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Level III Equity Portfolio Management Summary Graphs, charts, tables, examples, and figures are copyright 2016, CFA Institute Reproduced and republished with permission from CFA Institute All rights reserved 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 On average active – Also called enhanced indexing or risk-controlled active management management will give the – Variant of active management same return as passive management; but active – Outperform benchmark but keep tracking risk in control management has higher fees www.ift.world 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 Buy/sell shares at market close at NAV Shareholder accounting at the fund level can be a significant expense Exchange Traded Funds Buy/sell any time during trading day No fund level shareholder accounting Low index license fees Less tax efficient (because selling shares results in higher capital gains taxes) Higher index license fees 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 www.ift.world Passive investment vehicles 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 www.ift.world 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 www.ift.world Index weighting choices 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 www.ift.world Investment styles 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 www.ift.world 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 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 www.ift.world Advantages Disadvantages Returns-based Characterizes entire portfolio May be ineffective in characterizing current style analysis Facilitates comparisons of portfolios style Aggregates the effect of the investment Error in specifying indices in the model may lead process to inaccurate conclusions 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 Holdings-based Characterizes each position Does not reflect the way many portfolio style analysis Facilitates comparisons of individual managers approach security selection positions Requires specification of classification attributes In looking at present, may capture changes for style; different specifications may give in style more quickly than returns-based different results analysis More data intensive than returns-based analysis www.ift.world 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 Large-cap Value Blend Growth Mid-cap 27 58 Small-cap 0 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 www.ift.world 10 Investment strategies 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 www.ift.world 11 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 long-short investment manager Overall return: active return from longshort portfolio + gain/loss from futures position + interest on cash from 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 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 www.ift.world 12 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 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 www.ift.world 13 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 − λ𝐴 σ2A 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) www.ift.world 14 Active risk and return n Portfolio active return = n hAi rAi h2Ai σ2Ai Portfolio active risk = i=1 i=1 Where, hAi = the weight assigned to the ith manager σAi = the active risk of the ith manager Assuming no correlation between active returns 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 www.ift.world 15 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 core minimizes active risk, whereas the satellites add active returns using smaller portions of the portfolio Completeness fund Start with a group of active managers Add a completeness fund by identifying a basket or a number of trades which minimize the active risk of the portfolio Alpha and beta separation 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 www.ift.world 16 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: themes affecting the global economy the effect of those themes on various economic sectors and industries any special country or currency considerations 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: 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) collecting further financial information on companies passing the screen identifying companies from this subset that may be potential investments based on other company-specific criteria www.ift.world 17 ... 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:... fees www.ift.world 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... Outperform benchmark portfolio by investing in underpriced securities • Semiactive Management On average active – Also called enhanced indexing or risk-controlled active management management will
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