Reading 23 Equity Portfolio Management

Question 1

Equities as an inflation hedge

Answer 1

Common equities should offer superior protection against unanticipated inflation compared with conventional bonds. This phenomenon is so because companies’ earnings tend to increase with inflation, whereas payments on conventional bonds are fixed in nominal terms.

Question 2

Approaches to Equity Investment

Answer 2

In passive management, the investor does not attempt to reflect his investment expectations through changes in security holdings. The dominant passive approach is indexing, which involves investing in a portfolio that attempts to match the performance of some specified benchmark.

Another approach is active management, which historically is the principal way that investors have managed equity portfolios. An active manager seeks to outperform a given benchmark portfolio (the portfolio against which the manager’s performance will be evaluated).

The final approach is semiactive management (also called enhanced indexing or risk-controlled active management) and is in reality a variant of active management. In a semiactive portfolio, the manager seeks to outperform a given benchmark, as do active managers in general. A semiactive portfolio manager, however, worries more about tracking risk than an active manager does and will tend to build a portfolio whose performance will have very limited volatility around the benchmark’s returns.

Question 3

Active return, active risk, information ratio

Answer 3

Active return is the portfolio’s return in excess of the return on the portfolio’s benchmark. Tracking risk, the annualized standard deviation of active returns, measures active risk.

The information ratio equals a portfolio’s mean active return divided by tracking risk and represents the efficiency with which a portfolio’s tracking risk delivers active return.

Question 4

Stock index’s characteristics

Answer 4

• Boundaries of the stock index’s universe
• Criteria for inclusion
• Weighting of the stocks
• Computational method

Question 5

Index Weighting Choices

Answer 5

The three basic index weighting methods are price weighting, value (or float) weighting, and equal weighting.

Price weighted

The performance of a price-weighted index represents the performance of a portfolio that simply bought and held one share of each index component.

A price-weighted index is biased toward the highest-priced share.

A price-weighted index’s main advantage lies in the simplicity of its construction.

Value weighted

The performance of a value-weighted index would represent the performance of a portfolio that owns all the outstanding shares of each index component.

A value-weighted index self-corrects for stock splits, reverse stock splits, and dividends.

A subcategory of the value-weighted method involves adjustment of market cap weights for each issue’s floating supply of shares or free float—the number of shares outstanding that are actually available to investors. The resulting index is called a free float–adjusted market capitalization index, or float-weighted index for short.

The performance of a float-weighted index represents the performance of a portfolio that buys and holds all the shares of each index component that are available for trading.

A value-weighted index is biased toward the shares of companies with the largest market capitalizations.

The bias toward large market cap issues in value-weighted/float-weighted indices, however, means that such indices will tend to be biased toward:

• large and probably mature companies, and
• overvalued companies, whose share prices have already risen the most.

Another criticism of value-weighted/float-weighted indices is that a portfolio based on such an index may be concentrated in relatively few issues and, hence, less diversified than most actively managed portfolios.

Equal weighted. The performance of an equal-weighted index represents the performance of a portfolio in which the same amount of money is invested in the shares of each index component. Equal-weighted indices must be rebalanced periodically (e.g., monthly, quarterly, or annually) to reestablish the equal weighting, because varying individual stock returns will cause stock weights to drift from equal weights.

An equal-weighting methodology introduces a small-company bias because such indices include many more small companies than large ones. Moreover, to maintain equal weighting, this type of index must be rebalanced periodically. Frequent rebalancing can lead to high transaction costs in a portfolio tracking such an index. Another limitation of equal-weighted indices as indexing benchmarks is that not all components in such an index may have sufficiently liquid markets to absorb the demand of indexers.

Question 6

Specific passive investment vehicles

Answer 6

The major choices are:

• investment in an indexed portfolio;
• a long position in cash plus a long position in futures contracts on the underlying index, when such markets are available and adequately liquid; and
• a long position in cash plus a long position in a swap on the index. (That is, in the swap the investor pays a fixed rate of interest on the swap’s notional principal and in return receives the return on the index.)

Question 7

Difference between mutual funds and ETFs

Answer 7

The most obvious difference between conventional index mutual funds and ETFs is that shareholders in mutual funds usually buy shares from the fund and sell them back to the fund at a net asset value determined once a day at the market close. ETF shareholders buy and sell shares in public markets anytime during the trading day.

At least five economically significant differences separate conventional index mutual funds from indexed exchange-traded funds:

1. Shareholder accounting at the fund level can be a significant expense for conventional mutual funds in some markets, but ETFs do not have fund level shareholder accounting. To the extent that a fund has a large number of small shareholders, shareholder record-keeping will be a significant cost reflected in the fund’s expense ratio.
   Exchange-traded funds have no shareholder accounting at the fund level, so their expense ratios are typically lower than conventional mutual fund expense ratios for funds linked to comparable indices.
2. Exchange-traded funds generally pay much higher index license fees than conventional funds.
3. Exchange-traded funds are often much more tax-efficient than conventional funds in many markets, including the United States. At the fund level, the most significant tax difference between conventional funds and ETFs is in the process by which fund shares are redeemed. Unlike a traditional mutual fund that will ordinarily sell stocks inside the fund and pay cash to a fund shareholder who is redeeming shares, the redemption mechanism for an exchange-traded fund is usually “in kind” in the sense of being an exchange of shares. The fund typically delivers a basket of the fund’s portfolio stocks to a redeeming dealer who has turned in shares of the fund for this exchange.
4. Although ETFs carry brokerage commissions, the costs of holding an ETF long-term is typically lower than that for an index mutual fund. Due to the differences in redemption described previously, the management fees arising from taxes and the sale of securities in an ETF are ususally much lower than that for a mutual fund. Thus, an ETF investor does not pay the cost of providing liquidity to other shareholders the way a mutual fund does.
5. Index mutual funds are less frequently traded.

Question 8

The three most important categories of indexed portfolios

Answer 8

The three most important categories of indexed portfolios are:

• conventional index mutual funds;
• exchange-traded funds (ETFs), which are based on benchmark index portfolios; and
• separate accounts or pooled accounts, mostly for institutional investors, designed to track a benchmark index.

Question 9

Full replication of index

Answer 9

Full replication, where the number and liquidity of the issues permit using it, should result in minimal tracking risk. Apart from minimizing tracking risk, a full replication portfolio based on a value-weighted (or float-weighted) index has the advantage of being self-rebalancing because the stock weights in the portfolio will mirror changes in the index weights resulting from constantly changing stock prices.

Typically, the return on a full replication index fund may be less than the index return by an amount equal to the sum of:

• the cost of managing and administering the fund;
• the transaction costs of portfolio adjustments to reflect changes in index composition;
• the transaction costs of investing and disinvesting cash flows; and
• in upward-trending equity markets, the drag on performance from any cash positions (in the long run we expect equity returns to exceed the returns on cash, justifying the inclusion of this factor).

Attempting to fully replicate an index containing a large proportion of illiquid stocks will usually result in an index portfolio that underperforms the index. This phenomenon occurs because indices do not have to bear transaction costs but a real portfolio does. These transaction costs include brokerage commissions, bid–offer spreads, taxes, and the market impact of trades (the effect of large trades on the market price). There are two ways to build an index-tracking portfolio using a subset of stocks in the index: stratified sampling and optimization. Skillful use of these techniques should permit a portfolio manager to index successfully to even a very broad index containing illiquid securities.

Question 10

Optimization vs. Stratified sampling (also called representative sampling)

Answer 10

Another technique commonly used to build portfolios containing only a subset of an index’s stocks is optimization. Optimization is a mathematical approach to index fund construction involving the use of:

• a multifactor risk model, against which the risk exposures of the index and individual securities are measured. The multifactor model might include factors such as market capitalization, beta, and industry membership, as well as macroeconomic factors such as interest rate levels.
• an objective function that specifies that securities be held in proportions that minimize expected tracking risk relative to the index subject to appropriate constraints. The objective function seeks to match the portfolio’s risk exposures to those of the index being tracked.

An advantage of optimization compared with stratified sampling is that optimization takes into account the covariances among the factors used to explain the return on stocks. The stratified sampling approach implicitly assumes the factors are mutually uncorrelated.

Optimization has several drawbacks as an approach to indexation:

• First, even the best risk models are likely to be imperfectly specified. That is, it is virtually impossible to create a risk model that exactly captures the risk associated with a given stock, if only because risks change over time and risk models are based on historical data.
• Furthermore, the optimization procedure seeks to maximally exploit any risk differences among securities, even if they just reflect sampling error (this is the problem known as overfitting the data).
• Even in the absence of index changes and dividend flows, optimization requires periodic trading to keep the risk characteristics of the portfolio lined up with those of the index being tracked.

As a result of these limitations, the predicted tracking risk of an optimization-based portfolio will typically understate the actual tracking risk. That said, indexers have found that the results of an optimization approach frequently compare well with those of a stratified sampling approach, particularly when replication is attempted using relatively few securities.

Optimization must be updated to reflect changes in risk sensitivities from the factor model and this leads to frequent rebalancing.

!!! Optimization will provide lower tracking risk compared to stratified samplnig, but it requires more frequent rebalancing. If tracking risk is not highly important, the manager may want to consider stratified sampling since the trading costs in some emerging countries can be particularly high. Stratified sampling also does not require or depend on the use of a model.

Question 11

Equity Index Futures

Answer 11

Two additional indexing products exist portfolio trades (also known as basket trades or program trades) and stock index futures.

A portfolio trade is simply a basket of securities traded as a basket or unit, whereas a traditional security trade is done one share issue at a time. A portfolio trade is made when all of the stocks in the basket—most commonly, the components of an index—are traded together under relatively standardized terms.

The limited life of a futures contract and the fact that the most active trading in the futures market is in the nearest expiration contract means that a futures position must be rolled over periodically to maintain appropriate market exposure. Trading a basket of stocks can be relatively cumbersome at times, particularly on the short side where any uptick rule historically impeded basket transactions in US markets. (Uptick rules require that a short sale must not be on a downtick relative to the last trade at a different price. For example, if Microsoft is trading at $10 per share, the uptick rule requires investors to short the stock at a price above $10 if the security is down 10% or more from the previous day’s close.) Exchange-traded funds historically have been exempt from the uptick rule for short sales. This fact, and their lack of an expiration date, has made ETFs instruments of choice for many indefinite-term portfolio hedging and risk management applications.

Question 12

Equity Total Return Swaps

Answer 12

Conceptually, equity swaps resemble the more widely known fixed-income and currency swaps. The distinct feature of an equity swap is that at least one side of the transaction receives the total return of either an equity instrument or, more commonly, an equity index portfolio. The other side can be either another equity instrument or index or an interest payment. The most common nonequity swap counter payments are US dollar Libor for equity swaps based on US securities, or Libor in the appropriate currency for equity swaps based on non-US stocks.

Today, most equity swap applications are motivated by differences in the tax treatment of shareholders domiciled in different countries or by the desire to gain exposure to an asset class in asset allocation.

Equity swaps have another important application: asset allocation transactions. A manager can use equity swaps to rebalance portfolios to the strategic asset allocation.
Total costs to rebalance by trading the underlying securities may exceed the cost of an equity swap. Consequently, effecting the asset allocation change with a swap is often more efficient. Equity swaps are used in tactical asset allocation for similar reasons.

Question 13

Value Investment Style

Answer 13

• Value investors are more concerned about buying a stock that is deemed relatively cheap in terms of the purchase price of earnings or assets than about a company’s future growth prospects.
• Empirically, most studies have found that in the long run a value style may earn a positive return premium relative to the market.
• The main risk for a value investor is that he has misinterpreted a stock’s cheapness.
• Value investors also face the risk that the perceived undervaluation will not be corrected within the investor’s investment time horizon.
• The value investing style has at least three substyles: low P/E, contrarian, and high yield:

1. A low P/E investor will look for stocks that sell at low prices to current or normal earnings. Such stocks are generally found in industries categorized as defensive, cyclical, or simply out-of-favor. The investor buys on the expectation that the P/E will at least rise as the stock or industry recovers.
2. A contrarian investor will look for stocks that have been beset by problems and are generally selling at low P/Bs, frequently below 1. Such stocks are found in very depressed industries that may have virtually no current earnings. The investor buys on the expectation of a cyclical rebound that drives up product prices and demand.
3. A yield investor focuses on stocks that offer high dividend yield with prospects of maintaining or increasing the dividend, knowing that in the long run, dividend yield has generally constituted a major portion of the total return on equities.

There are two justifications of a value investing strategy:

• the first is that although a firm`s earnings are depressed now, the earnings will rise in the future as they revert back to the mean. One of the risks of this strategy however is that there is a good reason why the stock is priced so cheaply. Some stock will take a long tine to increase in value. The investor needs to consider it before investing.
• the second justification for value investors os that growth investors expose themselves to the risk that earnings and price multiples will contract for high-priced growth stocks.

Question 14

Growth Investment Styles

Answer 14

• Growth investors are more concerned with earnings. Their underlying assumption is that if a company can deliver future growth in earnings per share and its P/E does not decline, then its share price will appreciate at least at the rate of EPS growth.
• The major risk facing growth investors is that the forecasted EPS growth does not materialize as expected.
• The growth style has at least two substyles: consistent growth and earnings momentum.
• Companies with consistent growth have a long history of unit-sales growth, superior profitability, and predictable earnings.
• Companies with earnings momentum have high quarterly year-over-year earnings growth (e.g., EPS for the first quarter of 2011 represents a large increase over EPS for the first quarter of 2010). Such companies may have higher potential earnings growth rates than consistent growth companies, but such growth is likely to be less sustainable.

Question 15

Other Active Management Styles

Answer 15

• Market-oriented investors do not restrict themselves to either the value or growth philosophies.
• Market-oriented investors may be willing to buy stocks no matter where they fall on the growth/value spectrum, provided they can buy a stock below its perceived intrinsic value.
• The potential drawback of a market-oriented active style is that if the portfolio achieves only market-like returns, indexing or enhanced indexing based on a broad equity market index will likely be the lower-cost and thus more effective alternative.
• Among the recognized subcategories of market-oriented investors are market-oriented with a value bias, market-oriented with a growth bias, growth-at-a-reasonable-price, and style rotators.
• Growth-at-a-reasonable-price investors favor companies with above-average growth prospects that are selling at relatively conservative valuation levels compared with other growth companies. Their portfolios are typically somewhat less well diversified than those of other growth investors. Style rotators invest according to the style that they believe will be favored in the marketplace in the relatively near term.
• Another characteristic often used in describing the style of equity investors is the typical market capitalization of the issues they hold.

Question 16

Techniques for Identifying Investment Styles

Answer 16

Two major approaches to identifying style are returns-based style analysis, which relies on portfolio returns, and holdings-based style analysis (also called composition-based style analysis), which relies on an analysis of the characteristics of individual security holdings.

Question 17

Returns-based style analysis (RBSA)

Answer 17

This technique focuses on characteristics of the overall portfolio as revealed by a portfolio’s realized returns. It involves regressing portfolio returns (generally monthly returns) on return series of a set of securities indices. In principle, these indices are:

• mutually exclusive;
• exhaustive with respect to the manager’s investment universe; and
• distinct sources of risk (ideally they should not be highly correlated).

Returns-based style analysis involves a constraint that the coefficients or betas on the indices are nonnegative and sum to 1. That constraint permits us to interpret a beta as the portfolio’s proportional exposure to the particular style (or asset class) represented by the index.

Question 18

Holdings-based style analysis

Answer 18

Holdings-based style analysis, which categorizes individual securities by their characteristics and aggregates results to reach a conclusion about the overall style of the portfolio at a given point in time. For example, the analyst may examine the following variables:

• Valuation levels. A value-oriented portfolio has a very clear bias toward low P/Es, low P/Bs, and high dividend yields. A growth-oriented portfolio exhibits the opposite characteristics. A market-oriented portfolio has valuations close to the market average.
• Forecast EPS growth rate. A growth-oriented portfolio will tend to hold companies experiencing above-average and/or increasing earnings growth rates (positive earnings momentum). Typically, trailing and forecast EPS growth rates are higher for a growth-oriented portfolio than for a value-oriented portfolio. The companies in a growth portfolio typically have lower dividend payout ratios than those in a value portfolio, because growth companies typically want to retain most of their earnings to finance future growth and expansion.
• Earnings variability. A value-oriented portfolio will hold companies with greater earnings variability because of the willingness to hold companies with cyclical earnings.
• Industry sector weightings. Industry sector weightings can provide some information on the portfolio manager’s favored types of businesses and security characteristics, thus furnishing some information on style. In many markets, value-oriented portfolios tend to have larger weights in the finance and utilities sectors than growth portfolios, because of these sectors’ relatively high dividend yields and often moderate valuation levels. Growth portfolios often have relatively high weights in the information technology and health care sectors, because historically these sectors have often included numerous high-growth enterprises. Industry sector weightings must be interpreted with caution, however. Exceptions to the typical characteristics exist in most if not all sectors, and some sectors (e.g., consumer discretionary) are quite sensitive to the business cycle, possibly attracting different types of investors at different points in the cycle.

Question 19

Two Approaches to Style Analysis: Advantages and Disadvantages

Answer 19

Returns-based style analysis

Advantages

• Characterizes entire portfolio
• Facilitates comparisons of portfolios
• Aggregates the effect of the investment process
• Different models usually give broadly similar results and portfolio characterizations
• Clear theoretical basis for portfolio categorization
• Requires minimal information
• Can be executed quickly
• Cost effective

Disadvantages

• May be ineffective in characterizing current style
• Error in specifying indices in the model may lead to inaccurate conclusions

Holdings-based style analysis

Advantages

• Characterizes each position
• Facilitates comparisons of individual positions
• In looking at present, may capture changes in style more quickly than returns-based analysis

Disadvantages

• Does not reflect the way many portfolio managers approach security selection
• Requires specification of classification attributes for style; different specifications may give different results
• More data intensive than returns-based analysis

Question 20

Buffering

Answer 20

Buffering refers to rules for maintaining the style assignment of a stock consistent with a previous assignment when the stock has not clearly moved to a new style. Buffering reduces turnover in style classification and serves to reduce the transaction expenses of funds that track the style index.

Question 21

Style Drift

Answer 21

If a manager is hired as a value manager and over time begins to hold stocks that would be primarily characterized as growth stocks, that manager can be said to be experiencing style drift.

Question 22

Socially Responsible Investing

Answer 22

Socially responsible investing, also called ethical investing, integrates ethical values and societal concerns with investment decisions.

SRI stock screens include negative screens and positive screens.

Negative SRI screens apply a set of SRI criteria to reduce an investment universe to a smaller set of securities satisfying SRI criteria. SRI criteria may include:

• industry classification, reflecting concern for sources of revenue judged to be ethically questionable (tobacco, gaming, alcohol, and armaments are common focuses); and
• corporate practices (for example, practices relating to environmental pollution, human rights, labor standards, animal welfare, and integrity in corporate governance).

Positive SRI screens include criteria used to identify companies that have ethically desirable characteristics. Internationally, SRI portfolios most commonly employ negative screens only, a smaller number employ both negative and positive screens, and even fewer employ positive screens only.

Socially responsible portfolios have a potential bias towards growth stocks because they tend to shun basic industries and energy stocks, which are typically value stocks. Socially responsible portfolios also have a bias toward small-cap stocks.

Question 23

Long–Short Investing

Answer 23

• Long–short investing focuses on a constraint. Essentially, many investors face an investment policy and/or regulatory constraint against selling short stocks. Indeed, the constraint is so common and pervasive that many investors do not even recognize it as a constraint.
• In a traditional long-only strategy, the value added by the portfolio manager is called alpha—the portfolio’s return in excess of its required rate of return, given its risk. In a market-neutral long–short strategy, however, the value added can be equal to two alphas. This is because the portfolio manager can use a given amount of capital to purchase a long position and to support a short position.
• In the basic long–short trade, known as a pairs trade or pairs arbitrage, an investor is long and short equal currency amounts of two common stocks in a single industry (long a perceived undervalued stock and short a perceived overvalued stock), and the risks are limited almost entirely to the specific company risks. Even such a simple convergence trade can go terribly wrong, however, if the value of the short position surges and the value of the long position collapses.
• Probably the greatest risk associated with a long–short strategy involves leveraging.
• The main risk with long–short portfolios is the unlimited liability on the short trades. If a stock in which an investor has a long position loses all of its value, the most that could happen is that the investor loses his entire investment. With a short position, however, the investor’s upside is limited (stock goes to zero) but the liability is unlimited (theoretically, a stock can appreciate infinitely).
• Because a long-short, market neutral strategy has no systematc risk, its benchmark should be the risk-free rate.

Question 24

Price Inefficiency on the Short Side

Answer 24

Some investors believe that more price inefficiency can be found on the short side of the market than the long side for several reasons.

First, many investors look only for undervalued stocks, but because of impediments to short selling, relatively few search for overvalued stocks. These impediments prevent investor pessimism from being fully expressed.

Second, opportunities to short a stock may arise because of management fraud, “window-dressing” of accounts, or negligence. Few parallel opportunities exist on the long side because of the underlying assumption that management is honest and that the accounts are accurate. Rarely do corporate managers deliberately understate profits.

Third, sell-side analysts issue many more reports with buy recommendations than with sell recommendations. One explanation for this phenomenon is related to commissions that a recommendation may generate.

Fourth, sell-side analysts may be reluctant to issue negative opinions on companies’ stocks for reasons other than generic ones such as that a stock has become relatively expensive. Most companies’ managements have a vested interest in seeing their share price rise because of personal shareholdings and stock options. After an analyst issues a sell recommendation, therefore, he can find himself suddenly cut off from communicating with management and threatened with libel suits. His employer may also face the prospect of losing highly lucrative corporate finance business.

Question 25

Equitizing a Market-Neutral Long–Short Portfolio

Answer 25

A market-neutral long–short portfolio can be equitized (given equity market systematic risk exposure) by holding a permanent stock index futures position (rolling over contracts), giving the total portfolio full stock market exposure at all times. In carrying out this strategy, the manager may establish a long futures position with a notional value approximately equal to the value of the cash position resulting from shorting securities.

Equitizing a market-neutral long–short portfolio is appropriate when the investor wants to add an equity-beta to the skill-based active return the investor hopes to receive from the long–short investment manager.

The rate of return on the total portfolio equals the sum of:

• the gains or losses on the long and short securities positions,
• the gain or loss on the long futures position, and
• any interest earned by the investor on the cash position that results from shorting securities,

all divided by the portfolio equity.

Depending on carrying costs and the ability to borrow ETF shares for short selling, ETFs may be a more attractive way than futures to equitize or de-equitize a long–short alpha over a longer period than the life of a single futures contract.

** Generally if you are long 100% and short say 30% then you will have cash from the short sale proceeds . This is an alpha stratgey which presumably exploits your insights on both the long and short side. However you have reduced exposure to the market by being partially short .You may want more exposure through equity futures . So you might follow a process of equitizing the cash i.e. buy futures or ETF’s with the cash to gain systematic exposure.

Question 26

The Long-Only Constraint

Answer 26

Long–short strategies have an inherent efficiency advantage over long-only portfolios. That inherent advantage is the ability to act on negative insights that the investor may have, which can never be fully exploited in a long-only context.

A long-only constraint penalizes portfolios in two ways:

• First, it prevents the portfolio manager from fully exploiting a negative forecast on a given stock.
• Second, in a long-only portfolio, being unable to fully exploit a negative forecast also limits the ability of the portfolio manager to maximize positive forecasts.

Question 27

Short Extension Strategies

Answer 27

• Short extension strategies (also known as partial long–short strategies) modify equity long-only strategies by specifying the use of a stated level of short selling. These strategies attempt to benefit from a partial relaxation of the long-only constraint while controlling risk by not relaxing it completely. In contrast to market-neutral long–short strategies which specify long and short positions of equal value and an overall market beta of zero, short extension strategies are generally designed to have a market beta of one with long positions of 100 percent + x percent and short positions of x percent of capital invested.
• The idea behind short extension strategies is that the partial relaxation of the long-only constraint allows the portfolio manager to make more efficient use of his or her information. In a long-only portfolio, the manager’s maximum response to negative information is to avoid holding the stock (selling an existing position or not adding it to the portfolio). With a short extension strategy, the manager can also go short the stock.
• A 130/30 short extension strategy is inherently different from a 100/0 long-only strategy plus a 30/30 strategy. The key difference is that in the 130/30 strategy, portfolio decisions on long and short positions are coordinated, whereas with a combination of 100/0 and 30/30 strategies they are generally not.
• A short extension strategy has several potential advantages. In contrast to a long–short market neutral portfolio that is equitized using futures or swaps, a short extension strategy can be established even in the absence of a liquid swap or futures market. Another advantage is that relaxing the long-only constraint even to the extent of 20 percent to 30 percent can result in an appreciable increase in the proportion of a manager’s investment insight that is incorporated in the portfolio.
• A disadvantage of short extension strategies is that they gain their market return and earn their alpha from the same source. By contrast, with an equitized long–short market neutral portfolio, it is possible to earn the market return from one source and the alpha from another.
• Short extension strategies also differ from long–short market neutral strategies in how investors tend to perceive them. Because they are beta zero, long–short market neutral strategies are typically seen by investors as an alternative investment (even if the underlying investments are equities). Short extension strategies, however, are often seen as a substitute for long-only strategies in an investor’s portfolio largely because of their inherent market exposure.
• The 130–30 funds work by investing, say, $100 in a basket of stocks. They then short $30 in stocks that they believe to be overvalued. Proceeds from that short sale are then used to purchase an additional $30 in stocks thought to be undervalued. The name reflects the fact that the manager ends up with $130 invested in traditional long positions and $30 invested short.
• The trade-off between long-only, 130–30 and market neutral long-short funds depends on two factors:
  1) If one has a neutral or negative market view and does not want any beta exposure, then one should invest into a market neutral long-short hedge fund. However, if one has a positive market view and wants beta exposure, then one should invest into either a long-only or 130–30 strategy.
  2) If one believes that the fund manager can generate alpha from the short leg, then it is better to invest into a 130–30 strategy rather than a long-only strategy.
  However, if one believes, that the manager cannot generate alpha from short selling or that the higher gross exposure of a 130–30 fund is unbearable, then one should invest into a long-only strategy.

Question 28

Sell Disciplines/Trading

Answer 28

Several recognized categories of selling disciplines exist.

• First, an investor can follow a strategy of substitution. In this situation, the investor is constantly looking at potential stocks to include in the portfolio and will replace an existing holding whenever a better opportunity presents itself. This strategy revolves around whether the new stock being added will have a higher risk-adjusted return than the stock it is replacing net of transaction costs and taking into account any tax consequences of the replacement. Such an approach may be called an opportunity cost sell discipline. Based on the portfolio manager’s ongoing review of portfolio holdings, the manager may conclude that a company’s business prospects will deteriorate, initiating a reduction or elimination of the position. This approach may be called a deteriorating fundamentals sell discipline.
• Another group of sell disciplines is more rule driven. A value investor purchasing a stock based on its low P/E multiple may choose to sell if the multiple reaches its historical average. This approach may be called a valuation-level sell discipline. Also rule based are down-from-cost, up-from-cost, and target price sell disciplines. As an example of a down-from-cost sell discipline, the manager may decide at the time of purchase to sell any stock in the portfolio once it has declined 15 percent from its purchase price; this strategy is a kind of stop-loss measure.

Value investors frequently have relatively low turnover; they buy cheap stocks hoping to reap a longer-term reward. Annual turnover levels for a value manager typically range from 20 percent to 80 percent. Growth managers are trying to capitalize on earnings growth and stability. Company earnings are reported quarterly, semiannually, or annually, depending on the stock’s country of domicile. In any case, it is easy to understand that a growth portfolio would generally tend to have higher turnover than value—a range of 60 percent to several hundred percent for more short-term oriented investors.

Question 29

Semiactive Equity Investing

Answer 29

• Semiactive strategies (also known as “enhanced index” or “risk-controlled active” strategies) are designed for investors who want to outperform their benchmark while carefully managing their portfolio’s risk exposures. An enhanced index portfolio is designed to perform better than its benchmark index without incurring much additional risk. Although tracking risk (also called active risk) will increase, the enhanced indexer believes that the incremental returns more than compensate for the small increase in risk. Such a portfolio is expected to perform better than the benchmark on a risk-adjusted basis.
• Semiactive equity strategies come in two basic forms: derivatives based (also called synthetic) and stock based.
• Derivatives-based semiactive equity strategies intend to provide exposure to the desired equity market through a derivative and the enhanced return through something other than equity investments.
• This strategy has the advantage of being straightforward. It generally has narrower breadth (usually a duration or credit bet) and so requires a high IC to produce the same level of IR as the stock-based approach.
• Enhanced indexing strategies based on stock selection attempt to generate alpha by identifying stocks that will either outperform or underperform the index. Risk control is imposed in order to limit the degree of individual stock underweighting or overweighting and the portfolio’s exposure to factor risks and industry concentrations. The resulting portfolio is intended to look like the benchmark in all respects except in those areas on which the manager explicitly wishes to bet.
• The advantage of this approach is greater breadth than the synthetic approach. That said, as with all active strategies, obtaining a satisfactory IC or level of investment insight is the challenge.
• A semiactive stock-selection approach has several possible limitations. The first is that any technique that generates positive alpha may become obsolete as other investors try to exploit it. A successful enhanced indexer is always innovating. Also, quantitative and mathematical models derived from analysis of historical returns and prices may be invalid in the future. Markets undergo secular changes, lessening the effectiveness of the past as a guide to the future. Markets also occasionally undergo shocks that, at least temporarily, render forecasting or risk models ineffective.

Question 30

Fundamental Law of Active Management

Answer 30

In addition to a high degree of risk control, another reason for the popularity of enhanced index portfolios can be explained in terms of Grinold and Kahn’s Fundamental Law of Active Management. The law states that

IR ≈ IC√Breadth

Translated, this means that the information ratio (IR) is approximately equal to what you know about a given investment (the information coefficient or IC) multiplied by the square root of the investment discipline’s breadth, which is defined as the number of independent, active investment decisions made each year.

Well-executed enhanced indexed strategies may have a relatively high combination of insight and breadth, resulting from the disciplined use of information across a wide range of securities that differ in some important respects. (Note, however, that the number of independent decisions available per period does not necessarily increase with the size of the research universe.)

Question 31

Expected utility of the active return of the manager mix

Answer 31

U_A=r_A−λ_Aσ²_A

Where

U_A = expected utility of the active return of the manager mix

r_A = expected active return of the manager mix

λ_A = the investor’s trade-off between active risk and active return; measures risk aversion in active risk terms

σ²_A = variance of the active return

Question 32

Generally, investors are far more risk averse in active risk terms than in total risk terms, for several reasons

Answer 32

Generally, investors are far more risk averse in active risk terms than in total risk terms, for several reasons.

• For example, an investor can achieve the benchmark return by purchasing an index portfolio. To achieve an active return in his portfolio, however, the investor must believe both that successful active management is possible and that he has the necessary skill to select active managers who will outperform.
• Second, the investor is responsible for the whole equity portfolio, and his superiors will judge him based on how well the overall portfolio performs relative to the benchmark. Successful active management is difficult, and many who attempt it underperform. This fact produces a sort of institutional conservatism on the part of many investors.
• Finally, the investor realizes that as one moves up on the efficient frontier assuming more active risk, less manager diversification exists. For institutional investors, an overall active risk budget (target) in the range of 1.5 percent to 2.5 percent is fairly typical.

Question 33

Portfolio active risk if active returns are uncorrelated

Answer 33

If active returns are uncorrelated

Portfolio active risk = (∑ⁱ⁼¹_nh²_Aiσ²_Ai)^0,5

where:

h_Ai = the weight assigned to the ith manager

σ_Ai = the active risk of the ith manager

Question 34

Core-satellite portfolio

Answer 34

Core-satellite portfolio - a portfolio in which certain investments are viewed as the core and the balance are viewed as satellite investments fulfilling specific roles

Question 35

Manager’s “true” active return, manager’s “true” active risk

Answer 35

In reality, investors often wish to consider managers that are either value or growth and perhaps specialize within a given range of market capitalization. To evaluate such managers, it is useful to divide their total active return into two components:

1. Manager’s return − Manager’s normal benchmark = Manager’s “true” active return
2. Manager’s normal benchmark − Investor’s benchmark = Manager’s “misfit” active return

To review, the manager’s normal benchmark (normal portfolio) represents the universe of securities from which a manager normally might select securities for her portfolio. The term investor’s benchmark refers to the benchmark the investor uses to evaluate performance of a given portfolio or asset class.

The standard deviation of “true” active return is called manager’s “true” active risk (or “true” active risk); the standard deviation of “misfit” active return is manager’s “misfit” risk (or “misfit” risk). The manager’s total active risk, reflecting both “true” and “misfit” risk, is

Manager’s total active risk = [(Manager’s “true” active risk)²+ (Manager’s “misfit” active risk)²]^½

The most accurate measure of the manager’s risk-adjusted performance is the IR computed as (Manager’s “true” active return)/(Manager’s “true” active risk).

The “true”/“misfit” distinction has two chief uses:

• one relates to performance appraisal, and
• the other relates to optimizing a portfolio of managers.

The second use of the “true”/“misfit” distinction is in optimization. By disaggregating the active risk and return into two components, it is possible to create optimal solutions that maximize total active return at every level of total active risk and that also allow for the optimal level of “misfit” risk. Although it may seem that no “misfit” risk is desired, a nonzero amount may actually be optimal, because a high level of “true” active return may more than compensate for a given level of “misfit” risk. In other words, if you let the manager concentrate in the style he is familiar with, the manager is more likely to generate an excess return relative to his normal portfolio.

Question 36

Completeness fund

Answer 36

• A completeness fund, when added to active managers’ positions, establishes an overall portfolio with approximately the same risk exposures as the investor’s overall equity benchmark. For example, the completeness fund may be constructed with the objective of making the overall portfolio sector and/or style neutral with respect to the benchmark while attempting to retain the value added from the active managers’ stock-selection ability. The completeness portfolio may be managed passively or semiactively. This portfolio needs to be re-estimated periodically to reflect changes in the active portfolios.
• One drawback of completeness portfolios is that they essentially seek to eliminate misfit risk. As stated above, a nonzero amount of misfit risk may be optimal. In seeking to eliminate misfit risk through a completeness fund, a fund sponsor may be giving up some of the value added from the stock selection of the active managers.

Question 37

Alpha and Beta Separation

Answer 37

• Alpha and beta separation - a typical long active equity portfolio provides an investor with exposure to the market (beta) as well as to the active manager’s stock selection ability (alpha). As previously discussed, a market-neutral long–short strategy is a pure alpha strategy with no beta exposure.
• Portable alpha—that is, alpha available to be added to a variety of systematic risk exposures.
• One of this approach’s big advantages is that an investor can obtain the beta exposure desired while broadening the opportunity set for alpha to cover styles and even asset classes outside the beta asset class.
• Alpha and beta separation allows the investor to manage the market and active risks more effectively than if dealing solely with long-only managers. In doing so, the investor can also very clearly understand the fees being paid to capture market (inexpensive) and active (costly) returns.
• The risks are more clearly defined in an alpha and beta separation approach than in a long-only strategy.
• One of the advantages of an alpha and beta separation approach is that investor can better understand and manage the risks in an alpha and beta separation approach becaus the are more clearly defined. The investor also has a better idea of costs of investing. The passive beta exposure is typically cheaper than the active alpha exposure. In a portable alpha strategy, the investor can easily pick up systematic risk through a variety of positions using equity index positions while maintaining the long-short alpha.

Question 38

Developing a Universe of Suitable Manager Candidates

Answer 38

Consultants use both qualitative and quantitative factors in evaluating investment managers. The qualitative factors include the people and organizational structure, the firm’s investment philosophy, the decision-making process, and the strength of its equity research. The quantitative factors include performance comparisons with benchmarks and peer groups, as well as the measured style orientation and valuation characteristics of the firm’s portfolios. At all times, the investment consultant seeks consistency between a firm’s stated philosophy and process and its actual practices.

Question 39

The Predictive Power of Past Performance

Answer 39

Past performance is no guarantee of future results.

Question 40

Fee Structures of managers

Answer 40

• Fees are typically set in one of two basic ways: ad valorem and performance based. Ad valorem fees are calculated by multiplying a percentage by the value of assets managed (e.g., 0.60 percent on the first £50 million, and 0.45 percent on assets above £50 million). Ad valorem fees are also called assets under management (AUM) fees.
• A simple performance-based fee is usually specified by a combination of a base fee plus sharing percentage (e.g., 0.20 percent on all assets managed plus 20 percent of any performance in excess of the benchmark return). Performance-based fees can also include other features such as fee caps and “high-water marks.” A fee cap limits the total fee paid regardless of performance and is frequently put in place to limit the portfolio manager’s incentive to aim for very high returns by taking a high level of risk. A high-water mark is a provision requiring the portfolio manager to have cumulatively generated outperformance since the last performance-based fee was paid.
• Ad valorem fees have the advantage of simplicity and predictability. If a plan sponsor must budget fees in advance, an ad valorem approach makes estimation much simpler. In contrast, performance-based fees are typically quite involved, as every term of the performance-based fee must be precisely defined. But performance-based fees—particularly symmetric incentive fees that reduce as well as increase compensation—may align the plan sponsor’s interests with those of the portfolio manager by spurring the manager to greater effort.

Question 41

The Equity Manager Questionnaire

Answer 41

A typical equity manager questionnaire examines five key areas: organization/people, philosophy/process, resources, performance, and fees.

In the questionnaire’s first section, Organization/People, the investment firm must describe the firm’s organization and who will be managing the portfolio. Equity portfolio management is a people business; nothing is more important than having the right people in place.

The second section, Philosophy/Process, asks questions about how the equity portfolio will be managed. Typical questions concern:

• the firm’s investment philosophy and the market inefficiency that it is trying to capture, along with any supporting evidence for this inefficiency;
• the research process, including whether or not a top-down analysis is applied (top-down analysis is analysis that proceeds from the macroeconomy to the economic sector level to the industry level to the firm level);
• the risk management function, including management and monitoring of risk and risk models;
• how the firm monitors the portfolio’s adherence to its stated investment style, philosophy, and process;
• the stock selection process, including unique sources of information, and how the buy or sell decision is made; and
• the portfolio construction process.

The third section, Resources, looks at the allocation of resources within the organization. In particular, the focus is on the research process: how and by whom research is conducted, the outputs of this research, how the research outputs are communicated, and how the research is incorporated into the portfolio construction process. In addition, there are questions addressing any quantitative models used in research and portfolio construction, and the investments that have been made in technology. Finally, the trading function is examined in terms of turnover, traders, trading strategies, and the measurement of costs.

The fourth section, Performance, asks questions about what the equity manager considers to be an appropriate benchmark (and why) and what level of excess return is appropriate. There are also questions about how performance is evaluated within the firm, including causes of dispersion in the returns of similarly managed portfolios.

The final section deals with fees. Questions are typically about what is included in the fee, the type of fee (ad valorem or performance based), and any specific terms and conditions relating to the fees quoted.

Question 42

Top-Down versus Bottom-Up Approaches

Answer 42

Investors focusing their research primarily on macroeconomic factors or investment themes are said to use a top-down approach.

A more complex top-down example might involve a global portfolio. The investor might wish to identify:

1. themes affecting the global economy;
2. the effect of those themes on various economic sectors and industries;
3. any special country or currency considerations; and
4. individual stocks within the industries or economic sectors that are likely to benefit most from the global themes.

On the other hand, an investor focusing on company-specific fundamentals or factors such as revenues, earnings, cash flow, or new product development is said to follow a bottom-up approach.

A more complex bottom-up example might also involve a global portfolio. The investor might approach the problem by:

1. identifying factors with which to screen the investment universe (e.g., stocks in the lowest P/E quartile that also have expected above-median earnings growth);
2. collecting further financial information on companies passing the screen; and
3. identifying companies from this subset that may be potential investments based on other company-specific criteria.

Question 43

Buy-Side versus Sell-Side Research

Answer 43

Buy side refers to those who do research with the intent of assembling a portfolio, such as investment management firms.

Sell side refers either to independent researchers who sell their work, or to investment banks/brokerage firms that use research as a means to generate business for themselves. Sell-side research is also what most people hear on TV or read about in the newspaper. Buy-side research by its very nature is generally inaccessible to those outside of the investment firm generating the research.

Question 44

Separate or Pooled Accounts (Indexed institutional portfolios)

Answer 44

The principal difference between index mutual funds and exchange-traded funds on the one hand, and indexed institutional portfolios, on the other hand, is cost.

Indexed institutional portfolios managed as separate accounts with a single shareholder or, increasingly, as pooled accounts, are extremely low-cost products.

Question 45

Do value and growth stock cover all the universe of stocks?

Answer 45

The value and growth indices by definition do not contain all of the stocks in the broad index

Question 46

An investor places funds with a small-cap growth manager. The investor believes the manager can outperform other small-cap managers to generate alpha but also wants exposure (beta) to the broad S&P market.

Explain how the investor can retain the alpha but gain the desired beta using equity contracts?

Answer 46

To separate the alpha and beta, the investor could pick up the desired beta by taking a long position in a large-cap U.S. equity futures contract, such as the S&P 500 contract. To create the market-neutral alpha, the investor would then invest with a small-cap growth manager and short a small-cap growth equity index futures contract.

Question 47

Quantitative/qualitative considerations in hiring an investment manager?

Answer 47

Qualititative considerations are:

1. the firm`s investment approch
2. research
3. manager`s personne

Quantitative considerations are:

1. manager`s fees
2. performance record
3. style

Question 48

Compare misfir risks of the portfolios generated using a core-satellite approach, that is indexed to a broad market, generated using a completeness fund approach

Answer 48

Whenever the manager’s portfolio diverges from the investro’s portfolio, there will be misfit risk. An investor’s portfolio is one that the investor uses to evaluate the manager and may not be appropriate for their style. The investor’s portfolio is usually a broad market benchmark for that asset class.

• By design, the competeness fund results in a reduction of misfit risk.
• The indexed portfolio will have small misfit risk.
• The portfolio generated using a core-satellite approach will have the highest misfit risk because the sarellite portfolios allow for specialized manager styles.

Question 49

Which of the following selling disciplines would be best for an investor who is concerned about tax implications of a trade?

up-from-cost, opportunity cost, deteriorating fundamentals

Answer 49

If an investor facors in the transactions costs and tax consequences of the sale of the existing security and the purchase of the new security, this approach is referred to as an opportunity cost sell discipline.

Question 50

In which of the following selling disciplines would the investor sell the stock after it had reached its intrinsic value?

A) Up-from-cost.

B) Target price.

C) Valuation-level.

Answer 50

In a target price sell discipline, the manager determines the stock’s fundamental value at the time of purchase and later sells the stock when it reaches this level.

Question 51

Six Selling Disciplines

Answer 51

• 1. Opportunity cost sell discipline:*
• Exchanging securities while also considering transaction costs and tax consequences
• 2. Deteriorating fundamentals sell discipline:*
• Sell a firm whose business will worsen in the future
• 3.Valuation-level sell discipline:*
• Sell a stock if its P/E ratio rises to the ratio’s historical mean
• 4. Down-from-cost sell discipline:*
• Sell a stock if it’s price declines more than x% from the purchase price
• 5. Up-from-cost sell discipline:*
• Sell a stock if its price increased by X% from the purchase price
• 6. Target price sell discipline:*
• Sell the stock when it reaches its predetermined intrinsic value

Question 52

Buffering rules for equity style index

Answer 52

If an index has buffering rules, a stock is not immediately moved to a different style category when its style characteristics have slightly changed. The presense of buffering means thar there will be less turnover in the style indices and hence lower transaciotn costs from rebalancing for managers tracking the index.

Question 53

What are advantages of a long-short trade?

Answer 53

Long-only strategies are focused on using fundamental analysis to find undervalued stocks. In contrast, long-short strategies focus on exploiting the constraints many investors have. For example, institutions are unable to short a stock. If an investor would like to express a negative view of an index security in a ;ong-only strategy, he is limited to avoidance of the stock.

The distribution of potential active weights in a long-only portfolio is asymmetric.

Question 54

Compare the use of ETFs or equity futures combined with basket trades for tactical assetr allocation to take advantage of short-term mispricing

Answer 54

Equity fututres contracts have a fininte life and must be periodically rolled over into a new contract whereas ETFs have a theoretically infinite life. A basket may not be shorted if one of the components violates the uptick rule that a security may not be shorted if the last price movement was a decline. ETFs are not subject to the uptick rule.

Question 55

Use of holding-based style analysis in constructing indices, need for buffering

Answer 55

Most indices use holdings-based style analysis to characterize securities. Holding-based style analysis detects style changes more quickly than return-based style analysis.

If an index has buffering rules, a stock is not immediately moved to a different style category when its style characteristics have slightly changed.

Because holding-based style analysis detects style changes more quickly, buffering would become more necessary so that there is not excessive turnover within the index.

Question 56

Annual turnover of value and growth investors

Answer 56

• Value investors are typically long-term investors who buy undervalued stocks and hold them until they appreciate. Annual turnover for value managers varies from 20% to 80%.
• Growth managers base their decision on earnings growth and are less patient. They often sell after the next earnings statement comes out. Thus it is not unusual to see annual turnover of 60% to several hundred percent for these investors.

Question 57

Importance of mean reversion for diffirent types of indexing techniques

Answer 57

• Mean reversion is a cornstone of value investing
• Momentum investors do not want mean reversion
• Optimization is an indexing technique for which mean reversion is unimportant
• As far as market-cap investing goes, reversion to the mean is no more or less important for one capitalization group relative to any other capitaliztion group.

Question 58

Holding-based vs. return-based style analysis

Answer 58

1. Holding-based analysis requires more data then returns-based
2. Holding-based analysis can pick up style drift faster then return-based analysis
3. Holding-based analysis can yield different results depending on the method used

Question 59

Assume you have enhanced indexing with portfolios A,B and an Index. Formula for active risk?

Answer 59

σ_active² = w_A²(σ_A-σ_Index)²+w_B²(σ_B-σ_Index)²+(1-w_A-w_B)² (σ_Index-σ_Index)²

Question 60

Decision risk

Answer 60

As used by one authority on investing for private wealth clients, decision risk is the risk of changing strategies at the point of maximum loss.

When compared to institutional investors, decision risk is higher for private wealth clients, and tax issues are generally more complex for private wealth clients.

Question 61

A socially responsible portfolio tends to be more heavily weighted in?

Answer 61

A socially responsible portfolio tends to be more heavily weighted in growth stocks and small-cap stocks.

Question 62

Compared to passive management, active managers returns are?

Answer 62

Compared to passive management, active managers have average returns similiar to passive management before expenses.

After expenses, they underperform passive management on average.

Question 63

Which equity manager compensation plan would generate the greatest incentive for performance?

Answer 63

Performance-based fees (a symmetic compensation plan) align the interests of the equity manager and the investor, especially if they are symmetric. A symmetric compensation plan has both rewards for good performance and punishment for bad performance.

Question 64

A socially responsible portfolio tends to shun?

Answer 64

Socially responsible portfolios usually shun basic industries and energy stocks, which tend to be value stocks. This accounts for the bias towards growth stocks in socially responsible portfolios.

Question 65

A recession is expected in an economy within next year. Portfolio Manager A has shifted more of their stocks from the financial industry to the health care industry. Portfolio Manager B has shifted more of their stocks from the technology industry to the utility industry. Which manager will outperform or underperform? Why?

Answer 65

Both managers are exibiting style drift with both being beneficial to performance. Value mangers tend to have greater representation in the non-cyclical utility and cyclical financial industries whereas growth managers tend to have higher weights in the cyclical technology and non-cyclical health care industires.

Growth stock are more likely to outperform during a recession as there are few other firms with growth prospects and a premium would be placed on growth stock’s valuation.

Since the financial and technology industries are cyclical they will tend to under-perform during a recession whereas the healthcare and utility industries are non-cyclical and should outperform during a recession compared to cyclical stocks.

Question 66

What style index construction whould increase the portfolio turnover?

Answer 66

Index construction that whould increase the portfolio turnover:

• No overlap betweeen categories* - this tends to create more reassignments of a stock from one category to the other, which increases the number of rebalancing transactions.
• No buffering* - buffering would help avoid frequent changes of classification on stocks that have some characteristics of each style.
• Exclusion of holding companies* - because holding companies’ classifiactions are more stable over time, excluding holding companies would result in higher portfolios.

Question 67

Tracking risk

Answer 67

Annualized standard deviation of active returns

Measures active risk

Question 68

Boundaries of the stock index’s universe

Answer 68

Important in determining how well the index represents a specific population of stocks. The greater its number of stocks and the more diversified by industry and size, the better the index will measure broad market performance. A narrower universe will measure performance of a specific group of stocks.

Question 69

criteria for inclusion

Answer 69

Establishes any specific characteristics desired for stocks within the selected universe.

Question 70

Weighting of the stock

Answer 70

Is usually a choice among price weighting, value (or float) weighting, or equal weighting.

Question 71

Computational method

Answer 71

Includes variations such as price only and total return series that include the reinvestment of dividends. Only total return series capture the two sources of equity returns, capital appreciation and dividends.