CFA 2018 level 3 schweser practice exam CFA 2018 level 3 question bank CFA 2018 CFA 2018 r25 equity portfolio management IFT notes

Approaches to Equity Investing This section addresses LO.b LO.b: Discuss the rationales for passive, active, and semi-active enhanced index equity investment approaches and distinguish

Equity Portfolio Management

1 Introduction 3

2 The Role of the Equity Portfolio 3

3 Approaches to Equity Investing 3

4 Passive Equity Investing 4

4.1 Equity Indexes 4

4.2 Passive Investment Vehicles 5

5 Active Equity Investing 8

5.1 Equity Styles 8

5.2 Socially Responsible Investing 11

5.3 Long–Short Investing 12

5.4 Sell Disciplines/Trading 13

6 Semi-Active Equity Investing 13

7 Managing a Portfolio of Managers 14

7.1 Core-Satellite 17

7.2 Completeness Fund 17

7.3 Other Approaches: Alpha and Beta Separation 17

8 Identifying Selecting and Contracting with Equity Portfolio Mangers 18

8.1 Developing a Universe of Suitable Manager Candidates 18

8.2 The Predictive Power of Past Performance 18

8.3 Fee Structures 18

8.4 The Equity Manager Questionnaire 19

9 Structuring Equity Research and Security Selection 19

Summary 20

Examples from the Curriculum 29

Example 1 A Problem of Benchmark Index Selection 29

Example 2 Passive Portfolio Construction Methods 32

Example 3 Same Stock, Different Opinions 33

Example 4 One Style or Two? 33

Example 5 The Choice of Indexes in Returns-Based Style Analysis 34

Example 6 Returns-Based Style Analysis (1) 35

Example 7 Returns-Based Style Analysis (2) 38

Example 8 Do Portfolio Characteristics Match the Stated Investment Style? 39

Example 9 Returns-Based and Holdings-Based Style Analyses 40

Example 10 Style Drift or Not? 41

Example 11 Long–Short and Market Structure 42

Example 12 Illustration of the Fundamental Law of Active Management 42

Example 13 Derivatives-Based versus Stock-Based Semiactive Strategies 43

Example 14 A Pension Fund’s Performance Objectives 43

Example 15 Equity Manager Questionnaire (Excerpt) 45

Example 16 A Fee Proposal 49

Example 17 Top Down or Bottom Up? 50

This document should be read in conjunction with the corresponding reading in the 2018 Level III CFA®

Program curriculum Some of the graphs, charts, tables, examples, and figures are copyright

2017, CFA Institute Reproduced and republished with permission from CFA Institute All rights reserved

Required disclaimer: CFA Institute does not endorse, promote, or warrant the accuracy or quality of the

products or services offered by IFT CFA Institute, CFA®, and Chartered Financial Analyst® are

trademarks owned by CFA Institute

1 Introduction

Equities represent a significant portion of the portfolio for many investors Hence, equity portfolio

management decisions are very important This reading brings together a lot of knowledge learnt at

Level I and Level II and applies it in a practical manner

2 The Role of the Equity Portfolio

This section addresses LO.a

LO.a: Discuss the role of equities in the overall portfolio

Equity as an asset class represents a significant source of wealth in the world today US equity markets

amount to about half of the world’s equity markets

Equity can be found in both individual and institutional portfolios For example, pension funds typically

allocate on average about 47% to equities

Investing internationally across multiple markets offers diversification benefits

It has been observed that as compared to bonds, equities offer superior protection against

unanticipated inflation This is because companies are able to pass on some of the inflation to customers

and their earnings tend to rise with inflation

Historical data suggests that equities have long term rates of return They therefore play an important

role in the portfolio

3 Approaches to Equity Investing

This section addresses LO.b

LO.b: Discuss the rationales for passive, active, and semi-active (enhanced index) equity investment

approaches and distinguish among those approaches with respect to expected active return and

tracking risk

Passive Management

In passive management, investors do not change their security holdings even if their outlook changes

They assume that in general the equity market is efficient, hence indexing is the best strategy They

simply invest in a portfolio that attempts to match the performance of a benchmark index However, it

is important to note that this approach is not completely passive because the portfolio needs to change

when the index is reconstituted or when the weight of a stock in the index changes

Active Management

Active managers try to outperform the benchmark portfolio by investing in underpriced securities and

avoiding (or shorting) overpriced securities Although passive management is gaining popularity, active

management continues to be the dominant management style

Semiactive Management

This approach is also called enhanced indexing or risk-controlled active management It is a variant of

active management Here the manager tries to outperform benchmark but at the same time also tries to

keep tracking risk in control

Comparison

Refer to Exhibit 3, which shows a comparison of the three approaches Typically the enhanced indexing

approach tends to have the highest information ratio

Indexing Enhanced Indexing Active

Expected active return (excess return over

Tracking risk (standard deviation of active

LO.c: Recommend an equity investment approach when given an investor’s investment policy

statement and beliefs concerning market efficiency

While several variables need to be considered in making a decision about the appropriate investment

approach, the most important factor is the investor’s view on market efficiency If the investor

believes that markets are efficient, then a passive management strategy should be employed On the

other hand if the investor believes that there are inefficiencies in the market which can be exploited

then an active management strategy is preferable

4 Passive Equity Investing

According to William Sharpe:

 before accounting for transaction costs, the return on the average actively managed dollar will

equal the return on the average passively managed dollar; and

 after accounting for transaction costs, the return on the average actively managed dollar will be

less than the return on the average passively managed dollar

Therefore it makes sense to purse passive equity investing strategies

4.1 Equity Indexes

A stock index’s characteristics are determined by four choices:

1 Boundaries of stock index’s universe: Broader universe will measure overall market

performance Narrower universe will measure performance of only a specific group of stocks

2 Criteria for inclusion: Defines the requirements that a company must satisfy to be included in

(includes dividends)

LO.d: Distinguish among the predominant weighting schemes used in the construction of major

equity market indexes and evaluate the biases of each

Price weighted:

 Here each stock is weighted according to absolute share price

 The index is biased towards the highest price share

 The performance of the index represents the performance of a portfolio that simply bought and

held one share of each index component

 It is simple to construct The index is the sum of the share prices divided by the number of

shares

 The DJIA is the most prominent example of a price weighted index

Value weighted:

 Here each stock is weighted according to its market cap

 A sub category is float-weighted index, where the market cap is adjusted to reflect the number

of shares that are actually available to investors For example, if a large portion of shares is held

by promoters and is not available for trading then, it will be excluded in the free float market

 Here all stocks are weighted equally

 The index has a small company bias, because it includes many more small companies

 It requires frequent rebalancing because varying stock returns will cause stock weights to drift

from the calculated equal weights

Refer to Example 1 from the curriculum

4.2 Passive Investment Vehicles

This section addresses LO.e

LO.e: Compare alternative methods for establishing passive exposure to an equity market, including

indexed separate or pooled accounts, index mutual funds, exchange-traded funds, equity index

futures, and equity total return swaps

The main choices available for passive investment vehicles are:

1 Indexed portfolios

2 Equity index futures

3 Equity total return swaps

Indexed Portfolio

The main categories of indexed portfolios are:

 conventional index mutual funds

 exchange-traded funds (ETFs)

 separate accounts or pooled accounts

The following table shows a comparison between a conventional index mutual fund and an exchange

traded fund

Conventional (Open End) Index Mutual

Funds

Buy/sell shares at market close at NAV Buy/sell any time during trading day ETF

Shareholder accounting at the fund level

can be a significant expense

No fund level shareholder accounting ETF

Less tax efficient (because selling shares

results in higher capital gains taxes)

More tax efficient (because in-kind redemption process results in fewer taxable events)

ETF

Cost associated with providing liquidity to

shareholders who are selling fund shares

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

ETF

Separate accounts or pooled accounts

Generally, indexed institutional portfolios are managed as separate or pooled accounts (having multiple

portfolios under the same management) When a portfolio is large – as is the case with institutional

portfolios – the use of separate or pooled accounts is more cost effective compared to both

conventional index mutual funds and exchange traded funds

Equity index futures

 These are low cost vehicles for obtaining equity market exposure

 However they have finite lives, and must be rolled over to maintain a long term position

 In a portfolio trade, a basket of stocks are traded together

 However, a basket cannot be shorted if any of the components violate the uptick rule This

makes trading cumbersome

 Because of these reasons ETFs are more popular compared to index futures

Equity total return swaps

 They are a relatively low cost way of obtaining long term exposure to an equity market

 They major applications are:

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

a counterparty that holds underlying equities more tax efficiently

o Use equity swaps to rebalance portfolios because trading securities might be more

costly

Approaches to creating a indexed portfolio

This section addresses LO.f

LO.f: Compare full replication, stratified sampling, and optimization as approaches to constructing

an indexed portfolio and recommend an approach when given a description of the investment

vehicle and the index to be tracked

Full replication

 All stocks in the index are included in the portfolio

 The advantages are that the tracking risk is low and the portfolio only needs to be rebalanced

when the index constituents change

 The portfolio return is lower than index return due to:

o Administrative fees

o Transaction costs

o Cash drag

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

 Process

o A matrix is created using two or more dimensions

o The index stocks are placed in different cells of the matrix according to their

characteristics

o The weights of each cell is calculated

o Random sample are drawn from each cell and the samples are included in the index

based on the calculated weights

 Compared to full replication it has lower costs but higher tracking error

Optimization

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

o a multifactor risk model, against which the risk exposures of the index and individual

securities are measured, and

o an objective function that specifies that securities be held in proportions that minimize

expected tracking risk relative to the index subject to appropriate constraints

 It has lower tracking risk than stratified sampling

 The drawbacks are:

o Even the best models can be imperfectly specified

o There can be false signals due to overfitting of data

o Even in the absence of index changes and dividend flows, optimization requires periodic

trading to keep the risk characteristics of the portfolio aligned with the risk

characteristics of the index being tracked

Refer to Example 2 from the curriculum

5 Active Equity Investing

5.1 Equity Styles

Refer to Example 3 from the curriculum

This section addresses LO.g and LO.h

LO.g: Explain and justify the use of equity investment–style classifications and discuss the difficulties

in applying style definitions consistently

LO.h: Explain the rationales and primary concerns of value investors and growth investors and

discuss the key risks of each investment style

5.1.1 Value investment style

 Here the focus is to buy stocks that are relatively cheap in terms of purchase price of earnings or

assets

 The belief is that most investors over-pay for glamor (growth) stocks So it is best to avoid them

and look for value in the not-so-glamorous stocks

 Empirical studies show that value style may earn positive return premium relative to market

 The main risk of this strategy is that a stock’s cheapness can be misinterpreted A stock may be

cheap because of a good reason, and a value investor may fail to factor this reason

 The main sub styles are:

o Low price multiple

o High dividend yield

o Contrarian: Look for stocks which are in trouble and selling at low P/B

5.1.2 Growth Investment style

 Here the focus is to buy stocks which have high earnings growth

 The belief is that if earnings go up and P/E stays the same, then stock prices will go 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 a stock is trading at a premium, growth investors expects this premium to remain

 The main risk for a growth investor is that the expected growth does not materialize

 The main sub styles are:

o Consistent growth: Historical record of growth that is expected to continue in future

o Earnings momentum: Hold the stock as long as the momentum in earnings continues

and sell when the momentum breaks

5.1.3 Other active management styles

Market oriented style

 This style falls between value and growth An investor will buy a stock if the market value is less

than intrinsic value

 The sub styles are:

o Market-oriented with value-bias

o Market-oriented with growth-bias

o Growth-at-a-reasonable price

o Style rotators: Adopt a style that is expected to work in the near future

Market capitalization based style

 Small cap investors believe that smaller firms tend to be underpriced as compared to intensely

researched large cap stocks

 Mid cap investors believe that mid-caps are less researched than large caps and are less risky

than small caps

 Large cap investors favor the relative stability of large companies

Refer to Example 4 from the curriculum

5.1.4 Techniques for identifying Investment Styles

This section addresses LO.i

LO.i: Compare techniques for identifying investment styles and characterize the style of an investor

when given a description of the investor’s security selection method, details on the investor’s

security holdings, or the results of a returns-based style analysis

Two major approaches are:

Returns-Based Style Analysis (RBSA)

 Focus on characteristics of overall portfolio as revealed by portfolio’s realized returns

 Regress the portfolio returns against the return series of a set of security indexes

 The indexes should be 1) mutually exclusive, 2) exhaustive with respect to manager’s

investment universe, and 3) should have distinct sources of risk (ideally should not be highly

correlated)

 The regression coefficients or betas should be non-negative and sum to 1

 For example, Rp = 0.75 x LCVI + 0 x LCGI + 0.25 x SCVI + 0 x SCGI

Here the portfolio had a beta of 0.75 on a large-cap value index (LCVI), a beta of 0 on a large-cap

growth index (LCGI), a beta of 0.25 on a small-stock value index (SCVI), and a beta of 0 on a

small-stock growth index (SCGI) We could infer that the portfolio was run as a value portfolio

with some exposure to small stocks

Refer to Example 5 from the curriculum

Refer to Example 6 from the curriculum

Refer to Example 7 from the curriculum

Holdings-Based Style Analysis

 Here we categorize individual securities by their characteristics and aggregate results to reach a

conclusion about the overall style of the portfolio

 An analyst may examine the following variables:

o Valuation levels: A value oriented portfolio will have companies with low P/E, P/B ratios

o Forecast EPS growth rate: A growth oriented portfolio will have companies with high

forecasted EPS growth rate

o Earnings variability: A value-oriented portfolio will hold companies with greater earnings

variability because of the willingness to hold companies with cyclical earnings

o Industry sector weighting: Growth oriented portfolios tend to have higher weights for

industries such as IT and healthcare Value oriented portfolios tend to have higher weights for industries such as finance and utilities

Refer to Example 8 from the curriculum

Refer to Exhibit 15 which summarizes the advantages and disadvantages of the two approaches

Exhibit 15 Two Approaches to Style Analysis: Advantages and Disadvantages

Returns-based

style analysis

 Characterizes entire portfolio

 Facilitates comparisons of portfolios

 Aggregates the effect of the investment process

 Different models usually give broadly similar results and portfolio characterizations

 Clear theoretical basis for portfolio categorization

 Requires minimal information

 Can be executed quickly

Holdings-based style

analysis

 Characterizes each position

 Facilitates comparisons of individual positions

 In looking at present, may capture changes in style more quickly than returns-based analysis

 Does not reflect the way many portfolio managers approach security selection

 Requires specification of classification attributes for style; different

specifications may give different results

 More data intensive than based analysis

returns-5.1.5 Equity Style Indexes

This section addresses LO.j

LO.j: Compare the methodologies used to construct equity style indexes

A security may be assigned:

 to value exclusively or to growth exclusively in all instances;

 to value exclusively or to growth exclusively but only if the value of some characteristic exceeds

or is less than a specified threshold value; or

 in part to growth and in part to value

There is no clear definition available to distinguish between value and growth However, the trend is

towards using multiple variables – price, earnings, book value, dividends, growth rates, etc – in deciding

how to categorize a stock

Buffering refers to rules for maintaining the previous style assignment when the stock has not clearly

moved to a new style It reduces turnover in style classification and therefore reduces transaction

expenses

Refer to Example 9 from the curriculum

The following sections addresses LO.k

LO.k: Interpret the results of an equity style box analysis and discuss the consequences of style drift

5.1.6 The Style Box

The style box is a popular method of characterising a portfolio’s style The most widely recognized

version of the style box is the Morningstar style box

Refer to Exhibit 18 which shows the Morningstar style box for Vanguard Mid-cap growth fund As shown

most of the fund’s holdings are midcap growth stocks

Value Blend Growth

5.1.7 Style Drift

Style drift occurs when a portfolio manager deviates from his original stated style objective Professional

investors view inconsistency in style, or style drift, as an obstacle to investment planning and risk control

because:

 Investor does not get the desired exposure to a particular style

 The manager may be operating in an area outside his expertise

Refer to Example 10 from the curriculum

5.2 Socially Responsible Investing

This section addresses LO.l

LO.l: Distinguish between positive and negative screens involving socially responsible investing

criteria and discuss their potential effects on a portfolio’s style characteristics

Socially responsible investing (SRI), also called ethical investing, integrates ethical values and societal

concerns with investment decisions SRI criteria may include:

 industry classification, reflecting concern for sources of revenue judged to be ethically

questionable (tobacco, gaming, alcohol, and armaments are common focuses); and

 corporate practices (for example, practices relating to environmental pollution, human rights,

labor standards, animal welfare, and integrity in corporate governance)

The screens may be negative, for example where an investor refuses to invest in an alcohol, tobacco or

armaments company Or the screens may be positive, for example where an investor only wishes to

invest in companies that have good corporate practices

Analyst should understand the impact of an SRI criteria 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

This section addresses LO.m

LO.m: Compare long–short and long-only investment strategies, including their risks and potential

alphas, and explain why greater pricing inefficiency may exist on the short side of the market

This style focuses on exploiting the constraint that many investors face related to short sales The belief

is that since many investors cannot take short positions, stocks may become overvalued

Pair’s Trade

 Here an investor goes long an undervalued stock and goes short an overvalued stock from the

same industry

 The major risk comes from the use of excessive leverage, which can magnify losses

Price Inefficiency on the Short Side

The reasons for price inefficiencies can be:

 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

LO.n: Explain how a market-neutral portfolio can be “equitized” to gain equity market exposure and

compare equitized market-neutral and short-extension portfolios

A market-neutral long–short portfolio has no market exposure In other words the market beta is 0

Such a portfolio can be equitized (given equity market exposure) by taking a long position in equity

futures contracts This is an appropriate strategy when an investor wants to add an equity beta to the

return It is important to note that, in some markets ETF’s may be a more attractive way than futures to

equitize This is because futures contracts are short-term and need to be rolled over frequently This can

be costly

The Long-Only Constraint

The long-only constraint limits an investor’s ability to benefit from an extreme negative view on a stock

The most that the investor can do is reduce his weightage to 0 Thus, long-short strategies have an

advantage over long-only portfolios

Short Extension Strategies

Such strategies partially relax the long-only constraint by specifying the level of short selling allowed For

example 130/30 means an investor can short 30% of the portfolio value and use the proceeds to go long

on 130% of the portfolio value Refer to the table below for a comparison between an equitized

long-short strategy and a long-short extension strategy

Equitized long-short strategy Short extension strategy

Needs a liquid futures, swaps or ETF

market

Does not need a liquid futures, swaps or ETF market

It has zero beta and hence is

considered an alternative investment

It is a substitute to a long-only strategy and not considered an alternative investment

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

Refer to Example 11 from the curriculum

5.4 Sell Disciplines/Trading

This section addresses LO.o

LO.o: Compare the sell disciplines of active investors

An investor may need to sell stocks to rebalance or to raise cash The use of various strategies can help

the investor decide when to sell

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

Rule based: Sell when a certain rule or criteria is met For example a value investor might sell if the P/E

ratio rises above a certain level

Implications of sell discipline need to be evaluated on an after-tax basis Value investors generally have

relatively low turnover; they buy cheap stocks hoping to reap relatively long term reward

6 Semi-Active Equity Investing

This section addresses LO.p

LO.p: Contrast derivatives-based and stock-based enhanced indexing strategies and justify

enhanced indexing on the basis of risk control and the information ratio

This is a variant of active management and is also called ‘enhanced index’ or ‘risk controlled active’ In

this approach the manager tries to outperform the benchmark but also keeps tracking risk in control As

shown earlier in Exhibit 3, enhanced indexing strategies tend to have the highest information ratio

Semiactive equity strategies come in two forms:

Derivatives based

 Here the manager obtains exposure to the desired equity market through a derivative

 The enhanced return is obtained through something other than equity

 For example, if a manager is equitizing cash i.e holding cash and an long position in an equity

futures contract, then he can enhance his returns by altering the duration of the underlying

cash If the yield curve is upward sloping, he would invest in 3 year notes instead of 90 day bills

to get additional returns

Stock based

 Here the manager tries to generate alpha by identifying stocks that are underpriced or

overpriced

 If manager has no opinion on a stock then it will be kept at benchmark weight

 Risk is controlled by limiting the degree to which a stock can be underweighted or

overweighted

Fundamental law of active management

The fundamental law of active management states that an investor’s investment ratio (IR) is equal to

what he knows about a given investment (the information coefficient, IC) multiplied by the square root

of the number of investment decisions made each year (Breadth)

IR = IC√Breadth

The IC is measured by comparing the investor’s forecast against the actual outcomes Skillful managers

have higher IC The narrower an investor’s breadth, the greater the IC must be to produce a good

information ratio

Refer to Example 12 from the curriculum

Refer to Example 13 from the curriculum

7 Managing a Portfolio of Managers

This section addresses LO.q

LO.q: Recommend and justify, in a risk-return framework, the optimal portfolio allocations to a

group of investment managers

To allocate funds to equity an investor needs to choose between passive management and active

management As we move from passive management to active management, the expected active return

and active risk increases The combination of equity mangers that will maximize the active returns for a

given level of active risk (determined by the investor’s level of aversion to active risk) is obtained by the

following objective function

Maximize (by choice of managers) UA = rA− λ𝐴σA2

where,

UA = expected utility of the active return of the manager mix

rA= expected active return of the manager mix

λ𝐴 = the investor’s trade-off between active risk and active return; measures risk aversion in active risk

terms

σ𝐴2 = variance of the active return

Consider a hypothetical case where the performance of available managers is shown in Exhibit 21

Expected Active Return Expected Tracking Risk

Using the values in the above table, we can generate the following efficient frontier (Exhibit 22)

We can also generate the following waterfall chart (Exhibit 23) that shows the manager mix for each

level of active risk

Now, given a level of active risk, we can choose a manager mix that will maximize active returns For

example, for an active risk of 1.51%, the manger allocation is shown below (Exhibit 24)

Based on the efficient frontier graph in Exhibit 22, an active risk of 1.51 corresponds to an active return

of 1.92% This means the information ratio (IR) = 1.92 / 1.51 = 1.27

The portfolio active return and risk can also be calculated using the following formulae:

Portfolio active return = ∑ hAirAi

n

i=1Where,

ℎ𝐴𝑖= weight assigned to the ith manager

𝑟𝐴𝑖= active return of the ith manager

Portfolio active risk = √∑ hAi2 σAi2

n

i=1

Where,

h Ai = the weight assigned to the ith manager

σAi = the active risk of the ith manager

This following sections addresses LO.r

LO.r: Explain the core-satellite approach to portfolio construction and discuss the advantages and

disadvantages of adding a completeness fund to control overall risk exposures

7.1 Core-Satellite

In a core-satellite approach, majority of the funds are allocated to index or semi-active mangers (core)

and the remaining funds are allocated to a ring of active managers around the core (satellites)

The allocation shown earlier (Exhibit 24) is an example of core satellite allocation

The core minimizes active risk, whereas the satellites add active returns using smaller portions of the

portfolio

Refer to Example 14 from the curriculum

LO.s: Distinguish among the components of total active return (“true” active return and “misfit”

active return) and their associated risk measures and explain their relevance for evaluating a

portfolio of managers

To evaluate managers, we need to divide their total active returns into two components

1 Manager’s return − Manager’s normal benchmark = Manager’s “true” active return

2 Manager’s normal benchmark − Investor’s benchmark = Manager’s “misfit” active return

The manger’s total active risk can be calculated as:

Manager’s total active risk = [(Manager’s “true” active risk)2

+ (Manager’s “misfit” active risk)2]½

This distinction between ‘true’ active risk and ‘misfit’ active risk is useful for:

 Performance appraisal of the managers

 Optimizing a portfolio of managers

7.2 Completeness Fund

A completeness fund is similar to core-satellite approach However, here we first start with a group of

active managers We then add a completeness fund This is done by identifying 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

This section addresses LO.t

LO.t: Explain alpha and beta separation as an approach to active management and demonstrate the

use of portable alpha

In this approach beta exposure is obtained thorough an inexpensive index fund manager To get alpha

exposure, the investor can explicitly hire a market neutral long-short manager

The advantage of this approach is that alpha and beta returns can be generated from different markets

For example, the investor might want to get beta returns on a relatively efficient part of the equity

market (e.g Russel Top 200) and the alpha returns can be generated from asset classes even outside the

beta asset class (e.g a long-short portfolio of Japanese equity) This is also called portable alpha

8 Identifying Selecting and Contracting with Equity Portfolio Mangers

This section addresses LO.u

LO.u: Describe the process of identifying, selecting, and contracting with equity managers

The following sections address some of the issues that investors will face in identifying, selecting, and

contracting with equity managers

8.1 Developing a Universe of Suitable Manager Candidates

Typically investment consultants are used to identify suitable managers They start with a general

evaluation of a large number of managers Managers that seem good are then researched and

monitored further

Consultants use both qualitative and quantitative factors in evaluating investment managers Qualitative

factors include the people and organizational structure, the firm’s investment philosophy, the

decision-making process, and the strength of its equity research Quantitative factors include performance

comparisons with benchmarks and peer groups

8.2 The Predictive Power of Past Performance

Past performance is no guarantee of future results Managers who were top performers in the past, may

not be top performers in future However, past performance can still be useful For example, an active

manager who has consistently failed to beat his benchmark is unlikely to be considered a good active

manager

8.3 Fee Structures

Ad Valorem Fees

Ad valorem fees are calculated as a percentage of assets under management They are also called AUM

fees Example: 0.60 percent on the first £50 million, and 0.45 percent on assets above £50 million The

advantage of ad valorem fees are that they are simple and predictable The disadvantage is that they do

not align the interests of the manger and the investor

Performance Based Fees

This is typically a combination of a base fee plus a sharing percentage For example, 0.2% of AUM plus

20% of performance in excess of benchmark They can also include features like:

 Fee cap – Limits the total fees paid

 High watermark – Fees will be paid only if performance exceeds previous highest performance

The advantage is that they align the interests of investors and managers

The disadvantage of performance based fees are:

 They are complicated and require precise definition

 They are like a call option to a manger and encourage taking unnecessary risk

8.4 The Equity Manager Questionnaire

A questionnaire can be used to compare different potential mangers If the response to the

questionnaire is good, then the manager can be evaluated further A typical equity manager

questionnaire examines five key areas:

Refer to Example 15 from the curriculum

Refer to Example 16 from the curriculum

9 Structuring Equity Research and Security Selection

Top-Down versus Bottom-Up Approaches

This section addresses LO.v

LO.v: Contrast the top-down and bottom-up approaches to equity research

Top-down approach

In a top-down approach we start with country analysis then move down to industry and then to specific

securities

In top-down analysis an investor may hope to find:

1 themes affecting the global economy;

2 the effect of those themes on various economic sectors and industries;

3 any special country or currency considerations; and

4 individual stocks within the industries or economic sectors that are likely to benefit most from

the global themes

Bottom-up approach

In a bottom-up approach we start at the individual stock level, the focus is on security selection

The usual steps followed are:

1 identifying factors with which to screen the investment universe (e.g., stocks in the lowest P/E

quartile that also have expected above-median earnings growth);

2 collecting further financial information on companies passing the screen; and

3 identifying companies from this subset that may be potential investments based on other

company-specific criteria

Refer to Example 17 from the curriculum

Buy-Side versus Sell-Side Research

Buy-Side

 This is research with the intent of assembling a portfolio They may also use sell-side research

 The buy/sell decisions are generally made by a committee

 This research is generally inaccessible to outsiders

Sell-side

 This is research conducted by independent researchers who sell their work or investment

banks/brokerage firms which use research as a means to generate business

 Sell-side research is easily available to the general public

Industry Classification

Equity research is usually conducted as per industry/sector Hence it is important to have a system that

classifies similar companies into similar categories

The Global Industry Classification Standard (GICS) developed by Standard and Poor’s and MCSI divides

stocks into:

 10 Sectors (Consumer Discretionary, Consumer Staples, Energy, Financials, Health Care,

Industrials, Information Technology, Materials, Telecommunication, and Utilities);

 24 Industry Groups;

 68 Industries;

 154 Sub-Industries

Summary

a discuss the role of equities in the overall portfolio;

 Equity represents a significant source of wealth

 Equity can be found in both individual and institutional portfolios

 Equities offer superior protection against unanticipated inflation

 Equities have provided high returns over the long term relative to other asset classes

b discuss the rationales for passive, active, and semi-active (enhanced index) equity investment

approaches and distinguish among those approaches with respect to expected active return and

involves investing in underpriced securities to beat the market

3) Semi-active or enhanced indexing assumes that markets offer opportunities to achieve a positive

information ratio with limited risk relative to a benchmark It has two objectives, i) to outperform

benchmark and ii) to keep tracking risk in control

Indexing Enhanced Indexing Active

Expected active return (excess return over

benchmark)

Tracking risk (standard deviation of active returns) < 1% 1% – 2% 4%+

c recommend an equity investment approach when given an investor’s investment policy statement

and beliefs concerning market efficiency;

The most important factor in determining the appropriate investment approach is the investor’s view on

market efficiency

 If the investor believes that markets are efficient, then a passive management strategy should be

employed

 On the other hand, if the investor believes that there are inefficiencies in the market which can be

exploited then an active management strategy is preferable

d distinguish among the predominant weighting schemes used in the construction of major equity

market indexes and evaluate the biases of each;

Price weighted:

 Each stock is weighted according to absolute share price

 The index is biased towards the highest price share

 The performance of the index represents the performance of a portfolio that simply bought and

held one share of each index component

 It is simple to construct The index is the sum of the share prices divided by the number of

shares

 The DJIA is the most prominent example of a price weighted index

Value weighted:

 Each stock is weighted according to its market cap; sub category is float-weighted index

 The index is biased towards large companies that have high market-cap and towards overvalued

stocks

Equal weighted:

 All stocks are weighted equally

 The index has a small company bias, because it includes many more small companies

 It requires frequent rebalancing because varying stock returns will cause stock weights to drift

from the calculated equal weights

e compare alternative methods for establishing passive exposure to an equity market, including indexed

separate or pooled accounts, index mutual funds, exchange-traded funds, equity index futures, and

equity total return swaps;

The main choices available for passive investment vehicles are:

1 Indexed portfolios

2 Equity index futures

3 Equity total return swaps

Indexed Portfolios

The main categories of indexed portfolios are:

 conventional index mutual funds

 exchange-traded funds (ETFs)

 separate accounts or pooled accounts: When a portfolio is large, the use of separate or pooled

accounts is more cost effective compared to both conventional index mutual funds and exchange

traded funds

Conventional (Open End) Index Mutual Funds Exchange Traded Funds

Buy/sell shares at market close at NAV Buy/sell any time during trading day

Shareholder accounting at the fund level can be a

significant expense

No fund level shareholder accounting

Less tax efficient (because selling shares results in

higher capital gains taxes)

More tax efficient (because in-kind redemption process results in fewer taxable events)

Cost associated with providing liquidity to

shareholders who are selling fund shares

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

Equity index futures

 These are low cost vehicles for obtaining equity market exposure

 They have finite lives, and must be rolled over to maintain a long term position

 In a portfolio trade, a basket of stocks is traded together

 A basket cannot be shorted if any of the components violate the uptick rule This makes trading

cumbersome

 Because of these reasons ETFs are more popular compared to index futures

Equity total return swaps

 They are a relatively low cost way of obtaining long term exposure to an equity market

 The major applications are:

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

counterparty that holds underlying equities more tax efficiently

o Use equity swaps to rebalance portfolios because trading securities might be costlier

f compare full replication, stratified sampling, and optimization as approaches to constructing an

indexed portfolio and recommend an approach when given a description of the investment vehicle and

the index to be tracked;

Full replication: all stocks in the index are included in the portfolio

 Tracking risk is low and the portfolio only needs to be rebalanced when the index constituents

change

 The portfolio return is lower than index return due to: administrative fee, transaction costs, cash

drag

Stratified sampling: retain basic characteristics of the index without having to buy all stocks in the index

 Compared to full replication it has lower transaction costs but higher tracking error

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

model

Process

 Risk exposures of the index and individual securities are measured

 An objective function that specifies that securities and weights that minimize expected tracking

risk

Advantage:

o Lower tracking risk than stratified sampling

Drawbacks:

o Even the best models can be imperfectly specified

o There can be false signals due to overfitting of data

o Even in the absence of index changes and dividend flows, optimization requires periodic trading

to keep the risk characteristics of the portfolio aligned with the risk characteristics of the index

being tracked

g explain and justify the use of equity investment–style classifications and discuss the difficulties in

applying style definitions consistently;

h explain the rationales and primary concerns of value investors and growth investors and discuss the

key risks of each investment style;

Value investment style: buy stocks that are relatively cheap in terms of purchase price of earnings or

assets i.e stocks with low P/E or P/B ratios

 The belief is that most investors over-pay for glamor (growth) stocks So it is best to avoid them and

look for value in the not-so-glamorous stocks

 Empirical studies show that value style may earn positive return premium relative to market

 The main risk of this strategy is that a stock’s cheapness can be misinterpreted A stock may be

cheap because of a good reason, and a value investor may fail to factor this reason

 The main sub styles are: low price multiple, high dividend yield, contrarian (low price to book)

Growth investment style: buy stocks which have high earnings growth

 The belief is that if earnings go up and P/E stays the same, then stock prices will go 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 a stock is trading at a premium, growth investors expects this premium to remain

 The main risk for a growth investor is that the expected growth does not materialize

 The main sub styles are: consistent growth, earnings momentum

Market oriented style falls between value and growth; buy if the market value is less than intrinsic

value

Market capitalization based style: favor stocks based on market capitalization

i compare techniques for identifying investment styles and characterize the style of an investor when

given a description of the investor’s security selection method, details on the investor’s security

holdings, or the results of a returns-based style analysis;

Techniques for identify investment styles:

Returns-Based Style Analysis (RBSA)

 Focus on characteristics of overall portfolio as revealed by portfolio’s realized returns

 Regress the portfolio returns against the return series of a set of security indexes

 The indexes should be 1) mutually exclusive, 2) exhaustive with respect to manager’s investment

universe, and 3) should have distinct sources of risk

 The regression coefficients or betas should be non-negative and sum to 1

Holdings-Based Style Analysis

 Here we categorize individual securities by their characteristics and aggregate results to reach a

conclusion about the overall style of the portfolio

 An analyst may examine the following variables:

 Valuation levels: A value oriented portfolio will have companies with low P/E, P/B ratios

 Forecast EPS growth rate: A growth oriented portfolio will have companies with high forecasted

EPS growth rate

 Earnings variability: A value-oriented portfolio will hold companies with greater earnings

variability because of the willingness to hold companies with cyclical earnings

 Industry sector weighting: Growth oriented portfolios tend to have higher weights for industries

such as IT and healthcare Value oriented portfolios tend to have higher weights for industries

such as finance and utilities

Returns-based style

analysis

 Characterizes entire portfolio

 Facilitates comparisons of portfolios

 Aggregates the effect of the investment process

 Different models usually give broadly similar results

and portfolio characterizations

 Clear theoretical basis for portfolio categorization

 Requires minimal information

 Can be executed quickly; cost effective

 May be ineffective in

characterizing current style

 Error in specifying indexes

in the model may lead to inaccurate conclusions

Holdings-based style

analysis

 Characterizes each position

 Facilitates comparisons of individual positions

 In looking at present, may capture changes in style

more quickly than returns-based analysis

 Does not reflect the way many portfolio managers approach security selection

 Requires specification of classification attributes for style; different

specifications may give different results

 More data intensive than

returns-based analysis

j compare the methodologies used to construct equity style indexes;

Methodologies to construct indexes:

A security may be assigned:

 to value exclusively or to growth exclusively in all instances

 to value exclusively or to growth exclusively but only if the value of some characteristic exceeds

or is less than a specified threshold value

 in part to growth and in part to value

k interpret the results of an equity style box analysis and discuss the consequences of style drift;

The style box is a popular method of characterising a portfolio’s style The most widely recognized

version of the style box is the Morningstar style box

Morningstar Style Box for Vanguard Mid-Cap Growth Fund

Style drift occurs when a portfolio manager deviates from his original stated style objective Professional

investors view inconsistency in style, or style drift, as an obstacle to investment planning and risk control

because:

 Investor does not get the desired exposure to a particular style

 The manager may be operating in an area outside his expertise

l distinguish between positive and negative screens involving socially responsible investing criteria and

discuss their potential effects on a portfolio’s style characteristics;

Socially responsible investing (SRI), also called ethical investing, integrates ethical values and social

concerns with investment decisions