CFA 2018 r25 equity portfolio management

Approaches to Equity Investment • Passive Management – Investor does not attempt to reflect his investment expectations through changes in security holding – Equity market is efficient

Contents – Equity Portfolio Management

1 Introduction

2 The Role of the Equity Portfolio

3 Approaches to Equity Investing

4 Passive Equity Investing

5 Active Equity Investing

6 Semi-Active Equity Investing

7 Managing a Portfolio of Managers

8 Identifying Selecting and Contracting with Equity Portfolio

Mangers

9 Structuring Equity Research and Security Selection

2 The Role of the Equity Portfolio

• Equity represents a significant source of wealth

• Equity can be found in both individual and institutional portfolios

• Investing across multiple markets offers diversification benefits

• Equities offer superior protection against unanticipated inflation

• High historical long term rates of return

3 Approaches to Equity Investment

• Passive Management

– Investor does not attempt to reflect his investment expectations through changes in security holding

– Equity market is efficient  indexing is the best strategy

– Not really passive because portfolio needs to change when index is

reconstituted or when weight of a stock changes because of corporate

action

– Outperform benchmark portfolio by investing in underpriced securities

– Dominant management style

3 Approaches to Equity Investment

– Also called enhanced indexing or risk-controlled active management

– Variant of active management

– Outperform benchmark but keep tracking risk in control

4 Passive Equity Investing

According to William Sharpe:

4.1 Equity Indices

4.2 Passive Investment Vehicles

4.1 Equity Indices

Stock index’s characteristics are determined by

1 Boundaries of stock index’s universe

2 Criteria for inclusion

3 How stocks are weighted

4 How returns are calculated

Listen to this lecture if you need a refresher on security market indices…

http://www.youtube.com/watch?v=23qEK_mtMHo

To be included in the S&P 500, a company must meet the following minimum criteria:

Be a U.S company

Have a market cap of at least $4 billion

At least 50% of its stock must be held by the public

Four consecutive quarters of positive earnings

A stock price of at least $1 per share

Contribute to the overall balance of sectors within the S&P 500, to help it represent the overall

market sector make-up

Be listed on either the New York Stock Exchange or the NASDAQ Real Estate Investment

Trusts (REITs) and business development companies can also be included

The top 10 largest companies in the S&P 500 in 2011 were: Exxon Mobil, Apple, IBM,

Chevron, General Electric, Microsoft, AT&T, Johnson & Johnson, Procter & Gamble and Pfizer

The market cap of these 10 companies represent 20% of the market cap of the total S&P 500

The S&P 500 also seeks to make sure the industry sectors in the S&P 500 represent the

industries in the economy The sector percentages in the S&P 500 in 2010 were:

Information Technology (17.8%), Financial (15.1%), Energy (12.7%), Industrials (11.3%),

Consumer Staples (10.6%), Consumer Discretionary (10.6%), Materials (3.7%), Utilities

(3.4%), Telecom Services (3.1%) (Source: S&P 500 Factsheet)

Price Weighted Value Weighted Equal Weighted

Each stock weighted

according to absolute share

Biased towards high market-cap stocks  large companies, overvalued stocks

Suggestion: adjust component weights based

on fundamentals (such as P/E)

All stocks treated the same

Small company bias because such indices include many more small companies

Requires frequent rebalancing

Price Weighted

Value Weighted

Float Weighted

Equal Weighted

4.2 Passive Investment Vehicles

http://www.youtube.com/watch?v=lFV3S1PCQoM&feature=youtu.be

Refresher on swaps…

Indexed Portfolios

Conventional (Open End) Index Mutual

Buy/sell shares at market close NAV

Shareholder accounting at the fund level can

be a significant expense

Low index license fees

Less tax efficient (selling shares  capital

gains taxes)

Cost associated with providing liquidity to

shareholders who are selling fund shares

Can NOT short

Buy/sell any time during trading day

No fund level shareholder accounting

Higher index license fees

Tax efficient due to in-kind redemption process (fewer taxable events)

Transaction costs for those buying/selling ETF but those holding shares have protection

Short trades allowed

Indexed institutional portfolios could be managed as separate or pooled accounts

Pooling means having multiple portfolios under the same management (cost effective but

performance management is more difficult)

Indexed institutional portfolios have very low cost compared to both conventional index mutual funds and exchange traded funds

How do we create an index portfolio? Do we replicate the entire index?

If index has less than 1000 stocks which are liquid  Full Replication

Otherwise use stratified sampling or optimization

Full replication is common for indices like S&P 500 Why?

Index return – portfolio return = sum of:

Stratified Sampling: Allows manager to build a portfolio that retains the basic

characteristics of the index without having to buy all stocks in the index

Define multiple dimensions

Identify weights for each cell

Randomly select/sample

Include based on weights

Industry A Industry B Industry C Industry D

More dimensions and finer divisions  closer replication Lower cost but higher tracking

error compared to full replication

Optimization is a mathematical approach to index fund creation involving the use of:

Takes into account covariances among factors

used to explain returns on stocks

Even the best models are likely to be imperfectly

specified

Even in the absence of index changes this method

requires periodic trading to keep risk of portfolio

aligned with risks of index

Predicted tracking error is often understated

Simplistically assumes factors are uncorrelated

Results compare well with those of optimization

Stock index futures are low cost vehicles for obtaining for obtaining equity

market exposure… must rollover to maintain long term

Portfolio trades (basket trades) are an alternative to index futures

Trade basket of stocks (i.e entire portfolio)

Do not have to roll over as with futures contracts

Trading can be cumbersome at least with short sales

Equity total return swaps are a relatively low cost way of obtaining long term exposure to

an equity market

Major applications:

1) Receive total return of non-domestic equity index in return for an interest payment to a

counterparty that holds underlying equities more tax efficiently

2) Use equity swaps to rebalance portfolios (actually trading securities might be more costly)

5 Active Equity Investing

5.1 Equity Styles

5.2 Socially Responsible Investing

5.3 Long-Short Investing

5.4 Sell Disciplines/Trading

5.1 Equity Styles

Value vs Growth

Market Capitalization

Value Investment Styles Buy stocks which are relatively cheap in terms of purchase price of earnings or assets

Most investors over-pay for glamour (growth) stocks… so avoid them; look for value in the so-glamorous stocks

not-Empirical studies show that value style may earn positive return premium relative to market

Main risk is to misinterpret a stock’s cheapness

Questions to ask:

Low P/E Contrarian: Look for stocks which are in trouble and selling at low P/Bs (less than 1) High Yield

Sub-

styles

Growth Investment Style

Buy stocks which high earnings growth

If earnings up and P/E stays the same  stock prices goes up

Growth stocks have high sales growth relative to the market and tend to trade at high P/Es,

P/Bs and P/Ss ratios

If stocks is trading at a premium, growth investor expects this premium to remain

Main risk is that growth does not materialize

Sub-styles:

Consistent Growth (Ex: Dell)

Earnings Momentum (Use relative strength indicators)

Other Active Management Styles

Market-oriented style falls between value and growth; buy if market value < intrinsic value

Sub-styles:

Market-oriented with value-bias

Market-oriented with growth-bias

Growth-at-a-reasonable price

Style rotators

Techniques for Identifying Investment Styles

Two major approaches to identifying style:

1) Returns-Based Style Analysis (RBSA)

2) Holdings-Based Style Analysis (also called composition-based style analysis)

Returns-Based Style Analysis (RBSA)

Regress portfolio returns on return series of a set of securities indices

Indices should be mutually exclusive and exhaustive and should have distinct sources

of risk (ideally should not be highly correlated)

Regression coefficients or betas should be non-negative and sum to 1

Rp = 0.75 x LCVI + 0 x LCGI + 0.25 x SCVI + 0 x SCGI + error

Are we meeting the constraints? What can we conclude?

Read Example 5

The regression R-squared (coefficient of determination) measures style fit

1 – style fit  variation not explained by style, referred to as ‘selection’

Holdings-based style analysis categorizes individual securities by their characteristics and

aggregates results to reach a conclusion about the overall style of the portfolio

An analyst may examine the following variables:

Example 8: Is the portfolio manager

following a value investment style?

A security may be assigned:

Equity Style Indices

How can we distinguish between value and growth No clear definition; however, trend is towards

using multiple variables: price, earnings, book value, dividends, growth rates, etc

Buffering: rules for maintaining previous style when stock has not clearly moved to new style

Style index publishers use growth and value either as categories (no overlap) or as quantities (with

overlap)

Excerpt from Exhibit 16 MCSI Index Family:

Holdings -Based Style Analysis

Example 9 Based and Holdings- Based Style Analysis

Returns-Interpret style analysis results from both

approaches

The Style Box

Style Drift Professional investors view inconsistency in style, or style drift, as an obstacle

to investment planning and risk control

Example 10 Style Drift or Not?

5.2 Socially Responsible Investing

SRI criteria may include:

Understand impact on portfolio’s financial characteristics

If you know the potential biases introduced by SRI, you can take appropriate actions

determine the appropriate benchmark

5.3 Long-Short Investing

• Style investing is concerned with portfolio characteristics,

long-short investing focuses on a constraint

• Pairs trade (long-short trade)

– Major risk stems from excessive leverage

• Price inefficiency on the short sale side… why?

– Many investors only look for undervalued stocks

– Management fraud, window dressing, negligence

– Bias towards ‘buy’ recommendations

– Sell-side analysts may be reluctant to issue negative opinions

Equitizing a Market-Neutral Long-Short Portfolio

Equitize a market-neutral long-short position by holding a permanent stock index futures

position (essentially you are giving equity market systematic risk exposure)

Notional principal on futures contract = cash position from shorting securities

With this strategy investor has three sources of return:

1) Return from long-short strategy

2) Gain on forward contract

3) Interest on cash position

Appropriate when investor wants to add an equity beta to the return

Note: in some markets ETFs may be a more attractive way than futures to equitize

The long-only constraint limits an investor’s ability to benefit from an extreme

negative view on a stock

Short extension strategies (partial long-short) strategies partially relax the

long-only constraint Example: 130/30 Short 30 and go long 130

Equitized long-short strategy Short extension strategy

Needs a liquid futures, swaps or ETF

market

Zero-beta  alternative investment

Does not need a liquid futures, swaps or ETF market

Appreciable increase in the proportion of

a manger’s investment insight that is incorporated in the portfolio

Gain market return and earn alpha from the same source

Substitute to long-only strategy (not an alternative investment!)

Read

5.4 Sell Disciplines/Trading

• Substitution: replace existing holding when another stock offers higher adjusted return

risk-• Rule based: Sell when a certain rule or criteria is met… for example a value

investor might sell if P/E comes back to historical level

• Implications of sell discipline need to be evaluated on a after-tax basis

• Value investors generally have relatively low turnover; they buy cheap

stocks hoping to reap relatively long term reward

6 Semiactive Equity Investing

• Also called “enhanced index” or “risk-controlled active”

• Variant of active management

• Outperform benchmark but keep tracking risk in control

– High information ratio

• Semiactive equity strategies come in two forms

Derivatives based (synthetic) Stock based

Exposure to desired equity market

through a derivative

Enhanced return through something

other than equity

Generate alpha through underpriced and overpriced stocks

Limit degree to which you will underweight or overweight

Fundamental Law of Active Management

IC = Information Coefficient  correlation between forecast return and actual return

Breadth  Number of independent, active investment decisions made each year

7 Managing a Portfolio of Managers

Exhibit 23

Manager Allocation by Active Risk Level

Exhibit 24

Pension Fund Manager Mix assuming active risk

of 1.51%

IR = 1.92 / 1.51 = 1.27

7.1 Core-Satellite

This is a core-satellite portfolio

Index and semi-active at the core

Ring of active managers around the core

Core-satellite portfolio can be constructed using the rigorous approach show on previous

slides or a much simpler approach show in Example 14

True/misfit distinction has two main uses:

Performance appraisal

Optimizing portfolio of managers

7.2 Completeness Fund

• The completeness fund is a simpler strategy to manage overall

portfolio risk and return

• A manager may want to incorporate specific views with respect

to the benchmark creating active return, however, the risk also

goes up

• The manager then identifies a basket or a number of trades

which complete the fund, i.e minimize the active risk of the

portfolio

7.3 Other Approaches: Alpha and Beta Separation

8 Identifying, Selecting and Contracting with Equity Portfolio Managers

• Developing a universe of suitable manager candidates

• The predictive power of past performance

Fee Structure

Ad Valorem Fees Performance-Based Fees

Percentage of assets under

management (AUM)

Also called AUM fees

0.6% of first $50 mil

0.4% above that

Simple and predictable

Typically a combination of base fee plus sharing percentage

0.2% of AUM plus 20% of performance in excess of benchmark

Can include features like:

Fee Cap High Water Mark Needs precise definition Call option to the investment manager

Equity Manager Questionnaire

9 Structuring Equity Research and Security Selection

• Top-down versus bottom up approaches

• Buy-side versus sell-side research

• Industry classification

Top Down and Bottom Up Analysis

Top Down: Country  Industry  Security Selection

Bottom Up: Focus on security selection