Equity Flashcards
to pass CFA level 3
Process of fundamental active investment process
1) Define the investment universe in accordance with fund mandate
2) prescreen the investment universe to obtain manageable set of securities for detailed analysis
3) analyse the industry, competitive position and financial reports to the companies
4) forecast performance, most commonly based on cash flows or earnings
5) convert forecast to valuations
6) construct portfolio with desired risk profile
7) rebalance portfolio as needed
What is the process of quantitative active investment strategy
1) Define the market opportunity
2) Acquire and process data
3) back test the strategy
4) evaluate the strategy
5) construct the portfolio
What is active share
Active Share is a metric that measures how different a portfolio is from its benchmark in terms of holdings. It tells you what percentage of a portfolio’s investments are not shared with its benchmark. This helps in assessing how actively managed a portfolio is.
What is active risk?
Active risk is the standard deviation of active returns
Active risk (also known as tracking error) measures the variability or deviation of a portfolio’s returns from its benchmark due to the portfolio manager’s active investment decisions. It tells us how much risk is being taken by deviating from the benchmark.
What is thematic screening
Thematic investing focuses on investing in companies within a specific sector or following a specific theme such as energy efficiency or climate change
Rationale for choosing active management over passive
Confidence the manager has the expert knowledge and skill
Client preferences
Mandate from clients to invest in certain companies
Risks to active manager
- reputation risk
- key person risk
- higher portfolio turnover
Causes of tracking error
- management fees
- commissions on trades
- sampling
- intra day trading
- cash drag
Morningstar style box
In a style box - 2 factors - value and size - are each split into 3 groups
Growth based approaches
- Consistent long term growth
- Shorter term earnings momentum
- GARP (often uses peg ratio)
merits of long only investing
- long term risk premiums
- capacity and scalability
- limited legal liability laws
- regulations
- transactional complexity
- costs
- personal ideology
benefit of long short strategy
- greater ability to express negative ideas
- ability to use leverage
- ability to remove market risk
- greater ability to control exposure to risk factors
drawback of long/short strategy
- loss if market price increases
- some strategies require significant leverage
- cost of borrowing can become too high
- high management fees and implementation costs
Slippage
the differecne between the execution price and the midpoint of the quoted market bid/ask spread at the time the trade was entered
Heuristic and formal risk constraints
Based on experience or general ideas of good practice
statistical in nature
Rebalancing of portfolio
Rebalancing involves adjusting the portfolio’s constituent weights after price changes, mergers, or other corporate events have caused those weights to deviate from the benchmark index.
Reconstitution of the portfolio
Reconstitution involves deleting names that are no longer in the index and adding names that have been approved as new index members
Disadvantage of a factor based strategy
high concentration on risk exposures
Factor based strategies are risk or return oriented?
Return oriented strategies
what is fundamental management
- Based on manager’s discretion and judgement
- focus on selectively smaller number of firms
- can be top down or bottom up
Morningstar calculation
Morningstar calculates a score for value and growth on a scale of 0 to 100 using five proxy measures for each. The value score is subtracted from the growth score. A strongly positive net score leads to a growth classification, and a strongly negative score leads to a value classification. A score relatively close to zero indicates a core classification.
Lipper methodology
The Lipper methodology does have a core classification. It sums the Z-score of six portfolio characteristics over several years to determine an overall Z-score that determines either a value, core, or growth classification.
Contrairian investing
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. Therefore, contrarian investors purchase and sell shares against prevailing market sentiment.
Deep value investing
deep-value investing approach focuses on undervalued companies that are available at extremely low valuation relative to their assets. Such companies are often those in financial distress, which is not reflective of financial strength or demonstrated profitability.
High quality value investing
High-quality value investors focus on companies’ intrinsic values that are supported by attractive valuation metrics, with an emphasis on financial strength and demonstrated profitability. In their view, investors sometimes behave irrationally, making stocks trade at prices very different from intrinsic value based on company fundamentals.
Multifactor products active share and active risk
high active share - low active risk
Social investing
Refers to allocating capital to assets that address social challenges in the poorest of communities.
GARP
Definition:
A hybrid approach combining growth and value investing principles.
Characteristics:
Targets companies with above-average growth that are reasonably priced.
Key Metric: PEG (Price/Earnings to Growth) ratio.
Activist shareholding insights
Stake Size: Typically less than 10%; a full takeover is rarely pursued.
Investment Horizon: Shorter than buy-and-hold strategies but campaigns can last several years.
Diverse Participants: Includes hedge funds, pension funds, private investors, and others with varying strategies and time horizons.
Application of style analysis
Identifies manager strategies.
Assesses consistency with stated investment objectives.
Supports diversification and risk management.
Holding based style
Examines the actual portfolio holdings and their individual contributions to the portfolio’s investment style.
Holdings-based models are less effective for portfolios with significant derivatives, requiring caution in interpreting results.
returns based style analysis
Uses historical fund returns compared to style index returns.
Ideal when portfolio holdings are unavailable.
FTSE russell methodology
Employ a multifactor approach where a stock can exhibit characteristics of multiple styles.
A stock might be 60% value and 40% growth, based on predefined weights of factors like price-to-earnings or dividend yield.
Captures nuances of stocks with mixed attributes, enabling more flexible and realistic classification.
strenghts of HBSA
Accuracy: More precise as it evaluates actual portfolio holdings.
Transparency: Shows how each stock contributes to the portfolio’s style and ensures alignment with the fund’s stated philosophy.
Actionable Insights: Helps managers adjust portfolios to maintain the desired style.
disadvantages of hbsa
Requires detailed and up-to-date information on all holdings.
Historical analysis may be challenging without point-in-time databases.
Less effective for funds with significant derivative positions.
strenghts of rbsa
Ease of Use: Can be applied without knowing the portfolio’s specific holdings.
Constraints: Models often limit aggressive style identification (e.g., deep value or micro-cap).
Applicability: Widely used but less granular than holdings-based analysis.
disadvantages of rbsa
Data limitations and statistical flaws can lead to inaccuracies.
Derivative-heavy portfolios are harder to analyze using holdings-based methods.
how is manager alpha achieved?
Security selection.
Factor timing.
Building blocks of portfolio construction
- rewarded factor weighting (overeweighting or underweighting rewarded factors)
- alpha skillzz (timing factors, securities and markets)
- position sizing (to account for risks and active weights)
- breadth expertise (outperform by taking larger independent/uncorrelated decisions)
equitizing
Equitizing is a strategy where managers convert cash or other assets into an equity position. For example, if a manager wants exposure to a specific index but holds cash, they might use futures contracts or ETFs to replicate the index’s performance.
How can the investment manager’s universe be segmented
- segmentation by size and style
- segmentation by geography
- segmentation by economic activity
Rationales for positioning an equity portfolio along the passive active spectrum.
- Confidence in ability to outperform
- Client preference
- Availability of a suitable benchmark
- Client-specific mandates
- Risks and costs of active management
- Taxes
Growth strategy
Growth strategies focus on companies that are growing faster than their sector or the overall market.
In addition, growth
investors are typically willing to pay an above average valuation multiple for businesses.
Income investing
The income investing approach focuses on shares that offer relatively high dividend yields and positive dividend growth rates.
Special situations investing
The “special situations” investment style focuses on the identification and exploitation of mispricings that may arise as a result of corporate events such as divestitures or spinoffs of assets or divisions or mergers with other entities.
How to eliminate confirmation bias
Actively seeking out the opinions of other investors or team members and looking for information from a range of sources to
challenge existing beliefs may reduce the risk of confirmation bias
how to eliminate illusion of control
Investors should seek contrary viewpoints and set and enforce proper
trading and portfolio diversification rules to try to avoid this problem.
How to eliminate availability bias
Setting an appropriate investment strategy in line with the investment
horizon, as well as conducting a disciplined portfolio analysis with a long-term focus,
will help eliminate any short-term over-emphasis caused by this bias.
Eliminate loss aversion
A disciplined trading strategy with firmly established stop-loss rules is essential to prevent fundamental investors from falling into this trap
eliminate overconfidence
Regularly reviewing actual investment records and seeking constructive feedback from other professionals can help investors gain awareness of such self-attribution bias.
eliminate regret aversion
A carefully defined portfolio review process can help mitigate the effects of regret aversion bias.
eliminate anchoring bias
Analysts can try to avoid anchoring bias by consciously attempting
to avoid premature conclusions.
Eliminate status quo bias
Status quo bias can be mitigated by disciplined effort to avoid “anchoring” on the status quo.
Eliminate prudence bias
This bias can be mitigated
by conscious effort to identify plausible scenarios that would give rise to
more extreme outcomes and to give greater weight to such scenarios in the
forecast.
Self identification style analysis
Self-identification refers to a method where the investment manager or fund provider explicitly describes their investment style or strategy. Essentially, the fund’s style or classification is based on how the manager defines or markets it. This approach relies on subjective input rather than analyzing actual portfolio holdings or performance data.
Buffering
Buffering refers to the practice of allowing a certain level of tolerance or deviation before rebalancing or making changes to the index.
Packeting
splitting stock positions between the two indexes until the constituent clearly moves from one index to the other.
Managers
- Implementation approach
- security selection approach
- concentration
- Objective function
- constraints
(this is from a blue box question page 146)
- systematic or discretionary? (quantitative/qualitative)
- top down or bottom up
- diversifies, factor neutral, concentrated stock picker, etc
- explicit or implicit
- relative or absolute (to the benchmark)
Absolute risk ka objective function aur relative risk ka objective function
maximizing sharpe ratio and information ratio
statistical risk measures
VaR and active risk
Not usually used by discretionary managers as hard constraints
some points of slippage costs
- Slippage costs are usually more important than commission costs.
- Slippage costs are greater for smaller-cap securities than for large-cap securities.
- Slippage costs can vary substantially over time, especially when market
volatility is higher.
Net and gross exposure wrt to long short exposure
The absolute value of the longs minus the absolute value of the shorts is called the portfolio’s net exposure. The sum of the longs plus the absolute value of the shorts is called the portfolio’s gross exposure.
Long extension portfolio (example)
You invest 130% of your capital in stocks you expect to rise (long positions).
You borrow and short 30% of your capital in stocks you expect to fall (short positions).
Since the short positions generate cash, they help fund the extra 30% in long positions.
The result: 130% long – 30% short = 100% net exposure, but with 160% total gross exposure (130 + 30).
Market neutral investing
true market neutrality means hedging out market risk, so that overall market movements (bullish or bearish) don’t impact returns.
Imagine you’re a stock trader, and you buy $100 million of stocks you believe will go up (longs), and short $100 million of stocks you believe will go down (shorts). At first glance, this seems neutral, right? Not necessarily—because the risks of the long and short positions may not cancel each other out.
To truly be market-neutral, your portfolio must have a beta of zero—meaning it’s not affected by the broader market’s movements.
A portfolio with the following characteristics would be market-neutral using beta:
Long $100M in stocks with an average beta of 1 Short $80M in stocks with an average beta of 1.25 Market exposure: (100 × 1) - (80 × 1.25) = 0 This means the portfolio will not be affected by general market movements.
Managers may also neutralize exposure to other risk factors like Size, Value, and Momentum, ensuring their returns come purely from stock-picking skill.
Advantages of market neutrality
✅ Focus on Skill, Not Market Movements – Profits come from stock selection, not market direction.
✅ Lower Volatility – Because market risk is hedged out, returns tend to be more stable.
✅ Diversification Benefits – Since returns aren’t correlated with the stock market, market-neutral funds can help balance risk in a portfolio.
✅ Works in Any Market Condition – Unlike long-only strategies that struggle in downturns, market-neutral portfolios can perform in bull or bear markets.
Disadvantages of market neutrality
❌ Hard to Maintain Perfect Neutrality – Markets constantly shift, making it difficult to keep beta exactly at zero.
❌ Limited Upside in Bull Markets – Since market-neutral portfolios don’t benefit from general market gains, they might underperform during strong bull markets.
❌ Complex Execution – Requires advanced modeling and hedging techniques to construct properly.
❌ Higher Costs – Shorting stocks involves borrowing fees and margin costs, which can eat into returns.
Drawbacks of hedged portfolio (wahi wala jahan top quartiles ko long karte ho aur bottom quartiles ko short karte ho)
- Only the top and bottom quantiles are used.
- This approach assumes linearity between the factor and future stock returns. In fact, the payoff pattern between factor exposures and future stock returns is
becoming increasingly non-linear. - Portfolios under this approach tend to be concentrated—potentially in the same stocks for other portfolio managers implementing this approach for the same
factor. - Short sales may be impossible and/or expensive to execute.
- The result may not be a pure factor exposure as other risk factors are likely to be present.
Whats best in class approach?
Best-in-class is a form of positive screening that attempts to identify the
companies that score most favorably with regard to ESG-related risks and/or
opportunities.
Size/style classification advantage and disadvantage
First, portfolio managers can construct an overall equity portfolio that reflects desired risk, return, and income characteristics in a relatively straightforward and manageable
way.
Second, given the broad range of companies in each segment, segmentation by
size/style results in diversification across economic sectors or industries.
disadvantage
The key disadvantages of segmentation by size/style are that the categories
may change over time and may be defined differently among investors
Disadvantage of segmentation by economic activities
The key disadvantage of segmentation by economic activity is that the business activities of companies—particularly, large ones—may include more than
one industry or sub-industry.
Dividend capture
Additional income for equity portfolio. an equity portfolio manager
purchases stocks just before their ex-dividend dates, holds these stocks through the ex-dividend date to earn the right to receive the dividend, and subsequently sells the
shares.
explicit costs in trading
(its in equity overview)
brokerage commission costs, taxes, stamp duties, and stock exchange fees.
Implicit costs in trading
■ Bid–offer spread
■ Market impact (also called price impact), which measures the effect of the
trade on transaction prices
■ Delay costs (also called slippage), which arise from the inability to complete
desired trades immediately because of order size or lack of market liquidity
Benefits of Shareholder Engagement
for companies - better corporate governance
for shareholders - more info about the companies
Disadvantages of shareholder engagement
time consuming and can be costly for both shareholders and companies.
Second, pressure on company management to meet near-term share price or earnings targets
Third, engagement can result in selective disclosure of important information to
a certain subset of shareholders,
What is the Role of an Equity Manager in Shareholder Engagement?
- Activist Investing (take stakes to initiate change in company)
- Voting
Shareholder engagement, for shareholders - more info about the companies, what type of info though?
The investor may benefit from information obtained about the company, such as its strategy, allocation of capital, corporate governance, remuneration of directors and senior management, culture, and competitive environment within the aerospace industry.
How to reduce tracking error
- Minimize trading costs
- Equitization tools like derivatives
Pitfalls in quantitative investing
- look-ahead and survivorship
biases, - overfitting,
- data mining,
- unrealistic turnover assumptions,
- transaction costs,
- short availability.
Heuristic constraints may impose limits on
● concentration by security, sector, industry, or geography;
● net exposures to risk factors, such as Beta, Size, Value, and Momentum;
● net exposures to currencies;
● the degree of leverage;
● the degree of illiquidity;
● exposures to reputational/environmental risks, such as carbon emissions
Formal risk constraints include
● Volatility—the standard deviation of portfolio returns
● Active risk—also called tracking error or tracking risk
● Skewness—a measure of the degree to which return expectations are
non-normally distributed
● Drawdown—a measure of portfolio loss from its high point until it
begins to recover
● Value at risk (VaR)—the minimum loss that would be expected a certain
percentage of the time over a certain period of time given the modeled
market conditions, typically expressed as the minimum loss that can be
expected to occur 5% of the time
● CVaR (expected tail loss or expected shortfall)—the average loss that
would be incurred if the VaR cutoff is exceeded
● IVaR—the change in portfolio VaR when adding a new position to a
portfolio
● MVaR—the effect on portfolio risk of a change in the position size. In
a diversified portfolio, it may be used to determine the contribution of
each asset to the overall VaR.
Pure indexing Active share and risk
0 and 0
Factor neutral active share and risk
Low AR and low AS if diversified
No active factor bets
Diversified factor bets
Balanced exposure to risk factors and minimized idiosyncratic risk through high number of securities in portfolio
low AR and high AS
concentrated factor bets
you know… also idiosyncratic risk likely to be high
High AS & AR
Concentrated stock picker
Individual stock bets
Highest AS and AR
