Equity Investments

Question 1

Capital Appreciation

Answer 1

Capital appreciation is the increase in the market value of an investment or asset over time. It’s calculated by subtracting the purchase price from the selling price of an investment. For example, if an investor buys a stock for $10 per share and the price rises to $12, the investor has $2 in capital appreciation

Question 2

Dividend Income

Answer 2

Dividends are the percentage of a company’s earning that is paid to its shareholders as their share of the profits. Dividend income is defined by the IRS as any distribution of an entity’s property to its shareholders. An important component of equity returns; As dividends are considered income they are subject to taxes; depending on the dividend they are taxed as ordinary income or capital gains

Question 3

Diversification

Answer 3

Equity securities offer diversification benefits due to less-than-perfect correlation with other asset classes. When assets are less than
perfectly correlated, portfolio standard deviation will be lower than the weighted sum of the individual asset standard deviations

Question 4

Inflation Hedge

Answer 4

an investment that is made for the purpose of protecting the investor against decreased purchasing power of money due to rising prices of goods and services. The ideal investments for hedging against inflation include those that maintain their value during inflation or that increase in value over a specified period of time

Question 5

Client Constraints

Answer 5

may include environmental, social, and governance (ESG) considerations and religious beliefs. Portfolio managers can address these constraints using the following:

• Negative screening (i.e., exclusionary screening), which excludes companies or sectors that do not meet client standards.
• Positive screening (i.e., best-in-class screening), which seeks to uncover companies or sectors that rank most favorably with clients.
• Thematic investing screens equities based on a specific theme, such as climate change. A related approach is impact investing, which aims to meet investor objectives by becoming more actively engaged with company matters and/or directly investing in company projects

Question 6

Equity Investment Segmentation

Answer 6

There are three main segmentation approaches: size and style, geography, and economics activity (see next three definitions)

Question 7

Segmentation
Size and Style

Answer 7

Size and Style
Size, typically measured by market capitalization, can be categorized by largecap, mid-cap, or small-cap companies. Style can be categorized by growth or value companies, or a mix of these two
styles (sometimes referred to as blend or core). Investment style can be determined by analyzing company metrics, such as price-to-earnings ratios, priceto-book ratios, dividend yield, and earnings and/or book value growth. A style box can be used to rank (or score) companies or portfolios among to these metrics

Question 8

Segmentation
Geography

Answer 8

This approach categorizes international markets by stage of economic development, such as developed markets, emerging markets, and frontier markets. Examples for each economic development stage include the following:

• Developed markets: United States, United Kingdom, Germany, Australia, and Japan.
• Emerging markets: Brazil, Russia, India, China, and South Africa.
• Frontier markets: Argentina, Estonia, Nigeria, Jordan, and Vietnam

Question 9

Segmentation
Economic

Answer 9

This approach groups companies into sectors or industries by applying either a market-oriented or a production-oriented approach.

A market-oriented approach segments companies by markets served, how products are used by consumers, and how cash flows are generated. A production-oriented approach segments companies by products manufactured and inputs required during the production process. Note that applying either approach may lead to slightly different classifications. For example, a market-oriented approach may classify a coal company in the energy sector, while a production oriented approach may classify that same company in the basic materials sector.

The four primary classification structures for segmenting companies by economic activity are:
* Global Industry Classification Standard (GICS).
* Industrial Classification Benchmark (ICB).
* Thomson Reuters Business Classification (TRBC).
* Russell Global Sectors Classification (RGS)

Question 10

Equity Indices and Benchmarks

Answer 10

Equity market indices and equity portfolio benchmarks can be constructed based on a combination of size/style and geographic segmentation. For example, the MSCI Europe Large Cap Value Index and the MSCI China Small Cap Index combine elements from both size/style and geographic classifications. . Economic activity can also be used to subdivide equity indices by sector or industry. For example, the MSCI World Energy Index and the S&P Global Natural Resources Index track global companies categorized by sector/industry. Equity indices can also track unique client considerations, such as ESG practices.

Question 11

1. Equities typically offer diversification benefits when combined with other major asset classes in a portfolio. Discuss two reasons an economic crisis may affect the risk reduction archived through diversification?

Answer 11

Risk reduction is likely to be less than expected.
* The correlations are likely to move upward towards 1.0.
* The volatility of the assets is likely to increase

Question 12

2. Assume an investor is segmenting the equity investment universe by economic activity. Describe two advantages for applying this segmentation approach

Answer 12

• It allows portfolio managers to analyze, compare, and construct
  performance benchmarks based on specific sectors or industries.
• Diversification benefits are enhanced when investing across
  sectors or industries

Question 13

Optional Stock Dividend

Answer 13

Allows investors to choose between cash payment or stock dividends (i.e new shares). This “option” between cash and stock has value for the investor and can even be sold to another investor to immediately monetize the “option”

Question 14

Special Dividend

Answer 14

a one-time cash payment to investors (as opposed to the more typical periodic regular dividend)

Question 15

Securities Lending

Answer 15

Another way to generate current income. Securities lending is
often part of short selling. A short sale is the sale of a security that is not owned. To make the short sale, the seller must typically borrow the security in order to deliver it to the buyer when the short sale is made. The lender of the security is typically paid a fee and may also receive collateral or cash on which they can also earn a return. The lender also receives back the security lent at a future date. Securities lending is not unusual in index funds large institutional portfolios such as pension funds and endowments

Question 16

Stock Lending

Answer 16

Stock lending, also known as securities lending, is when you loan shares of stock that you own to another party, usually a financial institution, for a fee and interest charges. The borrower can use the stock for trading activities, such as short-sell trades, hedging, and arbitrage. You can earn money from stock lending by collecting a monthly fee from the borrower

Question 17

Covered Call

Answer 17

strategy involves writing a call option on a stock owned. The writer then loses the upside of the security if the price increases above the strike price

Question 18

cash-covered put

Answer 18

This involves selling a put option on stock and setting aside sufficient cash equivalents to pay for stock if the put buyer exercises their right

Question 19

Dividend capture

Answer 19

where an investor buys a stock right before its ex-dividend date, holds that stock through the ex-dividend date (entitling the investor to receive the dividend payment) and then sells the stock

Question 20

Equity Portfolio Fee/costs

Answer 20

Management and performance (incentive) fees
Administration fees
Marketing and Distribution fess
Trading costs
Investing Strategy costs

Question 21

Management fees

Answer 21

compensate the manager and pay research and analysis, computer hardware and software, compliance, and processing trades

Question 22

Performance Fees (incentive fees)

Answer 22

when the portfolio outperforms a stated return objective

Question 23

Administration Fees

Answer 23

Associated with corporate activities, such as measuring risk/return and voting on company issues

Question 24

Marketing and Distribution Fees

Answer 24

• Employing marketing, sales, and client services teams.
• Advertising investment products and services.
• Sponsoring and presenting at relevant conferences.
• Developing and distributing marketing materials (e.g., brochures).
• Fees from online platforms that offer multiple fund options (i.e., platform fees).
• Sales commissions from financial intermediary services (e.g., financial planners or brokers)

Question 25

Trading Costs

Answer 25

refers to cost associated with buying and selling securities

Question 26

Investment Strategy Cost

Answer 26

are an implicit cost related to the chosen investment strategy

Question 27

Corporate Strategy

Answer 27

Company objectives, constraints, growth opportunities, and
resources. Additional items may include company research, culture, products, competitive environment, and sustainability. Prioritizing stakeholder interests and balancing short-term obligations with long-term goals may also be items of interest for shareholders

Question 28

Capital Allocations

Answer 28

Selection process for new projects that add value, and strategy for potential mergers and acquisitions. Shareholders may also be interested in capital expenditures, use of leverage, payment of dividends, and equity financing.

Question 29

Corporate Governance

Answer 29

Internal controls and functions of the company’s audit and risk committee. Additional items include how the company manages regulatory and political risk

Question 30

Compensation Structures

Answer 30

Top management remuneration, incentives, and alignment with shareholder interests. Larger shareholders may influence future compensation structures

Question 31

Composition of the Board of Directors

Answer 31

The board’s experience, competence, diversity, culture, and effectiveness. Additional items include succession planning to address departing board members

Question 32

Activist Investing

Answer 32

1. Propose shareholder resolutions and launch media campaigns to influence the vote.
2. Seek representation on the company’s board of directors.
3. Launch proxy fights to win to achieve their goals. A proxy fight means seeking to persuade other shareholders to support their proposals.

Question 33

1. Explain why actively managed portfolios are typically subject to higher fees and costs than passively managed portfolios.

Answer 33

Such funds require more investment analysis and portfolio turnover than passively managed funds

Question 34

4. A client is concerned with low fees, seeks substantial value added versus their benchmark, has numerous ESG restrictions, and has selected a narrowly defined
   benchmark made up of large companies. Based on the client’s concerns, explain two reasons the client should favor a passive approach and two reasons the client should favor an active approach.

Answer 34

Passive:
(1) Passive managers can charge lower fees;
(2) The narrowly defined benchmark of presumably efficient large cap stocks is not going to provide the opportunity for active managers to find ways to add value.

Active:
(1) Active management is required to meet the desired value added;
(2) The ESG restrictions will require an active manager who uses various screening and other techniques to simultaneously meet this constraint and the overall objectives. This client sounds highly unrealistic in their objectives, but that was not the question asked

Question 34

2. Explain how shareholder engagement can benefit investors who are not actively involved in company issues.

Answer 34

They can earn a free ride, benefiting from the activities of others to increase the stock price without the time and cost of engagement

Question 35

3. Identify two disadvantages of shareholder engagement activities

Answer 35

(1) The cost and time commitment from shareholders and management,
(2) the desire to influence cash flows or stock prices in the short term, at the expense of long-term goals,
(3) the potential for insider trading violations, and (4) the potential for conflicts of interest

Question 36

5. Compared to passively managed funds, active funds tend to have higher research and trading costs. Identify and describe two additional types of risk for active managers and investors.

Answer 36

• Reputation risk results from violations to rules, regulations, client
  agreements, or moral principles.
• Key person risk results from essential individuals leaving the investment firm

Question 37

Elements of industry structure

Answer 37

1. Threats of new entrants in the industry
2. Threat of substitutes
3. Bargaining power of buyers
4. Bargaining power of seller
5. Rivalry among existing competitors

Question 38

Quality of Financial Statement information

Answer 38

Investigating the issue associated with the accuracy and detail of a firms disclosures

Question 39

Absolute valuation models

Answer 39

One that estimates an assets intrinsic value, which is its value arising from its investment characteristics without regard to the value of other firms.

Question 40

Intrinsic Value

Answer 40

The value of an asset or security by someone who has complete understanding of the characteristics of the asset or issuing firm

Question 41

Going concern assumption

Answer 41

simply the assumption that a company will continue to
operate as a business, as opposed to going out of business

Question 42

Framework that divides mispricing preceived by the analyst into two sources:

Answer 42

One between market price and the intrinsic value (actual mispricing) and the difference between the analyst’s estimate of intrinsic value (valuation error.

Question 43

Fair Market Value

Answer 43

the price at which a hypothetical willing, informed, and able seller would trade an asset to a willing, informed, and able buyer

Question 44

Investment Value

Answer 44

Value of a stock to a particular buyter

Question 45

Aggregate market value of equity

Answer 45

Equity return = Capital Appreciation + dividend yield