Equity Flashcards
ideal pairs trade
Two stocks make for an ideal pairs trade if (1) the current price ratio differs from its long-term average and shows historical mean reversion and (2) the two stocks’ returns are highly correlated.
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.
Stock borrowing: dividends and voting rights
stock borrower ensures that the stock lender is compensated for any dividends that the lender would have received had the stock not been loaned. But the voting rights are transferred to the borrower of the securities.
Cap weighting, single factor weighting, fundamental 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.
Fundamental weighting’s intended advantage is overweighting stocks priced below intrinsic value and underweighting overpriced stocks.
In a price-weighted index, the weight of each stock is its price per share divided by the sum of all the share prices in the index. As a result, a price-weighted index can be interpreted as a portfolio composed of one share of each constituent security.
Tracking error
Tracking error does not measure volatility of the portfolio; rather, it measures the volatility of the excess return between the index and the portfolio.
ETF vs mutual funds
Only ETF investors can purchase shares on margin, not mutual fund. Investors can take short positions in ETFs but not in mutual funds.
ETFs have smaller taxable events than mutual funds because of the in-kind transfer of securities between an authorized participant and the fund when redemptions occur. Disadvantages of using ETFs include the need to buy at the offer and sell at the bid price, paying commissions, and possibly facing illiquid markets at either purchase or sale.
total contribution to the return caused by active factor weighting
total contribution to the return caused by active factor weighting is (Underweighting of the Growth factor + Overweighting of the Quality factor) ÷ Total effect
Packeting
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.
stratified sampling
In stratified sampling, the portfolio manager holds a limited sample of the index constituents arranged in distinct strata or subgroupings. Arranged correctly, the various strata will be mutually exclusive and also exhaustive and should closely match the characteristics and performance of the index.
Alpha or return from unrewarded factors
Return from unrewarded factors = Actual monthly performance – Return from rewarded factors. “Alpha” = RA – ∑βpkFk
RA = Actual portfolio performance
βpk = The sensitivity of the portfolio (p) to each rewarded factor (k)
Fk = The return for each rewarded factor
Active share/ risks
A sector rotator typically has high active risk and could have either high or low Active Share, depending on whether a concentrated or diversified portfolio approach was followed.
A closet index would exhibit both low Active Share and low active risk, because such funds make few active bets.
If diversified stock picking: relatively high Active Share but relatively low active risk.
delivers the lowest active risk (3.2%) using far fewer securities (140), indicating an efficient approach.
In a single-factor model, if the factor exposure is neutralized, the active risk will be entirely attributable to the Active Share. The active risk attributed to Active Share will be smaller for more diversified portfolios with lower idiosyncratic risk. Active risk does rise with an increase in factor and idiosyncratic volatility.
The contribution of Country A to total portfolio variance
The contribution of Country A to total portfolio variance is calculated as follows:
Weight A × Weight A × cov(A,A) = 0.30 × 0.30 × 0.06250 = 0.005625
Weight A × Weight B × cov(A,B) = 0.03 × 0.50 × 0.15000 = 0.002250
Weight A × Weight C × cov(A,C) = 0.30 × 0.20 × 0.00675 = 0.000405
Or sum of coefficient A x Variance of the market factor return and covariances with the market factor return x covariance between the market factor and factor j
Country A’s contribution to total portfolio variance = 0.00828
The portfolio variance = (Std. dev.)2 = (0.132)2 = 0.01742.
The proportion of total portfolio variance contributed by Country A is 0.00828 ÷ 0.01742 = 47.5%.
Contrarian managers
Contrarian managers invest in stocks with low or negative earnings or low dividends. Contrarians expect the stocks to rebound once the company’s earnings rebound. Contrarian investors often point to behavioral finance research that suggests that investors tend to overweight recent trends and follow the crowd in making investment decisions
Effective no of shares = 1/HHI
Effective no of shares = 1/HHI
expected portfolio active return
breadth (number of truly independent decisions made each year by the manager):
expected portfolio active return =IC× sq root of BR×σRA×TC
Outline fundamental active investment process
- Define the investment universe and the market opportunity or investment thesis—the perceived opportunity to earn a positive risk-adjusted return to active investing, net of costs—in accordance with the investment mandate.
- Prescreen 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, most commonly in terms of cash flows or earnings.
- 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.
