MIP Ch 7: Equity Portfolio Management

Question 1

Name three different index weighting choices.

Answer 1

Price weighted - weight by share price

Value weighted - weight by market capitalization

Equal weighted - equal weights for each stock

Question 2

Name the two different techniques for identifying investment styles

Answer 2

Returns-based Style Analysis

Holdings-based Style Analysis

Question 3

State the four choices that determine a stock index’s characteristics

Answer 3

1. Boundaries of the stock index’s universe
   Ÿ Determines how well the index represents a group of stocks
2. Criteria for inclusion in the index
3. How the stocks are weighted
   Ÿ Usually price weighting, value weighting, or equal weighting
4. How returns are calculated
   Ÿ Price only or total return (including dividends)

Question 4

What are the reasons there may be more price inefficiency on the short side?

Answer 4

Many investors only look for undervalued stocks, not overvalued ones
Ÿ But short selling can be difficult when many investors are competing to borrow the
same shares

Stocks could be overvalued due to management fraud, creative accounting, or
negligence

Analysts usually have more buy recommendations than sell recommendations
Ÿ Creates more trading, which means more commissions

Analysts are reluctant to issue negative opinions because often own a stake in the
company

Question 5

Describe socially responsible investing (SRI).

Answer 5

Also called ethical investing

Devoted to the conscious creation of social impact through investment

Consider ethical values and societal concerns when making investment decisions

SRI commonly uses stock screens (positive and negative)

For example, may choose to exclude tobacco and gambling firms

Question 6

State the limitations of semiactive stock-selection

Answer 6

Any technique that generates a positive alpha will likely become obsolete

Models that worked historically may not work in the future

Shocks to the market could change everything

Question 7

State the fundamental law of active management.

Answer 7

IR IC
?
Breadth

Question 8

What are two key concerns for socially responsible investing (SRI)?

Answer 8

Could have increased concentration risk and less diversification

Question 9

State the five main categories of topics that should be included in an equity manager
questionnaire (according to MIP Ch 7)

Answer 9

1. Organization/People
2. Philosophy/Process
3. Resources
4. Performance
5. Fees

Question 10

What are the three sub-styles of value-oriented investing?

Answer 10

Low P/E

Contrarian

High dividend yield

Question 11

State the three main kinds of passive investment vehicles mentioned in MIP Ch 7.

Answer 11

1. Indexed Portfolios
2. Equity Index Futures
3. Equity Total Return Swaps

Question 12

State the advantages of equity indexing.

Answer 12

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

Question 13

How is the information ratio calculated?

Answer 13

The information ratio is the mean active return divided by the tracking risk

Question 14

What are the two growth investment sub-styles?

Answer 14

Consistent growth

Earnings momentum

Question 15

What are the three main approaches to equity investment?

Answer 15

1. Passive Management
   Ÿ Indexing is the dominant form of this strategy
   Ÿ The portfolio must be continuously adjusted to match the index
2. Active Management
   Ÿ Attempt to outperform an index
   Ÿ The active return is the portfolio return less the benchmark
   Ÿ Tracking risk is the annualized standard deviation of active returns
   Ÿ The information ratio is the mean active return divided by the tracking risk
3. Semiactive Management
   Ÿ This is also called enhanced indexing or risk-controlled active management

Question 16

State the advantages of returns-based style analysis.

Answer 16

Characterizes entire portfolio

Facilitates comparisons of portfolios

Aggregates the effect of the investment process

Different models usually give similar results

Clear theoretical basis

Requires minimal information

Can be executed quickly

Cost effective

Question 17

State the disadvantages of returns-based style analysis.

Answer 17

May be ineffective in characterizing current style

Error in specifying indices in model may invalidate results

Question 18

State the advantages of holdings-based style analysis.

Answer 18

Characterizes each position

Facilitates comparisons of individual positions

May capture style changes more quickly

Question 19

State the disadvantages of holdings-based style analysis.

Answer 19

Not consistent with how portfolio managers select securities

Different specifications will lead to different results

More data intensive

Question 20

State the disadvantages for value-oriented investing.

Answer 20

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

Question 21

Define alpha.

Answer 21

Alpha is the portfolio’s return in excess of that on a risk-matched benchmark

Measures the amount of active return

Question 22

Describe the two categories of selling disciplines.

Answer 22

1. Substitution strategy
   Ÿ Replace an existing holding when a better opportunity is available
   Ÿ Reasons include opportunity cost and deteriorating fundamentals
2. Rule driven strategy
   Ÿ Includes value-level, down-from-up, up-from-cost, and target price sell disciplines
   Ÿ A value investor may sell a stock of the P/E ratio rises to a certain level
   Ÿ Could determine to sell a stock if the price drops x% from the purchase price
   (down-from-cost)
   Ÿ Should analyze the after-tax effect

Question 23

Describe four reasons why investors are more risk averse when facing active risk vs.
total risk

Answer 23

1. Must assume successful active management is possible and the managers have
   the necessary skill
2. Many active managers fail to beat the benchmark / underperform
3. Superiors will judge how well the overall portfolio performs relative to benchmarks
4. As one moves up on the efficient frontier assuming more active risk, less manager
   diversification exists

Question 24

Describe the core satellite approach.

Answer 24

In the overall portfolio, could have core holdings of an index and semiactive
managers

Anchor an index portfolio and use active managers around the anchor to achieve
an acceptable level of active return

The active managers represent the ring of satellites

The goal is to add active return (alpha) through the satellites

Want an acceptable level of active return without too much active risk

Question 25

Describe a completeness fund.

Answer 25

A completeness fund makes the overall portfolio, active and passive
components, have the same risk exposure as the investor’s overall equity
benchmark

Must be adjusted periodically as the actively managed accounts change

Question 26

Describe the shortcomings of alpha-beta separation.

Answer 26

Shorting may not be allowed for some investors/institutions

Systematic risk may remain

Question 27

Describe portable alpha strategies.

Answer 27

Portable alpha is a strategy involving the combination of multiple positions (e.g.
long and short positions) so as to separate the alpha (unsystematic risk) from
beta (systematic, market risk) in an investment.

Portable alpha means that alpha is available to be added to a variety of
systematic risk exposures.

Question 28

Describe alpha-beta separation.

Answer 28

Have both long and short positions that have offsetting beta so that the portfolio
beta is zero. Long the position with greater alpha to get a portfolio with beta close
to 0 but positive alpha

Alpha
Ÿ Unsystematic Risk = Value Added by the Portfolio Manager = Return in excess of a
risk-matched benchmark

Beta
Ÿ Exposure to systematic, market-level risk