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CFA Level III > Equity > Flashcards

Flashcards in Equity Deck (32):
1

Equities as an Inflation Hedge

Protects purchasing power (good in long-run)
Earnings rise with inflation

Imperfect b/c of taxes

2

Information Ratio

Active Return / Tracking Risk

 

Higher IR = better risk-adjusted returns

3

Choose Passive Strategy If:

  1. Taxable
  2. High transaction costs
  3. Markets have high information efficiency
  4. Not familiar with market

4

Types of Indices

  1. Price-weighted - longer history and simple
    1. Touble with stock splits, etc.
    2. Replicates by buying 1 share of the stock
  2. Market-cap weighted - biased to large firms
    1. Float weighted (only investable shares)
  3. Equal weighted - biased towards small, higher costs

5

ETFs Pros/Cons vs Mutual Funds

ETFs Pros

  1. Trade more
  2. Tax efficient (doesnt buy/sell securities, just follows an index)
  3. Recordkeeping not maintained
  4. Costs are lower

ETFs Cons

  1. License fees are higher (S&P, Russell, etc)

6

Equity Futures Pros/Cons

Pros

  • Allows you to purchase all stocks in an index
  • Liquid and low transactions costs

Cons

  • futures have a finite life and requires rollover
  • uptick rule (can only short after an uptick in price)

7

Indexed Portfolio

Full Replication

Advantage: low tracking risk

Expenses higher with more and illiquid securities

Best When: less than 1000 stocks, liquid

8

Indexed Portfolio

Stratified Sampling

Definition: securities are chosen to replicate index weights by cell (market cap, style, style, etc.)

  • Advantage: lower costs
  • Disadvatange: higher tracking error
  • Assumes no correlation between cells

Best when: # of stocks is large, illiquid

 

9

Index Portfolio

Optimization

Matches factor exposures (beta, market cap, value, etc.)

Disadvantages

1, Changing sensitivities
2. Misleading if data is skewed
3. Frequent rebalancing

10

Value Investing

Focus on low P/E or P/B (depressed firms)

20-80% turnover

Substyles:

High dividend yield
Low price multiple - once economy/industry/firm improves outperforms
Contrarian - temporarily depressed

11

Growth Investing

High expected earnings growth

Does better during economic contraction
60-200% turnover

Substyles:

Consistent Earnings Growth
Momentum

12

Market-Oriented Investing

Blend/core portfolio - flexibility
Risk: How to indentify style

 

Substyles:

Value tilt
Growth tilt
Growth at a reasonable price (GARP)
Style rotation

13

Return-Based Style Analysis

Definition: Regressing returns against indices to determine exposure

*Must be nonnegative and sum to 1

Indices used must be:

  • Mutually exclusive
  • Exhaustive
  • Uncorrelated sources of risk

14

Return-Based Style Analysis

Results

Style fit = R2 = amount of return explained

Selection return = 1 - R2 = unexplained returns

15

Holdings-Based Style Analysis

Different Types of Value and Growth

Classifying securities;

Value or growth
Expected earnings per share growth: high = growth
Earnings volatility: high = value
Industry representation: utility/financial/energy = value

16

Return-based vs Holdings Based

                               Returns-Based       Holdings Based

Advantages         Portfolios based      Security based
                             Back by theory         Can detect style drifts
                             Low info req.

 

Disadvatanges  
     Does not account for holdings      Not consistent with
            Slow detecting style drift         manager selection

17

SRI

Positive screen = desirable characteristics (green)

Negative screen = exclude undesirable characteristics (tobacco)

 

Can lead to small cap and growth bias
Avoids basic industries and energy

18

Long-only vs Long-short

Long-only

invests in undervalued stocks (must avoid stocks they don't like).
Exposed to systematic and unsystematic risks

Long-short

Can buy undervalued and short overvalued
Can be market-neutral to eliminate systematic risk
Shorting may be inefficent due to expenses, some are not allowed

19

Why is the short side inefficient?

  • Long-only investors ignore overvalued securities
  • Sell-side analysts mostly make buy recommendations
    • Could fear making company mad
  • Insiders less likely to divulge negative information
  • Additional costs

20

Equitize & Market-Neutral Strategies

Market-Neutral: Earns 2 alphas (long and short) and Rf

Equitize: by investing cash in futures or ETFs
Earns 2 alphas and market return

 

21

Short Extension Strategies

Definition: limited short positions (130/30) with a net 100% long

*Cannot separate alpha from beta (market return)
*Best to do 130/30 (efficient) first instead of 100/0 then 30/30

22

Stock vs Derivatives Based Enhanced Indexing

Stock-based: under/overweight based on beliefs. Unknowns match benchmark

Derivatives: equity exposure through derivatives (long). Hold cash to collateralize and invest in fixed income to earn a yield

23

Fundamental Law of Active Management

Definition: IR = IC√IB

Skillful managers = higher IC
IB = number of forecasts

 

24

Allocating to Equity Managers

Driven by active return and active risk

Investors are more risk adverse when facing active risk (b/c its additional)

 

Note: Active returns are uncorrelated so you could choose more than 1

25

Portfolio IR Example

Manager       Allocation         Alpha            Tracking Error
A                        400                 0%                     0%
B                        100                  2                        4
C                        100                  4                        6
D                        100                  4                        6

Alpha = (4 / 7)(0) + (1 / 7)(2) + (1 / 7)(4) + (1 / 7)(4) = 1.43%

Variance = (4 / 7)2(0)2 + (1 / 7)2(4)2 + (1 / 7)2(6)2 + (1 / 7)2(6)2 = 1.7956, √1.7956 = 1.34%

IR = 1.43 / 1.34 = 1.07

26

Core-Satellite Portfolios

Completeness

  • Core-satellite: Start with core of portfolio, satellite managers are active
    • Minimizes active risk 
  • Completeness: starts with satellite managers then add core to track benchmark
    • Minimizes misfit risk

27

Calculating Value Add

Manager             Allocation              Estimated Alpha              Tracking Risk
A                             $25                             3%                                      5%
B                             $25                             4%                                      7%
C                           $150                             -0.1%                                   0.0%

1. Evaluate if Li can achieve an IR of 0.6 or better

Alpha = (25/200)(3) + (25/200)(4) + (150/200)(-0.1) = 0.80
Tracking error = (25/200)2(5)2 + (25/200)2(7)2 + (150/200)2(0)2

IR = .80/1.08 = 0.74 which exceeds 0.6

28

True Active Return

Misfit Active Return

Total Active Return

Total active return = manager's return - investor's benchmark

True active return = manager's return - normal benchmark

Misfit active return = manager's normal benchmark - investor's benchmark

 

Misfit = investors decision to go rogue

 

29

True IR

Total IR

Total Active Risk

Total active risk = √(true active risk)2 + (misfit active risk)2

Total IR: Total active return / Total active risk

True IR = true active return / true active risk

 

Example: Manager return = 14%, Investors benchmark, 16%, manager's benchmark 11%, total active risk 5.1%, misfit active risk 3.7%

Manager outperformed: 14 - 11 = 3%
Investors decision to deviate reduced returns: 11 - 16 = -5%

30

Manager Questionnaire

  1. Resources
  2. Investment philosophy and process
  3. Performance (benchmarks, alpha, risk, holdings)
  4. Organization and staff
  5. Fees

31

Manager Return and IR Example

Manager Return: 12.0%       Investors Benchmark: 10.0%
Managers benchmark: 15.0%      Managers total active risk: 5.5%
Managers misfit active risk: 4.0%

 

Total IR: (12 - 10) / 5.5 = 0.35
True Active Return: 12 - 15 = -3%
Misfit Active Return: 15 - 10 = 5%
True Active Risk: 5.52 = X2 + 42  = 14.252  √14.25 = 3.8%
True IR: -3 / 3.8 = -0.79

32

All active and misfit formulas

Total active return = manager's return - investor's benchmark

True active return = manager's return - normal benchmark

Misfit active return = manager's normal benchmark - investor's benchmark

Total active risk = √(true active risk)2 + (misfit active risk)2

Total IR = Total active return / Total active risk

True IR = true active return / true active risk