Buffering Vs Packeting

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I do understand the two terminologies however I am confused during practicing to identify the difference.
In CAFI Mock 1, I do not get why did not we pick packeting as the right answer, is it because in case of packeting the transfer would be a portion hence it won’t be refelected as an increase in number of stocks?
Exhibit 2 S&P 500 Index Funds

Manager A
Manager B
Manager C
Benchmark
S&P 500
S&P 500
S&P 500
Number of holdings: fund/index
498/500
504/500
475/500
Dividends reinvested
Next day
Same day
Next day
Management fee (in basis points)
12
15
10
Rebalance
Quarterly
Quarterly
Quarterly
Reconstitution
Quarterly
Quarterly
Semi-Annually
Q. As an indexing technique, the number of holdings in Manager B’s index most likely illustrates:
  1. reconstituting.
  2. packeting.
  3. buffering.
 
I was wondering the same thing. Logically thinking, packeting could increase the number of stocks as well.
 
carolinesherif wrote:
I do understand the two terminologies however I am confused during practicing to identify the difference.
In CAFI Mock 1, I do not get why did not we pick packeting as the right answer, is it because in case of packeting the transfer would be a portion hence it won’t be refelected as an increase in number of stocks?
Click to expand...
No, I believe it would be quite the opposite actually. This was a bit tricky of a a question as it requires some understanding of nuance I believe.
Buffering was the right answer because in the end, manager B had 504 stocks (from an index of 500) so he was only holding slightly more than the index is composed of. Buffering is a slow/gradual process of transition so the fact he was only just over was the indication I believe he was doing that.
By comparison, packeting is not gradual, once a stock breaches a the threshold, a certain amount of it is transitioned. How much is moved is subjective but in the end, when you are looking at an entire index of stocks and with all the movement that occurs, they add up and would not be seen as minimal. My guess is if manager B had been packeting, he would’ve held something more like 525-550 or more vs the 504 he had.
But that is my understanding of this, hope it helps. Perhaps if someone more knowledgeable about this aspect can chime in and provide better/further clarification.
 
This is a good logic but are there any more clarifications on that one?
 
A buffer places a band around the thresholds that define what goes in an index.
E.g., Large cap may be defined by all stocks >500M in market cap. If a company has a market cap of $505M at the time of reconstitution, it’ll be a large cap stock. If it tanks the next day to $495M, it’s technically not a large cap stock anymore, but if the buffer is set at $485M, it’ll still be a large cap stock. Meanwhile, a stock at $480M market cap may not have been a large cap stock, but due to a good ER report may have gone up to $510M. It’ll still be considered a mid-cap stock if the upper buffer for large cap is set at $515M.
As a PM that follows this index, you may have to choose a few stocks in addition to those in the index that are on the boundary to reduce tracking error, and also to reduce transaction costs and bid-ask spreads when trying to rebalance to match the benchmark.
 
I still don’t understand why packeting wouldn’t also be correct. Anyone have any further thoughts?
 
Elsewhere in the text, it says that buffering makes the index more investable compared to packeting. Based on the apparent preference the CFAI has about packeting, I will lean that way first on any related exam question.
 
Concerning packeting, can someone please explain what splitting stock positions into multiple parts mean?
Does it mean that if a manager with a small cap and mid cap mandates owns stock A in the small cap fund, and its market cap increases over the threshold to qualify as a mid cap, he won’t transfer the whole position in the mid-cap fund but just a portion of it? Holding this stock in both the small and mid cap fund?
 
My take on the whole subject of Buffering vs. Packeting:
1. A buffer would mean breathing the threshhold by not margin but by miles. Just to ensure that it is a not a momentary blip which the Managers would regret afterwards. So for instsnce if a stock migrates from small cap to mid cap it should just not crawl into mid cap (band 11) but do so in a resounding fashion. This means a small % of such stocks should at least reach the boundary just shy of the Large cap. This gives enough confidence and breathing space for the manager to ascertain that the stock indeed is a mid Cap category stock
2. Increase of packeting a sizeable portion must have reached that boundary and stay put there for considerable period. This validates the conviction the stock manager places on the buffer indeed the number of stocks in case of buffering would be marginally higher then that of the index where as the number of stocks in case of packeting will be sizeably higher than that of the index. In our example which means 505/500 does qualify for buffering where as 525 / 500 would have qualified for packeting had that one of the choices.
 
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