Managing Equity Portfolios

Question 1

What is Fundamental indexing

Answer 1

each stock’s index weighting is determined by four fundamental measures — not by its expected future size, as reflected in market capitalization

Question 2

four fundamental measures of Fundamental Indexing

Answer 2

• Trailing five-year cash flow (cash flow)
• Trailing five-year sales (sales)
• Trailing five-year gross dividends (dividends)
• Book value (book)

Question 3

drawback of cash flow metric

Answer 3

leads to over- or underexposure to highly cyclical companies.

Question 4

Book Value Metric - drawback

Answer 4

over or underexposure to companies with aggressive or conservative accounting practices.

Question 5

What is Risk Budgeting?

Answer 5

a process that limits the deviations of a portfolio’s return from a benchmark - used to create enhanced index portfolio.

Question 6

What is Enhanced indexing?

Answer 6

Index-like performance with some excess return net of costs

Question 7

4 steps of risk budgeting process

Answer 7

1. Determine benchmark.
2. Determine maximum acceptable tracking error.
3. Identify tactical asset allocation or specific return opportunities
4. Build a portfolio that deviates from the benchmark using the return opportunities identified in step three

Question 8

Purpose of step 2 in risk budgeting process (determine maximum acceptable tracking error)

Answer 8

sets a maximum for how large of an unexpected return “surprise” the portfolio could experience.

Question 9

Final purpose of risk budgeting

Answer 9

Maximize Portfolio’s expected excess returns without exceeding the tracking error limit determined in step two

Question 10

What is the selection dimension? (Active Manager)

Answer 10

identify underpriced securities

Question 11

What is the timing dimension (Active Manager)

Answer 11

anticipate general market movements

Question 12

sustainable growth rate equals…

Answer 12

Return on equity multiplied by the retention rate.

Question 13

How are enhanced active equity portfolios constructed?

Answer 13

by selling short undesirable smaller stocks and reinvesting the short sale proceeds into desirable long positions.

Question 14

two strategies to use in market-neutral investing:

Answer 14

absolute return and alpha portability

Question 15

what kind of strategy is long-short?

Answer 15

Absolute

Question 16

long-short equity strategy, there are two primary sources of return.

Answer 16

• Return from the long position greater than short position

* T-Bill Component

Question 17

long-only active investment managers try to build returns from two sources:

Answer 17

• exposure to systematic/market risk (beta)

* exposure to unsystematic / active risk (alpha).

Question 18

A portable alpha strategy consists of three components

Answer 18

The beta portfolio
The alpha portfolio
The cash portfolio

Question 19

three approaches to constructing an index fund

Answer 19

• replicating an index
• tracking an index
• fundamental indexing

Question 20

With this approach, a portfolio manager constructs a subset of the benchmark that faithfully mimics an index

Answer 20

Index tracking

Question 21

portfolio management styles fall into two categories

Answer 21

Active and Passsive

Question 22

How does replicating an index work?

Answer 22

manager holds each stock in the fund’s portfolio in exact proportion to its weighting within the index.

Question 23

Preferred methodology of constructing an index?

Answer 23

Index tracking

Question 24

value fund’s objectives are (2)

Answer 24

income and capital preservation

Question 25

difference between market-neutral management and more traditional active management (2)

Answer 25

• Market-neutral management eliminates the market’s effect.
• More aggressive in its stock shorting, amplifying
the approach by using leverage.

Question 26

Where do proceeds of T-Bills position come from in a long short portfolio?

Answer 26

The short position, where the manager receives proceeds from the sale

Question 27

Long short strategy return calculation

Answer 27

long - short + Tbill

Question 28

What is portable alpha strategy?

Answer 28

alpha portfolio is made beta neutral by using derivatives and added to a beta portfolio

Question 29

What is the purpose of portable alpha?

Answer 29

To enable a manager to budget risk and increase alpha without changing asset allocation mix.

Question 30

alpha portfolio should be three things:

Answer 30

• unrelated to its underlying market
• independent of its market direction
• absolute in nature (to generate positive returns).

Question 31

Difference between a managed account and a stock loan account when selling short

Answer 31

• in margin account, must have cash reserves on hand.

* In stock loan account, long positions serve as collateral

Question 32

One way managers can use stock index futures ( + ex: )

Answer 32

managers dont have to sell their position and buy a position in another index. they can use futures instead.
ex: sell TSX futures and Buy SP500 Futures

Question 33

example of how equity swap is used

Answer 33

• Portfolio manager holds position in Treasury bill
• Wants to earn return of TSX without selling position
• Enter into equity swap, where he gets return from TSX over certain period and agrees to pay T-Bill rate to counterparty

Question 34

Four industry trends driving growth in ETFs:

Answer 34

• Growth in fee-based business
• Growth in advisors as portfolio managers
• Demand for transparency
• Broad choices and ongoing innovation in ETFs