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

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 supe

Level III

Equity Portfolio Management

Summary

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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

Passive, active and semiactive approaches

• Passive Management: Equity market is efficient  indexing is the best strategy

– Lower turnover, lower transaction costs and lower taxes relative to active management

• Active Management: Outperform benchmark portfolio by investing in underpriced securities

• Semiactive Management

– Also called enhanced indexing or risk-controlled active management

– Variant of active management

– Outperform benchmark but keep tracking risk in control

On average active management will give the same return as passive management; but active

Passive investment vehicles

1) indexed portfolios, 2) equity index futures and 3) equity total return swaps

Indexed portfolio categories

Conventional index mutual funds, exchange-traded funds (ETFs) and separate accounts or pooled accounts

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

Low index license fees Higher index license fees

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

Short trades not allowed Short trades allowed

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

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 are 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

 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

Passive investment vehicles

Approaches to creating a indexed portfolio

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

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

o 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

o 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

o Risk exposures of the index and individual securities are measured

o 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

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

Index weighting choices

Value investment style: 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: 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 a if the market value is less than intrinsic value

Market capitalization based style: favor stocks based on market capitalization

Investment styles

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 indices

 The indices 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:

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

Advantages 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; cost effective

 May be ineffective in characterizing current style

 Error in specifying indices 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

Methodologies to construct indices

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

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

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

Morningstar Style Box for Vanguard Mid-Cap Growth Fund

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

Negative screen example: investor refuses to invest in an alcohol, tobacco or armaments company

Positive screen example: investor only wishes to invest in companies that have good corporate practices

Long-short investing: exploit 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: long an undervalued stock and short an overvalued stock from the same industry

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

Investment strategies

Equitized long-short strategy: Market-neutral portfolio can be equitized (given equity market exposure) by

taking a long position in equity futures contracts Appropriate when investor wants to add an equity beta to

skill-based active returns from a short investment manager Overall return: active return from

long-short portfolio + gain/loss from futures position + interest on cash from long-shorting securities

Short extension strategy: Long-only constraint limits an investor’s ability to benefit from an extreme

negative view on a stock Extension 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 Advantages:

• Does not need a liquid futures, swaps or ETF market

• 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

Investment strategies

Strategies for 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 and after-transaction cost basis

Semi-active equity strategies

Derivatives based

 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

 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

Strategies can be compared using the information ratio

IR = Active Return / Active Risk ≈ IC Breadth

Optimal portfolio allocations to a group of investment managers

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

Manager selection

• Develop universe of suitable manager candidates

• Study past results

• Evaluate investment process and strength of manager’s organization

• Evaluate fee structure (ad valorem fees, performance fees)

Active risk and return

Portfolio active return = hAirAi

n

i=1

Portfolio active risk = hAi2 σAi2

n

i=1

Information ratio = active risk / active return

True active return = Manager’s return − Manager’s normal benchmark

Misfit return = Manager’s normal benchmark − Investor’s benchmark

Manager’s total active risk = *(Manager’s “true” active risk)2 + (Manager’s “misfit” active risk)2]½

Where,

h Ai = the weight assigned to the ith manager

σAi = the active risk of the ith manager

Assuming no correlation between active returns