THE ROLES OF EQUITIES IN A PORTFOLIO Equity investments offer many benefits such as: • capital appreciation • dividend income • diversification • inflation hedging 2.1 Capital Appreciat
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Equities typically cover a sizable portion of an investor’s
portfolio Ownership interest, growth prospects and
investment opportunities in various businesses make
equities attractive to investors Publicly traded securities are considered more liquid than other asset classes
2 THE ROLES OF EQUITIES IN A PORTFOLIO
Equity investments offer many benefits such as:
• capital appreciation
• dividend income
• diversification
• inflation hedging
2.1 Capital Appreciation
Typically, long-term returns on equities outperform other
traditional asset classes mainly due to capital
appreciation
Equities tend to outperform (underperform) other asset
classes during strong (weak) economic growth
Stocks of companies with strong growth in earnings, cash
flows, revenues, competitive edge and/or value-added
assets exhibit capital appreciation
Dividends are the most common income source for an
equity portfolio Dividends represent a significant portion
of an investor’s long-term equity returns Companies pay
excess earnings to their shareholders through dividends
when reinvesting in projects is not feasible
2.3 Diversification with Other Asset Classes
In a portfolio context, equities provide significant
diversification benefits when combined with other asset
classes Securities whose returns are less than perfectly
correlated effectively reduce the risk of a portfolio (by
reducing the portfolio standard deviation well below the
standard deviation of individual investments)
The correlation of returns among asset classes may vary
over time During times of crises, correlation and volatility
(standard deviation) of asset classes increase
substantially
2.4 Hedge Against Inflation
Certain individual equities, sectors or companies provide
some protection against inflation e.g., some companies
that produce broad-based commodities, or companies that can pass along costs to customers
Some empirical studies have shown that real returns on equities are positively correlated with inflation, however, the degree of correlation may vary over time or by country or industry During a period of severe inflation, real returns on equity may become negatively correlated with inflation
Investors should be careful that inflation is a lagging indicator whereas equity price is a leading indicator of business
2.5 Client Considerations for Equities in a Portfolio
The equity portion of a client’s portfolio is driven by the client’s needs, circumstances and objectives, which are described in his investment policy statement (IPS)
The decision regarding ‘How much and what type of equities should be included in a portfolio’ is determined
by a client’s IPS Major sections of IPS are given below:
• Risk objectives – investor’s willingness and ability
to take risk and how risk is measured
• Return objectives – investor’s return objectives
and how returns are measured
• Liquidity requirements – investor’s immediate
liquidity needs
• Time horizon – associated time period to
achieve investment objectives
• Tax concerns – tax policies that can affect
investor’s returns
• Legal and regulatory factors - external
considerations regarding government, legal or regulatory issues
• Unique circumstances – other internal
(self-imposed) constraints requested by clients, also include religious constraints or ESG
(environmental, social and governance) issues etc ESG considerations determine the suitability
of certain sectors ESG filters may be in the form of:
o negative screening (or exclusionary screening) – exclude certain sectors or companies based on some criteria
o positive screening (or best-in-class)
Trang 2include certain sectors or companies that perform well with regards to ESG criteria
o thematic investing – investment in
companies that follow some specific themes or overcome some challenges (e.g energy-efficient, climate change)
o impact investing – is a related
approach that seeks to achieve financial returns as well as societal contribution
3 EQUITY INVESTMENT UNIVERSE
For effective portfolio evaluation and diversification,
portfolio managers divide companies and sectors into
various segments based on similar characteristics
Few segmentation approaches are given below:
3.1 Segmentation by Size and Style
This approach segment equities by incorporating the
size and style of equities
• Size is divided into three categories: small cap,
mid cap, large cap (based on their market
capitalization)
• Style is divided into three categories: value,
growth, combination (termed as core or blend)
Style is often determined through a scoring
system that incorporates many ratios or
measures (P/B, P/E, dividend yield, BV growth,
earnings growth etc.) Companies are
positioned along the value-growth spectrum
based on their scores
Size and style dimensions can be plotted as
categories or in the form of a scatter plot
Advantages: This approach enables fund managers to
construct portfolios with desired risk, return and income
attributes and also help them in adjusting their holdings
overtime as companies shift gradually from one segment
to another Additional advantages are diversification
and construction of proper performance benchmark
Disadvantage: Categories may change overtime or
different investors define these categories differently
3.2 Segmentation by Geography
Under this approach, equities are segmented into
various geographic markets e.g developed markets,
emerging markets, frontier markets
Advantages: Investing in different global equity market
offer huge diversification benefits
Disadvantages: As many companies are global in
nature, investing in a market may provide lower-than-expected exposure Portfolio is exposed to currency risk
3.3 Segmentation by Economic Activity
The equity universe can be divided into segments based
on their economic activity A commonly used classification system divides companies into groups using:
• Production-oriented approach: companies that produce similar products or use similar inputs in manufacturing
• Market-oriented approach: companies are grouped on the basis of markets they serve, revenues earned or customers
For example, a coal company can be classified as mining industry using the production-oriented approach
or in energy sector (based on the coal usage) using the market-oriented approach
Four major global classifications of equity universe based
on economic activity are:
i) Global Industry Classification Standard (GICS) ii) The Industrial Classification Benchmark (ICB) iii) The Thomson Reuters Business Classification (TRBC)
iv) The Russel Global Sectors Classification (RGS) Each classification system is further sub-divided into various sectors and sub-industry levels
Advantages:
This approach helps portfolio managers in portfolio diversification and in the construction of appropriate performance benchmarks
Practice: Example 1, Volume 4 Reading 26, Curriculum
Trang 3Disadvantages:
One problem with such classification is that business
activities of large companies usually incorporate many
industries
3.4 Segmentation of Equity Indexes and Benchmarks
Segmentation of equity indexes and benchmarks
combine some or all approaches mentioned earlier i.e
size & style, geography, industries/sectors, ESG considerations etc
Few examples of indexes are MSCI Europe Large Cap Growth Index, the MSCI World Small Cap Value Index etc
A more focused approach to the division of equity indexes apply industries/sectors at global level, e.g Global Natural Resources, Worldwide Oil and Natural Gas, Multinational Financials
4 INCOME AND COSTS IN AN EQUITY PORTFOLIO
Primary sources of income and costs for an equity
portfolio are given below
Unlike growth-oriented investors, investors who need
steady income prefer regular dividend paying stocks
Taxation is an important consideration for these investors
Some companies offer ‘special dividends’ when they
have extra cash Special dividend is a non-recurring
distribution of excess cash to shareholders
Optional stock dividends are a type of dividends where
shareholders can elect to receive either cash or new
shares This optionality (cash or stock dividend) has value
and some investors earn income by selling this option to
investment banks
4.2 Securities Lending Income
Some investors generate income for portfolios through
securities lending – a form of collateralized lending that
facilitates short sales Securities lending through equities
is called stock lending and those stocks are called stock
loans
Stock lenders receive fees for the loaned stocks The
lending fee is quoted on an annualized basis and may
differ in different markets Certain stocks called ‘specials’
are high in demand and can earn substantially high
fees The collateral may be subject to market risk,
liquidity risk operational risk etc
Lenders can earn additional revenue by reinvesting the
collateral income The overall income earned is reduced
by the administrative costs involved in the securities
lending program The borrower is liable to pay any
dividends received on those securities to the lender
Index funds, large actively managed pension funds, endowments and institutional investors are frequent stock lenders
4.3 Ancillary Investment Strategies
Dividend capture is a trading strategy to generate
income for an equity portfolio The primary purpose of this strategy is to capture stock dividends
Under this approach, portfolio managers buy stocks prior
to ex-dividend dates and immediately sell them after the ex-dividend dates Theoretically, an increase in portfolio income is offset by a decrease in portfolio value by the
same amount However, in practice share price
changes may vary due to factors such as income tax considerations, general stock market conditions, supply/demand of stocks, price movement of stocks
around ex-dividend dates etc
Writing (selling) options is another strategy to generate
portfolio income For example, portfolio income is generated by writing covered call or writing cash-covered put, however, the portfolio is exposed to risks, e.g writing a covered call would curb the upside potential from the appreciation of share price
Management fees are determined as a percentage of funds under management and incorporate direct costs of:
i) research (e.g remuneration, expenses related
to analysts and managers) ii) portfolio management (e.g trade processing costs, software, compliance)
Practice: Example 2, Volume 4
Reading 26, Curriculum
Practice: Example 3,Volume 4 Reading 26, Curriculum
Trang 4Management fee is typically higher for actively
managed portfolios as compared to passively managed
portfolios
Performance fees (a.k.a incentive fees) are earned by
portfolio managers based on fund’s performance over a
given period
Performance fee is specially related to hedge funds and
long/short equity portfolios where higher performance
fees provide incentives for managers to outperform their
return objectives
Typically, managers are not penalized when portfolio
performance is negative However, the performance fee
is subject to high-water mark (HWM), which is the highest
value a fund has achieved HWM ensures that the
performance fee is charged only for the increase in fund
value over the HWM value
4.6 Administration Fees
Administration fees are charged to equity portfolios for
various functions such as performance measurement,
rights issues, company meetings etc Sometimes this fee
is a part of management fees when investment
management firm performs these functions Several tasks
are performed by external parties such as custody fees,
depository fees, registration fees etc
4.7 Marketing and Distribution Costs
Marketing and distribution costs include costs such as:
• advertising costs
• sponsorship costs
• platform fees for fund services
• sales commissions for intermediaries
• costs related to marketing, sales, client-servicing staff
• costs related to communications with clients and prospects
Trading costs are related to buying/selling of securities These costs may be explicit or implicit in nature and are integrated into a portfolio’s total return
Explicit trading costs include brokerage commissions,
taxes, stamp duties, stock exchange fees
Implicit trading costs include bid-offer spread, market or
price impact, delay costs
Another trading cost is stock lending cost A fee is paid when equity portfolio managers borrow shares
4.9 Investment Approaches and Effects on Costs
Equity portfolio costs depend on the underlying strategy and trading frequency Passively managed portfolios have lower management fees and trading costs than actively managed portfolios Potential predatory trading can become hidden cost for index fund Predatory trading refers to purchase or sale of shares in anticipation of the inclusion or deletion of stocks from the index This is done by traders in the market to benefit from known investment actions of index funds
Investment strategies that involve frequent trading typically ‘demand liquidity’ and have higher trading costs Some other investment strategies ‘provide liquidity’ to the market
Shareholder engagement refers to active interaction of
shareholders with companies This includes various forms
of communication between management and
shareholders as well as voting on corporate issues The
primary purpose of shareholder engagement is the
resolution of matters that may affect the value of shares
Common shareholder concerns include:
• Strategy – strategic goals (short-term, long-term
goals), priority of interests, resources, constraints,
growth plans, competitor developments etc
• Allocation of capital – mergers, acquisitions,
expansions, financial leverage, capital
expenditures etc
• Corporate governance and regulatory and
political risk – internal controls, audit and risk
committees etc
• Remuneration – remuneration structures,
incentives for directors and senior management
• Composition of the board of directors –
succession planning, director expertise, culture, diversity etc
5.1 Benefits of Shareholder Engagement
Shareholder engagement may result in effective corporate governance structure and improved company performance
Trang 5Valuable company information help investors,
particularly active portfolio managers in achieving their
return objectives Active engagement of portfolio
managers not only improve the value of their portfolio
but also benefit other investors who do not participate in
shareholder engagement, a situation called “free rider
problem”
Other stakeholders interested in company matters in
various capacity may include creditors, customers,
employees, regulators, government, community
organizations etc Some external forces which can
influence the process of shareholder engagement
include media, the academic communities, corporate
governance consultants, proxy voting advisers
Measuring benefits of shareholders engagement is
difficult Presence of many non-financial factors (e.g
ESG) complicates quantification
5.2 Disadvantages of Shareholder Engagement
Following are some disadvantages associated with
shareholder engagement
• Time consuming and costly for shareholders
and company
• Pressures to achieve short-term targets hinder
management’s ability to accomplish long-term
goals
• Selective disclosures of specific, material,
non-public information may increase likelihood of
insider trading
• Conflict of interest may occur in certain
circumstances
5.3 The Role of an Equity Manager in Shareholder Engagement
The role of shareholder engagement for an active
portfolio manager is highly significant In some countries
it is legal or regulatory responsibility of investment firms to
provide written policies on shareholder engagements
involving regular meetings with company management
or investor relations teams
Some investment firms employ analysts or outside experts who deal with non-financial issues such as ESG
considerations, shareholder voting decisions, proxy advice, governance rating etc
5.3.1) Activist Investing
Activist investors take equity stakes in companies with the goal of employing a major change in the
companies Activists are commonly hedge funds The characteristics of hedge funds such less constraints, limited regulations and high-performance fees allow them to be much more flexible to intervene in the company matters or take representation on the companies’ boards Activists may use corporate takeover mechanisms to seek a controlling position on company’s board
5.3.2.) Voting
Two powerful ways for shareholders to participate in company matters are through general meeting (general assembly) and exercise their voting rights
Proxy voting, the most general form of investor participation in general meeting, is a form of voting by which shareholders authorize other individuals to vote on their behalf Through proxy voting, sometimes multiple shareholders attempt to take a joint action on certain company issues
Sometimes investors seek guidance and recommendations from external proxy advisory firms
In case of stock lending, voting rights are transferred to the borrower To avoid conflicts of opinion, some stock lenders recall shares prior to the record date They prefer
to hold proxy votes at the expense of losing lending income and potential reputation risk
On the contrary, some investors borrow shares specifically to exercise the voting rights attached This practice is called ‘empty voting’
6 EQUITY INVESTMENT ACROSS THE PASSIVE−ACTIVE SPECTRUM
The decision of active or passive equity management is
not binary Rather, equity portfolios are positioned across
a passive-active spectrum where funds lie at different
points on the spectrum
6.1 Confidence to Outperform
Active investment managers believe it’s possible to
outperform the benchmark Such confidence requires a
reasonable knowledge of the manager’s equity
investment universe and competitive analysis of other
managers exploiting similar investment strategies
The decision of active or passive investing is primarily based on client preferences Secondly, the decision is also influenced by investors’ beliefs regarding potentials for active investing to generate profit For example, whether the analysis will be fruitful or current stock prices already reflect the new information
Trang 66.3 Suitable Benchmark
A suitable benchmark attracts new funds The choice of
benchmark is particularly relevant for institutional clients
The characteristics that make a benchmark attractive
for equity investors are sufficient liquidity and adequate
number of securities in the benchmark to generate
satisfactory returns
6.4 Client Specific Mandate
Client-specific mandates (such as those related to
client’s unique needs, ESG considerations, positive or
negative screening etc.) usually require frequent
monitoring and supervision and thus are often managed
actively
6.5 Risks/Costs of Active Management
Active equity management is expensive and may face
reputation risk (associated with potential violations of
rules, regulations, client’s promises, ethical issues) or key
person risk
Passive management have lower turnover and is less
expensive than active management therefore usually
earns higher long-term average returns Active investing
strategies minimize taxes but suffer from higher trading
costs Tax laws vary from country to country
Practice: End of Chapter
Questions, Volume 4 Reading 26,
Curriculum
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