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Flashcards in Equity Portfolio Management Deck (21)
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Discuss the role of equities in the overall portfolio.


Second, the ability of an individual stock to hedge inflation will depend on its industry and its competitive position. Inflation Hedge - An inflation hedge is an asset whose nominal returns arc positively correlated with inflation.


Discuss the rationales foe passive, active, and semiactive (enhanced index) equity investment approaches and distinguish among those approaches with respect to expected active return and tracking risk.


-Passive Managers- don’t forecast -Active managers - try to outperform the bench mark -Semi active - earn for higher return than the benchmark while minimizing the risk of deviating from the benchmark Active return / tracking risk - Information ratio - It is expected active return / tracking risk . It is highest for semiactive managers and lowest for passive managers.


Recommend an equity investment approach when given an investor’s investment policy statement and beliefs concerning market efficiency.


If an IPS states it taxable - Passive asset allocation is likely favorable. efficient markets - passive stocks. large-cap stocks, indexing is suitable because these markets are usually informationally efficient. In small-cap markets. there may be more mispriced stocks. but the high turnover associated with active strategies increases transaction cost Foregin investor has less informaiton on local markets and Active management is futile.


Distinguish among the predominant weighting schemes used in the construction of major equity share indices and evaluate the biases of each.


A price weighted index is simply an arithmetic average of the prices of the securities
included in the index.

The primary advantage of a price-weighted index is - computationally simple.
There is also a longer history of data for price-weighted indices, so they can provide a long record of performance.

**A market capitilzation index ( or value index ) **is calculated by summing the total market value (current stock price times the number of shares outstanding) of all the stocks in the index.

This index better represents changes in aggregate investor wealth than the price-weighted index.

Equal weighted Index all stock returns are given the same weight (i.e., the index
is computed as if an investor maintains an equal dollar investment in each stock )

Biases -

The price-weighted index -. First, higher priced stocks will have a greater impact on the index’s value than lower priced Stock.

Second, firm splits its stock, repurchases stock, or issues stock dividends, As a stock’s price changes through time, so does its representation in the index.

A market capitilzation index ( or value index ) - firms with greater market capitalization have a greater impact on the index than firms with lower market capitalization.

  • these indices may be less diversified if they are overrepresented by large-cap firms.

institutional investors may not be able to mimic a value-weighted index if
they are subject to maximum holdings and the index holds concentrated positions.

equal-weighted index is biased toward small-cap companies because they will have the same weight as large-cap firms even though they have less liquidity.

More rebalenching -


Compare alternative methods for establishing passive exposure to
an equity market, including indexed separate or pooled accounts, index mutual
funds, exchange-traded funds, equity index futures, and equity total return

  1. mutual fund’s value (as calculated using the net asset value) is typially only provided once a day . ETF trades throughout the day.
  2. ETF - no record keeping / Mutal funds do
  3. index mutual funds -pay lower license fees to Standard & Poor’s and other index providers than ETF
  4. EFIs are more tax efficient than index mutual funds.
  5. although ETFs carry brokerage commissions. the costs of holding an ETF
    long-term is typically lower than that for an index mutual fund.——-

Indexed institutional portfolios may be managed as seperate or pooled accounts.

Index instituitional portfolios have lower management costs than ETF and Index mutual funds

Compared to ETFs - equity futures have two disadvantages. First, the futures contracts have a finite life and must be periodically rolled over into a new contract, at potentially less attractive terms.

Second, wing basket trades and futures contracts in combination
for risk management may be problematic because a basket may not be shorted if one of the components violates the uptic rule.

Total return EQUity swaps - thier lower cost makes equity swaps ideal for tactical asset allocation

Tax advantages - If don’t want to deal with with holding taxes -


Compare full replication, straitified sampling, and optimization as
approaches to constructing an indexed portfolio and recommend an approach
when given a description of the investment vehicle and the index to be tracked.


Full Replication - all stocks are purchased acording to weighing scheme in the index

Better when number of stocks are less than 1000. advantages of replication is that there is low tracking risk and the portfolio only needs to be rebalanced when the index stocks change or pay dividends.

stratified sampling (a.k.a, representative sampling), the portfolio manager separates the Stock. in an index using a structure of twa or more dimensions. industry, size, and price-carnings ratio

Tracking risk from stratified sampling decreases as the number of cellls increases in the structure.

Optimatzion model - uses factor model to match factor exposures of the fund to the indexes.
factor model accounts for the covariances between risk factors. In a stratified sampling procedure. it is implicitly assumed that the factors (e.g .• industry. size. price-earnings ratios) arc uncorrelated.

Despite the complexity of optimization. it generally produces even lower tracking risk than stratified random sampling.

The advantage of an optimization is that the
factor model accounts for the covariances between risk factors.


First, the risk sensitivities measured in the factor model are based on historical data and may change
once the model is implemented.

Second, optimization may provide a misleading model
if the sample of data is skewed by a particular security or time period of data.

Third, the optimization must be updated to reflect changes in risk sensitivities, and this leads to frequent rebalancing.


Explain and justify the use of equity investment-style classifications
and discuss the difficulties in applying style definitions consistently.

Explain the rationales and primary concerns of value investors and
growth investors and discuss the key risks of each investment style.


three important investment styles are -

Regardless of the explanation, a value investor must realize that there may be a good reason why the stock is priced so cheaply.

The value investor should consider what catalyst is needed for the stock to increase in price and how long this will take.

high dividend yield, low price multiple, and contrarian.

Low price multiple investors believe that once the economy, industry, or firm improves, their stocks will increase in value. Contrarian investors look for stocks that they believe arc temporarily depressed.

Growth investors may do better during an economic contraction than during an expansion.

consistent earnings growth and momentum -

market-oriented investing is used to describe investing that is neither value nor

The substyle of market-oriented investing are market-oriented with a value tilt,
market-oriented with a growth tilt, growth at a reasonable price (GARP), and style

Market capital based investing - small caps are underpriced than well cover large cap.


24.i: Compare techniques for identifying investment styles and
characterize the style of an investor when given a description of the investor’s
security selection method, details on the investor’s security holdings, or the
results of a returns-based style analysis




Colllpare the methodologies used to construct equity style indices.


there are three different methods used to assign a security to either a value or growth index.

1) stock is assigned to value or growth.
2) value, growth. or to a third neutral catcgoty.
3) a stock can be split between caregeries,

buffering means there will be less turnover in the style indices and, hence, lower
transactions Cost from rebalancing for managers tracking the index.


Interpret the results of an equity style box analysis and discuss the
consequences of style drift.


a matrix is formed with value/growth characteristics across the top and market cap along the side.

Style Drift—

First, the investor will not receive the desired style exposure.

if a manager starts drifting from the intended style, she may be moving into an area
ouuide her expertise.

returns-based style analysis and holdings-based style analysis
can both be used to evaluate style drift,

holdings. based style analysis considered to be the more effective of the two methods.


Distinguish between positive and negative screens involving socially
responsible investing criteria and discuss their potential effects on a portfolio’s
style characteristics.


screens can be negative -where the investor refuses to invest in a company they believe is unethical; or

Postive ,where the investor seeks out firms with ethical practices.

SRI portfolios tend to be tilted toward growth stocks. SRI screens have also been found to have a bias toward small-cap stocks.


Compare long-short and long-only investment strategies, including
their risks and potential alphas, and explain why greater pricing inefficiency
may exist on the short side of the market.


Long short strategy can eliminate systematic risk by pair trade, can earn 2 alphas

iN long only stratagyunderweighting is limited to the security’s weight in the portfolio,
whereas overweighting is unlimited)

a long-short investor can create a symmetric distribution of active weights,

Pricing Inefficiencies on the Short Side

  1. There are barriers to short sales that do not exist for long trades.
  2. Firm management is more likely to promote their firm’s stock through accounting manipulations
  3. Analysts on the sell-side are more likely to issue buy recommendations than sell recommendations.
  4. Sell-side analysts face pressure from firm management against issuing sell recommendations

ExpIain how a market-neutral ponfolio can be “equitized” to gain
equity market exposure and compare equitized market-neutral and shortextension portfolios.


a market-neutral strategy has no systematic risk exposure to the market.
Neither the direction nor magnitude of movement in the overall market is expected to affect the portfolio’s return

Log short one way to achieve market nuetrality - The short
sales fund the long positions and the portfolio holds cash. To add market exposure, long equity futures equivalent to the portfolio’s cash holdings are purchased and the cash fully collateralizes the contract positio

The portfolio return is:
The risk-free rate earned on the cash (equivalent) holdings.
The market return on the futures contracts.
The spread earned on the long-short positions.

In a short extension strategy, the manager shorts an
amount of securities equal to a set percentage of his long portfolio and then purchases an equal amount of securities


24.o: Compare the sell disciplines of active investors


Substitution is replacing an existing security with another with brighter prospects opportunity cost sell discipline. ( read official book )

deteriorating fundamentals sell discipline.- a manager conclude
that a firm’s business will worsen in the future

valuationlevel sell discipline, - if its PIE or P/B ratio rises to the ratio’s historical mean

In a down-from-cost sell discipline, the manager may sell a stock if its price declines more than say 20% from the purchase price

an up-from-cost sell discipline

In a target price sell discipline, the
manager determines the stock’s fundamental value at the time of purchase and later sells
the stock when it reaches this level.


24.p: Contrast derivatives-based and stock-based enhanced indexing
strategies and justify enhanced indexing on the basis of risk control and the
information ratio


Investors information ratio is IR~ IC * (IB)½
IR= information ratio
IC= information coefficient
IB = investor breadth

In these derivative-based strategies, the value
added (alpha) is coming from the non-equity portion of the portfolio and the equity exposure is coming through derivatives.

Disadvantages:- Sucessful managers are copied and alpha gets disappeared.

that a derivatives-based enhanced indexing strategy will have less breadth than a stock-based enhanced indexing strategy because the investor uses a derivatives contract
to gain exposure


24.q: Recommend and justify, in a risk-return framework, the optimal
portfolio allocations to a group of investment managers.


24.r: Explain the core-satellite approach to portfolio construction and
discuss the advantages and disadvantages of adding a completeness fund to
control overall risk exposures


expected active portfolio return = Σ w a,i * (Ra,i)

“the completeness fund may be constructed with the objective of making the overall portfolio sector and/or style neutral with respect to the benchmark while attempting to retain the value added from the active managers’ stock-selection ability.”


24.s: Distinguish among the components of total active return (“true”
active return and “misfit” active return) and their associated risk measures and
explain their relevance for evaluating a portfolio of managers.


Broad Based benchmark:- Investor’s Benchmark

manager’s normal portfolio - Manager Benchmark

1 Manager’s return − Manager’s normal benchmark = Manager’s “true” active return
2 Manager’s normal benchmark − Investor’s benchmark = Manager’s “misfit” active return

total active risk= SQRT (~(true active risk)² + (misfit active risk)² )

true information ratio = true active return/ True active risk

“To review, the manager’s normal benchmark (normal portfolio) represents the universe of securities from which a manager normally might select securities for her portfolio. The term investor’s benchmark refers to the benchmark the investor uses to evaluate performance of a given portfolio or asset class.”


24.t: Explain alpha and beta separation as an approach to active
management and demonstrate the use of portable alpha


The investor could pick up alpha by hiring a manager who specializes in long-short strategies in less efficient smallcap markets.

If the manager decides to take a different index exposure, she could keep
the small-cap alpha and pick up the beta exposure in some index


investor manage the risks in an alpha and beta separation approach


24.u: Describe the process of identifying, selecting, and contracting with
equity managers


Past Performance

Manager Questionnaires first section - the manager’s staff
and organizational structure

  • investment philosophy and procedures

—- how research is conducted and used. Other
details provided here include portfolio turnover, how quantitative models are utilized, and how trading functions


—- fee schedule


24.v: Contrast the top-down and bottom-up approaches to equity


bottom-up approach, the investor starts at the individual stock level. Stocks are
chosen on the basis of their individual characteristics and valuation

Top-down approach because the investor starts at the economy level and works her way down.

the investor determines the economy is going to expand,
cyclical stocks would be favored