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CFA Level 3 > Equity > Flashcards

Equity Flashcards

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1
Q

What are the roles of equity in a portfolio?

A
  1. Capital Appreciation
  2. Dividend Income
  3. Diversification - although correlation increases in time of crisis
  4. Inflation hedge - this does not apply to equities as a whole, but applies to certain sectors or stocks depending on the ability to pass on increases in input costs.
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2
Q

What are the pros and cons of segmenting equities based on size and style characteristics?

A 
Pros:
1. Simplifies portfolio management
2. Helps define a benchmark
3. Keeps managers within a style
Cons:
1. No clear category definitions
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3
Q

What are the pros and cons of segmenting equities by geography?

A 
Pros:
1. increase global diversification
Cons:
1. Country domicile does not mean you only capture that economy's risk
2. Currency risk
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4
Q

What is the difference between a market oriented and production oriented sector classification?

A

Market oriented is based on the way revenue is earned and the way customers use their products. Production oriented is about manufacturing process (inputs and outputs). For example, airlines could be classified as transportation or travel and leisure depending on how you view it.

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5
Q

What are the types of income and costs of an equity portfolio?

A 
Income:
1. Dividends
2. Securities lending income
3. Ancillary investment strategies
This includes dividend capture (buy before divided and sell after), covered calls, cash covered puts.
Fees:
1. Management fees
2. Performance fees
3. Administrative fees
4. External fees (custody, registration)
5. Marketing and distribution
6. Trading costs (explicit and implicit)
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6
Q

What is shareholder engagement? What are the benefits and drawbacks?

A 
This is the process of investors actively interact with companies (voting for example).
Benefits:
1. Potential to gain more information
2. Chance to add value
Costs:
1. Time consuming and costly
2. Pressures companies to reach ST targets
3. Potential conflicts of interest
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7
Q

Why would you engage in active investing?

A
  1. You have confidence to outperform
  2. Your clients prefer active management
  3. Unique client circumstances or preferences
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8
Q

Why would you engage in passive investing?

A
  1. You do not have confidence to outperform
  2. Your client prefers
  3. You don’t want to incur the risks and costs of active management
  4. You want to be very tax efficient
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9
Q

What are the key three requirements for selecting a benchmark for a passive investing strategy?

A
  1. It must be rules based (criteria for inclusion, rebalancing rules, consistent, predictable)
  2. It must be transparent - disclosure of rules and constituents
  3. It must be investable - performance can be replicated in the market
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10
Q

What is buffering? What is packeting?

A

This is the process of defining the ranges where stocks move across different classifications. For example, when does a small cap move to mid cap? Packeting is when you split stock positions into multiple parts. For example, you could include a stock in both indices and different weightings.

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11
Q

How do you find the effective number of stocks (after considering concentration) of an index?

A

Take the 1 /HHI (squared summed weights of constituents)

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12
Q

What are the basic three types of factor based strategies?

A
  1. Return oriented - yield, value, momentum
  2. Risk oriented - minimum variance, volatility weighted
  3. Diversification oriented - equally weighted, maximum diversification strategies
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13
Q

What causes tracking error?

A
  1. Fees
  2. Securities lending
  3. Intraday trading
  4. Cash balances
  5. Sampling
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14
Q

What are the key differences between fundamental and quantitative investing?

A

Fundamental is subjective and discretionary, whereas quant is objective and systematic.
Fundamental is based on bottom up research on companies whereas quants is about statistics and modelling. Risk is at the company level in fundamental but is at the portfolio/model level in quant

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15
Q

What are value based investing approaches?

A
  1. Relative value - price vs peers
  2. Contrarian investing - depressed cyclical names
  3. high quality value - strong ROE, growth,
  4. income investing - high yields and yield growth
  5. Deep value - could indicate inefficient pricing
  6. Restructuring
  7. Special situations
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16
Q

What are some basic top down investing strategies?

A
  1. Country and geographic
  2. Sector and indsutry
  3. Volatility based
  4. Thematic investors
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17
Q

What are some of the potential reasons for the existence of the value factor?

A
  1. Premium for financial distress

2. Behavioural biases - overselling, less attention

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18
Q

What are common tactics used by activists?

A
  1. Seeking board representation
  2. Proxy contests
  3. Talking to management
  4. Proposing changes in annual meetings
  5. Reduce management compensation
  6. Lawsuits against management
  7. Breaking up conglomerates
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19
Q

How does a company defend against activist investors?

A
  1. Dual Class
  2. Poison Pills
  3. Staggered boards
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20
Q

What are characteristics of a company activists would target?

A
  1. Slower revenue and earnings growth
  2. Negative share momentum
  3. Weaker corporate governance
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21
Q

What is statistical arbitrage?

A

This is when you try to take advantage of mean reversion or long term relationships. An example if pairs trading. This strategy can become risky if there is a structural change that means the historical relationship no longer holds.

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22
Q

What are the basic steps to take when you’re developing a fundamental equity portfolio management approach?

A
  1. Define the universe and potential opportunity
  2. Pre-screen the universe
  3. Understand
  4. Forecast company performance
  5. Convert forecasts into valuations
  6. Construct
  7. Rebalance
23
Q

What are some of the common pitfalls of fundamental equity management?

A
  1. Behavioural biases
  2. Value traps
  3. Growth traps
24
Q

How do you create a quant portfolio management strategy?

A
  1. Define market opportunity
  2. Acquire and process data
  3. Back test - take factor performance vs one period ahead performance
25
Q

What is the difference between the Pearson IC and Spearman IC?

A

Pearson is the correlation using factor score and one period ahead return
Spearman is the correlation between factor rank and performance one period ahead rank.

26
Q

What are some of the pitfalls of backtesting quant strategies?

A
  1. Survivorship bias
  2. Look-ahead bias - using information that was unavailable in the original time period
  3. Data mining
  4. Turnover, transaction costs, short availability
27
Q

What is the difference between a holdings based and return based style classification system?

A

A holdings based takes each holding and classifies based on active weightings. Return based uses regression to determine source of returns.

28
Q

What are the three sources of active return?

A
  1. Exposure to rewarded factors - OW vs UW
  2. Alpha
  3. Luck
29
Q

What is alternative beta and how is it related to alpha?

A

Alternative beta is exposure to a rewarded factor. This is not alpha, but is still active return. The idea behind this is that you could have achieved exposure through a passive product.

30
Q

What is factor timing?

A

This is generated through shifting beta exposures over time and is considered a source of alpha.

31
Q

What are two ways to size positions?

A
  1. Manage factor exposure

2. Stock picks - higher idiosyncratic risk

32
Q

What is the significance of “breadth” of experience? How does it convert to expected returns?

A

Success if a function of breadth of experience. If you are confident in each of your decisions, and expect uncorrelated decisions to each pay off, more decisions are diversifying. This is related to expected return = IC * sqrt breadth * SD of active return * TC. Basically, confidence in outperformance increases when it can be attributed to a larger sample size of decisions

33
Q

What does active share measure? How do you calculate it?

A

This measures the extend to which number and sizing of positions differ from the benchmark. This is the absolute value of the differences, summed, and divided by 2.

34
Q

What is the difference between active share and active risk?

A

Active share measures similarity the a benchmark which is controllable, whereas active risk measures the deviation of returns from benchmark.

35
Q

What is active risk a function of?

A
  1. Increases in factor risk volatility
  2. Idiosyncratic volatility
    Essentially, it is attributed to factor exposure or active share
36
Q

What are the steps in an effective risk budgeting process?

A
  1. Determine the best type of risk measure for your goals
  2. Understand how each aspect of the strategy contributes to its overall risk
  3. Determine the appropriate level of risk
  4. Allocate risk among factors and positions
37
Q

How is it possible to add active risk when adding a low volatility asset?

A

If your benchmark if very volatile and you add an uncorrelated asset, you have lower explained return and therefore have higher active risk.

38
Q

What are some common limitations to the level of risk you aim to take?

A
  1. Implementation issues (no leverage, shorts)
  2. Limited diversification opportunities
  3. Leverage levels reduce compounded returns in a multi period setting
39
Q

What are common heuristics used in risk management?

A
  1. Exposure concentration
  2. Net factor exposures
  3. Net currency exposures
  4. Degree of leverage
  5. Turnover
40
Q

What are the common formal measures of portfolio risk?

A

VaR, CVar, IVar, MVar, skewness, active risk, volatility

41
Q

How does AUM affect portfolio management?

A

The larger the AUM, the lower the explicit costs. However, implicit costs will go up. This is the opposite for small funds that lack scale.
Higher AUM increases position size in general.

42
Q

How do larger position sizes affect the ability to manage an equity portfolio?

A

Bigger positions make turnover very hard to manage and impact markets more when trading.

43
Q

What are the characteristics of a well constructed portfolio?

A
  1. Clear philosophy
  2. Consistent process
  3. Risk & structural process as promised
  4. Risk and cost efficient
44
Q

Explain the features of a long/short portfolio:

A
  1. You are able to express negative views
  2. You can extract pure factor exposures
  3. You can reduce market exposure
45
Q

What is the difference between a long short portfolio and a long extension portfolio?

A

A long short portfolio is unconstrained in net and gross exposure. A long extension is an enhanced equity portfolio where net exposure will always be 100%. For example, 130/30 portfolios.

46
Q

Explain the features of a market neutral fund

A

The purpose is to hedge out all or most market risk (beta). This is typically less volatile.

47
Q

What is the difference between pairs trading and stat. arbitrage?

A

Pairs trades go long strong performers and short weak. Stat. arb is a mean reversion trend that goes long underperformer and short outperformer. Pairs trading is about spreads widening, stat arb is about convergence

48
Q

What are the benefits and costs of long/short strategies?

A 
Benefits:
1. Reduce market risk
2. Alpha opportunity
3. Diversification
Costs:
1. Leverage
2. Higher active risk
3. Borrowing costs
4. Complexity
5. Lose market premium
49
Q

What is the difference between a systematic portfolio and a discretionary portfolio?

A
  1. Systematic is generally more diversified whereas discretionary has less positions
  2. Systematic is generally a quantitative strategy whereas discretionary is a fundamental strategy
50
Q

What is the difference between a top down and bottom up portfolio?

A
  1. Top down managers are concerned with macro factors and factor timing, sectors and sector rotation, volatility, themes, and events.
  2. Bottom up strategies are concerned with individual company business models, competitive advantages, relative value.
51
Q

What are the benefits and drawbacks of return based style analysis?

A

Benefits:
Can be more widely applied as you do not need to know all of the holdings of a portfolio
This can accommodate alternative return sources like derivatives.
Costs:
Make it difficult to detect aggressive positions due to unnecessary constraints
Generally less accurate than holdings based

52
Q

What are the benefits and drawbacks of holdings based style analysis?

A

Benefits:
Generally more accurate
Can detect more aggressive positions and analyze deeper
Costs:
You need all holdings and the attributes of those holdings
Limited data on derivatives

53
Q

How can a large fund reduce the implicit costs of trading?

A
  1. Reduce turnover
  2. Use a trading strategy that moves the markets less
  3. Gate the fund or return capital
  4. Expand number of holdings
54
Q

How do you calculate the contribution to total portfolio risk?

A

Sum of…

Weight A * Weight holding * Covariance, done for each holding

CFA Level 3 (28 decks)

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