Equity

Question 1

Equities as an Inflation Hedge

Answer 1

Protects purchasing power (good in long-run)
Earnings rise with inflation

Imperfect b/c of taxes

Question 2

Information Ratio

Answer 2

Active Return / Tracking Risk

Higher IR = better risk-adjusted returns

Question 3

Choose Passive Strategy If:

Answer 3

1. Taxable
2. High transaction costs
3. Markets have high information efficiency
4. Not familiar with market

Question 4

Types of Indices

Answer 4

1. Price-weighted - longer history and simple
   
   1. Touble with stock splits, etc.
   2. Replicates by buying 1 share of the stock
2. Market-cap weighted - biased to large firms
   
   1. Float weighted (only investable shares)
3. Equal weighted - biased towards small, higher costs

Question 5

ETFs Pros/Cons vs Mutual Funds

Answer 5

ETFs Pros

1. Trade more
2. Tax efficient (doesnt buy/sell securities, just follows an index)
3. Recordkeeping not maintained
4. Costs are lower

ETFs Cons

1. License fees are higher (S&P, Russell, etc)

Question 6

Equity Futures Pros/Cons

Answer 6

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)

Question 7

Indexed Portfolio

Full Replication

Answer 7

Advantage: low tracking risk

Expenses higher with more and illiquid securities

Best When: less than 1000 stocks, liquid

Question 8

Indexed Portfolio

Stratified Sampling

Answer 8

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

Question 9

Index Portfolio

Optimization

Answer 9

Matches factor exposures (beta, market cap, value, etc.)

Disadvantages

1, Changing sensitivities

2. Misleading if data is skewed
3. Frequent rebalancing

Question 10

Value Investing

Answer 10

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

Question 11

Growth Investing

Answer 11

High expected earnings growth

Does better during economic contraction
60-200% turnover

Substyles:

Consistent Earnings Growth
Momentum

Question 12

Market-Oriented Investing

Answer 12

Blend/core portfolio - flexibility
Risk: How to indentify style

Substyles:

Value tilt
Growth tilt
Growth at a reasonable price (GARP)
Style rotation

Question 13

Return-Based Style Analysis

Answer 13

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

Question 14

Return-Based Style Analysis

Results

Answer 14

Style fit = R² = amount of return explained

Selection return = 1 - R² = unexplained returns

Question 15

Holdings-Based Style Analysis

Different Types of Value and Growth

Answer 15

Classifying securities;

Value or growth
Expected earnings per share growth: high = growth
Earnings volatility: high = value
Industry representation: utility/financial/energy = value

Question 16

Return-based vs Holdings Based

Answer 16

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

Question 17

SRI

Answer 17

Positive screen = desirable characteristics (green)

Negative screen = exclude undesirable characteristics (tobacco)

Can lead to small cap and growth bias
Avoids basic industries and energy

Question 18

Long-only vs Long-short

Answer 18

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

Question 19

Why is the short side inefficient?

Answer 19

• 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

Question 20

Equitize & Market-Neutral Strategies

Answer 20

Market-Neutral: Earns 2 alphas (long and short) and R_f

Equitize: by investing cash in futures or ETFs
Earns 2 alphas and market return

Question 21

Short Extension Strategies

Answer 21

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

Question 22

Stock vs Derivatives Based Enhanced Indexing

Answer 22

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

Question 23

Fundamental Law of Active Management

Answer 23

Definition: IR = IC√IB

Skillful managers = higher IC
IB = number of forecasts

Question 24

Allocating to Equity Managers

Answer 24

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

Question 25

Portfolio IR Example

Answer 25

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

Question 26

Core-Satellite Portfolios Completeness

Answer 26

* 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

Question 27

Calculating Value Add

Answer 27

**_Manager Allocation Estimated Alpha Tracking Risk_** A $25 3% 5% B $25 4% 7% C $150 -0.1% 0.0% 1. 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

Question 28

True Active Return Misfit Active Return Total Active Return

Answer 28

**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

Question 29

True IR Total IR Total Active Risk

Answer 29

**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%

Question 30

Manager Questionnaire

Answer 30

1. **R**esources 2. **I**nvestment philosophy and process 3. **P**erformance (benchmarks, alpha, risk, holdings) 4. **O**rganization and staff 5. **F**ees

Question 31

Manager Return and IR Example

Answer 31

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

Question 32

All active and misfit formulas

Answer 32

**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 **​**