Session 10 - Equity Portfolio Management (II)

Question 1

Definition - Fundamental Approaches to Active Management

Answer 1

• • based on fundamental research into companies, sectors, markets, financial statements
• • the app. of analyst discretion and judgment
• • valuation models, quantitative screening, regressions to forecast future prospects (earnings & CFs & growth)
• • trying to get the stock’s intrinsic value or relative value compared to the shares of a peer group
• • focus attention on a small group of stocks and perform an in-depth analysis of each one
• • take large positions in their selected stocks
• • research on indvl companies —> risks at the company level - FV inaccurate, performance will differ from expectations, market fail to realize
• • monitor continuously and rebalance any time (discretionary)

Question 2

Definition - Quantitative Approaches to Active Management

Answer 2

• • involve analyst judgment at the model design stage
• • systematic process with limited involvement of human judgment or discretion
• • search for security and market characteristics and patterns that have predictive power using past and large amounts of data
• • analyzes a large group of stocks
• • spread holdings across a large group of holdings
• • invests in a basket of stocks and uses a portfolio optimizer –> risks at the portfolio level
• • program automatically rebalances at regular intervals (systematic)

Question 3

Definition - Bottom-Up Active Strategy

Answer 3

• • selects securities based on data at the company/asset level
• • begin analysis at the company level before forming an opinion on the wider sector or market

Question 4

Parameters for Bottom-Up Active Strategy (what do you compare between companies)

Answer 4

1. Business Model and Branding
   - - company’s overall strategy for running the business and generating profits
   - - strong brand names convey product quality and can give the company an edge
2. Competitive Advantages
   - - access to natural resources, superior technology, innovation, skilled personnel, corporate rep., brand strength, high entry barriers
3. Company Mgmt and Corporate Governance
   - - role is to allocate resources and capital to max. the growth of enterprise value for the company’s SH
   - - alignment of the mgmt interest with SH (min. agency), competence, stability, considerations for ESG attributes

Question 5

List the Bottom-Up Strategies/Categories

Answer 5

1. Valued Based
   i. Relative Value
   ii. Contrarian Investing
   iii. High-Quality Value
   iv. Income Investing
   v. Deep Value Investing
   vi. Restructuring and Distressed Investing
   vii. Special Situations
2. Growth Based

Question 6

Expand - Relative Value

Answer 6

• evaluating companies by comparing value indicators (P/E or P/B) to the industry’s avg

Question 7

Expand -Valued Based

Answer 7

• trading at a significant discount vs. intrinsic value

Question 8

Expand - Contrarian Investing

Answer 8

• buying out of favor stocks at low prices (against market sentiment)
• depressed cyclical stocks with low or negative earnings and low dividends
• believes the market overreacted to the information

Question 9

Expand - High-Quality Value

Answer 9

• consistent earnings power, above avg return on equity, financial strength, and great mgmt

Question 10

Expand -Deep Value Investing

Answer 10

• very low P/B, financial distress

- focus on undervalued companies that are available at extremely low valuation relatives to their assets

Question 11

Expand - Restructuring and Distressed Investing

Answer 11

• trade for companies before, during, or after bankruptcy
• if liquidation, they sell assets and pay out creditors and shareholders (if anything left)
• if sig. assets, generate an appropriate return on investment
• or restructure, give equity to creditors or ask creditors to extend when to payback

Question 12

Expand - Special Situation

Answer 12

• arises from corporate events such as mergers or spinoffs

Question 13

Expand - Growth Based Bottom-Up Strategy

Answer 13

• pick securities that have a lot of growth potential (expected to grow faster than their industry or market)
• above avg valuation multiple
• GARP seeks out companies with above avg growth at a reasonable price (PEG = P/E / expected earnings growth rate)

Question 14

Definition - Top-Down Active Strategy

Answer 14

• form an opinion of macro, market, industry/sectors, economic factors, (variables that affect many companies) and then select securities based on those opinions

Question 15

List - Strategies of Top-Down Active Strategy

Answer 15

1. Country and Geographic Allocation to Equities (futures or ETFs most appropriate)
2. Sector and Industry Rotation (sectors and industry ETFs)
3. Volatility - Based Strategies
4. Thematic Investment Strategies

Question 16

Expand - Country and Geographic Allocation to Equities (Under Top-Down Active)

Answer 16

• investing in different geographic regions based on the assessment of the regions’ prospects

Question 17

Expand - Sector and Industry Rotation (Under Top-Down Active)

Answer 17

• investing based on the view on the expected returns of various sectors and industries across borders

Question 18

Expand - Volatility- Based Strategies (Under Top-Down Active)

Answer 18

• investing based on views of volatility, implemented via derivative instruments
• those who believe they have the skill to predict future market volatility better than option implied volatility can trade on the VIX futures

Question 19

Expand - Thematic Investment Strategies (Under Top-Down Active)

Answer 19

• investing based on promising ideas or themes that will drive the market in the future

Question 20

What is the hedging portfolio approach pioneered and formulated by Fama and French? What are the drawbacks?

Answer 20

• choose a factor
• rank the stock universe by that factor
• divide the universe into groups referred to as quantiles
• long the best quantile and short the worst quantile
  Drawbacks
• middle quantiles is not used
• assumed that the rs between the factor and future stock return is linear
• portfolios built with this approach appears to be concentrated
• have to have the ability to short stocks
• portfolio is also exposed to other risk factors”

Question 21

Definition - factor-based Active Strategy

Answer 21

• factor = variable or characteristics in which the indvl assets returns are correlated/related
• identify significant factors that can predict future stock returns and construct a portfolio that tilts towards those factors
• rewarded factors - shown to be + related to LT return premium (size, value, quality, momentum)
• unrewarded factors - not proven to consistently provide LT return premium

Question 22

Equity style rotation strategy

Answer 22

• subset of Factor-Based Active Strategy

- based on the belief that different factors work well during some time periods and less well during other time periods

Question 23

Expand - Value Factor-Based Active Strategy

Answer 23

• found stocks with low P/E or high earnings yield (value stocks) tend to provide higher returns than growth
• value premium as compensation for increased risk for financial distress (value trap

Question 24

Expand - Momentum Factor-Based Active Strategy

Answer 24

• winners over the previous 12 months tend to outperform past losers
• attributed to behavioral biases or overreactions to information
• tend to become crowded and subject to extreme tail risk

Question 25

Expand - Growth Factor-Based Active Strategy

Answer 25

• growth potential, calculated using the company’s historical growth rate or projected forward growth rates

Question 26

What is a factor mimicking portfolio or FMP?

Answer 26

• theoretical implementation of a pure factor portfolio
• theoretical long/short portfolio that is dollar neutral with unit exposure to a chosen factor and no exposure to other factors
• invest in almost every stock, entering long or short positions without taking into account short availability issues or transactions costs

Question 27

Analyze activist strategies, including their rationale and associated processes

Answer 27

• taking stakes in companies and advocate for change in target companies
• different from distress bc activist go for good companies that underperform
• • slower revenue + earnings growth than market, negative share price momentum, weaker than avg corp. gov
• first screen and analyze opportunities in the market, buy target stock, study corporate structure, exit or buy more stocks, submit a proposal to company mgmt, threaten proxy contest, launch a proxy contest, negotiate settlement, shareholder vote

Question 28

Corporate raiders

Answer 28

take huge stakes in companies to influence operations, unlock value in the target companies to raise values of their shares

Question 29

Defenses for activist strategies

Answer 29

• poison plan - issue shares at a deep discount
• staggered board provisions - cannot be all replaced simultaneously
• dual-class share structure
• • public have no voting rights or almost no voting rights

Question 30

What are some tactics used by Activist Investors?

Answer 30

■ Seeking board representation and nominations
■ Engaging with management by writing letters to management calling for and explaining suggested changes, participating in management discussions with analysts or meeting the management team privately, or launching proxy contests whereby activists encourage other shareholders to use their proxy votes to effect change in the organization
■ Proposing significant corporate changes during the annual general meeting (AGM)
■ Proposing restructuring of the balance sheet to better utilize capital and potentially initiate share buybacks or increase dividends
■ Reducing management compensation or realigning management compensation with share price performance
■ Launching legal proceedings against existing management for breach of fiduciary duties
■ Reaching out to other shareholders of the company to coordinate action
■ Launching a media campaign against existing management practices
■ Breaking up a large conglomerate to unlock value”

Question 31

Describe active strategies based on statistical arbitrage and market microstructure

Answer 31

1. strategies use statistical and technical analysis to exploit pricing anomalies
   - - pair trading (needs mean reversion)
2. microstructure based arbitrage strategies = take advt of database and extensive analysis of the limited order book to identify temporary imbalance between buying and selling - spike that lasts for only a few milliseconds
3. event-driven strategies = market inefficiencies around corporate events such as M&A, earnings or restructuring announcements, share buybacks, special dividends, and spinoffs
   - - deal duration - need to decide which M&A transactions to participate in and how to weight each position

Question 32

Describe how fundamental active investment strategies are created;

Answer 32

1. Define the investment universe and the market opportunity (also = as investment thesis)
   - mainly determined by the mandate agreed on by the fund manager and the client
2. Prescreen the investment universe to obtain a manageable set of securities for further, more detailed analysis
3. Understand the industry and business for screened set by performing industry and competitive analysis and analysis of the financial report
4. Forecast company performance (CF or earnings)
5. Convert forecasts to valuations and identify ex-ante profitable investors
6. Construct a portfolio of these investments with the desired risk profile
   - overweighting overperform and underweight underperform
   - if no views on indvl sectors, establish a neutral industry position
7. Rebalance the portfolio with buy and sell disciplines.

Question 33

What are some pitfalls in Fundamental Investing?

Answer 33

1. Confirmation Bias
2. Illusion of Control
3. Availability Bias
4. Loss Aversion
5. Overconfidence Bias
6. Regret Aversion Bias
7. Value Trap

Question 34

Describe elements of a manager’s investment philosophy that influence the portfolio construction process;

Answer 34

• pursue active mgmt to generate portfolio returns in excess of BM returns for appropriate lvl of risks
• excess return = active return = differences in weights btw the active portfolio and BM

Question 35

Four main building blocks

Answer 35

1. Overweight or Underweight rewarded factors
2. Alpha Skills
3. Sizing Positions
4. Breadth of Expertise

Question 36

Expand - Overweight or Underweight rewarded factors - Building Blocks

Answer 36

• strategically adjusting the weights of the securities to create LT exposures to rewarded risks different than BM
• return that cannot be explained by rewarded factors is considered alpha, other relevant factors that are the model did not factor in, idiosyncratic risks (1- R^2)

Question 37

Expand - Alpha Skills - Building Blocks

Answer 37

• simple exposure to rewarded factors is not alpha but successfully timing the exposure would be alpha
• tactically adjustings the weights using skills/expertise in identifying mispriced securities, sectors, rewarded risks, and generate alpha that cannot be explained by LT exposure to rewarded risks

Question 38

Expand - Sizing Positions - Building Blocks

Answer 38

• balancing mgers’ confidence in their alpha and factor insights
• level of idiosyncratic risks impact on performance will be greater in the concentrated portfolio
• taking excessive idiosyncratic risks that can result in lucky or unlucky returns

Question 39

Expand - Factor-oriented manager - Building Blocks

Answer 39

• focused on creating a balanced exposure to rewarded factors –> maintains a diversified portfolio to minimize the impact of idiosyncratic risk

Question 40

Expand - stock picker - Building Blocks

Answer 40

• confident in their analysis of indvl securities –> concentrated portfolio which takes a higher degree of idiosyncratic risk
• • not driven by exposures to factors (even judged by factors) driven by securities we want to hold, still rewarded for rewarded factors

Question 41

Expand - Breadth of Expertise - Building Blocks

Answer 41

• success of getting consistent, positive active return is a function / related to the manager’s breadth of experience
• confidence in a manger’s ability to outperform the BM increases when it can be done to a larger sample of independent decisions
• Information coefficient = extent of manager’s forecasted active returns actually correspond/solidify to the managers realized active returns

Question 42

Systematic Approach for Constructing Actively Managed Equity Portfolio

Answer 42

• • portfolio construction process subject to a set of predetermined rules
• • look for premiums from holding balanced exposure to known reward factors
• • seek to avoid idiosyncratic risks by holding more (less concentrated portfolio) and has a more formal portfolio optimization process approach

Question 43

Discretionary Approach for Constructing Actively Managed Equity Portfolio

Answer 43

• portfolio construction left to the discretionary views of the manager
• • look for returns by researching the firm’s governance, business model, and competitive landscape (integrate nonfinancial variables)
• • more concentrated and takes a less formal approach

Question 44

Bottom-up Approach for Constructing Actively Managed Equity Portfolio

Answer 44

• • look at the risks and return characteristics of indvl companies and then set expectations for the environment
• • emphasizes security-specific factors
• • diversified or concentrated with security selection

Question 45

Top-Down Approach for Constructing Actively Managed Equity Portfolio

Answer 45

• • look to understand geopolitical, economic, financial, social environment and then forecast how it will affect the performance of assets, sectors, and securities
• • most likely involve factor timing = shifts portfolio based on their views on the performance of rewarded or unrewarded. country, sectors, and styles
• • more likely to have a concentrated portfolio with macro factors
• • diversified or concentrated with security selection (typically diversified)

Question 46

Distinguish between Active Share and active risk and discuss how each measure relates to a manager’s investment strategy

Answer 46

• Active shares - measures the extent to which portfolio differs (selection + sizing positions) from the BM
• • if Active shares = 0.5, 50% of the portfolio of the allocation positions are identical to the BM and 50% are not
• ** portfolio with fewer securities (concentrated) will have. a higher level of active share than the portfolio with more securities (more diversified)
• Active risks - measures the differences between the security weights in the portfolio and the BM but takes into account forward-looking estimates of correlations and variances
• -cannot control over Active risk bc active risk depends on correlations and variances which are beyond one’s control

Question 47

What will increase Active Risk?

Answer 47

• • the level of active risk will rise with an increase in factor and idiosyncratic volatility
• • high net exposure to a risk factor will lead to high active risk (E(Bp - Bbm)x Fk part of the formula
• • if factor exposure if fully neutralized (Bp - Bbm) = 0, active risk’s fully attributed to active share

Question 48

What will decrease Active Risk?

Answer 48

• • the number of securities is large (more diversified than concentrated)
• • the average idiosyncratic risk is small (overweight GM and underweight Ford = idiosyncratic risk is small)

Question 49

Distinguish between investment styles in terms of active share and active risk.

Answer 49

1. Pure Indexing
   - - copying what’s in the BM
   - - lowest Active Risk and Active Share
2. Closet Indexing
   - - active managers who are not really actively investing (active enough not to be an indexer)
   - - low Active Risk and Active Share
3. Factor Neutral and Diversified Stock Picks
   - high Active Share, low Active Risk
   - since neutralized, the active risk is fully attributed to active share
   - active risk attributed to active share will be smaller if # of secs. is large
4. and 5. Diversified factor bets vs Concentrated factor bets
   - diversification will lower the active risk
5. Concentrated Stock Picker
   - increase the active risk from Diversified factor bets
   - highest Active Share and Risk

Question 50

What are the Objectives and Constraints of portfolio mgmt?

Answer 50

• nature of objective function and constraints can indicate managers philosophy and style
• absolute framework = max. Sharpe ratio (return above rf / volatility) when risk = volatility
• relative framework = max. information ratio (active return / active risk) when use risk = active risk

Question 51

Discuss the application of risk budgeting concepts in portfolio construction;

Answer 51

1. Determine which type of risk measure if appropriate to her strategy
2. Understand how each aspect of the strategy contributes to the overall risk
3. Determine what level of risk budget is appropriate
4. Properly allocate risk among indvl positions/factors

Question 52

Discuss risk measures that are incorporated in equity portfolio construction and describe how limits set on these measures affect portfolio construction;

Answer 52

• risk constraints may be either formal or heuristic
• heuristic:
• • often based on experience or practice
• • limits on exposure concentrations, net exposures to factors (no beta greater than 1.2), net exposure to currencies, degree of leverage, turnover/trading related costs
• formal:
• • often statistical in nature and directly linked to the distribution of returns
• – volatility, active risk, skewness, drawdowns, VaR, CVaR, IVaR, MVaR
• • require estimates or predictions of risk

Question 53

Discuss how assets under management, position size, market liquidity, and portfolio turnover affect equity portfolio construction decisions;

Answer 53

• large AUM –> more implicit than explicit costs
• greater liquidity –> the greater the liquidity, the bigger position size the market can handle
• more portfolio turnover –> explicit
• market impact = price movement resulting from a manager’s sale/purchase
• the market impact is a function of the market cap. and average daily trading volume (ADV)
• smaller companies have lower ADV, larger % of their outstanding shares trade per day
• a manager’s investment approach and style will influence the extent to which he is exposed to market impact costs
• a large-cap fund can support a higher level of AUM than a small-cap fund
• • small-cap fund must either limit AUM, hold a more diversified portfolio, limit turnover, use derivatives

Question 54

Evaluate the efficiency of a portfolio structure given its investment mandate;

Answer 54

• well-constructued portfolio possess:
• a clear investment philosophy and a consistent investment process
• risk & structural characteristics as promised to investors
• a risk efficient delivery methodology
• reasonably low operating costs given the strategy
• low idiosyncratic risks relative to total risk

Question 55

Discuss the long-only approach to equity portfolio construction, including its risks, costs, and effects on potential alphas.

Answer 55

• • the conviction of negative views can be expressed t
• • short selling can reduce exposures
• • achieving a pure factor exposure requires a long-short portfolio
• net exposure = long position value - absolute short position value
• gross exposure = long position value + absolute short position value
• long extension (enhanced active equity strategy)
• • 130/30 - 130% long and 30% short
• • net exposure = 100% while gross exposure = 160%
• • allows for greater alpha and more efficient exposure to rewarded factors

Question 56

Benefits and Costs of Long/Short Strategies

Answer 56

Benefits
- short positions can reduce market risks
- shorting expands benefits from other risk premiums and alpha
- combination of long and short positions allows for greater diversification potential
Costs/Cons
- short positions might reduce the market return premium
- shorting may amplify the active risk
- higher implementations costs and greater complexity associated with shorting and leverage relative to long only

Question 57

Discuss the market neutral approach to equity portfolio construction, including its risks, costs, and effects on potential alphas.

Answer 57

• • hedge out most market risk
• • attempt to match and offset the systematic risks of the long position with those of the short positions
• • the objective is to neutralize risks for which the manager has no comparative forecasting advantage
• • usually less volatile than long-only
• • BM typically fixed income instruments (FI have beta of 0)
• • low correlation with other strategies (diversification role)
• • examples include pairs trading and statistical arbitrage (long unperf, short overperf)
• • limitations:
• – not all risks can be efficiently hedge and have limited upside in bull markets