Session 9 - Equity Portfolio Management (I)

Question 1

Discuss considerations in choosing a benchmark for a passively managed equity portfolio;

Answer 1

1/ Desired Market Exposure
- driven by the objectives and constraints in the IPS
- cap, style, segment (broad or sector)
2/ Risk Factor Exposure
- arises from size, investment style, price momentum, and liquidity
- historically, small-cap and value company’s returns > large-cap + growth

Question 2

What Initial requirements does an index need to meet?

Answer 2

1/ Transparent
- BM provider disclose rules and which constituents needed to create the index without complicated methodologies
2/ Rules Based
- include/remove constituent, rebalance frequency
- must be objective, consistent, predictable
3/ Investable
- performance can be replicated in the market
- uses free float adjust (only count shares that are not owned. by founders, government, and other companies)

Question 3

What are some ways index providers limit stock migration problems?

Answer 3

• arises when a stock increases/decreases in market cap and move from small to mid-cap status
• Buffering
• Packeting

Question 4

Buffering

Answer 4

• establish ranges/buffer zones that define whether a stock belongs in one index or another
• likely the reason why the portfolio has more stocks than the index

Question 5

Packeting

Answer 5

If a cap. increases and is btw mid and large-cap indexes, a portion of the holdings is transferred to large-cap and the rest stays in mid-cap
– on the next reconstitution date, if the stock’s cap remains large-cap, the remainder of the shares are moved out fo the mid-cap and into large-cap index

Question 6

What are different weighting methods used to construct an index?

Answer 6

1/ Market cap weighting
2/ Price Weighting
3/ Equally Weighting
4/ Company or stock's fundamental characteristics
5/ Volatility Reducing

Question 7

Market Cap Weighting

Answer 7

• market cap = price x # of shares outstanding
• can be seen as liquidity weighted index bc large-cap stocks tend to have the highest liquidity and greatest capability to handle flows at manageable costs
• portfolio is mean-variance efficient = offers the highest return for a given lvl of risks, a reasonable proxy for the market portfolio

Question 8

Price Weighted

Answer 8

• weight is the share’s price/sum of all share prices in the index
• portfolio consists of one share of each constituent
• stock split affects this
• not ideal as in reality, people does not hold the same number of shares

Question 9

Equally Weighted

Answer 9

• produce the least concentrated portfolio
• constituent weight of 1/n, n=number of stocks
• requires regular rebalancing as soon as trading of the stock constitution starts again