SS11 - Equity Portfolio Management

Question 1

Are equities a good hedge for inflation?

Answer 1

Yes, equitites tend to be a good inflation hedge.

However, effectivness depends on:

• industry
• competitive position (if the company can pass on price increases to the consumer or not)

Question 2

What are some risk factors for stocks?

Answer 2

• Size
• P/E
• Leverage

Question 3

What are the three methods of equity portfolio management?

Answer 3

• passive
  
  • buy all the securities in the index
• semi-active
  
  • try to outperform index but have savme level of risk
• active
  
  • try to outperform benchmark, dont need to match risk

Question 4

The information ratio is highest for which equity management style?

Answer 4

Semi-active management has the highest IR.

Question 5

Under what condidtions would an investor prefer passive management?

Answer 5

• investor is taxable
• to invest in large cap stocks (they are the most efficient)
• believe in efficiency of markets
• investing in international stocks (because you probably dont have expertise)

Question 6

What are the four major index types?

Answer 6

1. price-weighted
2. value-weighted
3. float-weighted
4. equal-weighted

Question 7

What are the advantages of a price-weighted index?

Answer 7

• easy to calculate
• long track record

Question 8

What is the purpose of a float-adjusted index?

Answer 8

A float-adjusted index recognizes the fact that the number of shares outstanding and the number that are investable by the general public is generally not the same.

Question 9

What are the biases of each index type?

Answer 9

• price-weighted
  
  • bias by high-priced stocks
  • price is arbitrary
  • assumes investor purchases one share of each stock in index
• value- and float-weighted
  
  • higher market cap stocks dominate
  • these may be mature of overvalued
  • may be less diversified (more large cap)
• equal-weighted
  
  • biased toward small caps
  • rebalancing will incur substantial t-costs
  • finding liquidity on some of the smaller names may be an issue

Question 10

What are **four methods **of passive equity investing?

Answer 10

• index mutual fuds, ETFs
• separate or pooled accounts
• equity futures
• equity total return swap

Question 11

What are some features of mutual funds compared to ETFs?

Answer 11

• not traded frequently
• more record keeping
• usually lower license fee paid to idx providers
• less tax efficient (liquidations are taxable evetns for the fund)
• higher long-term cost

Question 12

What are some features of ETFs compared to mutual funds?

Answer 12

• trades throughout the day
• less record keeping
• pay higher license fee to idx provider
• more tax efficient
• lower long-term costs
  *

Question 13

What are two disadvantages of an equity future relative to an ETF?

Answer 13

• Equity futures have finite lives and need to be rolled. (at potentially less attractive terms)
• basket may not be shorted if one component violates the uptick rule

Question 14

What are some features of full replication?

Answer 14

• lowest tracking error
• only needs to be rebalanced when divs paid or instruments added/removed
• earns less return than index itself due to t-costs

Question 15

What are some features of stratified sampling?

Answer 15

• dont need to purchase all stocks in the index
• cell matching by risk factors
• assumes risk factors are uncorrellated

Question 16

What are some features of **optimization **to create an index fund?

Answer 16

Advantages:

• uses risk model to match risk exposure of index
• objective function minimizes risk subject to certain constraints
• does account for correllation between factors
• lower tracking error than stratified sampling

Disadvantages:

• sensitivities based on historical data
• needs to be updated as risk sensitivities change
• can be misleading if data is skewed

Question 17

What are the three styles of equity investing?

Answer 17

• Growth
• Value
• Market-oriented

Question 18

Whar are some features of the **value style **of equity investing?

Answer 18

• focus on numerator (P/E, P/B), earnings growth
• want low price relative to assets
• Justifications
  
  • earnings are mean reverting. if temporarily depressed, they will revert in the future
  • growth investors are paying too much

Question 19

What are three sub-styles within the value style?

Answer 19

• low price multiple
• high dividend yield
• contrarian

Question 20

What are some features of the growth equity investment style?

Answer 20

• focus on denominator (P/E, P/B)
• looking for high expected earnings growth

Question 21

What are **two substyles **within the growth style?

Answer 21

• consistent earnings growth
• momentum

Question 22

What are some features of a market-oriented equity investment style?

Answer 22

• doesn’t focus on growth or value
• try to create market coverage

Question 23

What are **four substyles **within the market-oriented style?

Answer 23

• growth at a resonable price (GARP)
• market oriented with growth tilt
• market oriented with value tilt
• style rotators
  
  • shift to hottest style

Question 24

What are three methods you can use to determine if a PM is telling the truth?

Answer 24

1. returns-based analysis
2. holdings-based analysis
3. equity boxes

Question 25

What is the basic process for a **returns-based analysis?**

Answer 25

1. find series of indices (exhausetiv, mutually exclusive) 2. regress the returns of the portfolio on the returns of the indices 3. if R^2 = 100%, we can conclude that returns can be explained by *systematic *(market) risk 4. Do this over multiple periods to ensure consistency

Question 26

What is the basic process for a **holdings-based analysis?**

Answer 26

1. Characterize holdings along a variety of dimensions * value/growth * expected EPS growth rate * earnings volatility * industry representation Holdings-based is better for capturing style drifts more quickly.

Question 27

What are some features of **long-short equity investing?**

Answer 27

* can create alphas on 2 sides (long and short) * can eliminate systematic risk * can reinstate market risk via various vehicles * mutual fund * ETF * swap * index futures

Question 28

What the reasons there is larger potential alpha on the short side?

Answer 28

* need to find a lender * firm management more likely to promote value of stock using accounting manipulation or other means (more likely to be overvalued than undervalued) * analysts more likely to issue buy recommendations than sell recommendations * analyts want to avoid angering mgmt of the firm analyst is following

Question 29

What are the **sources of alpha** in an **equitized long-short portfolio?**

Answer 29

1. alpha on long positions 2. alpha on short positions 3. interest on cash from short sale (short rebate) 4. return on equity futures contract

Question 30

What are **two methods of enhanced indexing?**

Answer 30

* derivatives-based * often has alpha through fixed income * stock-based * manager under- or over-weights index stocks based on view of stock's prospects

Question 31

What is the **fundamental law of active management?**

Answer 31

IR = IC \* SQRT(Breadth) IR is a function of two things: * depth of knowledge about securities * number of *independent *decisions

Question 32

What are **two approaches to portfolio construction?**

Answer 32

* core-satellite approach * have core holding (passive or enhanced index) (active risk managed here) * add some number of active managers (active return added here) * completeness fund approach * less exact * completeness fund is combined with active portfolio so that the combined portfolio is similar to the benchmark

Question 33

What are the components of **total active return**?

Answer 33

return_total = return_true+ return_misfit return_true = portfolio - normal portfolio return_misfit = normal portfolio - investor benchmark

Question 34

What are some features of an **equity total return swap?**

Answer 34

* investor exchanges return on an equity security or an interest rate for the return on a equity index * can synthetically diversify a portfolio in one transaction (more cheaply than buying stocks) * can have tax advantages (US investor can use swap to get exposure to european stocks. cpty is responsible for the taxes and may be tax advantaged)

Question 35

What are the advantages and disadvantages of **returns-based analysis?**

Answer 35

Advantages * characterizes entire portfolio * enables comparisons of entire portfolios * summarizes results of investment process * methodology backed by theory * different models usually result in same conclusions * low cost; can be executed quickly Disadvantages * may be inaccurate due to style drift * misspecified indices can lead to misleading conclusions

Question 36

What are the advantages and disadvantages of **holdings-based analysis?**

Answer 36

Advantages * characterizes each security * enables comparisons of securities * can detect style drifts more quickly Disadvantages * not consistent with the method used by managers to select securities * requires subjective judgement to classify securities * requires more data than returns-based analysis

Question 37

What are the two *general *biases of SRI portfolios?

Answer 37

Tilts towards: * growth * small-cap

Question 38

What is **alpha-beta** **separation?**

Answer 38

* Manager gains systematic risk exposure through low cost index fund or ETF * alpha is added through long-short strategy