Equity Portfolio Management

Question 1

What is semiactive equity management?

Answer 1

Semiactive equity management (a.k.a. enhanced indexing or risk-controlled active management) attempts to earn a higher return than the benchmark while minimizing the risk of deviating from the benchmark.

Question 2

What is the information ratio?

Answer 2

The information ratio combines expected active return and tracking risk into one risk-adjusted return measure. It is the expected active return divided by the tracking risk, so it shows the manager’s active return per unit of tracking risk (a.k.a. tracking error).

Question 3

Rank (lowest to highest) the equity investment approaches by their information ratio, historically.

Answer 3

1. Passive
2. Active
3. Semiactive

Question 4

Describe a price-weighted index.

Answer 4

A price-weighted index is simply an arithmetic average of the prices of the securities included in the index. Computationally, a price-weighted index adds together the market price of each stock in the index and then divides this total by the number of stocks in the index. The divisor of a price-weighted index is adjusted for stock splits and changes in the composition of the index, so the total value of the index is unaffected by the change.

Question 5

Describe a market capitalization-weighted index (value weighted).

Answer 5

A market capitalization-weighted index (value index) is calculated by summing the total market value (current stock price time the number of share outstanding) of all the stocks in the index.The value-weighted index assumes the investor holds each company in the index according to its relative weight in the index.

Question 6

Describe a equal-weighted index.

Answer 6

In an equal-weighted index, all stock returns are given the same weight (i.e., the index is computes as if an investor maintains an equal dollar investment in each stock in the index). These indices must be periodically rebalanced to maintain equal representation of the component stocks.

Question 7

What are the biases in a price-weighted index?

Answer 7

1. Higher priced stocks will have a greater impact on the index’s value than lower priced stocks.
2. The price of a stock is somewhat arbitrary and changes through time as a firm splits its stock, repurchases stock, or issues stock dividends. As a stock’s price changes through time, so does its representation in the index.
3. The price-weighted index assumes the investor purchases one share (or the same number of shares) of each stock represented in the index, which is rarely followed by any investor in practice.

Question 8

What are the biases in a value-weighted index and the free float-adjusted market capitalization index?

Answer 8

1. Firms with greater market capitalization have a greater impact on the index than firms with lower market capitalization. This means that these indices are biased toward large firms that may be mature/or overvalued.
2. These indices my be less diversified if they are over-represented by large-cap firms.
3. Some institutional investors may not be able to mimic a value-weighted index if they are subject to maximum holdings and the index holds concentrated positions.

Question 9

What are the biases of the equal-weighted index?

Answer 9

1. The equal weighted index is biased towards small-cap companies because they will have the same weight as large cap firms even though they have less liquidity. Many equal-weighted indices contain more small firms than large firms.
2. The required rebalancing of this index creates high transaction costs.
3. The emphasis on small-cap stocks means that index investors may not be able to find liquidity in many of the index issues.

Question 10

Give examples of price-weighted indices.

Answer 10

1. DJIA

2. Nikkei Stock Average

Question 11

Give examples of value-weighted indices.

Answer 11

1. S&P 500
2. Russell Indices
3. DAX 30

Question 12

Give examples of equal-weighted indices.

Answer 12

1. Value Line Composite Average

Question 13

When may equity passive strategies be preferable?

Answer 13

Investor is/has

1. Taxable.
2. An information disadvantage in global markets.
3. Investing in informationally efficient large-cap markets.
4. Wants to avoid the high transactions costs in small-cap markets.

Question 14

What are the differences between mutual funds and ETFs?

Answer 14

1. Mutual funds trade once a day, ETFs trade through out the day.
2. ETFs do not have to maintain recordkeeping for shareholders, whereas mutual funds do.
3. Index mutual funds usually pay lower license fees to index providers, relative to the fees that ETFs pay.
4. ETFs are generally more tax effcient.
5. The cost of holding ETFs are lower.

Question 15

Compared to ETFs, what are the two disadvantages of equity futures?

Answer 15

1. Futures contracts have a finite life and must be periodically rolled over into a new contract.
2. Using basket trades and futures contracts in combination for risk management can be problematic because a basket may not be shorted if one of the components violates the uptick rule.

Question 16

Describe Optimization as an approach to constructing an indexed portfolio.

Answer 16

Optimization uses a factor model to match the factor exposures of the index. It accounts for the covariances between the risk factors.

Question 17

What are possible problems with optimization in index construction.

Answer 17

The risk sensitivities may change through time. This may provide misleading results and lead to frequent rebalancing.

Question 18

When is each approach to constrcting indexed portfolios preferable?

Answer 18

• Full replication is more appropriate for small indices when the index stocks are liquid and when the manager has more funds.
• Stratified sampling is more appropriate when the number of stocks in the index is large and/or the stocks are illiquid.
• Optimization leads to lower tracking risk than stratified sampling.

Question 19

What are the three main categories of investment style and their characteristics?

Answer 19

Value investor - focuses on stocks with low price multiples (e.g., P/E ratio, P/B ratio)
Growth investor - favors stocks with high past and future earnings growth.
Market-oriented investor - Cannot be easily classified as value or growth.

Question 20

What are the two techniques for identifying investment styles?

Answer 20

Returns-based style analysis - The returns on a manager’s fund are regressed against the returns for various security indices (e.g., large-cap value stocks, small-cap value stocks). The regression coefficients are constrained to be nonnegative and to sum to one.

Holding-based style analysis - Evaluates portfolio characteristics using the following attributes: value or growth, expected earnings growth, earnings volatility, and industry representation.

Question 21

What are the advantages of returns-based style analysis?

Answer 21

Advantages: Low cost, quick, and consistent method of characterizing an entire portfolio.
Disadvantages: The regression may be misspecified, and it may be slow to detect style changes.

Question 22

What are the advantages of holdings-based style analysis?

Answer 22

Advantages: It can characterize individual securities, and detect style changes quickly.
Disadvantages: It subjectively classifies securities, requires more data, and is not consistent with how most managers invest.

Question 23

What are the reasons for pricing inefficiencies on the short side of equity trades?

Answer 23

1. Impediments to short sales.
2. Management is more likely to promote the firm’s stock.
3. Analysts are more likely to issue buy then sell recommendations.
4. Pressure analysts face from management against issuing sell recommendations.

Question 24

What are the sell disciplines of active investors?

Answer 24

1. Opportunity cost sell discipline (Substitution).
2. Deteriorating fundamentals sell discipline.
3. Valuation-level sell discipline.
4. Down-from-cost sell discipline.
5. Up-from-cost sell discipline.
6. Target price sell discipline.

Question 25

What is the fundamental law of active management?

Answer 25

The fundamental law of active management states that an investor’s information ratio is a function of their depth of knowledge and the number of independent investment decisions. Information ratio = Information coefficient times the square root of the information breadth.

Question 26

What are the two information ratios?

Answer 26

One is the true active return/ true active risk.
The other is based on the fundamental law of active management. This law is formally described as Information ratio = Information coefficient times the square root of the information breadth.

Question 27

What is the core-satellite approach to managing active equity managers?

Answer 27

In a core-satellite approach, the investor has a ore holding of a passive index and/or an enhanced index that is complemented by a satellite of active manager holdings.

Question 28

What is a completeness fund.

Answer 28

The completeness fund complements the active portfolio so that the combined portfolios have a risk exposure similar to the benchmark. It can minimize active risk while maintaining active return. However it may result in a reduction in active return due to misfit risk.

Question 29

What is true active return?

Answer 29

.manager’s total return - manager’s normal portfolio return

Question 30

What is the misfit active return?

Answer 30

manager’s normal portfolio return - investor’s benchmark return

Question 31

What is the total active risk?

Answer 31

The square root of the sum of true active risk squared and misfit active risk squared

Question 32

What is the true information ratio?

Answer 32

true active return / true active risk

Question 33

What are the five sections of the manager questionnaire?

Answer 33

1. Staff and organizational structure.
2. Investment philosophy and procedures.
3. Resources and research utilization.
4. Performance.
5. Fee schedule.

Question 34

What attributes are used to characterize a security in holdings-based analysis?

Answer 34

1. Value or growth.
2. Expected earnings per share growth rate.
3. Earnings volatility.
4. Industry representation.

Question 35

What are the disadvantages of returns-based analysis?

Answer 35

1. May be inaccurate dye to style shift.

2. Misspecified indices can lead to misleading conclusions.

Question 36

What are the disadvantages of holdings-based analysis?

Answer 36

1. It is not consistent with the method used by many managers to select securities.
2. Requires subjective judgement to classify securities.
3. Requires more data than returns-based analysis.

Question 37

What are the risks of style drift?

Answer 37

1. The client may not be getting their desired style exposure.
2. The manager may be moving into an area outside her expertise.

Question 38

When screening for socially responsible investing (SRI), what are the potential effects on a portfolio;s style characteristics?

Answer 38

1. SRI portfolios tend to be tilted towards growth stocks.

2. SRI screens have been found to have a bias toward small-cap stocks.

Question 39

What is an alpha and beta separation approach?

Answer 39

The investor gains a systematic risk exposure (beta) through a low-cost index fund or ETF, while adding an alpha through a long-short strategy.This may be particularly suitable for markets that are highly efficient and difficult to generate an alpha from.

Question 40

Are investors more risk averse with total risk or active risk, and why?

Answer 40

Active risk.

1. To obtain an active return the investor must accept active risk. To believe that active return is possible, the investor must believe that there are active managers who can produce it and that the investor can successfully pick them.
2. An active equity style is judged against a passive benchmark. It is difficult to generate alpha and those who don’t face pressure from their superiors.
3. Higher active returns mean more is invested with the high return active manager, resulting in less diversification.

Question 41

What is a float adjustment in the construction of international equity benchmarks?

Answer 41

Float adjustment is the downward adjustment of the capitalized weight of companies in an index to reflect the reduced number of shares that are freely traded.

Question 42

What are the three trade-offs that managers tracking international indices need to be aware of?

Answer 42

1. Breadth vs. Liquidity.
2. Precise float-adjustment vs. Transactions Costs from Rebalancing.
3. Objectivity and Transparency vs. Judgement when constructing a index.

Question 43

What is the effect that a country’s classification as either a developed or an emerging market can have on market indices and on investment in the country’s capital markets?

Answer 43

If an emerging country has become to large for an emerging markets index, it will artificially inflate both the average performance and size of countries in the index. When an emerging county is reclassified as developed, the country’s equities become more widely traded, which can help increase the rate of development.

Question 44

List the key internal stakeholders.

Answer 44

1. Stockholders.
2. Employees.
3. Managers.
4. Members of the Board of Directors.

Question 45

List external stakeholders.

Answer 45

1. Customers.
2. Suppliers.
3. Creditors.
4. Unions.
5. Governments.
6. Local Communities.

Question 46

What is the purpose of the stakeholder impact analysis (SIA).

Answer 46

To force the company to make choices among the stakeholders and identify which groups are most critical to the company.

Question 47

What are the components of the stakeholder impact analysis (SIA).

Answer 47

1. Identify the relevant stakeholders.
2. Identify the critical interests and desires of each group.
3. Identify the demands of each group on the company.
4. Prioritize the importance of various stakeholders to the company.
5. Provide a business strategy to meet the critical demands.

Question 48

How does the principal-agent relationship (PAR) arise and how can problems develop?

Answer 48

The PAR arises when one group delegates decision making or control to another group. PAR can create problems because the group receiving the power (the agent) generally has an asymmetric information advantage over the group making the delegation (the principal). The problem begins when the agent uses the information advantage for their own interest to the detriment of the interest of the principal.

Question 49

How does unethical behavior arise and how can it be avoided?

Answer 49

1. Agents who whose personal ethics are flawed are more likely to violate business ethics. Hire people who have a good moral compass.
2. A failure to realize an issue may lead to an ethics violation. Ask whether every decision has ethical implications.
3. A flawed business culture where management sets unrealistic goals leads to ethics violations. Management must communicate that ethical behavior is expected.
4. Unethical leadership will set the tone and lead to violations.

Question 50

What is the Friedman doctrine and explain any misconceptions?

Answer 50

Narrowly address the social responsibility of business (not business ethics). It concluded that the only social responsibility is to increase profits “within the rules of the game”, meaning through “ open and fair competition without deception or fraud”. Remember: The assertion that Friedman moves into business ethics due to the follow the rules caveat is wrong.

Question 51

Define Utilitarianism and explain its flaw.

Answer 51

Utilitarianism argues business must weigh the consequences to of each action and seek to produce the highest good for the largest number of people. Modern cost-benefit analysis is an application of this principal. One flaw is that many costs and benefits are hard to measure. The other flaw is that utilitarianism fails to consider that justice defined as the greatest food for many could come at the expense of exploiting a smaller subgroup.

Question 52

Define Kantian ethics.

Answer 52

Kantian ethics argues that people are different from other factors of production. They are more than just an economic input and deserve dignity and respect. This is widely accepted but is not sufficient to be a complete philosophy.

Question 53

Define rights theory.

Answer 53

Rights theories argue that all individuals have fundamental rights and privileges. The greatest good utilitarianism cannot come in violation of the rights of others. Furthermore, managers must have a moral compass. Manager must recognize that even if an action is legal, it may violate fundamental rights and be unethical.

Question 54

Define justice theory.

Answer 54

Justice theories focus on a just distribution of economic output. Justice is met if all participants would agree the rules are fair if the results would be acceptable when decided under a “veil of ignorance” (i.e., participants not knowing what results they will personally receive ahead of time). Justice theories begin with political liberty, encompassing the right of free speech and to vote, and extend to issues of society’s division of wealth and income. They recognize unequal divisions of wealth and income may be acceptable under the differencing principal, which holds the unequal division must benefit the least-advantaged members of society.

Question 55

What are three ways to control principal-agent relationship (PAR) problems?

Answer 55

1. Shape the behavior of agents so their actions are in alignment with management.
2. Reduce they asymmetry of information.
3. Remove agents who misbehave and violate ethics.