FinQuiz smart summary,equity porfolio management

APPROACHES TO EQUITY INVESTMENT Passive Management Active Management Semi Active expectations in security selection.. PASSIVE EQUITY INVESTING return active investment underperform after

1 INTRODUCTION

Decision of how to invest in competing equity investments ranks second to how much to allocate to equities

SD = Standard Deviation

ER = Equity Research

MF = Mutual Fund

2 THE ROLE OF THE EQUITY PORTFOLIO

economic factors & no exact home-market equivalent

tax real return, price competition may limit price
due to inflation)

Both domestic & international equities play an important role in individual/institutional portfolios

3 APPROACHES TO EQUITY INVESTMENT

Passive Management Active Management Semi Active

expectations in security selection

indexing

implementation

Seeks to outperform benchmark through security selection

More concerned about tracking risk while trying to beat benchmark

Information ratio ⇒ mean active return / tracking risk (efficiency with which tracking risk deliver active return)

4 PASSIVE EQUITY INVESTING

return (active investment underperform after-cost basis)

small cap (heavy transaction cost) & unfamiliar overseas markets

4.1 Equity Indices

To perform technical analysis & β calculation

returns are calculated, determine stock index’s characteristics

L/S = Long-Short

IR = Information Ratio CSP = Core-Satellite Portfolio

4.1.1 Index Weighting Choices

price

shares

buying one share of each index component

Simple to construct & can go back far into the past

investing same proportion as each index component in index

Self corrects for stock splits & reverse stock splits etc

Float weighted index ⇒ subcategory

factor

return to avg dollar invested passively

(representative & minimum tracking error)

equal $ investment in each index component

Weighting Scheme Biases

(can change through splits, stock dividends etc)

(mature & overvalued companies)

restriction (e.g maximum holdings)

transaction cost)

4.1.2 Equity Indices: Composition & Characteristics of Major Indices

Price weighted & equal weighted indexes are very few in numbers now days

Indices

Committee-determined indices Algorithm (formula based)

Low turnover (low transaction cost & tax)

away from intended segment

High cost & taxes

Fund must evaluate tradeoff b/w transaction cost & difference in return premiums

4.2 Passive Investment Vehicles

4.2.1 Investment in indexed portfolio

Long position in cash & long position in futures

Long position in cash & long position in Swap

Mutual Funds Exchange Traded Funds Trading frequency Trade at NAV once at market close Trade in public market anytime during trading day

Cost of providing liquidity Yes No, due to in-kind creation/redemption

Shareholder accounting expense Yes No fund level shareholder accounting

Difference b/w Indexed Mutual Funds & ETFs

Indexed institutional portfolios (separate or pooled) are cost efficient than MF & ETFs

& custody expense

Separate or Pooled Accounts

Indexing a Portfolio

than 1000 & liquid

weighted index, is self rebalancing, trading required only for reinvestment

of dividends & to reflect changes in index composition

return on index (administrative cost, transaction cost, cash drag)

/cells (industry value, growth etc)

Place each stock into a cell & match cell weight into portfolio as cell weight into index

error

index fund from non-diversified index

index & individual securities risk exposures are measured & minimize the tracking error

among factors (advantage)

Risk change over time & model is based on historical data

error than stratified sampling when used in combination with full replication

4.2.2 Equity Index Futures

4.2.3 Equity Total Return Swaps

Motivated by different tax treatment of shareholders in different countries or to acquire exposure to an asset class for strategic/tactical asset allocation (less cost of rebalancing)

5 ACTIVE EQUITY INVESTING

5.1 Equity Styles

Focus is low share price relative to earning or BV

High earning growth companies are key considerations

Intermediate grouping for investments (neither value nor growth)

5.1.1 Value Investment Styles

causing
in multiple & stock price

Growth investing contains risk of contraction in earnings &

multiples

Low P/E ⇒ invests in stock with low price hoping industry &

stock will recover & P/E will improve

Contrarian ⇒ investment in very depressed industries usually P/B < 1

Yield investor ⇒ focus on high current & future dividend yield (component of total return)

5.1.2 Growth Investment Styles

Focus on future EPS growth rate & major risk is that growth will not take place & price will

Consistent growth ⇒ invest in companies with long growth history

Earning momentum ⇒ higher quarterly year-over-year earnings growth but less sustainable

expansion

5.1.3 Other Active Management Styles

falls (growth / value)

Drawback ⇒ if portfolio achieves market like return, indexing or enhanced indexing presents a lower cost alternative

Market oriented with value biased (hold well diversified portfolios)

Market oriented with growth biased (hold well diversified portfolios)

Growth-at-reasonable price ⇒ investor favors companies with above avg growth with conservative valuation (portfolios are less diversified than other growth investors)

Style rotators ⇒ invest in most favored near term style

Market Capitalization

stocks (less research)

of small cap

than large cap (opportunities exist)

cap

More financial stability

superior analysis

5.1.4 Techniques for Identifying Investment Styles

Return based style analysis Holding based style analysis

of indices

Mutually exclusive & exhaustive

β on indices are nonnegative & sum to 1

Normal benchmark ⇒ benchmark with same systematic risk exposure as manager’s portfolio

R2 determine style fit & 1-style = selection

return

characteristics & draw overall style conclusion

low P/E, P/B & high dividend yield( vice versa for growth) & market oriented has valuation close to market avg

portfolio ⇒ larger weight in utilities & finance sector

are higher

Two approaches to style analysis: Advantages and Disadvantages

Returns-based style

analysis

portfolio characterizations

conclusions

Holdings-based

styles analysis

than returns-based analysis

security selection

Requires specification of classification attributes for style;

different specifications may give different results

5.1.6 The Style Box

Style box is used for looking at a style

(value, core & growth)

firms

5.1.7 Style Drift

5.2 Socially Responsible Investing

Consider ethics, social & religious concerns while taking investment decisions

Negative stocks screens ⇒ reduce investment universe

Positive SRI Screens ⇒identify companies with ethically desirable characteristics

cap stocks

objective & constraints

style analysis

5.3 Long-Short investing

constraints (short selling)

hold two alphas

Portable alpha ⇒ added to variety of systematic risk exposures

Pair trade ⇒ long / short in two single industry firms’ stocks by equal currency amounts (almost zero β, only firm specific risk)

Leverage used in L/S strategy magnifies risk & return

If the price of short position tend to rise, loss can be unlimited

5.1.5 Equity Style Indices

Overlap ⇒ some securities may be assigned in part to both value & growth

No overlap ⇒ security is assigned to either value, growth or market oriented

Buffering ⇒ rules for maintaining the previous stock assignment when stock has not clearly moved to a new style

5.3.2 Equitizing a Market-Neutral Long-Short Portfolio

ETF is an alternative to futures & cost effective way of equitizing & de-equitizing

benchmarked against relative index

5.3.3 The Long-Only Constraint

insights” over long only portfolio

(can’t take short position)

5.3.4 Short Extension Strategies

100/0 & 30/30 they are not (consider two portfolios)

5.4 Sell Disciplines/Trading

Strategy of Substitution Deteriorating Fundamentals Rule Driven

opportunity by considering transaction cost & taxes

discipline

Valuation level (e.g if P/E reaches historical avg.)

Target price sell discipline

Reduce or eliminate a position if company’s business prospects are expected to deteriorate

These sell disciplines are not mutually exclusive

5.3.1 Price Inefficiency on the Short Side

alpha than long side)

Short positions difficult to obtain (e.g find lender)

to be overvalued rather than undervalued)

commissions & potential buyers > sellers & short sellers

sell recommendations [against standard I (B)]

6 SEMIACTIVE EQUITY INVESTING

managing portfolio risk exposure

Highest IR as compared to indexing & active management

Basic Forms

return through something other than equity investments

through duration management

Identify overvalued & undervalued stocks & outperform through stock selection

data,will not work if economy changes

Fundamental Law of Active Management

Where IC = information coefficient (effectiveness of investment insight)

Breadth = no of independent active investment decision

Higher the ratio, the better it is

7 MANAGING A PORTFOLIO OF MANAGERS

classes to use & how to invest within each asset class

risk

Where

஺ = expected utility of active return of manager mix

஺ = expected active return

⋌஺ = active risk aversion

஺ = variance of active return

have the skill to select outperforming managers

performance is judged relative to benchmark, which is difficult to outperform

(active risk limitation by institutional investors)

௡

Where

ℎ஺௜ = weight assigned to ith manager

஺௜ = active return of ith manager

ଶ

௡

ଶ if returns are correlated include covariance term under square root sign

7.1 Core-Satellite

Core-satellite portfolio ⇒ consists of a core holding (index & semi active) &

satellite (active managers)

other heuristic

may have different benchmarks

Decomposition of Active Return

True Active Return Misfit Active Return

Manager’s return - manager’s normal benchmark

Manager’s normal benchmark - investor’s benchmark

Decomposition of Active Return

True Active Return Misfit Return

  =      

Total active risk =  ! ᇱ   "ଶ+! ᇱ  "ଶ#

Completeness fund ⇒ when added to active managers’ positions, establishes an overall portfolio with same risk exposure as investor’s overall equity benchmark

losing part of true active return

7.2 Completeness Fund

∝ $Long on Japanese manager portfolio !TOPIX index"&

Long active equity portfolio ⇒ provides both α & β exposure

Market neutral L/S ⇒ can better manage α & β (can use portable α in asset class outside β asset class)

not really be market neutral

7.3 Other Approaches: Alpha & Beta Separation

8 IDENTIFYTING, SELECTING, AND CONTRACTING WITH EQUITY PORTFOLIO MANAGERS

When funds are delegated to outside management a consultant is required for investment manager search

8.1 Developing a Universe of Suitable Manager Candidates

managers are talented & truly add value

etc) & quantitative (comparison with peers, style orientation etc) factors

8.2 The Predictive Power of Past Performance

result”

manager exhibiting consistent underperformance from benchmark not likely to be selected)

8.3 Fee Structures

Fee cap ⇒ upper limit to total fee (limit manager from high risk)

High water mark ⇒ provision requiring cumulatively generated outperformance since last performance-based fee paid

Symmetric incentives fees ⇒ reduce (poor performance) as well as increase (good performance) compensation (better align manager &

plan sponsor interest)
Manager’s revenue volatility

One-sided performance based fee ⇒ conveys a call option to investment manager & value is determined through option pricing model

8.4 The Equity Manager Questionnaire

Five Sections

process, risk management function, stock selection process etc)

portfolio managers, length of time the team has together etc

etc

portfolio construction etc)

Fifth Section

Type of fees (ad valorem or performance based) & terms & conditions related to fees

9 STRUCTURING EQUITY RESEARCH AND SECURITY SELECTION

ER is necessary component of active & semi active investing

9.1 Top-Down versus Bottom-Up Approaches

Focus on company-specific fundamentals

macro insights

9.2 Buy-Side versus Sell-Side Research

work) or investment banks / brokerage to generate business

& produce reports on companies &

industries

(investment management firms)

structure(analyst prepares report, presents

to committee that reviews & decides upon the conclusion)

9.3 Industry Classification

industry or sector lines

industry & sub-industry

When funds are delegated to outside management a consultant is required for investment manager search

8.1 Developing a Universe... data-page="11">

8.4 The Equity Manager Questionnaire

Five Sections

process, risk management function, stock selection process etc)

portfolio managers, length of time the... generate business

& produce reports on companies &

industries

(investment management firms)

structure(analyst prepares report, presents

to committee that reviews