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CFA Level III > Equity > Flashcards

Equity Flashcards

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CFA flashcards
1
Q

Equities as an Inflation Hedge

A

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

Imperfect b/c of taxes

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2
Q

Information Ratio

A

Active Return / Tracking Risk

Higher IR = better risk-adjusted returns

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3
Q

Choose Passive Strategy If:

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

Types of Indices

A
  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
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5
Q

ETFs Pros/Cons vs Mutual Funds

A

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)
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6
Q

Equity Futures Pros/Cons

A

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)
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7
Q

Indexed Portfolio

Full Replication

A

Advantage: low tracking risk

Expenses higher with more and illiquid securities

Best When: less than 1000 stocks, liquid

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8
Q

Indexed Portfolio

Stratified Sampling

A

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

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9
Q

Index Portfolio

Optimization

A

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

Disadvantages

1, Changing sensitivities

  1. Misleading if data is skewed
  2. Frequent rebalancing
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10
Q

Value Investing

A

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

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11
Q

Growth Investing

A

High expected earnings growth

Does better during economic contraction
60-200% turnover

Substyles:

Consistent Earnings Growth
Momentum

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12
Q

Market-Oriented Investing

A

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

Substyles:

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

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13
Q

Return-Based Style Analysis

A

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
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14
Q

Return-Based Style Analysis

Results

A

Style fit = R2 = amount of return explained

Selection return = 1 - R2 = unexplained returns

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15
Q

Holdings-Based Style Analysis

Different Types of Value and Growth

A

Classifying securities;

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

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16
Q

Return-based vs Holdings Based

A

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

17
Q

SRI

A

Positive screen = desirable characteristics (green)

Negative screen = exclude undesirable characteristics (tobacco)

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

18
Q

Long-only vs Long-short

A

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

19
Q

Why is the short side inefficient?

A
  • 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
20
Q

Equitize & Market-Neutral Strategies

A

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

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

21
Q

Short Extension Strategies

A

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

22
Q

Stock vs Derivatives Based Enhanced Indexing

A

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

23
Q

Fundamental Law of Active Management

A

Definition: IR = IC√IB

Skillful managers = higher IC
IB = number of forecasts

24
Q

Allocating to Equity Managers

A

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

25
Q

Portfolio IR Example

A

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

26
Q

Core-Satellite Portfolios

Completeness

A
  • 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
27
Q

Calculating Value Add

A

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

28
Q

True Active Return

Misfit Active Return

Total Active Return

A

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

29
Q

True IR

Total IR

Total Active Risk

A

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%

30
Q

Manager Questionnaire

A
  1. Resources
  2. Investment philosophy and process
  3. Performance (benchmarks, alpha, risk, holdings)
  4. Organization and staff
  5. Fees
31
Q

Manager Return and IR Example

A

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

32
Q

All active and misfit formulas

A

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

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CFA Level III (13 decks)

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