Equity Flashcards
Describe the roles of equities in the overall portfolio.
The roles of equities in a portfolio include:
* capital appreciation
* dividend income
* diversification benefits
* potential to hedge inflation
The allocation to equity must be consistent with the client’s investment objectives and constraints.
What are client considerations that investors with environmental, social, and governance (ESG) considerations have?
Negative: Exclude
Positive screening: Include
Thematic Investing: (example Energy Efficiency)
Impact Investing: Seek to achieve targeted social/environmental objectives and financial performance.
Describe how an equity manager’s investment universe can be segmented.
Size: market capitalization
Style: growth, value, or blended
Geographic segmentation: which includes developed markets, emerging markets, and frontier markets
Economic activity segmentation: by sectors or industries. Classification can be based on a
* market-oriented
* production-oriented
Or combinations: of the previous can be used.
Describe the types of income associated with owning and managing an equity portfolio.
Dividends: mostly in the form of regular dividends received.
Lending securities: for a fee and earning funds on cash collateral received.
Writing options: for the premium received.
Dividend capture: through buying a stock just before and selling it just after it goes ex-dividend.
Describe the types of costs associated with owning and managing an equity portfolio and their potential effects on portfolio performance.
Management fees: Managers typically charge regular and some charge performance-based. Some managers cover all services in the management fee.
Others also charge additional fees for specific additional services, or coordinate with third-party providers who provide and charge fees for specific services.
Other costs to consider are:
* Transaction and trading costs: which may be explicit or implicit.
* Strategy costs: generally active strategies will have higher cost. Passive strategies may incur hidden costs such as predatory pricing.
* Liquidity demands: momentum strategies that buy in up or sell in down markets demand liquidity and typically pay high market impact costs.
Describe the potential benefits of shareholder engagement and the role an equity manager might play in shareholder engagement.
Shareholder engagement: refers to shareholders and managers seeking to influence the companies they invest in through calls and/or shareholder voting.
* Engagement benefits the company with improved corporate governance.
* It may benefit shareholders through higher stock price.
* Free riders who don’t incur the costs of engagement also benefit.
Activist investors take this further and propose resolutions to be voted on and seek the support of others or engage in proxy fights to achieve their goals.
Describe rationales for equity investment across the passive–active spectrum.
Equity portfolios are often characterized as being actively or passively managed. However, in practice, portfolios may exhibit characteristics from both investment strategies.
Rationales for equity portfolios to span across the passive–active spectrum include:
* manager confidence
* client preferences
* benchmark selection
* client mandates
* active management costs/risks
* taxes
An equity index as a benchmark for equity investment strategies must be?
- rules-based
- transparent
- investable
What are the 3 considerations in choosing a benchmark?
- determine the desired market exposures
- be consistent with the client’s objectives and constraints
- identify the method used for constructing the index.
Constructing and maintaining an index involves?
The weighting method to construct the index:
1. market-cap weighting
2. price weighting
3. equal weighting
4. fundamental weighting
Considering the level of stock concentration: the “effective number of stocks” can be determined as the reciprocal of the Herfindahl-Hirschman index (HHI).
Frequency of rebalancing: updating the weights of the stocks in the index:
Reconstitution: removing and replacing stocks that no longer fit the index market exposure.
Compare passive factor-based strategies to market-capitalization-weighted indexing.
Passive factor-based strategy: The return/risk characteristics of an index can be replicated by creating a portfolio with the same exposures to a set of risk factors as the index.
There are 3-types of passive factor-based strategies:
1. return oriented
2. risk oriented
3. diversification oriented
Common factors are:
* growth
* value
* size
* yield
* momentum
* quality
* volatility
Compare different approaches to passive equity investing.
3-common approaches to passive equity investing involve the use of:
1. pooled investments, such as open-end mutual funds and ETFs
2. derivatives-based strategies
3. separately managed index-based portfolios
What are the 3-methods of constructing passively managed index-based equity portfolios?
Full replication: hold and match the weights of all the securities in the index (full replication)
Stratified sampling: select a more liquid sample of securities to replicate the index (often based on cell matching)
Optimization: use a more technical and quantitative approach to maximize desirable characteristics and/or minimize undesirable characteristics.
Blended approaches: using a combination of these methods are also common.
Discuss potential causes of tracking error and methods to control tracking error for passively managed equity portfolios.
Tracking error initially declines as sample size increases but then increases as costs:
* transaction
* management
* illiquidity
outweigh the gains of increasing sample size.
Intra-day trading and cash drag also create tracking error.
Reducing tracking error requires a continuing evaluation of the tradeoff between the benefits of larger sample size and increasing costs.
Derivatives can be used to reduce the effects of cash drag.
Explain sources of return and risk to a passively managed equity portfolio.
Attribution analysis: is a key tool in helping the manager identify the sources of tracking error.
Securities lending: can generate fee income to offset some of the costs of managing the portfolio and reduce tracking error.
Corporate governance and investor activism: are important for both passive and active investors.
Compare fundamental and quantitative approaches to active management.
Active equity managers can be broadly divided into 2-groups:
* fundamental managers: which use discretionary judgment
* quantitative managers: which use rules-based (systematic) data-driven models
Analyze bottom-up active strategies, including their rationale and associated processes.
Bottom-up strategies analyze information at the company level to generate investment ideas.
Bottom-up strategies can be divided into:
* value
* growth
Value sub-styles include:
* relative value
* contrarian
* high-quality value
* income investing
* deep-value
* restructuring and distressed debt
* special situations
Analyze top-down active strategies, including their rationale and associated processes.
Top-down strategies focus on:
* macroeconomic environment
* demographic trends
* government policies
Top-down strategies could focus on:
* geography
* industry
* equity style rotation
* volatility-based strategies
* thematic investment ideas
Analyze factor-based active strategies, including their rationale and associated processes.
Quantitative strategies often use factor-based models, which aim to identify factors that drive performance historically and are likely to continue to do so in the future.
Factors can be based on fundamental characteristics such as:
* value
* growth
* price momentum
* unconventional data
Analyze activist strategies, including their rationale and associated processes.
Activist investors specialize in taking meaningful stakes in listed companies and then publicly pushing for changes to the management, strategy, or capital structure of the company that they believe will enhance value.
Describe active strategies based on statistical arbitrage and market microstructure.
Statistical arbitrage funds look to profit from anomalies in technical market data (prices and volumes), for example, pairs trading.
What are some Pitfalls in fundamental investing?
Pitfalls in fundamental investing include:
* behavioral biases
* the value trap
* the growth trap
Behavioral biases include:
* confirmation bias
* illusion of control
* availability bias
* loss aversion
* overconfidence
* regret aversion
What are Event-driven strategies?
Event-driven strategies exploit market inefficiencies that may occur around:
* mergers and acquisitions
* earnings announcements
* bankruptcies
* share buybacks
* special dividends
* spin-offs
Describe how fundamental active investment strategies are created.
The fundamental active investment process consists of the following steps:
1. Define the investment universe
2. Define the market opportunity
3. Analyze the industry, competitive position, and financial reports.
4. Forecast performance
5. Convert forecasts to valuations
6. Construct a portfolio with the desired risk profile.
7. Incorporate any top-down view on sectors/markets
8. Rebalance the portfolio with buy and sell disciplines.
