ifa.com/Library/Support/Articles/Popular/StudyConfirmsValueOfIndexing.asp

Thanks for that. So if a Fund Manager uses a particular "model" which I understand from past discussions, may or may not be revised on a quarterly basis (if necessary) then if BHP, in the model, is included at (say) 20% of the portfolio, then if on any one day BHP shoots to 30% of the portfolio, dont they have to re-balance? So the question is are they re-balancing dynamically, weekly, monthly, or quarterly.

From the strategist.
I had a quick look but could not find the mandate specifications for StateStreets. Regular re-balancing affects a fund's performance via transaction costs - even an active manager - so I suspect Index funds also use a Tactical Asset Allocation Overlay (TAA) - that is they use derivatives to readjust their position back to the benchmark (model) - easy for an index fund - they just use the SPI200. The question then is when do they use the TAA - I am having lunch with a guy who might know so I'll ask him. With any fund there is a tolerance band around the benchmarks - even with an index fund - so that you don't have to worry about "noise" movements. There is a view that index managers actually make a profit in excess of the market return due to (a) timing [i.e not chasing the noise] (b) overweight / under weight stocks by not re-balancing each day (or week), so at the end of the year they only pay a return equal to the Index - they keep the rest !!!. This view is certainly discussed on US sites such as dealmaker.com and abnormalreturns.com.

So far, this appears to suggest "fund managers" use the future as an emergency holding tank, buying and selling the future as the market fluctuates. At the end of a period they re-balance according to the net balance in the tank, by unwinding the futures positions. If the futures account is net-short, sell the physical, buy the future. If net-long, sell the future, buy the physical. ie arbitraging.

Traditional funds are rebalanced daily, but only priced once a day
Current trends are seeking to re-balance more frequently
Many US fund managers are patenting their rebalancing systems