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.
