Week 6 - Equities

Question 1

why are retirees or those transitioning to retirement worried about inflation?

Answer 1

purchasing power of retirement savings particularly in low interest environment.

returns from FI securities will be depressed for long term.

Question 2

Risks of EM

Answer 2

relatively high beta and illiquidity, sensitivity to the world economy, propensity towards volatility

Question 3

weaker argument for investing in EM

Answer 3

diversification benfits are limited given high correlation with other equities

Question 4

EM has a ____ to world equities

Answer 4

high beta

Question 5

EM is a risky investment partly because

Answer 5

they are weighted towards commodities and other economically sensitive sectors and away from consumer related areas

Question 6

What can dampen the impact of equity fluctuations for australian investors

Answer 6

positive correlation between returns from EM and $A

$A tends to fall when EM is weak and vice versa

Question 7

Strongest argument for investing in RM

returns argument. Should you rely on economic growth?

Answer 7

caution against relying on higher economic growth rates to generate higher equity returns.

due to lack of evidence of the associatoin.

Question 8

Strongest argument for investing in RM

Answer 8

Capturing a return premium —> higher returns

Risk compensation for hugh beta/volatility + relative illiquidity (beta and illiquidity risk)

alpha may be further augmented by effective manager, esp EM managers that run high tarcking error (8%)

Question 9

Alpha opporunity from investing in EM

What faciliates alpha generation?

Answer 9

less efficient markets, reflecting lower sell-side analyst coverage, more insiders, short-selling constraints weaker regulation

Question 10

Alpha opporunity from investing in EM

Answer 10

active EM managers have historically generated relatively high alpha, which has low correlation with other equity-based alpha sources.

Question 11

Impact of substituting EM for a portion of WE exposure

implication

Answer 11

mean and std increase with allocation to EM

BUT

the increase std is less when unhedged EM are substituted for Hedged world equities, as this best captures the risk reductoin benefits of the correlation with $A

is higher ER adequate to justify allocation due to higher portfolio risk?

Question 12

Equities: role in the total portfolio

small cap companies

Answer 12

the illqiduity risk with small cap companies can be substantial in some circumstances.

Question 13

Equities: role in the total portfolio

benefit

Answer 13

Very active media coverage, long data history, massive data available.

Equity is readily available.

Question 14

Equities: role in the total portfolio

liquidity

Answer 14

Equity market is mostly liquid. Most of stocks are stocks on asx 200. very liquid are listed companies.

except

Small cap stocks and emerging market stocks, they are not that liquid.

Large companies in emerging markets, the trading is not very active. E.g. Ownership can be concentrated. Company controlled by institutional investors, government. They do not buy or sell often.

Question 15

Overall equity market: Return

Forecast equity market return

Answer 15

look at the equity market risk premium (Attract investors from safe asset, offer level of compensation for that risk)

Question 16

Overall equity market: Return

So far, the latest estimate from leading investment banks,in US, theequity risk premium

Answer 16

3-3.5% per annum.

Question 17

Overall equity market: Return

Equity risk premium puzzle

Answer 17

realized return over US stock market is much higher (7% p.a.) than government bond returns (1% p.a.), which is hard to be explained by known factors: transaction costs, illiquidity, risk aversion of investors.

Question 18

ERP problems

dividends yield

influence of imputation system

Why in Australia the average dividend yield is higher than US.

Answer 18

In the Australian market, the existing tax system, especially the imputation credits, encourages Australian firms to pay out more dividends instead of retaining the dividends cash to invest in NPV projects

Question 19

ERP problems

Answer 19

Throwing uncertain parameters into a model that requires assumption like constant growth

• constant growth rate. Lots of factors driving the equity market growth or economic growth. Trade war?
• dividend yield can be volatile (high at 8% low as -3-4% in AU)
• expectation of rf comes with more confidence

need to supplement with qualititative analysis

Question 20

If investor is client in our assignment investment horizon is 10 years +, how are you going to forecast expected return in asutralian market, which rate are you going to choose.

Answer 20

Going to forecast expected return = risk free rate + australian equity risk premium.

Why do we prefer equity risk premium of over 10 year gov bond? Investment horizon is long term. Want to have an equity risk premium based on long term gov bond. Here we hhappen to have 10 year gov bond.

Question 21

What if investor’s investment horizon is 30-50 years in 20-30

Answer 21

Try to align investor’s investor horizon with matuiry of risk free gov instruments

Question 22

When you try to forecast required return from a long term proejct?

Answer 22

the equity risk premium over a corporate bond index might be more appropriate in terms of the term of the project and the very specific business risks involved in your calculation.

Question 23

what is proxy for rf rate

Answer 23

Short term gov bond as proxy for risk freerate

Long term gov bond as proxy for risk free rate or going to use

Question 24

Overall equity market: risk

Australia

Answer 24

Expereienced a significant drop after 2001 when monetary policy came into effect and resource boom. Whole economy sat into healthy pace of development

• Another spike during GFC
• Commodity market is driver of equity market in australia

Question 25

Overall equity market: Drivers ## Footnote •What causes fluctuations: a fundamental view

Answer 25

–Change in expected cash flows –Change in discount rate (valuation of equities)

Question 26

Overall equity market: Drivers ## Footnote •What causes fluctuations: some macro influences

Answer 26

–Economy –Profit-share –Inflation –Resource utilization –Monetary environment (monetary policy, general liquidity) –Buying and selling power (funds flows, portfolio positions) –Risk aversion / risk premiums –Valuation (relative, absolute)

Question 27

impact of labour's policy

Answer 27

This is going to affect institutional investors. Lots of individual investors. Investors in mature aage. They have an asset allocation towards cash and generating securities

Question 28

Role of imputation credit and return

Answer 28

offsets tax liability --\> higher-after tax return The average franking level of Australian companies is 80%.

Question 29

Austrliana investors get imputation creditors from

Answer 29

investment in australian equity market. That is part of expected return in australian equity

Question 30

Risk & return within equity portfolios

Answer 30

* Tracking error * Beta (e.g. single factor CAPM, multi-factor models) * Common factors –Carhart 4-factor model (Fama-French 3-factor + price momentum) –Investment style –Industry: banks, resource, industrial, retail etc. look at concentration of industry in portfolio. –Factor models, e.g. BARRA, Northfield, proprietary •Stock-specific risk

Question 31

Risk & return within equity portfolios

Answer 31

* Tracking error * Beta (e.g. single factor CAPM, multi-factor models) * Common factors –Carhart 4-factor model (Fama-French 3-factor + price momentum) –Investment style –Industry: banks, resource, industrial, retail etc. look at concentration of industry in portfolio. –Factor models, e.g. BARRA, Northfield, proprietary •Stock-specific risk

Question 32

Emerging market equities considered to be a source of excess return where you

Answer 32

may generate exotic beta.

Question 33

Australia equity started long term out performance against world equity starting from

Answer 33

arly 2000. came to an end in 2013, 14 and 15. over 15 and 16 see subtantial underperfomrance of austrlian equity relative to world equity

Question 34

what is australian equity returns experiencing now and why

Answer 34

returns converting to world equity. Australian market does not outperform WE b/c australian economy is closely related to economic development of emerging markets particularly the export of minerals. 1. 2013-2014 collapse in commodity price which are important for australian economy

Question 35

When we consider diversified portfolio of a typical australian investor have 30% of australian equity, 30% of world equities ehdged to a dollar. And another 20% of fixed income and another 20% of alternative and cash. With this diversified portfolio,

Answer 35

When you invest in australian market you have indirect exposure to emerging market b/c Asutralian equity is closely related and driven by demand of emerging markets

Question 36

Implicit EM exposures

Answer 36

on average global equity fund allocates 10% to EMs ## Footnote ; large US or European based firm derive a significant portion of their revenue from EMs too Asset allocation should take these implicit exposures into consideration.

Question 37

Investors taking big positions in EM should be cautious

Answer 37

: high volatility, occasional crisis, increasing correlation with world equity market. Diversification is limited due to high correlations with world equities.

Question 38

Beta of EM on world equities in A$ vs. US$ i

Answer 38

Beta here is sensitivity of emerging market investment to world equity market movement. Hi risk of EM: average beta is 1.2 for EM relative to world equities, US$ based. higher risk than world equity. Beta of 1.2 indicates higher risk than market BUT, beta of EM in A$ term, EM beta reduces to 0.9 **_EM exposure might be a good source of high return and reduced portfolio risk based on the positive correlation between EM returns and Aussie dollar_**

Question 39

we include additonal exposure to emerging markets for US investors

Answer 39

because beta of EM relative to world equity is \> 1, and WE is major driver of total portfolio returns and risk for portfolio we may potentially introduce additional total portfolio risk

Question 40

Australian invstor, 90% of total portfolio variation can be explained by world equity. Exposure to emerging market which has beta less than 1, how does this affect total portfolio risk and return? I am an AUD investor is it a good idea if I have additional emerging market exposure?

Answer 40

Single most important driver of total portfolio risk is world equity. New asset that has beta less than 1 to the world equity, may potentially reduce my total portfolio risk. When you hold diversified portfolio, risk should be assessed at total portfolio level. Australian investor, hold equity in AUD. Hedge exposure back to AUD

Question 41

If I have a balanced portfolio of 60% world equity and 40% of world fixed income, 90% of total portfolio variation can be explained by? Now I have portfolio of 60% ncluding domestic and world equity and world FI. What is the motst important driver of total portfolio variation?

Answer 41

World equity still world equity key most important driver of total portfolio is world equity index.