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Section 3 - Equity Investments > MIP 7 - Equity Portfolio Management > Flashcards

MIP 7 - Equity Portfolio Management Flashcards

1
Q

What are the three main approaches to equity investment?

A
  1. Passive Management
    • Indexing is the dominant form of this strategy
    • The portfolio must be continuously adjusted to match the index
  2. Active Management
    • Attempt to outperform an index
    • The active return is the portfolio return less the benchmark
    • Tracking risk is the annualized standard deviation of active returns
    • The information ratio is the mean active return divided by the tracking risk
  3. Semiactive Management
    • This is also called enhanced indexing or risk-controlled active management
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2
Q

Name three different index weighting choices

A
  • Price weighted - weight by share price
  • Value weighted - weight by market capitalization
  • Equal weighted - equal weights for each stock
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3
Q

Index price weighting definition, advantages, and disadvantages

A
  • Stocks are weighted by their share price (Dow Jones Industrial Average)
  • Can be replicated by purchasing one share of each stock in the index
  • (+)
    • It is simple to calculate and gather historical price information
  • (-)
    • The index must be adjusted for events such as stock splits
    • Biased towards the highest priced share, which is arbitrary
      • Apple before split
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4
Q

Index Value (market-cap) weighting definition, advantages, and disadvantages

A
  • Also called market-capitalization weighted
  • Can be replicated by purchasing shares in porportion of all the outstanding shares of each stock in the index
  • (+)
    • This method self corrects for stock splits
  • (-)
    • Biased towards companies with larger market capitalizations (which could be older or overvalued firms)
      • FAANGM
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5
Q

Index Float weighting definition, advantages, and disadvantages

A
  • A form of value or market-cap weighting
    • S&P 500
  • Could adjust the market cap weights for each issue’s floating supply of shares (available to investors)
  • Excludes corporate cross-holdings and large holdings by founding shareholders
  • Thus limiting to trading shares
  • Float-weighting is generally regarded as the best approach
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6
Q

Index Equal weighting definition, advantages, and disadvantages

A
  • Invest the same amount in each stock in the index
  • (-)
    • More weight given to smaller, potentially less liquid companies
    • Generally has more frequent rebalancing
    • Higher rebalancing and trading costs
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7
Q

State the four choices that determine a stock index’s characteristics

A
  1. Boundaries of the stock index’s universe
    • Determines how well the index represents a group of stocks
    • The greater number of stocks in the index, the better the index will measure broad market performance
  2. Criteria for inclusion in the index
  3. How the stocks are weighted
    • Usually price weighting, value weighting, or equal weighting
  4. How returns are calculated
    • Price only or total return (including dividends)
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8
Q

Drawbacks of optimization as an approach to indexing

A
  • Even best risk models are imperfectly specified
  • Tends to exploit risk differences when they are just sampling errors
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9
Q

State the advantages of equity indexing.

A
  1. Lower management expenses
  2. Lower trading costs
  3. Lower portfolio turnover
  4. Lower tracking error
  5. Higher tax efficiency
  6. A logical way to gain exposure to market with which an investor may be unfamiliar (e.g. overseas markets)
  7. Typically better informational efficiencies
  8. Passive indexing has outperformed active management based on historical returns net of fees
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10
Q

State the three main kinds of passive investment vehicles mentioned in MIP Ch 7

A
  1. Indexed Portfolios
  2. Equity Index Futures
  3. Equity Total Return Swaps
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11
Q

Equity Total Return Swaps as Passive Investment Vehicles

A
  • At least one side of the swap transaction receives the total return on an equity index
  • The other side can be a different equity index or interest rate
  • Allows for quick diversification
  • Most are tax-driven transactions today
  • Can also be used to rebalance asset allocations (i.e. increase or decrease equity exposure)
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12
Q

Overview of Value Investment Styles

A
  • Want to buy relatively cheap stocks
  • Not concerned about earnings or growth prospects
  • Assume other investors do not accurately judge future risk and return prospects (overreact to bad news)
  • Some evidence does support positive returns for value stocks
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13
Q

What are the three sub-styles of value-oriented investing?

A
  • Low P/E
  • Contrarian
  • High dividend yield
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14
Q

State the disadvantages for value-oriented investing

A
  • The stock may be cheap for a reason the manager does not know
  • Even if the security is not properly valued, the holding period may not capture when the price correction occurs
  • Trigger events may be required for price changes
  • Investors often confuse cheap with a large liquidity premium
  • Note: The bottom line is that an investor needs to make sure they understand why they think the stock is a value. If they are wrong, then the strategy obviously may not work
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15
Q

Overview of Growth Investment Styles

A
  • More concerned with earnings rather than price
  • Tend to invest in growth industries
  • Usually trade at high P/E ratios
    • ​Price takes all future earnings into account Earnings; earning are current
  • Counting on the market continuing paying a premium for the stock
  • There is the risk that forecast growth is not realized
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16
Q

What are the two growth investment sub-styles?

A
  • Consistent growth
  • Earnings momentum
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17
Q

Overview of Market-Oriented Investment Styles

A
  • styles focus more on a broad market index
  • May only get general market returns, which means should just use a passive strategy
  • Subcategories
    • market-oriented with a value bias
    • market-oriented with a growth bias
    • growth-at-a-reasonable-price
      • com​bines tenets of both growth and value investing
    • style rotators
      • ​“time” relative performance of style
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18
Q

Name the two different techniques for identifying investment styles

A
  • Returns-based Style Analysis
  • Holdings-based Style Analysis
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19
Q

Returns-based Style Analysis for Identifying Investment Styles

A
  • Characteristics of portfolio are revealed through realized returns
  • Regress portfolio returns on indices that are mutually exclusive, cover the manager’s investment universe, and have distinct sources of risk
  • Can use this to calculate the portfolio’s beta with respect to various styles
20
Q

State the advantages of returns-based style analysis

A
  • Characterizes entire portfolio
  • Facilitates comparisons of portfolios
  • Aggregates the effect of the investment process
  • Different models usually give similar results
  • Clear theoretical basis
  • Requires minimal information
  • Can be executed quickly
  • Cost effective
21
Q

State the disadvantages of returns-based style analysis

A
  • May be ineffective in characterizing current style
  • Error in specifying indices in model may invalidate results
22
Q

Holdings-based Style Analysis for Identifying Investment Styles

A
  • Drill down type approach
  • Also called composition-based style analysis
  • Categorizes individual securities by their characteristics
  • Aggregates results to get overall style
  • Could examine the following variables
    • Valuation level
    • Forecast EPS growth rate
    • Earnings variability
    • Industry sector weighting
23
Q

State the advantages of holdings-based style analysis

A
  • Characterizes each position
  • Facilitates comparisons of individual positions
  • May capture style changes more quickly
24
Q

State the disadvantages of holdings-based style analysis

A
  • Not consistent with how portfolio managers select securities
  • Different specifications will lead to different results
  • More data intensive
25
Q

The Style Box

A
  • This is the most popular way of looking at style
  • Morningstar’s 3x3-style box is well recognized; it is created using a holdings-based style analysis
  • Different criteria can lead to drastically different style boxes for the same portfolio
  • Large, mid, small cap vs value, core, growth
26
Q

Advantages of Long-short vs Long-only Investing Strategy

A
  • Long-only strategy not only limits the ability to take advantage of negative information but also limits his ability to exploit positive information
  • Long-short strategy allows a manager to fully exploit both positive & negative views on a stock by using leverage
27
Q

State the limitations of semiactive stock-selection

A
  • Any technique that generates a positive alpha will likely become obsolete
  • Models that worked historically may not work in the future
  • Shocks to the market could change everything
28
Q

Fundamental Law of Active Management

A

a function of:

  • the information coefficient (what you know about the investment)
  • and the breadth (number of independent , active decisions made each year)
29
Q

How is the information ratio calculated?

A

The information ratio is the mean active return divided by the tracking risk

30
Q

Describe the two categories of selling disciplines

A
  1. Substitution strategy
    • Replace an existing holding when a better opportunity is available
    • Reasons include opportunity cost and deteriorating fundamentals
  2. Rule driven strategy
    • Includes value-level, down-from-up, up-from-cost, and target price sell disciplines
    • A value investor may sell a stock of the P/E ratio rises to a certain level
    • Could determine to sell a stock if the price drops x% from the purchase price (down-from-cost)
    • Should analyze the after-tax effect
31
Q

Define alpha

A
  • Alpha is the portfolio’s return in excess of that on a risk-matched benchmark
  • Measures the amount of active return
32
Q

Describe four reasons why investors are more risk averse when facing active risk vs. total risk.

A
  1. Must assume successful active management is possible and the managers have the necessary skill
  2. Many active managers fail to beat the benchmark / underperform
  3. Superiors will judge how well the overall portfolio performs relative to benchmarks
  4. As one moves up on the efficient frontier assuming more active risk, less manager diversification exists
33
Q

Utility function for for optimizing allocations to a group of managers

A
  • focus on maximizing active return for a given level of active risk
    UA= rA - lAσA2
    UA = expected utility of the active return of the manager mix
    rA = expected return of the manager mix
    lA = (lamda) investor’s trade-off between active risk and active return
    σA2= variance of the active return
  • The desired amount of active risk determines the mix of specific managers
34
Q

Components of active return

A
  • Manager’s Return - Manager’s Normal Benchmark = Manager’s True Active Return
  • Manager’s Normal Benchmark - Investor’s Benchmark = Manager’s Misfit Active Return
35
Q

Manager’s Total Active Risk

A
36
Q

What are the reasons there may be more price inefficiency on the short side?

A
  • Many investors only look for undervalued stocks, not overvalued ones
    • But short selling can be difficult when many investors are competing to borrow the same shares
  • Stocks could be overvalued due to management fraud, creative accounting, or negligence
  • Analysts usually have more buy recommendations than sell recommendations
    • Creates more trading, which means more commissions
  • Analysts are reluctant to issue negative opinions because often own a stake in the company
37
Q

State the five main categories of topics that should be included in an equity manager questionnaire (according to MIP Ch 7)

A
  1. Organization/People
  2. Philosophy/Process
  3. Resources
  4. Performance
  5. Fees
38
Q

Describe the core satellite approach

A
  • In the overall portfolio, could have core holdings of an index and semiactive managers
  • Anchor an index portfolio and use active managers around the anchor to achieve an acceptable level of active return
  • The active managers represent the ring of satellites
  • The goal is to add active return (alpha) through the satellites
  • Want an acceptable level of active return without too much active risk
39
Q

Describe a completeness fund

A
  • A completeness fund makes the overall portfolio, active and passive components, have the same risk exposure as the investor’s overall equity benchmark
    • ​while capturing active managment skills (stock selection)
  • Must be adjusted periodically as the actively managed accounts change
  • Essentially seeks to eliminate misfit risk, but a non-zero amount of misfit risk may be optimal.
40
Q

Describe the shortcomings of alpha-beta separation

A
  • Shorting may not be allowed for some investors/institutions
  • Systematic risk may remain
41
Q

Describe portable alpha strategies

A
  • Portable alpha is a strategy involving the combination of multiple positions (e.g. long and short positions) so as to separate the alpha (unsystematic risk) from beta (systematic, market risk) in an investment.
  • Portable alpha means that alpha is available to be added to a variety of systematic risk exposures
42
Q

Describe alpha-beta separation

A
  • Have both long and short positions that have offsetting beta so that the portfolio beta is zero. Long the position with greater alpha to get a portfolio with beta close to 0 but positive alpha
  • Alpha
    • Unsystematic Risk = Value Added by the Portfolio Manager = Return in excess of a risk-matched benchmark
  • Beta
    • Exposure to systematic, market-level risk
43
Q

Describe socially responsible investing (SRI)

A
  • Also called ethical investing
  • Devoted to the conscious creation of social impact through investment
  • Consider ethical values and societal concerns when making investment decisions
  • SRI commonly uses stock screens (positive and negative)
    • For example, may choose to exclude tobacco and gambling firms
44
Q

What are two key concerns for socially responsible investing (SRI)?

A
  • increased concentration risk
  • less diversification
45
Q

Stratified Sampling

A
  • First divide the underlying stocks into cells (e.g. industry, value, growth)
  • Find sample stocks for each cell
  • Then invest a portion in each cell
  • Must comply with regulatory diversification requirements
  • Could try and match the index while optimizing some feature

Section 3 - Equity Investments (7 decks)

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