ASSET MANAGEMENT DEPARTMENT

Equity Indexing Framework

14/08/2007

BECHARA M BARDAWIL, CFA – Senior Portfolio Manager, Asset Management

Objective

The purpose of this document is to set the framework for an

equity indexing methodology, which would be used in developing
the required procedures for the creation and management of
equity index funds.

The document will include a description of existing indexing

techniques and the appropriateness of each, as well as an
examination of the various constraints and considerations
relevant to the equity index replication process.

Purpose of Equity Indexing

Equity indexing refers to a low-cost mechanical investment

process designed to gain exposure to either the broad equity
market, or a segment characterized by country, region, market
capitalization, sector or some other characteristic like style
(growth/value stocks).
In practical terms, an index fund is created by replicating a
benchmark or index relevant to the target market or subset.

Equity Benchmarks (Indices)

An index is designed to be as representative as possible, and

virtually any equity index can be replicated with varying difficulty
depending on the investability and liquidity of the stocks
comprising the benchmark.

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Equity indices are made more relevant, and replicable, if adjusted

for Free Float. This is particularly true for emerging markets
where many firms have a large portion of their shares held as
controlling interest by a few large entities (governments, founding
families) etc.. This greatly reduces the number of outstanding
shares that can actually be traded and/or increases the cost of
acquiring the required number of shares.

While weighted according to market capitalization, most

international equity indices adjust for float. The lower the float,
the lower the weight of the respective company within the index.
To that end, companies included in such investable indices are
required to disclose free float figures regularly, otherwise they
would be dropped from the index. Examples of such indices
include S&P Emerging Markets indices and the CASE 30 index,
among others.

In the absence of a float-adjusted index for the target market or

segment, it is recommended that the portfolio manager create a
more appropriate index prior to replication.

Tracking Error

Tracking error is a measure of how closely the portfolio follows

the relevant benchmark. It mainly arises from market frictions
(transaction costs) during the replication and maintenance
process, and it is unavoidable. Tracking error is also due to
imperfect matching of index weights, dividend treatment by the
index, taxation, and the necessary presence of a cash component
(cash drag).

There are two components of tracking error: an exogenous

component and an endogenous component.

The exogenous component of tracking error is due to changes in

the Index Divisor arising from changes in index constituents
during revision periods (the most significant factor), changes in
shares outstanding, changes in free float etc.

The endogenous component of tracking error results from the

policies, techniques and procedures of the portfolio managers.
This component includes cash management, dividend treatment,
choice of replication method, among others.

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Tracking error calculation

Tracking error is sometimes calculated as the cumulative

difference of return between the portfolio and the index. This
yields a historical record of the deviation from the benchmark.

Tracking Error = ∑R Portfolio − ∑ RIndex

However, tracking error is more often considered as a risk metric

and is calculated as the average periodic difference between the
returns of the portfolio and those of the index (standard deviation
of the difference of portfolio and index returns):

∑ (R Portfolio − RIndex ) 2
Tracking Error = i =1

N −1

The latter includes probabilistic information which can be used in

ex-ante, i.e. in predicting tracking error going forward. However,
since there is no evidence tracking error is normally distributed,
the predictive usefulness of this calculation is limited.

A tracking error derived from a multi-factor model is much more

useful. However, implementing such models on
emerging/developing markets might prove impossible due to lack
of sufficient data.

Minimizing tracking error

A portion of the tracking error can be controlled through efficient

trading policies and the maintenance of a cash pool to mitigate
brokerage costs.

Besides the obvious remedy of negotiating better brokerage

terms, some minor market timing and/or avoiding basket trades
can lower overall tracking error, provided the ensuing savings in
brokerage fees outweigh the tracking error introduced by
imperfect replication.

The cash component can also be used to mitigate tracking error

by optimizing the proportion of cash in the portfolio such that
the reduction in brokerage fees is greater than the tracking error
generated by the cash drag.

One technique used to improve tracking is charging transaction

fees to the fund (not the manager) to offset transaction costs.

Although not currently available in emerging markets, future

contracts can be used to gain timely exposure to index assets till
such time when an actual purchase of the asset is warranted.

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Index Replication Methodologies

There are two methodologies or management techniques used to

track or replicate an index:

- Complete Replication
- Sampling

Complete Replication

As the name suggests, complete replication entails purchasing all

of the stocks in the index according to their respective market
capitalization proportion. For example if share A is in the index
and has a market cap of $250 million, and the sum of the market
caps of all the stocks in the index equals $1 billion, then 25% of
the index fund should be invested in stock A.

Tracking error in the case of complete replication is limited to

transaction costs (fees, brokerage, and slippage) and to drag due
to the necessary cash pool.

Sampling

Sampling involves purchasing only a representative portion of the

stocks in the index. This creates an additional component to
tracking error which is supposed to be random, meaning that
tracking error as standard deviation of return differentials would
increase, but tracking error as the cumulative difference between
the portfolio and the benchmark would not.

There are two main methods to create a sampled portfolio:

- Stratified Sampling
- Optimization

Stratified Sampling

This is a technique used when the index contains a large number

of stocks and/or includes many illiquid stocks, which would
render a full replication too costly if not impossible.

The procedure starts with classifying the stocks of the index

across some key characteristics (like size, industry, PE, growth
etc..). A matrix is then created with cells representing
combinations of the characteristics. An example of such cells
would be the group of companies within the banking sector
growing by more than 15% with a size greater than $200 million.
A weight is then assigned for each cell in the matrix based on the
total weight of the cell’s companies within the index. A stock is

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then selected randomly from each cell and assigned the weight of
that cell in the portfolio.

Stratified sampling allows the portfolio manager to mimic the key

characteristics of the index without having to fully replicate it.

The lower number of transactions and the avoidance of illiquid

stocks reduces transaction costs but increases tracking
imperfection. Increasing the number of dimensions in the matrix
reduces tracking error which is due to imperfect replication, but
increases transaction costs. Running simulations would help
tweak matrix size to find the right balance between replication
fidelity and transaction costs.

Optimization

Instead of selecting a stock randomly from each cell, optimization

selects the proper sample using a multi-factor utility function
which minimizes tracking error. Factors affecting stock
performance are identified, and a mathematical relationship
between these factors and each stock is formulated. The stock
weights are optimized to solve for the tightest tracking error.

This is a complex method that relies heavily on the stock-factor

covariance estimates, which often leads to improper tracking
error estimates.

However, sampling optimization has proved superior to stratified

sampling.

The Appropriate Methodology

Choosing between full replication and sampling methodologies

depends on several criteria, including index structure, rules and
liquidity, the fund’s size, and how much of a priority tight tracking
actually is.

Tracking may be improved in some cases by using both, i.e. fully

replicating the largest stocks in the index and sampling the rest.

Going forward

Having defined the framework for indexing, the document will be

followed up by running simulations on the target index for the
purpose of designing a clearly delineated policies and procedures
manual.

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References

- CASE 30 Index Rules, Cairo & Alexandria Stock Exchanges

- Cash Management for Index Tracking, Connor-Leland, Financial Analysts Joumal
CFA Institute- November-December 1995
- Medium and Small Capitalization Indexing, George U. Sauter, The Vanguard
Group
- Optimal Index Tracking under Transaction costs and Impulse Control, Buckley-
Korn, International Journal of Theoretical and Applied Finance
- S&P Emerging Markets Indices – Index Methodology, Standard & Poor’s
Understanding Tracking Error, Craig Chambers, Umbono Fund Managers
- The Dilemma –Tracking Error vs. Transaction Cost, Value Added September 1999
- Tracking Error and the Information Ratio, Jay Shein, The Journal of Investment
Consulting

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