Chapter 7 Flashcards
What is the bottom up approach to investing?
-beginning by seeking out individual securities to include in a portfolio
What does a value oriented investor look for in a security?
- low P/E ratios
- trade at discount to book value
- willing to wait a long time to see value
Describe Benjamin Graham’s Asset Value Strategy
“an investment operation is one which upon thorough analysis promises safety of principal and a satisfactory return. Operations not meeting these requirements are speculative”
- net current asset value approach
- selecting stocks that sell for 66.67% of less of their current asset value
What are the four elements of Warren Buffet’s investment strategy?
- Turn off the stock market
- Do not worry about the economy
- Buy a business, not a stock
- Manage a portfolio of businesses
What are Warren Buffet’s 10 basic analytical tenets?
- Equities will outperform
- Soundness and potential of a security is the true measure of value
- Ability to analyze fundamental soundness of individual businesses lessens the need to broadly diversify
- Investors are not always rational
- Risk is not based on price but on economic value
- Focus on 10 to 12 securities of the highest value from high potential companies and stay with them for the long term
- The most important measuring stick is intrinsic value and WACC
- Minimize the impact of transaction costs
- Measure returns on an after tax basis
- Use the power of compounding returns to maximum advantage
What does a growth oriented investor look for?
- focuses on superior earnings growth rates relative to the market
- usually has higher turnover
What are the three approaches to constructing an index fund?
- Replicating an index
- Tracking an index
- Fundamental indexing
What is a risk with ‘replicating an index’?
Tendency to be over-diversified, which occurs when the next stock added contributes little or no reduction to the portfolio’s unsystematic risk
Describe index tracking
-subset of index that faithfully mimics it (high correlation but not identical)
What are two examples of index tracking models?
- sampling model (capture correlation by using the larger cap stocks in the index)
- mathematical model (using historical data in order to construct a fund that does not hold all of the underlying index but nevertheless mimics it well)
Define tracking error
-the standard deviation of the return difference between the portfolio and the index
Describe market capitalization indexing
- uses market capitalization as the method for security weighting
- advantages include diversification, low turnover, broad market participation, and modest expenses
Describe the structural return drag of market capitalization indexing
if market is semi-efficient, most stocks will priced above their intrinsic value –> those priced above their intrinsic value will have a capitalization higher than merited and an erroneously high index weighting. Capitalization weighted indexes systematically overweight overpriced securities and underweight underpriced securities
Describe fundamental indexing
- each stock’s index weighting is determined by four fundamental measures thus diluting weighting errors and erasing the link between portfolio weight and over or under valuation
- the four factors are 1. cash flow 2. sales 3. dividends and 4. book value
- ideally looking at trailing 5 year numbers
What is it important to use the four factors in fundamental indexing versus one?
- using a single metric can lead to a skewed sample of companies
- a blend of measures along with multi-year smoothing can mitigate exposure to problems and reduce turnover
What is closet indexing?
- active managers build a portfolio close enough to an index to match performance
- goal is that underachieving active managers avoid getting fired
Define and describe risk budgeting
- a process that limits that deviations of a portfolio’s return from a benchmark
- helps prevent big negative return surprises and is designed to protect an investor from their own greed
- requires an investor to visualize active investment decisions in terms of the risks assumed, not the returns expected
Describe enhanced indexing
- results in portfolios that are designed to provide index-like performance with some excess return net of costs
- active risk is introduced by slightly overweighting and underweighting securities
A typical enhanced index portfolio’s active risk is not allowed to exceed what % per annum?
2%
What are the four steps of the risk budgeting process?
- Determine the portfolios
- Determine the portfolios maximum acceptable tracking error
- Identity the tactical asset allocation or specific return opportunities among securities
- Build a portfolio that deviates from the benchmark using the return opportunities identified in step three
Using risk budgeting to help in security selection is far more difficult than using it for asset allocation. Why?
- difficulty arises from the volume of calculations (ie. 4 asset classes to choose from vs. thousands of individual securities to choose from)
- there is no evidence that managers can produce positive alpha on a consistent basis over time or that there is any systematic relationship between alpha and tracking error
What is the main drawback of using risk budgeting?
-an investor could have much higher return opportunities at slightly higher risk levels
In practice, the majority of funds are actively managed to some degree by using what 3 active strategies?
- sector rotation
- timing or momentum strategies
- search for undervalued stocks
Describe the size effect
- the smallest capitalization firms (small caps) generate consistently higher returns on a conventional risk-adjusted basis
- it is an anomaly to the CAPM and MPT
What are some of the explanations for the size effect?
- argument that small firm betas are biased downward
- errors-in-variables (fluctuation of size)
- liquidity effecting price
Define enhanced active equity investing
- an active portfolio manager overweights the securities they expect to outperform and underweights those they expect to underperform
- uses short selling (shorts and reinvests proceeds long)
What are the three main reasons why enhanced active equity managers may want to short securities?
- To take advantage of a singular opportunity
- To exploit relative returns between two stocks
- to hedge out industry exposure in order to isolate an alpha return
Define and describe long-short investing
- also known as market neutral
- portfolio construction technique designed to take greater advantage of information within equity markets
- differs from active management because it eliminates the market’s effect and is more aggressive in its stock shorting (higher use of leverage)
What are the two strategies used in market neutral investing?
- absolute return
- alpha portability
In a long-short strategy, what are the two primary sources of return?
- Return from the long-short positions
2. T-bill component (proceeds from short are reinvested in t-bills)
What are 3 of the benefits of long-short investing?
- the returns generated by the strategy are independent of market direction
- long-short equity strategies use information more efficiently which results in higher risk adjusted returns
- the alpha generated is portable to other asset classes, which can be beneficial to rebalancing and asset allocation
What are 3 drawbacks of long-short investing?
- More expensive to maintain
- Capacity of long-short strategies is limited (ie. liquidity issues on the short side)
- If shorting a dividend paying stock, the dividends must be reimbursed if short on ex-div day
Define and describe portable alpha strategy
- portable alpha is the process of using derivatives or short selling to separate the alpha and beta return decisions and apply the alpha to portfolios made up of other asset classes
- portable alpha enables a manager to budget risk and increase alpha without drastically changing a portfolio’s asset allocation mix
- alpha portfolio is made beta neutral and added to a beta portfolio
What are the three components of a portable alpha strategy?
- The beta portfolio (the market risk)
- The alpha portfolio (alpha is the measure of a manager’s skill in adding value by taking active risk, which is any non-benchmark-like security exposure)
- The cash portfolio
An alpha portfolio should be three things:
- unrelated to its underlying market
- independent of its market direction
- absolute in nature (to generate positive returns)
What are 5 benefits of portable alpha?
- by liberating the security selection return from the benchmarks to which the securities belong, portable alpha allows investors to maximize both manager selection and asset class allocation
- can liberate PMs if they have neglected their own areas of skill in order to pursue the returns their clients favour - it frees managers to focus on the universes within which they feel they have the greatest skills and the highest potential to add value
- by divorcing security selection from asset allocation, portable alpha gives investors increased flexibility in structuring the overall fund
- when added to a portfolio, portable alpha can reduce volatility and increase efficiency
- Portable alpha offers investors control over risk budgeting
Define and describe an alpha engine
- a source of unsystematic returns
- the most important piece of a portable alpha solution
- when selecting an alpha engine, the objective is to find a consistent and positive source of excess return that has a low correctional with the beta to which it is being transported
When selecting an alpha engine, an investor may err in one of three ways:
- select an inconsistent, unsustainable alpha engine
- use an alpha engine that is inappropriate to meet their desired objectives
- incorrectly estimate the magnitude and volatility of betas embedded in an alpha engine
Alpha transport may face interference in the form of ___________________.
unavailability or illiquidity of derivatives instruments
The enhanced index equity portfolio can take small active positions by no more than:
plus or minus 18%
What is the key difference between a stock loan account and a margin account?
- the manager is not the prime broker’s customer as would be the case with a regular margin account but instead is a counter-party in the stock loan transaction
- managers can use the stock loan account to directly borrow the shares they want to sell and the shares they purchase serve as collateral for the one’s they have borrowed
- in a margin account the broker is an intermediary between the stock lender and the manager
- in the stock loan account the broker arranges the collateral for the securities lenders (ie. proceeds are available for managers to purchase long)
When do portfolio managers typically establish long hedges?
-when they want to add positions to a portfolio but do not yet have the cash available
How is a long hedge is implemented?
- by buying equity index futures, which gives managers market exposure on an interim basis
- when cash becomes available managers replace futures position with actual stocks they want to add
What is the formula used to determine the number of contracts needed to hedge a portfolio?
Hedge ratio= Portfolio beta x (dollar value of portfolio to be hedged over dollar value of one futures contract)
dollar value of futures contract = trading value x multiplier
What are four industry trends that are driving the next level of growth in EFTs?
- Growth in fee based business
- Growth in advisors as PMs
- Demand for transparency
- Broad choices and ongoing innovation in ETFs
What are the 5 key features of ETFs?
- Transparency
- Targeted exposure with diversification
- Tax efficiency
- Lower costs
- Liquidity
What are 8 benefits of ETFs from the perspective of the advisor?
- Transition management (keeping money invested/limit cash drag)
- Core and satellite management
- Simplified exposure to previously harder to access asset classes or strategies
- Rebalancing
- Tactical asset allocation
- Model consistency (ie. for small accounts)
- Tax loss selling
- Hedging
What is the most misunderstood aspect of ETFs?
- the volume traded does not demonstrate liquidity as it does for a stock
- supply and demand DO NOT drive price
- an ETF is simply a basket of securities, therefore if the underlying is liquid then so is the ETF
- liquidity can also be adjusted by the market maker
What are some of the key innovations in the ETF world?
- Segmentation of the broad market into sectors
- Difference approaches to weight the holdings (other than market cap)
- Country specific
- Strategy based
