Sparse Index Tracking Portfolios 

In recent years, the landscape of investment options, particularly indices, has significantly expanded. This development offers promising opportunities for advisors looking to diversify portfolios. However, navigating the vast array of available options poses a considerable challenge. These specialized investment choices are instrumental in constructing portfolios tailored to meet specific financial objectives. Nevertheless, the abundance of options introduces the question of how to integrate these indices effectively into investment strategies. This article addresses this crucial issue, aiming to simplify the process for advisors, enabling them to use indices to their fullest potential while ensuring resources are efficiently allocated towards their primary goal: asset raising. By optimizing the use of indexing strategies, advisory businesses can enhance their bottom line, fostering an environment of success and financial prosperity. 

 This article focuses on the passive tracking of equity market indices. Passive investing has gained prominence recently, as many alternative investment managers struggle to outperform global stock markets. Index tracking involves creating a portfolio that mimics the performance of a specific index. Realizing the performance of an index can be achieved through Direct indexing. When applied to a benchmark index, direct indexing calls for investors to hold long positions in the index’s constituent assets, in sizes that directly reflect the weight allocated to each asset. Such an idealized implementation is referred to as full replication and tracks the index perfectly in a frictionless environment.  

Replicating an index through direct indexing is a trade-off between tracking error and complexity. 

In practice, exact tracking is difficult to realize because of, spreads, slippage, brokerage commissions brokerage fees and exchange fees, some of which are fixed while others are dependent on transaction numbers and sizes. Further, there is the operational burden of managing the numerous positions required to express a typical index. One should, therefore, consider replicating the index, to an acceptable level of tracking-error, by taking up positions in a reduced percentage of the index constituents.  

Good approximations to make replication easier manage are to lower the frequency of trading and reduce the number of assets. 

By reducing the rebalance frequency and the size of the portfolio, one achieves several benefits: 

  • Reduced operational burden by managing a portfolio of fewer holdings, 
  • Improved liquidity as the constituent names are typically more liquid and consequently, spreads tend to be tighter, and slippage is better controlled. 
  • Reduced brokerage as there are fewer transactions 
  • Reduced frequency of trading, such as re-balancing on a quarterly or semi-annual basis keeps costs in check.  

One shortcoming is that the reduced order approximation may require larger individual positions giving rise to a measurable execution footprint and a market impact at large AUM. The management of large re-balancing trades is addressed by deploying algorithmic execution.  

 The Standard & Poor’s 500 (S&P 500) is one of the world’s best-known indices and one of the most used stock market benchmarks. Over the past three decades, the average annual total-return of the index exceeds 9.5%; despite the 2000-2002 dot-com bubble, the severe financial crisis of 2008 where the market lost 37% of its value and the more recent 2020 Covid 19 pandemic. One could naturally ask if it would be possible to own a portfolio that returned a performance in-line with the S&P 500 Index, in fact tracking it is easily done with the State Street SPY ETF. 

 ETFs require a minimum size to be economic, so many interesting ideas remain inaccessible to the investor without using direct indexing. 

In contrast, most specialized or esoteric indices, receive no attention since seeding a new ETF requires meaningful seed capital to make it commercially viable for the issuer. In this optic, tracking portfolios through direct indexing is one approach to gaining exposure. With all cash positions held by the investor, full transparency is implicit, and any revenue derived from lending, dividends and taxation flows directly to the bottom-line. Direct indexing ushers in an era of mass customization and bespoke index design.  

 Reduced Cardinality may sound complex, but simply describes a portfolio objective that naturally seeks a reduced number of assets. 

Taking this idea further, a Sparse Tracking Portfolio is a practical implementation of a tracking portfolio through direct indexing. Formulated as a constrained optimal portfolio construction with concentration limits, cardinality bounds turn-over control and sector fidelity, the solution is a portfolio of far fewer names than the parent index while retaining its sector profile allocation. 

Viking Harbour has developed innovative tools designed to enable advisors to optimize portfolio performance effectively, without reallocating resources from other business areas. Our technology for systematic allocation leverages established quantitative methods crafted by our specialists. It streamlines the process of evaluating new asset allocations and alternative investments, generating illustrative scenarios and proposals. This allows advisors to dedicate their focus and time to the fundamental aspects of their advisory services as well as enhancing overall efficiency and strategic decision-making.