Practical Financial

Optimization
Chapter 7
Index Funds
Stavros A. Zenios
HERMES European Center of Excellence on Computational Finance
and Economics
University of Cyprus
The Wharton Financial Institutions Center
University of Pennsylvania

Overview

Preview
Basics of Index Funds
Indexation Models
International Index Funds

©2002, S.A.Zenios

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7.2 Basics of Market Indices

Index:
„ A statistics that summarizes the relative changes of
a set of variables

Broad view Narrow view

Value Industry

Growth Sector

Geographical criteria

©2002, S.A.Zenios

7.2 Basics of Market Indices

Why use an index?

„ Comprehensive measure of market trends
„ Benchmark
Passive management of a portfolio
Tracking Indices
Active portfolio management performance
„ 769 all-equity actively managed funds during 1983—1989
underperformed the S&P500 by 200 to 500 basis points.
„ ¼ of the best performers continued to perform equally well
„ ¼ of the best performers were worst performers in the
subsequent period
©2002, S.A.Zenios

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7.2 Basics of Market Indices

Rules driven indices

„ detailed rules determine the choice of securities in the index
„ predictable composition
Discretionary indices
„ An index designed by a committee
„ Considerations:
trading analysis, liquidity, ownership, fundamental analysis, market
capitalization, sector representation
„ Example: the pronounced bias towards stocks after 1999

©2002, S.A.Zenios

7.2 Basics of Market Indices

Creating an index

Practical considerations
„ Liquidity of securities
„ No barriers to entry
„ Stable composition
„ Representation of the universe of securities a
manager actually invests in
Weights
„ Equally-weighted
„ Price-weighted
„ Cap-weighted

©2002, S.A.Zenios

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7.2 Basics of Market Indices
Examples

Example Indices:
„ NYSE (3000 stocks listed), S&P 500, GBI Broad Index, S&P MidCap
400, S&P SmallCap 600, Salomon Brother’s Index of mortgage-backed
securities

Composition of the JP Morgan’s GBI Broad

©2002, S.A.Zenios

7.2 Basics of Indices

Notation
j = {1,2, K , K } the securities in the index (risk factors)
i ∈U the university of all securities
( w j ) Kj=1 , ( r j ) Kj=1 weights, returns
K
R I ( w, r l ) = ∑ w j r jl return of the index under scenario l
j =1

©2002, S.A.Zenios

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7.2 Basics of index funds
Implementing an index fund

Creating an index fund

„ Matching an index, i.e. its growth rate mimics that of the index
„ Enhanced-index or index plus
Challenges
1. Large number of instruments to choose from
2. Transaction costs (net return can be non-positive)
3. Reinvestment of the proceeds
4. Liquidity risk
Models:
„ Structure-based models
„ Co-movements based models

©2002, S.A.Zenios

7.3 Indexation models

The linear programming approach

Step 1
Cells with given
characteristics are
consolidated
wc

Step 2
Stocks are entered
in each cell

©2002, S.A.Zenios

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7.3 Indexation models
Index tracking model

1, if bond i belongs to jth cell

indicator function δ ij = 
0, otherwise

Maximize F ( x )
x∈X

subject to

∑δ ij ix = w j , j = 1,2, K, k , K K

∑x
i =1
i =1

x≥0
©2002, S.A.Zenios

7.3 Indexation models

Co-movements

Approach
„ The return of the index and the returns of the securities in the universe of the
available securities are uncertain
„ Replication of the index response to the risk factors
Tracking error:
Rε ( x, w, r l ) = RP ( x, r l ) − RI ( w, r l )
m K
Rε ( x, w, r l ) = ∑ ril xi − ∑ w j rjl
i =1 j =1

Positive and negative deviations:

 m 
y+l = max 0, ∑ ril xi − RI ( w, r l )
 i =1 
 m

y l = R( x, w, r l ) = y+l − y−l
y−l = max 0, RI ( w, r l ) − ∑ ril xi 
 i =1 

©2002, S.A.Zenios

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7.3 Indexation models
Co-movements: Tracking Model

m
Maximize ∑ ri xi
x∈ X
i =1

subject to
m

∑ r x − R (w, r ) ≥ −ε ,
i =1
i
l
i I
l
all l ∈ Ω (tracking constraint)
m

∑x
i =1
i =1

x≥0
Two - sided tracking model :
m
− ε ≤ ∑ ril xi − RI ( w, r l ) ≤ ε tracking constraint
i =1

©2002, S.A.Zenios

7.4 International Index Funds

Motivation

Composite indices
„ Strategic asset allocation – long time horizons
„ Tactical asset allocation – short time horizons
Risk Factors
„ Local market risk factors (sub-indices)
„ Exchange rate risk
Applications:
„ Global indices
„ Corporate bond indices

©2002, S.A.Zenios

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7.4 International Index Funds
Integrated-Disintegrated model

Global index
return
IG
Structuring the
indexed portfolio
γi
Determine weights
for each market i in
Index return Index return Index return
the global index
I1 Ij IK

Determine weights wi1 wij wiK

U1 U1 UK
for each market j in γi
the global index and
holdings for each
bond i
Determine weights for
Market each bond i in the
return market j

Market Ωj
return Market
Bond picking return
decisions based
on the weights Ω1 ΩK
xij Structuring the
indices

©2002, S.A.Zenios

7.4 International Index Funds

Notation

Notation:
„ Markets j = 1, K , K
„ Sample from the universe Ωj of securities: U j , j = 1,K , K
„ Weights wij of the security i in the jth sub-index.
K
„ Overall (global) index weights γ j , γ j = 1
j =1
∑
„ Weight of the global index in the jth sub-index
m

∑w
i =1
ij = γ j , all j

©2002, S.A.Zenios

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7.4 International Index Funds
Notation

Problem of index fund manager

„ Determine the zj of the portfolio value invested in the jth
market, and pick the bonds from each market Ωj to add to
the portfolio with proportion xij
Disintegrated or decentralized model: K
„ Pick the zj and then choose the xij so that ∑x i =1
ij = zj

Integrated approach
„ Jointly determine the zj and xij

©2002, S.A.Zenios

7.4 International Index Funds

Notation

l
Local return: rij
m
Local portfolio return: R pj ( x, r l ) = ∑ rijl xij
i =1
Exchange rate: E 0j , E lj
Exchange rate appreciation: elj = E lj / E 0j
K
Portfolio return in base currency: R p ( x, r l ) = ∑ elj R pj ( x, r l )
j =1

( ) ( )
K
Return of the composite index: RI γ , r l = ∑ e ljγ j R j w, r l
j =1

©2002, S.A.Zenios

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7.4 International Index Funds
Integrated Indexation model

( )
K
max ∑ p l ∑ elj R pj x, r l
x∈ X
l∈Ω j =1

subject to

( ) ( )
K
− ε ≤ ∑ e lj R pj x, r l − RI γ , r l ≤ ε , all l ∈ Ω
j =1
K m

∑∑ x
j =1 i =1
ij =1

x≥0
m
z *j = ∑ xij*
i =1

©2002, S.A.Zenios

7.4 International Index Funds

Breaking up the model

Strategic allocation:
K K
 m 
R p ( z , R pj ( w, r l )) = ∑ e lj R pj ( w, r l ) z j = ∑ elj  ∑ wij rijl  z j
j =1 j =1  i =1 
Model to determine the optimal zj :
K
max ∑ p l ∑ e lj R pj ( w, r l ) z j
x∈ X
l∈Ω j =1

subject to
K
− ε ≤ ∑ e lj R j ( w, r l ) z j − RI (γ , r l ) ≤ ε , all l ∈ Ω
j =1
K

∑z
j =1
j =1

©2002, S.A.Zenios
z≥0

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7.4 International Index Funds
Breaking up the model

Tactical allocation for international index funds

for each j = 1,2, K, K solve

Maximize ∑ p l R pj ( x, r l )
x∈ X
l∈Ω

subject to
( ) ( )
− ε ≤ R pj x, r l − R j w, r l ≤ ε , all l ∈ Ω
m

∑x
i =1
ij = z *j

x≥0

©2002, S.A.Zenios

7.4 International Index Funds

The value of integration

©2002, S.A.Zenios

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7.4 International Index Funds
Operational model for international index funds

Motivation:
„ Accounts for transaction costs in portfolio revision
„ Allows cash infusion or withdrawal
„ Liquidity and diversification constraints
„ Decision variables are defined in terms of face
values than as proportions of total assets

©2002, S.A.Zenios

7.4 International Index Funds

Operational model for international index funds

Notation
xij face value invested in security i in the jth currency
yij face value sold of security i in the jth currency
zij face value of security i in the jth currency that remains as
inventory in the indexed portfolio
+
v risk free investment in the base currency

v0 initial holdings in the risk free asset in the base currency

b0ij face value of initial inventory of security i in the jth currency
P0bij current bid price of security i in the jth currency
P0aij current ask price of security i in the jth currency

©2002, S.A.Zenios

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7.4 International Index Funds
Operational model for international index funds

Initial value of the portfolio

K m
V0 = v0 + ∑ E 0j ∑ P0bij b0ij
j =1 i =1

Inventory balance
zij = b0ij + xij − yij
Cashflow balance
K
 m m

v + = v0 + ∑ E 0j  ∑ P0bij yij − ∑ P0aij xij 
j =1  i =1 i =1 
Value at the end of the holding period
( )
K m
VTl = v + + ∑ E lj ∑ 1 + rijl P0bij zij
i =1 i =1
Rate of return
V l − V0
R lp ( x, y, z , v + , r l ) =
V0
©2002, S.A.Zenios

7.4 International Index Funds

Operational model for international index funds

max
+
x , y , z ,v ∈ X
∑ p R (x, y, z, v
l∈Ω
l l
p
+
, rl )
subject to
zij − xij + yij = b0ij , all i = 1,..., m, j = 1,..., K
K
 m a  + K 0 m b 
∑
j =1
E  ∑ P0ij xij  + v − ∑ E j  ∑ P0ij yij  = v0
0
j
 i =1  j =1  i =1 
( ) (
− ε ≤ R lp x, y, z , v + , r l − RI γ , r l ≤ ε , for all l ∈ Ω )
x, y , z , v + ≥ 0

©2002, S.A.Zenios

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7.5 Models for Corporate Bond
Index Funds

Challenges
„ Diverse sources of risk inherent in the bond market
„ The number of securities in the index is large
Risks
„ Changes in the term structure of risk free rates
„ Changes in the term structure of credit spreads
„ Changes in the credit rating of the bond
„ The likelihood that the bond will go into default
„ The amount recovered if a bond goes into default

©2002, S.A.Zenios

7.5 Models for Corporate Bond

Index Funds

International indexation can track corporate

bond indices
Subindices are not country-specific but by
„ Credit rating
„ Sector
„ Maturity date
Currency risk is eliminated
that is, E lj = 1

©2002, S.A.Zenios

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7.5 Models for Corporate Bond Index
Funds – Enhanced index funds

©2002, S.A.Zenios

7.5 Models for Corporate Bond Index

Funds – Enhanced index funds

©2002, S.A.Zenios

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7.5 Models for Corporate Bond Index
Funds – Tracking the Merrill Lynch Index

Value of a 100USD investment in the Merrill Lynch US Treasury index and in

indexed portfolios constructed using treasury securities only
©2002, S.A.Zenios

7.5 Models for Corporate Bond Index

Funds – Tracking the Merrill Lynch Index

Tracking Performance of index-plus portfolios that track the Merrill Lynch

US Treasury index by investing in both treasury securities and corporate
bonds
©2002, S.A.Zenios

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7.5 Models for Corporate Bond Index
Funds – Salomon Brothers Index

Value of 100USD investment in the Salomon Brothers Index of

mortgage-backed securities, and in indexed portfolios using a single
period and a stochastic model

©2002, S.A.Zenios

7.5 Models for Corporate Bond Index

Funds – Salomon Brothers Index

Tracking errors of the two indexed portfolios on Salomon Brothers Index

of mortgage-backed securities of the two portfolios constructed using a
single-period and a stochastic programming model vs. the index

©2002, S.A.Zenios

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7.5 Models for Corporate Bond Index
Funds – Callable bond index

Value of a 100USD investment in the callable bond index and

in indexed portfolio developed using a single-period and multi
period model

©2002, S.A.Zenios

7.5 Models for Corporate Bond Index

Funds – Callable bond index

Tracking errors of the indexed portfolios developed using a single

period and a stochastic programming model tracking the callable
bond index.

©2002, S.A.Zenios

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