Equities Flashcards
Equity Securities Provide Benefits
- Capital Appreciation
- Dividend Income
- Diversification
- Hedge against inflation
ESG Investing
- Negative Screenings: exclusionary screening
- Positive Screenings: uncover companies that area in favor (best in class)
- Thematic Investing: screen based on a theme
- Impact Investing: More actively engaged with companies the Portfolio manger is investing in.
Approaches to Segmenting an Investment Universe
- Size: measured by market capitalization
- Style: Value, growth, or core (blend)
- Geography: developed markets, emerging markets, and frontier markets
- Economic Activity
Economic Activity:
* Market Orientated Approach
* Production Orientated Approach
Segmentation by Size and Style
Advantages: for portfolio managers:
* Can construct a portfolio in a manageable way.
* Diversification across economic sectors and industries.
* Can construct performance benchmarks for specifics.
* Reflects a company’s maturity and potentially change its growth/value orientation.
Disadvantages:
* Categories may change over time
* May be defined differently by different investors.
Equity Segmentation by Geography
Benefits: can facilitates global diversification
Weaknesses:
* May provide lower than expected exposure to a specific market because companies are global in nature.
* Potential currency risk investing in foreign equity markets.
Economic Activity Approach
Advantage:
* Can create portfolio benchmarks for a specific industry or sectors
* Diversification benefits
Disadvantage: Some companies don’t have pure business lines (product, service, sectors, or industries)
Income Strategies
- Dividends
- Optional Stock Dividend
- Special Dividend: One-time cash payment
- Security Lending
- Writing Call Options
- Cash Secure Put
- Dividend Capture
Security Lending
- Collateral: Lender will earn some income from an reinvestment return of the treasuries or cash.
- Earn a Fee
- The lender will still get the dividend on the stock
- The lender gives up voting rights
Issues:
* If there is a lot of short selling in the security lent, is not beneficial to the lender.
* Quality of the borrower and ability to return the securities.
* Lender relinquishes the right to vote the shares during the loan period.
Different Fees and Costs
- Management & Performance Incentive Fees: Direct cost of research and costs of portfolios
- Administrative Fes: voting, corporate action, custodian, depository, and registration
- Marketing and Distribution Fees: Marketing, sales, advertising, sponsorship, producing & distributing brochures, platform fees, and sales commissions
- Trading Costs: incorporated into a portfolio’s total return and included in the overall performance
- Investment Strategy Costs
Investment Strategy Costs
Momentum Strategy: Demand liquidity in the market place, but time & delay and slippage costs go down.
Contrarian Strategy: Opposite of a momentum strategy and will supply liquidity in the market place.
Shareholder Engagement
- Interacting directly with company to influence stock price in the future
- Vote on things in general meeting
- Effect for a company stock price to go up
Free Riders
Shareholder who benefit from shareholder engagement actions but don’t contribute anything
Limitations (Issues) of Shareholder Engagement
- Active equity managers are more likely than passive equity managers to be involved
- Larger investors (with deep pockets) are more likely to be involved
- If successful “free riders” will benefit as well.
- Focuses on short-term goals rather than long-term goals.
- Can lead the investor to acquiring material non-public information
- Shareholder engagement can create potential conflicts of interest
Rational for Active management
- Confidence in Portfolio Manager
- Preference for active management
- Mandate from a Client: Criteria, set standards, religion, or ESG
Criteria when Selecting a Benchmark
- Rules Based: Rules must be objective, consistent, and predictable
- Transparent: Methodology, rules, publicly available, clearly understandable
- Investable: Can you buy all the securities? Return and risks performance
Buffering
- Buffer Zone: If a stock should move from one index to another
- Makes the transition a more gradual and orderly process
- Establishing ranges around breakpoints
Items Needed to Select a Benchmark
- Rules Based: Including or excluding securities
- Rebalancing: Consistent objective, predictable
- Consideration: Choosing a benchmark
- Market Exposure Desired
- Idea Methods: Constructing and maintaining
Types of Indexes (Weights)
- Market Capitalization
- Fundamental
- Equal weight
- Price
Price Weighted
- Same number of shares of each stock in the index (1 share of each stock). An example is the Dow Jones
- Issues: Higher-priced stock impacts the overall index more
- Impacted by stock dividends or splits.
Market Capitalization
- Price of the shares x number of shares outstanding
- Most indexes use this method such as the S&P & EFAI
- Issues: Large-cap stock that have a higher capitalization will dominate
- Liquidity-weighted: Large-caps will have more liquidity
- Check to see if the index is float adjusted or not - Most are Free-Float Adjusted
Free Float adjusted
- Without the index may be less investable.
- Excludes shares not available to the public (founders, government, or other companies)
- More accurately reflects the actual liquidity it does not lower its liquidity
Equally Weighted
- Regardless of the price or shares of the stock because the same amount is invested in each stock.
- Issues: Prices are volatile thus, rebalancing because very frequent.
- Small-Cap Bias: The lower the price will have more shares.
- There could be limited investable capacity due to the heavier weight in small-caps.
- Least concentrated index portoflio based on HHI.
Fundamental Weighting
- A certain factor is selected such as dividends, cash flows, P/E….etc.
- The idea is that there will be a reversion to the mean based on fundamental attributes.
Ways of Creating a Passive Portolfio
- Passive Market Capital Weights: Track an index by a subset or all securities at a low cost
- Passive Factor-Based Strategies (Smart Beta): Portfolio with exposures to certain factors as in an index (tracks the risk factors)
Common Risk Factors
- Growth
- Value
- Size
- Yield
- Momentum
- Quality
- Volatility
Types of Passive Factor-Based Strategies
Return-Oriented Strategies:
* Momentum
* Dividend Yield
* Fundamentally-weighted strategies
Risk-Oriented Strategies:
* Volatility Weighting
* Minimum Variance Investing: Portfolio with the highest return and the lowest risk.
Diversification-Oriented Strategies:
* Equally-weighted portfolios
* Maximum diversification strategies
Approaches of Passive Equity Investing
- Pooled Investment Funds: ETFs and Mutual Funds
- Derivative Strategies: Currency and derivative overlay
- Separately Managed: Index-based SMAs
Opened-Ended Mutual Funds
- Redemptions are at the end of the day
- Advantages: lower costs more convenient and more liquid than ETFs
- Disadvantages: Taxes on redemption of sale of shares within the fund is a taxable event to all fund holders
ETFs
Advantages:
* Only taxable event are dividends or when the individual investor sales their own shares
* They are easy to trade (intraday ).
* Investors can buy ETFs using margin borrowing.
* Investors can take a short position in ETFs.
* Track more indexes than index mutual funds.
* Can be more tax-efficient than index mutual funds
* Typically have lower expense ratios
Disadvantages:
* Commission costs may offset the expense ratio advantage
* Market illiquidity when buying/selling.
* Less liquid
* Higher transactions cost
* Higher trading commissions
Derivative Overlay
- Completion Overlay: Take the portfolio as it is right now and move back to the index risk exposure. This is to try and match the beta of the index
- Rebalancing Overlay: Match reconstitution of the index as securities are added or deleted
- Currency Overlay: Add the foreign currency risk that the portfolio is exposed to.
Pros vs Cons of Derivative Overlay Positions
Advantages:
* Quick, cheap, and effect to adjust the exposures of the portfolio
* Trade in very liquid markets
* Much easier to leverage a portfolio
Disadvantages:
* Expiration dates: Need to rollover periodically
* Contracts: Some of them have position limits
* Special Portfolio Needs
* Over the Counter: Addition counterparty credit risks
* Basis Risk: Leads to tracking errors future and spot rates, might not be the same
Equity Index Swaps
Used to obtain market exposure synthetically
Advantages:
* Flexibility : Possible to initiate on any equity index
* Are a low-cost alternative to cash-based approaches
* They can be used to leverage or hedge a position.
Disadvantages:
* Counterparty default risk
* Liquidity risk: Customized swap transactions are illiquid
* Interest rate risk: By paying the floating interest rate.
* Tax policy risk: Tax laws giving favorable tax treatment now might change
Index Matching Strategies
- Full rebalancing
- Stratified Sampling
- Optimization
- Blended
Full Replication
- The portfolio mirriors the index
- Might have a very high cost
- Works well with a very liquid and small number of securities
- Cash flows are difficult to replicate
- Lowest Tracking Error and Active Risk
Stratified Sampling
- This strategy will not own all the stock in the index, creates a situation where the risks are as same as the index.
- Holds a subset of the securities in the index.
- Mutually exclusive and mutually exhaustive
- The more dimensions used, the smaller tracking error
Optimization
Advantages:
* Typically involves maximizing a desirable characteristic or minimizing an undesirable characteristic
* Lower Tracking error than stratified sampling
* Take into account correlation and covariance of each stock in the portfolio
Disadvantages:
* Historical data and relationships can change
* Created portfolio might not be mean variance efficient
Blended
Can use a mixture such as full replication to a degree, then use stratified and/or optimization
Tracking Error
Defined as the standard deviation of its excess return.
Differcnes are From:
* Management Fees
* Use of sampling
* Commissions: such as bid-ask spreads
* Liquidity: high transaction costs
* Use of Intraday trading costs
* Cash Drag
Active Equity Strategies
- Factor Based: Have a higher concentration risk.
- Activism
- Statical Arbitrage
- Fundamental
- Quantitative
Fundamental
- This strategy is based on opinion “discretionary”
- Researchers will use financial statements to forecast the future
- There will be fewer positions, but large amounts invested per security in the portfolio
- Risks: What if the analyst is wrong, using a wrong model, or misvaluing the intrinsic value of a stock