Equity

Question 1

Type I vs Type II Errors

Answer 1

When assessing manager skill, the NULL is that the manager is NOT skilled, so the ALTERNATIVE is that the manager DOES have skill

Type I

When the null is incorrectly rejected

–> fund hires a bad manager

Type II

When the null is false but NOT rejected

–> fund fails to hire good managers

Question 2

Buffering

Answer 2

Buffering involves establishing ranges around breakpoints that define whether a stock belongs in one index or another. Some index providers have adopted policies intended to limit stock migration problems and keep trading costs low for investors who replicate indexes. Size rankings may change daily with market price movements, so buffering makes index transitions a more gradual and orderly process. As long as stocks remain within the buffer zone, they stay in the current index, and as a result, the holdings of the fund may exceed the holdings of the index.

Question 3

Packeting

Answer 3

Packeting involves splitting stock positions into multiple parts. For example, if a mid-cap stock’s capitalization increases and breaches the breakpoint between the mid-cap and large-cap indexes, a portion of the total holding is transferred to the large-cap index but the rest stays in the mid-cap index. On the next reconstitution date if the stock value remains large cap and all other qualifications are met, the remainder of the shares are moved out of the mid-cap index into the large-cap index.

Question 4

Impact vs. Thematic vs. Production oriented investing

Answer 4

Thematic**: focusing on a specific **sector, such as clean energy or climate change, is thematic investing.

Impact investing may target environmental objectives but additionally influences measurable financial returns through engagement with a company or by direct investment.

The production-oriented approach groups companies that manufacture similar products or use similar inputs in their manufacturing processes.

Question 5

Dividend Capture

Answer 5

shares that are about to go ex-dividend are purchased and sold after they go ex-dividend

Question 6

Statistical Arbitrage

Answer 6

technical stock pricing and volume data –> generate returns

aim to profit from either mean reversion or taking advantage of mkt microstructure inefficiencies

usually quant, but sometimes can incorporate judgment from a fundamental mgr

Pairs trading = poopular stat arb strat: Find two stocks in same industry that are historically highly correlated –> Profit by taking advantage of a temporary breakdown in this relationship –> Buy underperforming one and short the outperforming one –> profit from mean reversion

Risk: the breakdown persists and there’s no mean reversion

Market microstructure based arb = adv of mispricing caused by imbalances in supply/demand that are only expected to last for a few milliseconds

–> Need tools to analyze limit order book of an exchange and the ability to do high-frequency trading

Question 7

Value Trap

Answer 7

Stock appears to be attractive bc of a signficant price fall, but might actually be overvalued and go down more

Eg if you only buy based on PE you will prob eventually buy something that actually just sucks fundamentally and the company may fail

Need to also determine it’s trading below INTRINSIC value given future prspects, ID the trigger that will lead to upward revaluation

Question 8

Growth Trap

Answer 8

Future growth prospects already reflected (or over-reflected) in stock price

Eg mkt price could reflect rly aggressive growth of 15%, but if it only hits 12% decline in value

Trap is that growth stocks generally trade at rly high PE and even modest shortfalls in growth can mean huge declines in PE and stock price

Question 9

Pearson Information Coefficient

Answer 9

One of two variations of IC

IC = measure of predictive power of a quant model –> if there’s a strong relationship between factor exposure and performance the factor has high predictive power

IC is the correlation between factor exposure and holding period return

will be between +1 and -1 (or +100% and - 100%)

a monthly value of even 5-6% is considered very strong

for Pearson the IC of the raw data is sensitive to outliers

–> SPEARMAN addresses this issue and is more robust

NOTE: we are not looking at absolute earnings yield, but rather how far earnings yields are from the average earnings yield in terms of standard deviations –> if this is related to future performance of securities, the Factor has predictive power

Question 10

Spearman Information Coefficient

Answer 10

a more robust version of Pearson IC because Pearson is sensitive to outliers in data

Spearman = the correlation of the RANK of the factor scores and the RANK of subsequent performance

SEE WORD DOC PRACTICE PROB RESPONSES FOR EXAMPLE

Question 11

Pitfalls of Quant Investing

Answer 11

Surviroship bias –> backtesting only applied to existing companies –> strat will look better than it is

Look-ahead bias: using info in the model to give signals at a time when the info wasn’t actually available–> eg using YE financials to generate signals for January –> when in reality you wouldn’t get public YE financials until later in the year like march

Data-mining/overfitting: when you look for data a lot until you find data that supports/suggests the strategy worked

Turnover: constraints on turnover might limit mgr ability to follow a strategy

Lack of availability of stock to borrow: constrain short strategy

Transaction costs: erode returns for a strategy that looked good in backtesting

Quant overcrowding: when too many quant mgr nerds use similar strategies–> if a straegy is crowded, poor performance could cause a lot of mgrs to exit at the same time, exaggerating losses and leading to margin calls, vicious cycle –> eg short interest

Question 12

RBSA vs HBSA: Strengths and Limitations

Answer 12

Question 13

Merits of Long-only Strategies

Answer 13

LT Risk Premiums like mkt risk premium are earned by going net LONG. If you short sell over the long term youll have negative returns –> SHORTER TIME HORIZON would prefer short exposure

Capacity and Scalability: short selling is restricted by availability of stocks to borrow –> long only has more capacitym especially for large-cap funds

Limited legal liability: max a long investor can lose is your basis, whereas “naked” (unhedged) short downside is theroetically unlimited

Regulations: in some countries ban short selling (in the interest of fin mkt stability)

Transactional complexity: is higher if you short. Longs just have to buy and sell, whereas short sellers have to source, provide collateral to lender of shares, risk lender recalls, and deal w brokers / other counterparty risk

Costs: more mgmt fees and operating expense for long/short vs long only

Personal ideology: investor might object to short selling (bc moral objection to profiting on others failure, or they think expertise of mgrs in short selling isnt consistent, or are against levering up like some L/S strats do)

Question 14

L/S Funds: Gross and Net Exposure

Answer 14

Gross exposure = (sum of value of long positions plus the absolute value of the short position, expressed as % of invetor’s capital)

Net exposure = (difference btwn value of long positions and value of short positions as % of investor capital)

Question 15

Long Extension

Answer 15

Long/Short Strategy

= constrained to have net exposure of 100%

Eg long position of 130% and short position of 30% (referred to as a 130/30 fund)

HINT: Think EXTENSION because you’re EXTENDING exposure of your portfolio to short, but such that you still have 100% net exposure

Constrained bc mgr has no real discretion over gross/net exposure

Would be preferred by investors who want 100% net mkt exposure but also want mgr to do some shorting to benefit from negative views

Question 16

Market-Neutral Strategy

Answer 16

= aim to remove mkt exposure via L/S exposures

Should have lower vol than long-only**, and **low correlation w other strategies

Objective: neturalize risks where mgr doesn’t think they have comparative advantage in forecastigng –> can focus on their specific skills

Often used for diversification purposes rather than returns

Can be done via pairs trading or statistical arb

Eg long 200M assets w mkt beta of 0.9 and short $150M of assets w mkt beta of 1.2, giving it net mkt beta of 0

If L/S positions of equal size (and thus have equal betas), gross exposure will be twice the long position value and net exposure will be zeroVery hard to maintain zero beta given constantly changing correlations

Question 17

Benefits / Drawbacks of L/S strategies (vs. Long-only)

Question 18

Slippage

Answer 18

= the diff btwn execution price and the midpoint of the bid/ask (bid/ask when the trade was first entered)

–> Mkt impact cost of a single trade

Four notable conclusions on slippage based on recent empirical data:

• Slippage costs are usually higher than explicit costs.
• Slippage costs are greater for smaller-cap securities than for large-cap securities.
• Slippage costs are not necessarily greater in emerging markets.
• Slippage costs are substantially higher in times of high market volatility.

Small cap mgrs might have increasing slippage cost as their AUM grows –> should close fund or change strat

Since small caps have higher impact costs, a fund w a focus on large caps can do higher AUM than a similar strategy fund that focuses on smallcaps

EXAMPLE P 234

Question 19

The three requirements for an index to be the basis of an equity investment strategy

Answer 19

Index must be:

1) Investable
2) rules-based
3) transparent

Question 20

Benchmark Weighting Methods:

1) Mkt-Cap weighting

2) Equal weighting

3) Price weighting

4) fundamental weighting

Answer 20

1) Mkt-Cap = each weighted by its % of mkt cap in index –> typically based on free floating shares only (available for trading/not closely held)

2) Equal = invest equal amounts in each portfolio stock –> weights each stock the same –> reduces concentration risk, slow to change sector exposures –> more VOLATILE than mkt weighting –> small-cap, low liquidty stocks are overweighted

3) Price weighting –> weight each portflio stock by its price –> hold equal number of shares of each stock –> gives stocks with higher share prices larger index weights (DJIA is an example)

4) fundamental weighting = weights by proportion of the total index value of a fundamental factor, like sales or dividends –> eg if a stock pays 3% of all the divs of an index, it’ll have a 3% weight in a div-weighted index –> considered to be RETURN-oriented because strategies here focus on factors that have determined the differences in return

Question 21

HHI and Effective # of Stocks

Answer 21

HHI = sum of the squared weights of stocks in a portfolio

NOTE: be careful if a portfolio is only partially equities–if you’re looking for the HHI of the whole portfolio you need to also multiply by the overall equity weight:

eg consider a portfolio that’s 70% equities, with 30% of that in ABC and the remaining 70% in XYZ:

(0.3 x 0.7)² = 0.0441

+

(0.7 x 0.7)² = 0.2401

= HHI = 0.2842

Effective # of stocks is simply the inverse of HHI = (1/HHI)

HIGHER HHI = more concentrated

LOWER EFFECTIVE # = more concentrated

Question 22

Reasons why a NARROWER corridor can be used before triggering rebalancing

Answer 22

1) Low transaction costs –> doesnt cost much to rebalance frequently
2) Low client risk tolerance –> narrow corridor = better control of portfolio risk
3) LOW correlations between asset classes –> eg if deviations in weighting are not closely controlled, those deviations can quickly become much larger as classes move in opposite directions
4) if markets are mean-reverting –> because selling what has gone up in price to purchase what has gone down in price is likely to generate profits
5) if markets are highly volatile –> because deviations in weighting are not closely controlled, those deviations can quickly become much larger (note that if transaction costs are high, costs may outweigh benefits, so transaction costs should be factored into the decision)

Question 23

3 Reasons why Passive approach would be better than active

Answer 23

1) passive = low turnover, lower cap gains vs active –> lower taxes
2) if you believe equity mkts are efficient, ability to generate alpha is limited –> supports passive approach
3) if you want low tracking risk

Question 24

Fundamental Law / Expected Return Formula

Answer 24