Equities Flashcards
Overview of Equity Portfolio Management
what have the typical annual dividend yields been like?
1-3%
What is a more stable - dividend or return?
dividend
Negative Screening (or exclusionary screening)
excludes companies or sectors that do not meet client standards
Positive screening (best in class screening)
seeks to uncover companies or sectors that rank most favorably with clients
Thematic Investing
Screens equities based on a specific theme, such as climate change. Related to impact investing.
Impact Investing
Aims to meet investor objectives by becoming more actively engaged with company matters and/or directly investing in company projects
What is size and style investing?
matrix with one axis as size: large/medium/small and the other axis as style: value/blend/growth
What are the advantages of segmenting by size and style?
- portfolio managers can better address client investment characteristics in terms of risk and return characteristics
- potential for greater diversification benefits by investing across different sectors or industries.
- ability to construct relevant benchmarks for funds that invest in a specific size/style category
- ability to analyze how company characteristics change over time
What are the different types of segmentation by economic activity?
- market oriented approach
- production oriented approach
eg investing solely on companies that invest in oil production and transportation industries
Market oriented approach
Segments companies by markets served, how products are used by consumers, and how cash flows are generated
Production oriented approach
Segments companies by products manufactured and inputs required during the production process.
Optional stock dividend
Allows investors to choose between cash payments or stock dividends (ie new shares). The option has value for the investor and can also be immediately sold to monetize the option.
Covered call
involves writing a call option on a stock owned. writer loses upside of the security if the price increases above the strike price.
Cash covered put
Selling put options on stock and setting aside sufficient cash equivalents to pay for the stock if the put buyer exercises their right. the risk of the seller is the put buyer will only exercise the right of the stock declines in value
Dividend capture
investor buys a stock right before its ex-dividend date, holds the stock through ex-dividend date and then sells the stock
proxy fight
seeking to persuade other shareholders to support their proposals
A strategy that focuses on relatively new, fast-growing companies in emerging industries is most likely employing which strategy?
small cap growth
Free rider problem
when some shareholders do shareholder activism and other shareholders who do not participate in it also benefit.
Will adding bonds to a passive fund trading S&P500 reduce its risk?
No
Predictability of correlations is uncertain
If you lend out a stock, do you lose on the dividends?
No
Dividends on loaned stock are “manufactured” by the stock borrower for the stock lender - stock borrower ensures that the stock lender is compensated for any dividends that the lender would have received had the stock not been loaned.
Characteristic requirements for equity benchmarks (TRI RULES)
Must be:
1. Rules based: Rules for including and excluding stocks in the portfolio, the weighting scheme and the rebalancing frequency must be consistent, objective and predictable so investors can replicate the investment performance of the index
- Transparent: rules underlying the index are public, clearly stated and understandable to investors
- Investable: investors can replicate the return and risk performance of the index
Risk Factor Exposure of a passive portfolio
Expected sensitivity of portfolio returns to various risk factors
Methods of Index Weighting
- Market Cap Weighting
- Price Weighting
- Equal Weighting
- Fundamental Weighting
Market Cap Weighting
Based on total market cap (free float shares)
It is the market portfolio in CAPM
Price Weighting
Weighting each portfolio stock by its price.
Can be achieved with a portfolio that holds an equal number of shares of each index stock, which gives stocks with higher share price larger index weights. eg DJIA
Equal Weighting
Investing equal amounts in each portfolio stock.
It is factor indifferent - it randomizes factor mispricing and because of its small cap bias relative to market cap weighting, returns are more volatile than for market cap weighting.
It can also produce marginally better returns before transaction costs when stock prices vary around their intrinsic value
Fundamental Weighting
Weighting index stocks by their proportions of the total index value of a fundamental factor eg sales, income, dividends, etc.
Herfindahl-Hirschman Index (HHI)
sum of W^2
Effective number of stocks
1/ HHI
Ranges from 1/n to 1
How are concentration risk and HHI related?
As HHI increases, concentration risk increases
Reconstitution
Process of removing and replacing stocks that no longer fit the desired market exposure of an index
Practices to reduce trading costs associated with migration of a stock between indexes on reconstitution dates
- Buffering
- Packeting
Buffering
Establishing a threshold level for the change in a firm’s capitalization risk that must be met before moving it from one index to another on reconstitution date
Makes the index benchmarks more investable
Packeting
When a mid-cap company’s capitalization increases so that it qualifies as a large-cap stock, half of the portfolio position is moved to the large-cap index on the reconstitution date. If the stock still meets the criteria for inclusion in the large-cap index at the next reconstitution date, the remainder of the position is moved from the mid-cap to the large-cap index.
Fama and French 5 factors
- Market Risk (Beta, standardizes covariance of returns with return on the market)
- Firm Size
- Book to Market Value
- Operational Profitability
- Investment Intensity (growth rate of assets)
Momentum-Based Indexes
Typically overweight stocks that have outperformed a benchmark index over the most recent period of a specified length
Types of factor-based strategies
- Risk Oriented
- Return Oriented
- Diversification Oriented
What factors are return-oriented strategies based on?
dividend yield, momentum, fundamentally weighted strategies
What factors are risk-oriented strategies based on?
Volatility weighting (weights are inverse of price volatility)
Minimum-Variance investing (traditional Markowitz framework where portfolios are selected that minimize portfolio variance, subject to constraints such as maximum or minimum sector or country weights)
Diversification-oriented strategies
Include equally weighted portfolios and maximum diversification strategies (maximizing the ratio of the weighted average volatility of individual stocks to the portfolio volatility)
Pooled Investments
Open-ended mutual funds
ETFs
How do ETFs eliminate taxable gains?
Do not have to sell stocks in response to shareholder redemption requests
Overlay positions
Derivatives based strategies (options, futures, contracts)
What are the different types of overlays?
- Completion Overlay: move the portfolio back to risk exposure of the index eg by adjusting portfolio’s beta to match the index beta
- Rebalancing overlay: efficiently and cheaply matches the reconstitution of the index as securities are added and dropped
- Currency overlay: adjusts the foreign exchange risk of portfolio holdings denominated in a foreign currency
Separately Managed Equity-Index Based Portfolios
Hold all constituent stocks in the index or a representative sample.
Require regularly updated data on the index; sophisticated trading and accounting systems; well established broker relationships to facilitate program trading and lower trading commissions; and compliance systems to ensure compliance with laws, regulations and internal company policies
Methods of constructing passively managed index-based equity portfolios
- Full replication
- Stratified Sampling
- Optimization
Stratified Sampling
To reduce the costs of full replication, but still approximate the factor exposures of the underlying index
Index stocks are divided into strata (subsets) based on key risk characteristics.
Random samples of stocks within each strata are selected for inclusion in the portfolio.
The weight of the stocks selected for each strata are such that the portfolio risk factor exposures match those of the index portfolio
Strata of the constituent stocks must be mutually exclusive and exhaustive
The more criteria used in constructing strata, the smaller the tracking error
Optimization
Uses mean-variance analysis to minimize tracking error.
Typically maximizes desirable result or minimizes an undesirable characteristic subject to one or more constraints
How does optimization work for an index portfolio?
Seeks to minimize tracking error relative to the underlying index, and constraints may include a minimum number of stocks, a style tilt that matches that of the underlying index, or a minimum capitalization, among other possibilities.
Optimization can also be combined with stratified sampling, with optimization performed on each strata of a stratified sample.
What are the advantages of optimization?
- reduction of tracking error versus stratified sampling
- explicitly account for the covariances of constituent stock returns, rather than relying on a characteristic, such as industry sector, in constructing the portfolio
What is the blended approach for passive portfolio construction?
Large liquid index stocks: full replication
Thinly traded stocks: stratified sampling or optimization
Attribution analysis
Helps managers identify sources of tracking error and hopefully reduce them
What are passive investing proxy votings?
Mostly used by passive managers to reduce costs associated with research on a myriad of corporate issues across broad portfolio of companies
Does using free float in market cap weighting increase or decrease liquidity?
Increase because they more accurately reflect its actual liquidity
Which method of portfolio construction is used when a portfolio manager is tracking an index with a large number of constituents or managing a relatively low level of assets?
Stratified Sampling
What is Basis Risk?
Results from using a hedging instrument that is imperfectly matched to the investment being hedged.
Basis risk can arise when the underlying securities pay dividends, because the futures contract tracks only the price of the underlying index.
Stock splits do not affect investment performance comparison
Factor Based Investment Strategies are?
- risk based
- return oriented
- diversification oriented
Return oriented
How do you decide the number of stocks in a price weighted index?
Price weighted indices have the same number of stocks - one share of each constituent security
What is the difference in risk in fundamental versus quantitative approaches?
Fundamental: risk to the strategy lies at the individual company level if the analyst has misestimated intrinsic value, or the market fails to recognize the mispricing and the security remains mispriced
Quantitative: risk to the strategy lies at the portfolio level if the factors do not deliver the performance as predicted by the model
What is the difference in rebalancing frequency for fundamental versus quantitative managers?
Fundamental manager continuously monitors stock positions and rebalances at any time to their current opinion
Quantitative managers automatically rebalance according to the systematic rules of the strategy at predetermined intervals such as monthly or quarterly
What are the types of bottom up approaches?
- Value-based strategies
- Growth-based strategies
Value-based approaches
Attempt to identify securities that are trading below their estimated intrinsic value. sub-styles include:
- relative value
- contrarian investing
- high-quality value
- income investing
- deep-value investing
- restructuring and distressed debt investing
- special situations: identifies mispricings due to corporate events such as divestures, spin-offs or mergers
GARP
growth at reasonable valuation
Makes use of PEG ratio (select the security with the lowest GARP ratio)
Smart beta
Identify betas that are related to systematic return and rotate your portfolio exposures into those betas (factors) that are expected to outperform.
It is a form of top-down approach that identifies basic drivers of return as opposed to bottom-up approach of identifying individual security misvaluations
Rewarded and unrewarded factors
Rewarded factors: factors shown to have a positive association with a long-term positive risk premium
Unrewarded factors: factors that do not offer a persistent return
Hedged Portfolio Approach
- rank the investable stock universe by the factor (eg fr size factor, rank by market cap)
- divide the universe into quintiles
- long the best quintile and short the worst quintile
- performance of this long/short portfolio is tracked over time and represents the performance of the factor
Drawbacks to hedged portfolio approach
- information in middle quintiles is lost
- Assumes that relationship between factor and stock return is linear
- portfolios can appear diversified when the manager uses multiple factors to select securities, but if the factors are highly correlated to each other, the diversification is likely to be less than expected
- approach assumes the manager can short stocks to create the hedged portfolio
- hedged portfolio is not a “pure” factor portfolio because it will typically have significant exposures to other risk factors
Factor Mimicking Portfolio
theoretical long/short portfolio that is dollar neutral with a unit (one for one) exposure to a chosen factor and an exposure of zero to other factors. these theoretical portfolios tend to be spread across a broad array of stocks. Managers may encounter liquidity and short-selling constraints when attempting to construct them.
Factor Timing
Equity Style Rotation: where the manager believes that different factors work well at different times. These strategies allocate to portfolios that represent factor exposures when that particular style is expected to outperform.
Proxy Contest
Shareholder vote to force the proposed changes on the company
What are the typical defenses that are used by management resisting the activist’s proposed changes?
- use of multi-class share structures, which grant multiple votes to founders
- poison pill clauses, which allow existing shareholders to purchase more shares in the target company at a discount, diluting the stake of the activist
- staggered board provisions: board is re-elected partially each year, hence can not be replaced simultaneously
What is the most efficient strategy to overlay
Equity index futures
Statistical Arbitrage Strategies
Make extensive use of technical stock price and volume data to exploit pricing inefficiencies. Typically, they aim to profit from mean reversion in related share prices or by taking advantage of opportunities created by market microstructure issues
What are the types of statistical arbitrage strategies?
- pairs trading
- Market microstructure based
What are market microstructure based arbitrage strategies?
Take advantage of mispricing opportunities occurring due to imbalances in supply and demand that are expected to only last for a few milliseconds
Risk Arbitrage Strategy
Type of event driven strategy associated with M&A activity
Cash merger: buy target after deal has been announced because prices will be lower because of risk of the deal failing. Manager profits if the deal is completed.
Share for share transaction: short sell the shares of the acquirer and purchase the shares of the target company in the same ratio as the proposed share exchange of the deal. Manager profits if the deal is completed.
Value Trap
Where a stock that appears to be attractive because of a significant price fall may in face be overvalued and decline further.
Value managers need to also determine if the sock is trading below intrinsic value given the company’s future prospects and identify the trigger than will lead to upward revaluation of the stock
Growth Trap
Where favorable future growth prospects are already reflected, or over-reflected, in the price.
How does risk exposure compare for factor based investing versus broad market cap weighting?
Relative to broad market cap weighting, passive factor based strategies tend to concentrate risk exposures, leaving investors exposed during periods when a chosen risk factor is out of favor
Information Coefficient (IC)
Correlation between factor exposures and subsequent portfolio returns
The idea is that if there is a strong relationship between factor exposure and subsequent performance, then the factor has high predictive power.
What are the 2 variations of IC?
- Pearson IC
- Spearman Rank IC
Pearson IC
Ranges between -1 to 1 and -100% to +100%. A monthly value of even 5% - 6% is considered very strong
But it is sensitive to even a few outliers (extreme high or low historical return)
Spearman Rank IC
Addresses the problem of sensitivity to outliers of Pearson IC. Considered more robust and superior.
It is the correlation of the rank of the factor scores and rank of subsequent performance.
Quant overcrowding
If many quantitative managers follow similar strategies
What are the 2 main approaches in style analysis
- Holdings Based Approach
- Returns-Based Approach
Morningstar Style Box
A type of holdings based style analysis
- Size: large cap, mid cap, growth
- Style: value, blend or core, growth
The approach acknowledges that a single security can exhibit both value and growth characteristics at the same time.
Returns Based Style Analysis
Aims to identify the style of a fund through regression of the funds returns against a set of passive style indices. By imposing a constraint on the regression that the sum of the slope coefficients should sum to a value of 1, the slope coefficients can be interpreted as the manager’s allocation to that style during the period.
Return of portfolio = A + b1SCG + b2LCG + b3SCV + b4LCV + error
What are the advantages of holdings-based analysis?
- generally more accurate because it uses actual portfolio holdings
- assesses each individual holding’s contribution to style
Advantages of returns-based analysis
- does not require information on holdings
- can be easily and universally applies
Disadvantages of returns-based analysis
Constraints on outputs can limit detection of extreme styles
Disadvantages of holdings-based analysis
- requires the availability of all portfolio constituents and style attributes of each
- limited derivatives data may hinder analysis if derivatives are used.
- different systems with different definitions of style will classify the same portfolio in different ways
If you see an S&P 500 index holding 504 securities, is it an example of buffering or packeting?
Buffering
If a company has a goal to be ESG sensitive by preferring investments that focus on companies that help the environment with respect to clean energy and climate change, is it impact investing or thematic investing?
Thematic Investing.
Impact investing may target environmental objectives, but additionally influences measurable financial returns through engagement with a company or by direct investment
Does securities lending come in the way of proxy voting?
Yes - when using securities lending, the voting rights are transferred to the borrower of the securities.
Sources of active returns
- Level o strategic long-term exposures to rewarded factors (rewarded factors are those that are widely accepted as offering long-term positive risk premiums - market risk or beta, size, value, liquidity etc
- Tactical exposures to mispriced securities, sectors and rewarded risks that generate alpha (risk that cannot be explained by long-term exposure to rewarded factors). Alpha is directly related to manager skilll.
- Idiosyncratic risk (from concentrated active positions) that generates returns related to luck (labeled luck because it is not due to market risk exposure or value-added alpha)
Formula for decomposition of realized (ex post) active return
Active return = sigma (beta of portfolio minus beta of rewarded factor) * return of rewarded factor + alpha + epsilon
alpha - active return attributable to manager skill
epsilon: idiosyncratic return - noise or luck (good or bad)
What are the 3 building blocks of portfolio construction?
- factor weightings
- alpha skills
- position sizing
- breadth of expertise
Alpha Skills
returns related to the unique skills and strategies of the manager. can be generated through factor timing (which is skill in identifying when a factor might outperform/ underperform its average return)
Which risk does position sizing impact the most?
Idiosyncratic Risk
Fundamental Law of Active Management
Expected active return of the portfolio = IC x (sqrt BR) x SD of active returns x TC
TC = transfer coefficient, a number between 0 and 1 that measures the level to which the manager is constrained - TC will take a value of 1 if the manager has no constraints, and 0 if the manager is fully constrained
Fundamental or Quantitative portfolios - which get rebalanced more frequently?
Quantitative - usually rebalanced at regular intervals such as monthly or quarterly.
What is the first step of the quantitative investment process?
Define the market opportunity
What is the fundamental active investment process?
- Define the investment universe and the market opportunity
- Pre-screen the investment universe to obtain a manageable set of securities for further, more detailed analysis
- understand the industry and business for this screened set by performing industry and competitive analysis and analyzing financial reports
- forecast company performance
- convert forecasts to valuations and identify ex ante profitable investments
- construct a portfolio of these investments with the desired risk profile
- rebalance the portfolio with buy and sell disciplines
Factor Timing
Skill in identifying when a factor might outperform or underperform its average return
What is TC in the fundamental law of active management?
Transfer Coefficient: a number between 0 and 1 that measures the level to which the manager is constrained
TC will take a value of 1 if the manager has no constraints and 0 if the manager is fully constrained
Active Share
Measures degree to which the number and sizing of positions in a manager’s portfolio are different from those of a benchmark
Active share = 0.5 x |sum of Wpi - Wbi|
of average of overweightings and underweighteings - can take a value between 0 and 1
Active Risk
Tracking Error - standard deviation of active returns
= sqrt (active returns ^2 / T-1)
Differentiate between active share and active risk
Active risk is affected by the degree of cross-correlation between securities, whereas active share is not.
A portfolio manager can completely control active share because they control the weights of the securities in the portfolio. However, a manger cannot completely control active risk because predicted active risk depends on estimations of correlations and variances of securities that may be different from those actually realized.
High net exposure to a risk factor leads to a high level of?
active risk
a portfolio with no net factor exposure will have active risk attributed entirely to?
active share
active risk attributable to active share is inversely proportional to?
number of securities in the portfolio
If factor and idiosyncratic risks increase?
active risk increases
Factor Bets
when portfolio’s exposure to one or more risk factors differs from that of the benchmark.
involves increase in active share (but higher active share does not mean factor bets have been taken)
Closet Indexer
A fund that advertises itself as bein actively managed but is substantially similar to an index fund in its exposures
When are absolute risk measures appropriate?
When the investment objective is expressed in terms of total returns (eg long/short equity manager benchmarked against cash plus a margin)
When are relative risk measures appropriate?
When the investment objective is to outperform a market index
Higher portfolio turnover and shorter investment horizon - how do they impact market impact costs?
Increase market impact costs
Slippage Costs
difference between the execution price and the midpoint of the quoted market bid/ask spread at the time the trade was first entered
Which costs are usually higher? Slippage of explicit?
Slippage
Which has higher slippage cost - small cap or large cap?
Small cap
Is slippage costs greater in emerging markets?
Not necessarily
How does volatility impact slippage costs?
Increases it
Net Exposure
Difference in the value of the long positions and the value of the short positions, expressed as a % of investor’s capital
If you are long 80m USD and short 30m USD, what is the gross and net explosure?
Gross: 110%
Net: 50%
Long extension
long/short strategies typically constrained to have a net exposure of 100%
Preferred by investors that want 100% net market exposure but also wish to allow the manager to engage in some level of short selling in order to benefit from negative views
Market Neutral Portfolios
Aim to remove market exposure through their long and short exposures.
eg long 200m with beta 0.9 and short 150m with beta 1.2
net market beta = 0
What is the purpose of having market neutral strategies?
diversification and not higher returns
What is the biggest risk in pairs trading and what is the best way to mitigate it?
The biggest risk in pairs trading is that the observed price divergence is not temporary and could be due to structural reasons.
Frequent use of stop-loss rules, which are set to exit trades when a loss limit is reached addresses this risk.
A fund primarily invests in the stocks of companies with poor earnings performance that are out of favor with the market and appear to be influenced by investor behavioral trends. Stocks are selected on the basis of company analysis by the company’s analysts. the fund uses sector overlays to control risk.
Which investment strategy is the fund using?
Contrarian
What is a way to mitigate loss aversion bias?
Stop-loss rules
Which method of style analysis is best used to properly classify the Lunnar Hedge-X fund?
It uses a variety of techniques to achieve alpha, including long–short equity portfolios with substantial futures and options overlays to control risk. Lunnar suggests its clients use a combination of the Lunnar Hedge-X fund along with its more traditional funds to improve the Sharpe ratio of its overall portfolios.
Manager B holds a highly diversified portfolio that has balanced exposures to rewarded risk factors, high active share, and a relatively low active risk target.
Manager B’s portfolio is most likely consistent with the characteristics of?
Multi-factor manager
Most multi-factor products are diversified across factors and securities and typically have high active share but have reasonably low active risk (tracking error), often in the range of 3%.
Most multi-factor products have a low concentration among securities in order to achieve a balanced exposure to risk factors and minimize idiosyncratic risks.
