R27 Passive Equity Investing

Question 1

Features of a Market Cap Weighted Index

Answer 1

• Constituent company’s weight in the index is calculated as its market capitalization divided by the total market capitalization of all constituents of the index
• The capitalization-weighted market portfolio is mean–variance efficient
• Most common form of market-cap weighting is free-float weighting
• Reflects a strategy’s investment capacity
• Can be thought of as a liquidity-weighted index because the largest-cap stocks tend to have the highest liquidity
• Bias to large cap stocks

Question 2

Features of a Price Weighted Index

Answer 2

• The weight of each stock is its price per share divided by the sum of all share prices in the index
• Represents one share of each constituent company - this is unrealistic however.
• Stock split for any constituent of the index complicates the index calculation
• e.g. DJIA

Question 3

Features of a Equally Weighted Index

Answer 3

• Have constituent weights of 1/n, where n represents the number of stocks in the index.
• Equally weighted indexes require regular rebalancing because immediately after trading in the constituent stocks begins, the weights are no longer equal
• Small-cap bias
• Limited investment capacity. The smallest-cap constituents of an equally weighted index may have low liquidity.

Question 4

HHI

Answer 4

Σw²

^{M<span>easure of stock-concentration risk in a portfolio</span>}

^{HHI of 1/n would signify an equally weighted portfolio, and a value of 1.0 would signify portfolio concentration in a single security.}

^{As HHI increases so does risk.}

Question 5

Effective number of stocks

Answer 5

1/HHI

Estimation of the effective (or equivalent) number of stocks, held in equal weights, that would mimic the concentration level of the chosen index

Question 6

Common Equity Risk Factors & Strategies

Answer 6

1. Growth
2. Value
3. Size
4. Yield
5. Momentum
6. Quality
7. Volatility

Strategies:

1. Risk orientated
2. Return Orientated
3. Diversification Orientated