Equity Flashcards
Rebalancing overlay
vs
Completion overlay
Portfolio overlays most useful when?
Rebalancing overlay involves reconstitution of holdings back to a benchmark (full replication)
Completion overlay mean readjusting risk exposures of an equity portfolio back to benchmark weights (stratified sampling)
You would use a portfolio overlay when the benchmark has large derivative or FX exposures. Volatile benchmarks require more frequent rebalancing.
Fundamental approach to beating a passive benchmark =
Quantitative approach to beating a passive benchmark =
Methodology
Valuation process
Portfolio construction and re balancing
Fundamental:
Methodology: Focus on a smaller group of stocks bottom up, top down, value or growth
Valuation process: Prescreen on stringent financial market criteria, in depth analysis of companies. Buy or sell candidates relative to intrinsic value.
Portfolio construction and re balancing: Set price targets and sell when reached.
Quantitative:
Methodology: Maximise the objective function. Focus on a large group of stocks using time series or cross sectional time series analysis identifies factors with stable positive information coefficient.
Valuation process: Construct factor exposures across shares in same industry. Forecast volatility of each factor.
Portfolio construction and re balancing: Determine factors to over and underweight. Rebalance at regular intervals.
Fundamental = In depth analysis. Over under valued stocks. Price targets for sales.
Quantiative = Maximise objective function. Factor exposures from time series analysis. Regular rebalance.
Value base approached:
Relative value
Contrarian investing
High Quality value
Income investing
Deep value investing
Restructuring and distressed debt investing
Relative value - Comparing price multiples such as P/E and P/B to peers.
Contrarian investing - Purchasing or selling securities against prevailing market sentiment.
High Quality value - Equal emphasis is placed on both intrinsic value and evidence of financial strength, high quality management, and demonstrated profitability (the “Warren Buffet” approach).
Income investing - Focus is on high dividend yields and positive dividend growth rates.
Deep value investing - Focus is on extremely low valuations relative to assets (e.g., low P/B), often due to financial distress.
Restructuring and distressed debt investing - Investing prior to or during an expected bankruptcy filing.
Smart beta
Smart beta is a top down approach that identifies basic drivers. Rotating portfolio exposures into factors that are expected to outperform.
Pearson IC
Spearman Rank IC
Q. Suppose a positive, nonlinear relationship exists between stock returns and a risk factor. An analyst computes both a Pearson information coefficient and a Spearman Rank information coefficient. Which of the following relationships is most likely?
Pearson IC = correlation between factor exposure and subsequent period returns, high correlation means factor is good signal for predicting future returns. Disadvantage, Pearson IC is sensitive to outliers.
Spearman Rank IC is correlation coefficient of factor score rank against stock returns rank, better predictor than Pearson IC because less sensitive to outliers. Eg does earnings yield E/P drive strong performanc. At 40% yes it does, at 1.2% it doesn’t.
Pearson IC and Spearman Rank IC can contradict each other b/c of outliers affecting Pearson score.
A. The Pearson information coefficient is less than the Spearman Rank information coefficient.
Holdings-Based Style Analysis
Returns-based style analysis
Self identification
The holdings-based approach is bottom up and looks at the attributes of each individual stock in a portfolio and aggregates these attributes to conclude the overall style of the portfolio. A common application of this idea is the Morningstar Style Box.
Advantage = More accurate as it uses actual portfolio holdings. It also assesses each individual holdings contribution style.
Disadvantage = Requires the availabilty of all portfolio constituents and style attributes. Different systems will define style differently. DERIVATIVES HINDERED. overlay strategies is likely to hinder style anlalysis.
Returns based style analysis: Regresses fund returns against a set of passive style indices such as Large/Small cap Growth/Value LCG, SCV etc..
Rp=a+b1SCG+b2LCG+b3SCV+b4LCV+ε
Advantage - does not require information on holdings. Easily AND Universally applied.
Dis = Constraints on outputs limits extreme styles.
Self identification of funds would be used if you have significant short position and derivative overlays.
Key top down indicators?
Sector and industry rotation top down or bottom up?
Bottom Up indicators?
Special situations
Event driven
Contrarian investing
Volatility based,
thematic and country/geographic
GARP
Statistial arbitrage
Index futures and options
Deep value
Income investing
High quality value
Distressed securities
Contrarian investing
allocation. bottom up or top down?
Rotating into deep-value companies?
Top Down:
1. Country and geogrpahic allocation.
2. Sector and industry rotation.
3. Volatility based strategies - VIX, options, futures.
4. Thematic investment strategies. Disruptive tech etc..
- Sector and industry rotation can be BOTH top-down macro and bottom-up fundamental. Key word ‘recession’ would guide to top down.
Bottom Up:
Looks at individual asset and company level.
Business model and branding
Competitive advantages
Company management
Top Down:
Event driven, Thematic, Volatility, statistical arbitrage, index futures, options based and country/geographic.
Bottom up:
Special situations
Deep value
Income investing
High quality value
Distressed securities
Contrarian investing
GARP is a bottom up strategy.
Rotating into deep-value companies is a top down approach if driven by a macro reason
Steps of a quantitative investment process
A quantitative active investment process is structured as follows: (1) define the market opportunity (also known as the investment thesis); (2) acquire and process data that is required for the strategy; (3) back test the strategy; (4) evaluate the strategy; and (5) construct the portfolio.
What is a factor mimicking portfolio?
What is a factor tilting portfolio?
A dollar Neutral long/short portfolio that aim to gnerate a unit exposure to a single factor. They are relatively expensive to construct due to the trasnsaction costs.
A factor tilting portfolio is designed to track a benchmark with small tilts towards factors the manager expects to out perform.
Active Share
Factor bets
Active risk
Minimized with high or low covariance?
Scalable with short positions?
1% Long Autos / 1% Short Autos is swapped out with 1% long Bank / 1% short Industrial. What is the change to Active share and Active risk?
Active Share (a number between 0 and 1) measures how similar the portfolio is to the benchmark in terms of its stock holdings; the lower the value of Active Share, the closer the portfolio is to the benchmark. Change a 1%long/1%short auto position to a 1%long bank, 1%short industrial and Active share will not change as long as the absolute change is the same.
A manager makes factor bets when their portfolio’s exposure to one or more risk factors differs from that of the benchmark. Taking factor bets necessarily involves increased Active Share, whereas a higher value of Active Share does not necessarily imply that factor bets have been taken (for example, a manager might hold stock A instead of stock B, but the two stocks may have identical factor exposures).
Active risk measures the extent to which the active return (portfolio return minus benchmark return) varies from period to period through dispersion of returns. It can be seen as a consequence of Active Share and factor bets. On the same example 1%long/1%short auto to 1%long bank, 1%short industrial active risk will INCREASE as it measures the dispersion of differences. Correlation of the new pair is lower which will INCREASE Active Risk.
Active risk can be MINIMIZED by picking a fund with HIGH covariance with the benchmark being replicated.
Not scalable by increasing leverage when short positions are used.
4 Primary Economic Activity Segments
GICS = market oriented approach
Industrial classification benchmark = production oriented
Thomson Reuters business classification = production oriented
Russell Global Sector Classification = production oriented
Freerider issue
People benefitting from the active shareholder engagement who do nothing themselves.
Rebalancing
vs
Reconstitution
- buffering
- packeting
Rebalancing - Regularly adjusting portfolio weights
vs
Reconstitution - replacing stocks which no longer meet the desired market exposure.
- buffering = more GRADUAL than packeting ie Russel 3000 index may have 3,005 holdings.
- packeting = putting larger amounts but small positions in so you end up with more holdings than the index ie Russel 3000 index may have 3,100 holdings.
Fama french 5 factor model
- Market size (beta)
- firm size (market value of equity)
- book-to-market value
- operating profitability (operating income/beginner shareholder equity)
- Investment intesity (growth rate of total assets)
PFBS Passive factor based strategies - 3 types
- Return oriented
- Risk oriented
- Diversification oriented
Positives / negatives
- Return oriented = dividend yield or momentum (High PE or Small Cap) (Overweight Momentum factor)
- Risk oriented = volatility weighted (overweight low volatility factor)
- Diversification oriented = maximum diversification benefits/ number of stocks (overweight highest no stocks fund choice)
+ less costly than active management
+ more expensive than pure passive given trading costs
How is tracking error effected by adding new stocks?
As no. of new stocks is added, the tracking error first decreases and then increases once less liquid stocks enter.
Do Passives have voting rights?
Who gets voting right for lent securities? Can it be mitigated?
Who gets the dividend for lent securities?
Yes as passive manager has fiduciary responsibility to its investors too to use proxy voting.
Voting rights are transferred to the borrower. Activists would not lend their own securities when trying to influence a company. It can be mitigated by returning shares ahead of a vote.
The lender receives the dividends as if they had not lend the shares.
Voting = lost by lender
dividends = retained by lender
Fama french hedged portfolio approach
Rank a universe by factor, divide into deciles or other amount. Long top decile, short bottom decile.
Factors include: Size (Mkt Cap), Value (low P/B), Momentum, Quality (low non-cash accruals and positive revisions), Unstructured data (underlying customer success)
Activist investing?
Company outlook following activist stake? Re growth and debt.
Launching a proxy contest if open letter is ignored. Usually only a 10% so a minority position (not a major shareholder).
Activism leads to improved growth, profitability and corporate governence. AND higher debt levels.
Detailed building blocks of portfolio construction.
A manager focus on rewarded factors targets which?
A manager looking to time the market targets which?
A manager which targets momentum targets which?
- Rewarded risk factors (size, momentum and value)
- Alpha skills = being able to time changes to factor exposures
- Sizing of positions = luck
- Breadth
A manager who focusses on rewarded factors (size, value, momentum) would not rely on alpha skills. He would not be factor timing.
A manager who tries to time the market would be targeting alpha.
A momentum trader would target the momentum factor. Rewarded by the momentum factor but size agnostic. Active risk would be high. Alpha would be high.
Heuristic risk constraint
Formal Constraints
Based on experience or general ideas ie limits on exposure to individual positions and leverage as well as industry and geographic limits.
Heuristic constraint:
Maximum size of 5x the benchmark weight or 2%.
Weighted average market cap of no less than 75% of the index to maintain size factor.
Formal constraints are distinct from heuristic controls and often statistical in nature.
-Volatility, active risk, Skewness, Drawdowns, VaR, CVaR, IVaR, MVaR.
Formal risk constraints
Conditional VaR
Incremental VaR
Marginal VaR
Conditional VaR = expected loss given VaR is exceeded
Incremental VaR = change in VaR when adding a new position
Marginal VaR = Impact of a very small change in position size to VaR
Market impact from portfolio turnover and time horizons?
Higher portfolio turnover and shorter time horizons leads to higher market impact.
Gross exposure vs net exposure for 80m long and 30m short
Can you have gross long 100%?
Long extension vs EMN net exposure looks like what?
Gross = 110%
Net = 50%
50% long and 50% short = 100% gross long 0% net.
Long extension would be 160% gross exposure 100% net exposure.
EMN would be 0% net exposure.
Long only typically allows for greater investment capacity than other approaches.
Look ahead bias
Data Mining
Look ahead bias results from creating a model when information was unknown or unavailable at the time the investment decision was made.
Data mining where a model passes a backtest but does not make common sense
Hedged portfolio approach
Long top decile. Short bottom decile. It could be most to least indebted companies. More debted companies generally underperform. A drawback of the approach is that middle decile debt levels are best performing deciles.
Style Factors
Disadvantages of factor based approach compared to market cap weighted?
*1. Value - Long low PE, Short High PE.
*2. Growth - Long highest ROA yoy and short Lowest ROA yoy. It must be yoy growth not simple ROA!
*3. Price Momentum - Stock price changes Long past winners, Short past losers. Extreme tail risk for an unwind and add a sector neutralization to remove top sectors.
4. Quality
5. Unconventional data
Disadvantages of a factor based include concentrated risk exposures.
Active decision making creates higher fees for these strategies
Which factors to look for in each Factor.
Quality measures
Growth
Value
Momentum
Quality = profitability, sustainability
Growth = yoy EPS growth/ROA (note CHANGE in EPS Growth)
Value = Low PE and PB
Momentum = 12 month STOCK price change
Structured data
Unstructured data
Structured data - traditional financial statements
Unstructured data - credit card statements, satellite images and online word mentions.
Fundamental Active Investment Process
1 Defne the investment universe and the market opportunity—the perceived
opportunity to earn a positive risk-adjusted
return to active investing, net of
costs—in accordance with the investment mandate. e market opportunity
is also known as the investment thesis.
2 Prescreen the investment universe to obtain a manageable set of securities
for further, more detailed analysis.
3 Understand the industry and business for this screened set by performing
industry and competitive analysis and analyzing nancial reports.
4 Forecast company performance, most commonly in terms of cash ows or
earnings.
5 Convert forecasts to valuations and identify ex ante protable investments.
6 Construct a portfolio of these investments with the desired risk prole.
7 Rebalance the portfolio with buy and sell disciplines.
Creating a quantitative Active Strategy
The first step in creating a quantitative, active strategy is to
1. Define the market opportunity or investment thesis.
2. Data is acquired, processed, and transformed into a usable format. This step is followed by back-testing the strategy, which involves identifying the factors to include as well as their weights.
3. Finally, the strategy performance should be evaluated using an out-of- sample back-test.
Discretionary bottom up approach
Discretionary top down
Systematic bottom up
Systematic top down
Fundamental
Quantitative
Alpha from top down is usually generated how?
Alpha from bottom up is usually generate how?
Discretionary bottom up approach - security specific factors, factor timing, concentrated or diversified portfolios.
Discretionary top down - Macro factors, factor timing diversified or concentrated.
Systematic bottom up - Security specific factors, No factor timing, diversified
Systematic top down - Macro factors, factor timing, diversified.
Fundamental - Lower number of stocks and reliance on manager discretion and judgement
Quantitative - Reliance on computer modelling
Systematic = diversified, (aka Low idiosyncratic risk)
Top down = Macro factors
Bottom up = Security specific
Discretionary = factor timing, (plus: non financial measures such as ESG, concentrated portfolios.)
Discretionary investment process searches for active returns from FIRM-SPECIFIC factors such as pricing power and competitive landscape on a smaller subset of securities.
Systematic investment approach is designed around extracting premiums from a balanced exposure to known, REWARDED FACTORS across a broad universe of securities.
Alpha from top down is usually generated how? Factor timing.
Alpha from bottom up is usually generate how? A product of security selection
Return from unrewarded factors =
Return from rewarded factors =
High/low R^2 indicates what?
Return from unrewarded factors = Actual fund performance - Return from rewarded factors
Return from rewarded factors = (Fund Market Factor performance x Market Factor performance) + (Fund Size factor x Size factor) + ( Fund value factor x value factor) + (Momentum value factor x Momentum factor)
High R^2 shows that much of the return is explains by rewarded factors
Low R^2 shows variability of returns is not explained by rewarded factors.
Objective function:
Absolute approach
Relative approach
The explicit objective stated for systematic managers, it may be to maximise sharpe ratio or maximise information ratio.
Absolute approach seeks to maximise sharpe ratio. Rp - Rf / SD
Relative approach seeks to maximise information ratio. Active return/Active risk
Neccessary characteristics of a Passive equity index:
Should be:
Rules-based
Transparent
Investable
Securities lending
What happens to voting rights? How can it be mitigated.
How to offset cash and dividend drag?
Used to generate fee income which can be used to cover PORTFOLIO EXPENSES, produce a better match of index performance and lower tracking error.
Voting rights are transferred to the borrower. It can be mitigated by recalling shares ahead of a vote.
Cash drag is dealt with using futures or swaps.
Implicit costs
Market Impact costs
Slippage costs
Market impact costs will be larger for high AUM funds due to delays in completing trades.
High portfolio turnover.
High urgency funds.
Small cap securities due to less liquidity.
(Market impact costs can be mitigated by patient investors taking time to build positions)
][
Slippage = difference between execution price and the midpoint of bid-ask quotes at the time the trade was entered.
Slippage is greater for small cap stocks.
EM does NOT make a difference.
Vary but usually higher during increased volaitlity.
(more important than commission costs)
Necessary characteristics of a Passive equity index:
Should be:
Rules-based
Transparent
Investable
Two portfolios have similar active and absolute risks, similar costs, and similar manager alpha skills, then High or Low active share preferred?
The portfolio with the highest Active Share is preferable because this will leverage the alpha skill of the manager and have higher expected return
Four most rewarded factors to offer a return premium =
Market (Beta) (BETA IS A REWARDED FACTOR!)
Size (Small cap)
Value
Momentum
Highest risk efficient returns
Lowest Active risk
Lowest number of securities
Separately Managed account.
Use of Program Trading on trading close prices to replicate the index. (Trade on close)
Optimisation vs Stratified sampling
Which will lead to higher tracking error?
Optimization aims to maximise desirable characteristics and minimise undesirable characteristics while minimizing tracking error and requires higher levels of technical sophistication. Portolios may NOT be mean variance efficient though unless catered for in the optimisation process.
Stratified sampling may lead to higher tracking error but leads to lower costs error.
Lowest Active Risk/Active Share (X/Y axis) to Highest Active Risk to Active Share
Pure Indexing, Closet Indexing, Factor Neutral & Diversified stock picks, Concentrated Factor Bets, Concentrated Stock Picker.
Highest Sector Deviations (circa 15%), High Active Risk, Either high or low Active share (circa 15%) =
Highest Active Risk, High active share, Low sector deviations =
Low single security contribution, Second Highest Sector deviation =
High Active Share, Low active risk =
(lowest) Pure Indexing, Closet Indexing, Factor Neutral & Diversified stock picks, *Concentrated Factor Bets, Concentrated Stock Picker (Highest)
*Sector rotator
Highest Sector Deviations (circa 15%), High Active Risk, Either high or low Active share = Sector rotator (concentrated factor bets) *
Highest Active Risk, High active share, Low sector deviations = Concentrated stock picker
Low single security contribution, Second Highest Sector deviation = Diversified Multi-factor manager (think “low single security contribution due to diversified nature”) Balanced exposure to rewarded risk factors#
High Active Share, Low active risk = Diversified stock picker (top left of XY chart)
High Active share, High Active risk = Concentrated stock picker.
Sector bets effects Active risk only.
Risk efficient returns
Best risk adjusted returns for a LOWEST number of shares and LOWEST Active risk.
Excess return from active factor weighting
Percentage of excess return
Compare ‘active weight x factor return’ for weights which are different
ie 29% quality fund vs 23% quality BM (both over and underweight positions count) is an active weight however 30% Momentum Fund vs 30% Momentum BM is not’
Excess reutn = Add up the ACTIVE factor weights.
Percentage of excess return = Find the BM to Fund DIFFERENCE of ALL factors. Then see what the percentage of active factor return from previous equation and divide by total.
Excess return from factor weighting = -0.04%
Total return difference = -0.22%
Percentage of excess return = -0.04/-0.22 = 18.18%
What does Neutralising sectors mean regarding price momentum?
Sector neutral price momentum reduces big sector bets and reduces downside risk.
Rationale for investing along the active passive spectrum?
Confidence in ability to outperform
Client preference
Availability of a suitable benchmark
Client specific mandates
Risks and costs of active management
Taxes
Portfolio construction approaches
Stratified sampling - less holdings than the index
Full replication - Same number of stocks as the index (more stocks may be a sign of buffering)
Optimisation - Less stocks than the index matching risk exposures of an index (may be used alongside stratified sampling)
