Equity Flashcards
Give 4 potential roles of equity in a portfolio
- Capital appreciation
- Dividend income
- Diversification benefits
- Potential to hedge inflation
4 ways to segment the equity investment universe
- Size (market cap.) and style (growth, value…)
- Geographic (developed, emerging…)
- Sector/ Industry
- Combination approach (of the above)
4 potential ways to extract income from equity holdings
- Dividends (regular dividends received)
- Lending securities for a fee and earning funds on cash collateral received
- Writing options for the premium received
- Dividend capture (buying a stock just before and selling it just after it goes ex-dividend)
How are manager fees typically charged wrt equity?
Regular and performance fees separated
Often charge additional fees for additional services, each is different
3 costs beyond management fees to consider with an equity investment account
- Transaction/ trading costs
- Strategy costs (generally active have higher costs)
- Liquidity demands (e.g momentum funds typically have high market impact costs)
What is predatory pricing in an equity fund context and where are its impacts primarily felt?
When other participants anticipate and trade ahead of passive funds
This primarily impacts passive funds
What 3 things are required of an equity index investment strategy?
- Rules based
- Transparent
- Investable
Give 3 considerations in choosing a benchmark for an equity investment strategy
- Determine desired market exposures
- Be consistent with stated objectives and constraints
- Identify the method used for constructing the index
Present 4 weighting methods used to construct an equity index
- Market-cap weighting
- Price weighting
- Equal weighting
- Fundamental weighting
How would you derive the level of stock concentration (effective number of stocks)?
Reciprocal of the Herfindahl-Hirschman Index
HHI = nΣi=1 wi^2
Effective number of stocks = 1/ HHI
What are two continuous adjustments made to equity indices?
Rebalancing: Updating weights of stocks in the index
Reconstitution: Removing and replacing stocks that no longer fit the index market exposure desired
Describe a passive factor-based strategy, identify 7 factors used, and outline 3 passive factor-based strategies
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
- Growth
- Value
- Size
- Yield
- Momentum
- Quality
- Volatility
i. Return oriented
ii. Risk oriented
iii. Diversification oriented
Give 3 common approaches to passive equity investing
- Pooled investments (open ended mutual funds, ETFs)
- Derivatives-based strategies
- Separately managed index-based portfolios
Provide 3 methods of constructing passively managed index based equity portfolios
- Hold and match weights of all securities in the index (full replication)
- Select a more liquid sample of securities to replicate the index (stratified sampling)
- Use a technical/ quantitative approach to maximise desirable characteristics and minimise undesirable ones
[Blended approaches of these methods are also common]
How does tracking error relate to sample size?
What are two other factors creating tracking error?
Initially declines with larger sample size, but then increases as costs (transaction/ management/ illiquidity) outweigh the gains of increasing sample size
Intra-day trading and cash drag also impact
What is employed to reduce tracking error?
What can be used to reduce the effects of cash drag?
Continuing evaluation of trade off between benefits of increased sample size and increasing costs
Derivatives can be used to limit cash drag
What is cash drag, in the context of equity fund investing?
Performance impact of holding a portion of the portfolio in cash (lower return)
What can attribution analysis benefit?
Attribution analysis is a key tool in identifying sources of tracking error
Define tracking error
The difference between the returns on a benchmark (target index) and those on a portfolio (index fund)
What are two benefits of securities lending?
- Fee income, offsetting management costs
- Reduction of tracking error
Contrast Fundamental and Quantitative managers along the following 8 criteria
1. Style
2. Decision-making
3. Primary resources
4. Information used
5. Analyst focus
6. Purpose of analysis
7. Portfolio construction
8. Monitoring and rebalancing
1.
Fundamental: Subjective
Quantitative: Objective
2.
Fundamental: Discretionary
Quantitative: Systematic
3.
Fundamental: Human skill/ experience
Quantitative: Expertise in statistical modelling
4.
Fundamental: Research
Quantitative: Data/ statistics
5.
Fundamental: Convictions on small number of securities
Quantitative: Applying rewarded factors to broad universe of securities
6.
Fundamental: Forecast future corporate performance
Quantitative: Find historical relationships between factors and performance likely to persist
7.
Fundamental: Judgement and conviction (within risk parameters)
Quantitative: Optimization
8.
Fundamental: Continuous monitoring. Rebalancing to changing views
Quantitative: Automatic systematic rebalancing
What are the two forms of bottom-up investing?
Value
Growth
Give 5 examples of value investing strategies
Relative value
Contrarian
Income investing
Restructuring/ distressed debt
Special situations
What are 4 things top-down equity analysis could focus on?
- Geography
- Industry
- Equity style rotation
- Volatility based strategies
What do quantitative strategies typically employ, and what are these based on?
Factor-based models (i.e identify factors which have driven performance in the past and will continue to do so going forward)
Based on fundamental characteristics (value, growth, price momentum, unconventional data etc.)
Describe the activities of
- Statistical arbitrage funds
- Event-driven strategies
- Look to profit from anomalies in technical market data (e.g. pairs trading)
- Event driven strategies exploit market inefficiencies around M&A/ earnings announcements/ bankruptcies/ spin-offs etc.
What are the 7 steps to the fundamental active investment process?
- Define investment universe in line with fund mandate
- Prescreen investment universe to arrive at eligible securities for detailed analysis
- Analyse industry, competitive position & financial reports of the companies
- Forecast performance (cash flows/ earnings)
- Convert forecasts to valuations
- Construct portfolio of profitable investments with desired risk profile
- Rebalance portfolio with buy/ sell disciplines
What are 3 pitfalls in fundamental investing (for equities)?
- Behavioural biases
- Value trap
- Growth trap
Give 5 behavioural biases which can impact fundamental investing decision making
- Confirmation bias
- Illusion of control
- Availability bias
- Loss aversion
- Overconfidence
Give the 5 steps to the quantitative active investment process
- Define market opportunity
- Acquire and process data
- Back-test the strategy
- Evaluate the strategy
- Portfolio construction
What are 5 common pitfalls in quantitative investing?
- Look-ahead/ Survivorship bias
- Overfitting
- Data mining
- Unrealistic turnover assumptions
- Transaction costs
Contrast the two main approaches used in style analysis (provide detail)
Holdings-based: aggregate the style scores of individual holdings
Returns-based: regress historical portfolio returns against a set of style indexes
Describe the 3 building blocks of an active return for a portfolio manager
- Active rewarded factor (β weightings) [e.g factor exposure to market, size, momentum, liquidity, value etc]
- Alpha skills (primarily generates excess return by identifying mispricing/ inefficiencies)
- Position Sizing (large positions effect all 3 sources of active returns, but also generate a high idiosyncratic risk)
What is breadth and what does it imply as it increases?
The number of independent decisions a manager makes per year
Higher breadth implies higher ability to outperform benchmarks
Give the equation for the fundamental law of active management
E(RA) = ICx√BRσRAxTC
IC: information correlation
BR: breadth (number of independent decisions)
TC: Transmission Coefficient
Give an example of an absolute and a relative constraint
maximise Sharpe ratio subject to maximum volatility
maximise information ratio subject to maximum active risk
Give the Sharpe ratio formula
Rp- Rf/ σp
Give information ratio formula
Rp - Rb/ Tracking error
Tracking error: standard dev. of excess return wrt. benchmark rate of return
What does Active Share measure and what is the formula?
How do you interpret its output?
The degree to which the number and sizing of positions in a manager’s portfolio differ from those of a benchmark
Active Share = 1/2 nΣi=1 |Wp,i - Wb,i|
Between 0 and 1, the lower the Active Share, the more similar the holdings to the benchmark
Describe Active Risk
Also known as tracking error, standard deviation of portfolio returns - benchmark returns
What are the two sources of Active Risk?
Give the formula
((TΣt=1(RAt)^2)/(T-1))^1/2
- Factor exposure (active beta)
- Idiosyncratic risk from concentrated positions (variance from skill and luck of manager)
Active Risk (σRA) =
(σ^2(Σ(βpk-βbk) x Fk) +σ^2e)^1/2
What is Risk Budgeting?
The process by which contribution to total risk of the portfolio is allocated to constituents of the portfolio in the most efficient manner
Give formulae for:
- The contribution of asset i to absolute portfolio variance
- The contribution of factor i to absolute portfolio variance
- CVi = nΣj=1wi x wj x Cij = wi x Cip
- CVi = nΣj=1 βi x βj x Cij = βi x Cip
Give the formula for the contribution of asset i to relative portfolio variance
CAVi = nΣj=1 x (wpi- wbi)x(wpj-wbj)x RCij
= (wpi - wbi) x RCip
What are 3 practical considerations when considering appropriate level of portfolio risk?
- Implementation constraints (e.g size limits on positions) causing IR degradation as active risk increases
- Limited diversification opportunities in higher risk investments
- Leverage increasing volatility and lowering geometric average compounded returns over multiple periods
What are the two forms of risk constraints?
What can magnify estimation error?
- Heuristic (based on experience e.g arbitrary position limits)
- Formal (based on statistical measures (e.g VaR)
Estimation error can be magnified by leverage or idiosyncratic risk of concentrated positions
Why must a small-cap stock firm limit its AUM or diversify or adapt its trading strategy?
To limit impact costs (i.e the costs of causing price movement when executing trades)
What are 5 factors impacting investors’ choice between long only and long/ short strategies?
- Long-term risk premia
- Capacity/ Scalability
- Limited legal liability
- Regulation
- Costs
What do long extension portfolios guarantee?
What is a 130/30 fund?
They guarantee 100% net exposure with a specified short exposure
130% long and 30% short positions
What do market-neutral portfolios attempt to achieve? Give an example of one type
Aim to remove market exposure through offsetting long and short positions
Pairs trading
What is quantitative pair trading referred to as?
Statistical arbitrage
What are 4 benefits of long/ short strategies?
- Express negative views
- Gear into high conviction long-positions
- Removal of market risk to diversify
- Ability to better control risk factor exposures
What are 5 risks with/ drawbacks to long/ short strategies?
- Potential large losses (prices not bounded above)
- Negative exposures to risk premia
- Potentially high leverage for market-neutral funds
- Collateral demands from prime brokers
- Being subject to a short squeeze on short positions
