MIP 7 - Equity Portfolio Management Flashcards
What are the three main approaches to equity investment?
- Passive Management
- Indexing is the dominant form of this strategy
- The portfolio must be continuously adjusted to match the index
- Active Management
- Attempt to outperform an index
- The active return is the portfolio return less the benchmark
- Tracking risk is the annualized standard deviation of active returns
- The information ratio is the mean active return divided by the tracking risk
- Semiactive Management
- This is also called enhanced indexing or risk-controlled active management
Name three different index weighting choices
- Price weighted - weight by share price
- Value weighted - weight by market capitalization
- Equal weighted - equal weights for each stock
Index price weighting definition, advantages, and disadvantages
- Stocks are weighted by their share price (Dow Jones Industrial Average)
- Can be replicated by purchasing one share of each stock in the index
- (+)
- It is simple to calculate and gather historical price information
- (-)
- The index must be adjusted for events such as stock splits
- Biased towards the highest priced share, which is arbitrary
- Apple before split
Index Value (market-cap) weighting definition, advantages, and disadvantages
- Also called market-capitalization weighted
- Can be replicated by purchasing shares in porportion of all the outstanding shares of each stock in the index
- (+)
- This method self corrects for stock splits
- (-)
- Biased towards companies with larger market capitalizations (which could be older or overvalued firms)
- FAANGM
- Biased towards companies with larger market capitalizations (which could be older or overvalued firms)
Index Float weighting definition, advantages, and disadvantages
- A form of value or market-cap weighting
- S&P 500
- Could adjust the market cap weights for each issue’s floating supply of shares (available to investors)
- Excludes corporate cross-holdings and large holdings by founding shareholders
- Thus limiting to trading shares
- Float-weighting is generally regarded as the best approach
Index Equal weighting definition, advantages, and disadvantages
- Invest the same amount in each stock in the index
- (-)
- More weight given to smaller, potentially less liquid companies
- Generally has more frequent rebalancing
- Higher rebalancing and trading costs
State the four choices that determine a stock index’s characteristics
-
Boundaries of the stock index’s universe
- Determines how well the index represents a group of stocks
- The greater number of stocks in the index, the better the index will measure broad market performance
- Criteria for inclusion in the index
- How the stocks are weighted
- Usually price weighting, value weighting, or equal weighting
- How returns are calculated
- Price only or total return (including dividends)
Drawbacks of optimization as an approach to indexing
- Even best risk models are imperfectly specified
- Tends to exploit risk differences when they are just sampling errors
State the advantages of equity indexing.
- Lower management expenses
- Lower trading costs
- Lower portfolio turnover
- Lower tracking error
- Higher tax efficiency
- A logical way to gain exposure to market with which an investor may be unfamiliar (e.g. overseas markets)
- Typically better informational efficiencies
- Passive indexing has outperformed active management based on historical returns net of fees
State the three main kinds of passive investment vehicles mentioned in MIP Ch 7
- Indexed Portfolios
- Equity Index Futures
- Equity Total Return Swaps
Equity Total Return Swaps as Passive Investment Vehicles
- At least one side of the swap transaction receives the total return on an equity index
- The other side can be a different equity index or interest rate
- Allows for quick diversification
- Most are tax-driven transactions today
- Can also be used to rebalance asset allocations (i.e. increase or decrease equity exposure)
Overview of Value Investment Styles
- Want to buy relatively cheap stocks
- Not concerned about earnings or growth prospects
- Assume other investors do not accurately judge future risk and return prospects (overreact to bad news)
- Some evidence does support positive returns for value stocks
What are the three sub-styles of value-oriented investing?
- Low P/E
- Contrarian
- High dividend yield
State the disadvantages for value-oriented investing
- The stock may be cheap for a reason the manager does not know
- Even if the security is not properly valued, the holding period may not capture when the price correction occurs
- Trigger events may be required for price changes
- Investors often confuse cheap with a large liquidity premium
- Note: The bottom line is that an investor needs to make sure they understand why they think the stock is a value. If they are wrong, then the strategy obviously may not work
Overview of Growth Investment Styles
- More concerned with earnings rather than price
- Tend to invest in growth industries
- Usually trade at high P/E ratios
- Price takes all future earnings into account Earnings; earning are current
- Counting on the market continuing paying a premium for the stock
- There is the risk that forecast growth is not realized
What are the two growth investment sub-styles?
- Consistent growth
- Earnings momentum
Overview of Market-Oriented Investment Styles
- styles focus more on a broad market index
- May only get general market returns, which means should just use a passive strategy
- Subcategories
- market-oriented with a value bias
- market-oriented with a growth bias
-
growth-at-a-reasonable-price
- combines tenets of both growth and value investing
-
style rotators
- “time” relative performance of style
Name the two different techniques for identifying investment styles
- Returns-based Style Analysis
- Holdings-based Style Analysis