P1 - Index Based Equity Strategie

Question 1

Explain the five risk factor from Fama French Model (M,S,BtM,P,I)

Answer 1

• Market risk premium - like beta
• Firm size
• Book to market ratio
• Operating profitability
• Investment intensity

Question 2

Explain the following return oriented estrategies
(i) Momentum based strategie
(ii) Dividend yield strategies
(iii) Fundamental weighted strategies

Answer 2

• Overwheight companies that outperform maket from the most recent period
• Overwheight companies with high relative dividens

Question 3

Explain the risk oriented strategies

Answer 3

• Include use techiniques like volatility weighting, minimum variance investing

Question 4

Explain the diversification orient strategies

Answer 4

Include equally weighted portifolios and maximum diversification strategies

Question 5

Explain the aproaches to index based equity investing and basic caracteristcs
(1) Pooled investment

Answer 5

EXAMPLE ETF’s - Open end mutua funds
- Low transaction costs
- Don’t have to sell stocks on redemption
- Higher transaction costs from commissions and the bid and ask spread

Question 6

Explain the aproaches to index based equity investing and basic caracteristcs
(2) Derivatives based strategies

Answer 6

Use of derivatives (options, futures contracts, and swaps) TO RECREATE the risk/return perfirmance of an index
- The COMPLETION OVERLAY is the adjustment to back to the risk exposure of the index, for match portifolio beta to match with index beta

Question 7

Explain the aproaches to index based equity investing and basic caracteristcs
(3) Separately managed index portifolio

Answer 7

-Constituents stocks in the index or a representative sample
- Require regulary updated data on the index
- Sophisticated data trading and accounting systems

Question 8

Describe the two methods for construction of index based equity portifolio and pros and cons

Answer 8

(i) Full replication - Reduce tracking error but can increase the transaction costs
(ii) Stratified Sampling - Random sample stratified stocks that match with index portifolio

Question 9

Describe the process of optimization in the context of portifolio rebalance.
Main pros and cons

Answer 9

Uses mean-variance to minimize traking error. Usually maximizes RETURN and minimizes undesirable caracteristchs VARIANCE.

Cons
Use historical relationships, that change over time
Pros
Reduce tracking error and relying on qualitative caracteristcs

Question 10

Explain the pros and cons of using ETF’s in the process of index matching

Answer 10

Pros
- Lower cost
- Time consumption
- Reduce taxable gains

Cons

• Commisions
• Bid and Ask spread
• Iliquid on secondary markets

Question 11

Discuss pros and cos of derivative equity index vs. cash based strategies

Answer 11

Two adv
- Lower transaction cost
- Easy to leverage
- Trade in iliquid markets
Two disadvantage
- Time to expiration need to roll over
- Limitation of portifólio needs vs. market disposal

Question 12

Explain the concept of tracking error and the main causes

Answer 12

Is the sd of the diferences between index port return and published index return

Main causes > Managment fees, commissions, sampling, intra day trading,

cash drag- hold positions that can reduce return on bull market and increase return in bear market