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FINM3008 > Week 6 - Equities > Flashcards

Week 6 - Equities Flashcards

1
Q

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

A

purchasing power of retirement savings particularly in low interest environment.

returns from FI securities will be depressed for long term.

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2
Q

Risks of EM

A

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

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3
Q

weaker argument for investing in EM

A

diversification benfits are limited given high correlation with other equities

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4
Q

EM has a ____ to world equities

A

high beta

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5
Q

EM is a risky investment partly because

A

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

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6
Q

What can dampen the impact of equity fluctuations for australian investors

A

positive correlation between returns from EM and $A

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

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7
Q

Strongest argument for investing in RM

returns argument. Should you rely on economic growth?

A

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

due to lack of evidence of the associatoin.

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8
Q

Strongest argument for investing in RM

A

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%)

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9
Q

Alpha opporunity from investing in EM

What faciliates alpha generation?

A

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

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10
Q

Alpha opporunity from investing in EM

A

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

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11
Q

Impact of substituting EM for a portion of WE exposure

implication

A

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?

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12
Q

Equities: role in the total portfolio

small cap companies

A

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

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13
Q

Equities: role in the total portfolio

benefit

A

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

Equity is readily available.

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14
Q

Equities: role in the total portfolio

liquidity

A

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.

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15
Q

Overall equity market: Return

Forecast equity market return

A

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

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16
Q

Overall equity market: Return

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

A

3-3.5% per annum.

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17
Q

Overall equity market: Return

Equity risk premium puzzle

A

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.

18
Q

ERP problems

dividends yield

influence of imputation system

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

A

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

19
Q

ERP problems

A

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

20
Q

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.

A

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.

21
Q

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

A

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

22
Q

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

A

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.

23
Q

what is proxy for rf rate

A

Short term gov bond as proxy for risk freerate

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

24
Q

Overall equity market: risk

Australia

A

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
25
Q

Overall equity market: Drivers

•What causes fluctuations: a fundamental view

A

–Change in expected cash flows

–Change in discount rate (valuation of equities)

26
Q

Overall equity market: Drivers

•What causes fluctuations: some macro influences

A

–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)

27
Q

impact of labour’s policy

A

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

28
Q

Role of imputation credit and return

A

offsets tax liability –> higher-after tax return

The average franking level of Australian companies is 80%.

29
Q

Austrliana investors get imputation creditors from

A

investment in australian equity market.

That is part of expected return in australian equity

30
Q

Risk & return within equity portfolios

A
  • 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

31
Q

Risk & return within equity portfolios

A
  • 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

32
Q

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

A

may generate exotic beta.

33
Q

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

A

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

34
Q

what is australian equity returns experiencing now and why

A

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
35
Q

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,

A

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

36
Q

Implicit EM exposures

A

on average global equity fund allocates 10% to EMs

; 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.

37
Q

Investors taking big positions in EM should be cautious

A

: high volatility, occasional crisis, increasing correlation with world equity market.

Diversification is limited due to high correlations with world equities.

38
Q

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

i

A

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

39
Q

we include additonal exposure to emerging markets for US investors

A

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

40
Q

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?

A

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

41
Q

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?

A

World equity

still world equity

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

FINM3008 (15 decks)

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