Equity Flashcards
Equities as an Inflation Hedge
Protects purchasing power (good in long-run)
Earnings rise with inflation
Imperfect b/c of taxes
Information Ratio
Active Return / Tracking Risk
Higher IR = better risk-adjusted returns
Choose Passive Strategy If:
- Taxable
- High transaction costs
- Markets have high information efficiency
- Not familiar with market
Types of Indices
- Price-weighted - longer history and simple
- Touble with stock splits, etc.
- Replicates by buying 1 share of the stock
- Market-cap weighted - biased to large firms
- Float weighted (only investable shares)
- Equal weighted - biased towards small, higher costs
ETFs Pros/Cons vs Mutual Funds
ETFs Pros
- Trade more
- Tax efficient (doesnt buy/sell securities, just follows an index)
- Recordkeeping not maintained
- Costs are lower
ETFs Cons
- License fees are higher (S&P, Russell, etc)
Equity Futures Pros/Cons
Pros
- Allows you to purchase all stocks in an index
- Liquid and low transactions costs
Cons
- futures have a finite life and requires rollover
- uptick rule (can only short after an uptick in price)
Indexed Portfolio
Full Replication
Advantage: low tracking risk
Expenses higher with more and illiquid securities
Best When: less than 1000 stocks, liquid
Indexed Portfolio
Stratified Sampling
Definition: securities are chosen to replicate index weights by cell (market cap, style, style, etc.)
- Advantage: lower costs
- Disadvatange: higher tracking error
- Assumes no correlation between cells
Best when: # of stocks is large, illiquid
Index Portfolio
Optimization
Matches factor exposures (beta, market cap, value, etc.)
Disadvantages
1, Changing sensitivities
- Misleading if data is skewed
- Frequent rebalancing
Value Investing
Focus on low P/E or P/B (depressed firms)
20-80% turnover
Substyles:
High dividend yield
Low price multiple - once economy/industry/firm improves outperforms
Contrarian - temporarily depressed
Growth Investing
High expected earnings growth
Does better during economic contraction
60-200% turnover
Substyles:
Consistent Earnings Growth
Momentum
Market-Oriented Investing
Blend/core portfolio - flexibility
Risk: How to indentify style
Substyles:
Value tilt
Growth tilt
Growth at a reasonable price (GARP)
Style rotation
Return-Based Style Analysis
Definition: Regressing returns against indices to determine exposure
*Must be nonnegative and sum to 1
Indices used must be:
- Mutually exclusive
- Exhaustive
- Uncorrelated sources of risk
Return-Based Style Analysis
Results
Style fit = R2 = amount of return explained
Selection return = 1 - R2 = unexplained returns
Holdings-Based Style Analysis
Different Types of Value and Growth
Classifying securities;
Value or growth
Expected earnings per share growth: high = growth
Earnings volatility: high = value
Industry representation: utility/financial/energy = value
Return-based vs Holdings Based
Returns-Based Holdings Based
Advantages Portfolios based Security based
Back by theory Can detect style drifts
Low info req.
Disadvatanges
Does not account for holdings Not consistent with
Slow detecting style drift manager selection
SRI
Positive screen = desirable characteristics (green)
Negative screen = exclude undesirable characteristics (tobacco)
Can lead to small cap and growth bias
Avoids basic industries and energy
Long-only vs Long-short
Long-only
invests in undervalued stocks (must avoid stocks they don’t like).
Exposed to systematic and unsystematic risks
Long-short
Can buy undervalued and short overvalued
Can be market-neutral to eliminate systematic risk
Shorting may be inefficent due to expenses, some are not allowed
Why is the short side inefficient?
- Long-only investors ignore overvalued securities
- Sell-side analysts mostly make buy recommendations
- Could fear making company mad
- Insiders less likely to divulge negative information
- Additional costs
Equitize & Market-Neutral Strategies
Market-Neutral: Earns 2 alphas (long and short) and Rf
Equitize: by investing cash in futures or ETFs
Earns 2 alphas and market return
Short Extension Strategies
Definition: limited short positions (130/30) with a net 100% long
*Cannot separate alpha from beta (market return)
*Best to do 130/30 (efficient) first instead of 100/0 then 30/30
Stock vs Derivatives Based Enhanced Indexing
Stock-based: under/overweight based on beliefs. Unknowns match benchmark
Derivatives: equity exposure through derivatives (long). Hold cash to collateralize and invest in fixed income to earn a yield
Fundamental Law of Active Management
Definition: IR = IC√IB
Skillful managers = higher IC
IB = number of forecasts
Allocating to Equity Managers
Driven by active return and active risk
Investors are more risk adverse when facing active risk (b/c its additional)
Note: Active returns are uncorrelated so you could choose more than 1
Portfolio IR Example
Manager Allocation Alpha Tracking Error
A 400 0% 0%
B 100 2 4
C 100 4 6
D 100 4 6
Alpha = (4 / 7)(0) + (1 / 7)(2) + (1 / 7)(4) + (1 / 7)(4) = 1.43%
Variance = (4 / 7)2(0)2 + (1 / 7)2(4)2 + (1 / 7)2(6)2 + (1 / 7)2(6)2 = 1.7956, √1.7956 = 1.34%
IR = 1.43 / 1.34 = 1.07
Core-Satellite Portfolios
Completeness
- Core-satellite: Start with core of portfolio, satellite managers are active
- Minimizes active risk
- Completeness: starts with satellite managers then add core to track benchmark
- Minimizes misfit risk
Calculating Value Add
Manager Allocation Estimated Alpha Tracking Risk
A $25 3% 5%
B $25 4% 7%
C $150 -0.1% 0.0%
- Evaluate if Li can achieve an IR of 0.6 or better
Alpha = (25/200)(3) + (25/200)(4) + (150/200)(-0.1) = 0.80
Tracking error = (25/200)2(5)2 + (25/200)2(7)2 + (150/200)2(0)2
IR = .80/1.08 = 0.74 which exceeds 0.6
True Active Return
Misfit Active Return
Total Active Return
Total active return = manager’s return - investor’s benchmark
True active return = manager’s return - normal benchmark
Misfit active return = manager’s normal benchmark - investor’s benchmark
Misfit = investors decision to go rogue
True IR
Total IR
Total Active Risk
Total active risk = √(true active risk)2 + (misfit active risk)2
Total IR: Total active return / Total active risk
True IR = true active return / true active risk
Example: Manager return = 14%, Investors benchmark, 16%, manager’s benchmark 11%, total active risk 5.1%, misfit active risk 3.7%
Manager outperformed: 14 - 11 = 3%
Investors decision to deviate reduced returns: 11 - 16 = -5%
Manager Questionnaire
- Resources
- Investment philosophy and process
- Performance (benchmarks, alpha, risk, holdings)
- Organization and staff
- Fees
Manager Return and IR Example
Manager Return: 12.0% Investors Benchmark: 10.0%
Managers benchmark: 15.0% Managers total active risk: 5.5%
Managers misfit active risk: 4.0%
Total IR: (12 - 10) / 5.5 = 0.35
True Active Return: 12 - 15 = -3%
Misfit Active Return: 15 - 10 = 5%
True Active Risk: 5.52 = X2 + 42 = 14.252 √14.25 = 3.8%
True IR: -3 / 3.8 = -0.79
All active and misfit formulas
Total active return = manager’s return - investor’s benchmark
True active return = manager’s return - normal benchmark
Misfit active return = manager’s normal benchmark - investor’s benchmark
Total active risk = √(true active risk)2 + (misfit active risk)2
Total IR = Total active return / Total active risk
True IR = true active return / true active risk
