2018 Study Session # 12, Reading # 25 “EQUITY PORTFOLIO MANAGEMENT” SD = Standard Deviation ER = Equity Research MF = Mutual Fund L/S = Long-Short IR = Information Ratio CSP = Core-Satellite Portfolio IT = Information Technology INTRODUCTION Decision of how to invest in competing equity investments ranks second compared to how much to allocate to equities THE ROLE OF THE EQUITY PORTFOLIO As an investor’s domestic market‘s global weight increases, so does his domestic market focus Investing across countries provides diversification because no one market fully captures all global economic factors & no exact home-market equivalent Equities provide inflation hedge (certain limitations, taxes are not inflation hedged so reduce after tax real return, price competition may limit price due to inflation) Equities play growth role in portfolio For the above reasons investors are equity biased in their asset allocation Both domestic & international equities play an important role in individual/institutional portfolios APPROACHES TO EQUITY INVESTMENT Passive Management Semi Active Management Active Management Investor does not reflect his expectations in security selection Dominant passive approach is indexing Indexed portfolios are passive in implementation Seeks to outperform benchmark through security selection More concerned about tracking risk while trying to beat benchmark Information ratio ⇒ mean active return / tracking risk (efficiency with which tracking risk deliver active return) Efficient markets favor indexing Information ratio is higher in enhanced indexing Client constraints should also be considered when selecting an appropriate approach PASSIVE EQUITY INVESTING Historically before cost avg active return is approximately equal to index return (active investment underperform after-cost basis) Passive investing has tax benefit than active investing (low turnover) Indexing is appropriate in large cap equity market (informationally efficient), small cap (heavy transaction cost) & unfamiliar overseas markets 4.1 Equity Indices Indexes are used to; Create index fund As benchmark To perform technical analysis &β calculation Explain factors that influence share prices Boundaries of index universe, criteria for inclusion, weighting schemes & how returns are calculated, determine stock index’s characteristics Copyright © FinQuiz.com All rights reserved 2018 Study Session # 12, Reading # 25 4.1.1 Index Weighting Choices Price Weighted Value Weighted Weighted according to absolute share price Index = sum of price / adjusted no of shares Index performance can be matched by buying one share of each index component Simple to construct & can go back far into the past Equal Weighted Weighted according to market cap Performance can be matched by investing same proportion as each index component in index Self corrects for stock splits & reverse stock splits etc Float weighted index ⇒ subcategory ⇒ consider investable MV of equity Weight of stock in float adjusted index = market cap weights× adjustment factor Float weighted return represents return to avg dollar invested passively Float weighting considered best index (representative & minimum tracking error) Each index stock weighted equally Performance can be matched through equal $ investment in each index component Must be rebalanced periodically Weighting Scheme Biases Price Weighted Value Weighted Equal Weighted Biased towards the highest-priced stock Absolute share price level is arbitrary (can change through splits, stock dividends etc.) Biased towards large market cap (mature & overvalued companies) Less diversified Not suitable due to regulatory restriction (e.g maximum holdings) Small company bias Rebalanced periodically (high transaction cost) Illiquid index components 4.1.2 Equity Indices: Composition & Characteristics of Major Indices Price weighted & equal weighted indexes are very few in numbers these days Indices Committee-determined indices Low turnover (low transaction cost & tax) Not reconstituted regularly and may drift away from intended segment Algorithm (formula based) High cost & taxes Reconstituted regularly (no drift) Fund must evaluate tradeoff b/w transaction cost & difference in return premiums Copyright © FinQuiz.com All rights reserved 2018 Study Session # 12, Reading # 25 4.2 Passive Investment Vehicles 4.2.1 Investment in indexed portfolio Long position in cash & long position in futures Indexed mutual funds Long position in cash & long position in Swap ETFs Separate or pooled accounts Difference b/w Indexed Mutual Funds & ETFs Mutual Funds Exchange Traded Funds Trading frequency Trade at NAV once at market close Trade in public market anytime during trading day Index licensing fee Lower Higher Tax efficiency Lower Higher Cost of providing liquidity Yes No, due to in-kind creation/redemption Shareholder accounting expense Yes No fund level shareholder accounting Separate or Pooled Accounts Indexed institutional portfolios (separate or pooled) are cost efficient than MF & ETFs In some cases securities lending revenue can equal or exceed total portfolio management & custody expense Indexing a Portfolio Full Replication Stratified Sampling Suitable when securities in index are less than 1000 & liquid Minimum tracking risk Full replication based on value/float weighted index, is self rebalancing, trading required only for reinvestment of dividends & to reflect changes in index composition Return of full replicated fund is less than return on index (administrative cost, transaction cost, cash drag) Divide index along a no of dimensions /cells (industry value, growth etc.) Place each stock into a cell & match cell weight into portfolio as cell weights in the index Greater the no of cells lesser the tracking error Stratified sampling can be used to create index fund from non-diversified index Optimization Use multifactor risk model against which index & individual securities risk exposures are measured & minimize the tracking error Optimization considers covariance among factors (advantage) Three disadvantages: Risks change over time & model is based on historical data Sampling error Requires periodic rebalancing Optimization produces lower tracking error than stratified sampling when used in combination with full replication 4.2.2 Equity Index Futures Exchange of future for physicals ⇒ exchange the stock basket for future contract on index (reduce transaction cost) Facilitate risk management transaction Rolling costs (futures position must be rolled over) Shorting on Basket trades impeded due to Uptick rule (i.e no short sale on down tick relative to last trade at a different price) ETFs are better risk management & hedging tools (no uptick rule, lack of expiration date) Copyright © FinQuiz.com All rights reserved 2018 Study Session # 12, Reading # 25 4.2.3 Equity Total Return Swaps Motivated by different tax treatment of shareholders in different countries or to acquire exposure to an asset class for strategic/tactical asset allocation (less cost of rebalancing) ACTIVE EQUITY INVESTING To outperform benchmark within risk & other constraints Range of products from active to passive to satisfy investors’ needs 5.1 Equity Styles Value Growth Focus is low share price relative to earnings or BV High earning growth companies are key considerations Market oriented Intermediate grouping for investments (neither value nor growth) Market cap frequently specified in describing investor’s style Styles play a role in risk management & performance evaluation 5.1.1 Value Investment Styles Focus on cheap stocks relative to earnings or BV Possible arguments: Earnings have mean reverting tendency so earnings will causing in multiples & stock prices Growth investing contains risk of contraction in earnings & multiples Main risks Misinterpreting a stock’s cheapness Undervaluation may not correct with in investment horizon Three substyles Low P/E ⇒ Invest in stocks with low price hoping industry & stock will recover & P/E will improve Contrarian⇒ investment in very depressed industries usually P/B < Yield investor ⇒ focus on high current & future dividend yield (component of total return) 5.1.2 Growth Investment Styles Focus on future EPS growth rate & major risk is that growth will not take place & price will Substyles Consistent growth ⇒ invest in companies with long growth history Earning momentum ⇒ higher quarterly year-over-year earnings growth but less sustainable Growth investors better in economic contraction than economic expansion Copyright © FinQuiz.com All rights reserved 2018 Study Session # 12, Reading # 25 5.1.3 Other Active Management Styles Market oriented investor buys stocks below its perceived intrinsic value irrespective of where it falls (growth / value) Drawback ⇒ if portfolio achieves market like return, indexing or enhanced indexing presents a lower cost alternative Substyles Market oriented with value biased (hold well diversified portfolios) Market oriented with growth biased (hold well diversified portfolios) Growth-at-reasonable price ⇒ investor favors companies with above avg growth with conservative valuation (portfolios are less diversified than other growth investors) Style rotators ⇒ invest in most favored near term style Market Capitalization Small Cap Mid Cap Large Cap Opportunity for mispriced stocks (less research) Better growth prospects Micro cap ⇒ smallest part of small cap Less well researched than large cap (opportunities exist) Less volatile than small cap More financial stability Add value through superior analysis 5.1.4 Techniques for Identifying Investment Styles Return based style analysis Regress portfolio return on return series of set of indices Indices should be Mutually exclusive & exhaustive Not be highly correlated βs on indices are nonnegative & sum to Normal benchmark ⇒ benchmark with same systematic risk exposure as manager’s portfolio R2 determine style fit & 1-style fit = selection Error term in regression equation reflects style return Holding based style analysis Categorize individual securities by their characteristics & draw overall style conclusion Value-oriented portfolio has clear bias towards low P/E, P/B& high dividend yield (vice versa for growth) & market oriented has valuation close to market avg Greater earning variability ⇒ value oriented portfolio⇒ larger weight in utilities & finance sector Growth portfolios ⇒ health care & IT weights are higher Two approaches to style analysis: Advantages and Disadvantages Advantages Returns-based style analysis Holding-based style analysis Characterizes entire portfolio Facilitates comparisons of portfolios Aggregate the effects 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 Characterizes each position Facilitates comparisons of individual positions In looking at present, may capture changes in style more quickly than returns-based analysis Disadvantages May be ineffective in characterizing current style Error in specifying indices in the model may lead to inaccurate conclusions 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 Copyright © FinQuiz.com All rights reserved 2018 Study Session # 12, Reading # 25 5.1.5 Equity Style Indices Style indices construction uses multiple variables (price, earnings, book value etc) Index publishers capture licensing fees from ETF & other investment products All style indices use holding-based style analysis Overlap ⇒ some securities may be assigned in part to both value & growth No overlap ⇒ security is assigned to either value, growth or market oriented Buffering ⇒ rules for maintaining the previous stock assignment when stock has not clearly moved to a new style Buffering reduces turnover & transaction expenses Index publisher uses growth & value as categories (no overlap) or as quantities (with overlap) 5.1.6 The Style Box Style box is used for looking at a style Style box used by Morningstar divides fund portfolio by market cap (large, mid, small)& style (value, core & growth) Categorizing a stock by size is relatively standard technique but techniques used in styles are diverse across firms 5.1.7 Style Drift Inconsistency or straying from stated style Two consequences Investor may lose exposure to desired style Manager is operating outside area of expertise 5.2 Socially Responsible Investing Consider ethics, social & religious concerns while taking investment decisions Negative stocks screens ⇒ reduce investment universe Positive SRI Screens ⇒identify companies with ethically desirable characteristics SRI often exhibits style bias towards growth investing & market cap bias towards small cap stocks Two benefits of being aware of these biases Portfolio manager tries to minimize their biases if inconsistent with client’s objective & constraints Manager can chose appropriate benchmark Progress towards style bias issue can be identified & measured through return-based style analysis 5.3 Long-Short investing Style investing focuses on portfolio characteristics while L/S investing focuses on constraints (short selling) Long only strategy can hold single alpha while L/S market neutral (zero β) holds two alphas Portable alpha ⇒ added a variety of systematic risk exposures Pair trade ⇒ long / short in two single industry firms’ stocks by equal currency amounts (almost zero β, only firm specific risk) Leverage used in L/S strategy magnifies risk & return If the price of short position tends to rise, loss can be unlimited Copyright © FinQuiz.com All rights reserved 2018 Study Session # 12, Reading # 25 5.3.1 Price Inefficiency on the Short Side Four pricing inefficiencies exist on short side (can cause higher short side alpha than long side) Short positions difficult to obtain (e.g find lender) Management manipulations & window dressing (stock is more likely to be overvalued rather than undervalued) More frequent issuance of “buy” recommendations due to greater commissions & potential buyers > sellers & short sellers Fear of management lawsuits & business lost prevent analyst from sell recommendations [against standard I (B)] 5.3.2 Equitizing a Market-Neutral Long-Short Portfolio Equitizing⇒ market exposure through futures& Swaps Notional value of futures= value of cash position from short position Rate of return on total portfolio is sum of; G/L on L/S securities position G/L on long futures position Interest earned on cash position All above divided by portfolio equity ETF is an alternative to futures & cost effective way of equitizing & de-equitizing Market neutral L/S should be benchmarked against RFR & equitizing should be benchmarked against relative index 5.3.3 The Long-Only Constraint L/S strategies have advantage of “allowing action on negative insights” over long only portfolio Investor’s opportunity set is not symmetric for long only portfolio (can not take short position) 5.3.4 Short Extension Strategies Modify long-only strategy by specifying a stated level of short selling Generally designed to have market β of More efficient use of negative information In 130/30 strategy, L/S portfolio decision are coordinated (consider single portfolio) while in 100/0 & 30/30 they are not (consider two portfolios) Several advantages of short extension No need for liquid futures a swap market as in equitizing market natural L/S Manager’s investment insight as compared to long only Disadvantage Market return & alpha from same source (less flexible than equitizing market neural L/S) Market neutral L/S is considered part of alternative investments 5.4 Sell Disciplines/Trading Strategy of Substitution Deteriorating Fundamentals Replace existing holding with better opportunity by considering transaction cost & taxes Also known as opportunity cost sell discipline Reduce or eliminate a position if company’s business prospects are expected to deteriorate These sell disciplines are not mutually exclusive Copyright © FinQuiz.com All rights reserved Rule Driven Valuation level (e.g if P/E reaches historical avg.) Down-from-cost Up-from-cost Target price sell discipline 2018 Study Session # 12, Reading # 25 SEMIACTIVE EQUITY INVESTING Designed to outperform benchmark while carefully managing portfolio risk exposure Highest IR as compared to indexing & active management Basic Forms Derivative-Based Stock Based Achieve desired equity exposure through derivatives& enhanced return through something other than equity investments Most common strategy ⇒ equitize a cash portfolio & add value through duration management Low investment breadth Straight forward strategy Identify overvalued & undervalued stocks & outperform through stock selection Risk is controlled through factor exposure & industry concentration If manager has no opinion on stock, hold it at benchmark weight Limitations Positive alpha may disappear as other mangers try to exploit it Quantitative & mathematical models, based on historical data, will not work if economy changes Fundamental Law of Active Management IR ≈ IC √Breadth Where IC = information coefficient (effectiveness of investment insight) Breadth = no of independent active investment decisions Higher the ratio, the better it is MANAGING A PORTFOLIO OF MANAGERS When investing a pool of assets, determine overall asset allocation i.e which classes to use & how to invest within each asset class Allocation should maximize expected total return at a given level to total risk ܿ ݕܾ( ݁ݖ݅݉݅ݔܽܯℎܷ )ݏݎ݁݃ܽ݊ܽ݉ ݂ ݁ܿ݅ = ݎ −⋌ ߜଶ Where ܷ = expected utility of active return of manager mix ݎ = expected active return ⋌ = active risk aversion ߜଶ = variance of active return How much active risk an investor assumes determines mix of managers Investors are more averse to active risk than total risk, because; They believe that successful active management is possible & that they have the skill to select outperforming managers Answerable to someone i.e institutional conservatism, where overall performance is judged relative to benchmark, which is difficult to outperform More active risk less manager diversification on efficient frontier (active risk limitation by institutional investors) ܲ∑ = ݊ݎݑݐ݁ݎ ݁ݒ݅ݐܿܽ ݈݂݅ݐݎୀଵ ℎ ߜ Where ℎ = weight assigned to ith manager ߜ = active return of ith manager ଶ ଶ Portfolio active risk (active returns are uncorrelated);ඥ∑ୀଵ ℎ ߜ if returns are correlated include covariance term under square root sign Copyright © FinQuiz.com All rights reserved 2018 Study Session # 12, Reading # 25 7.1 Core-Satellite Core-satellite portfolio ⇒ consists of a core holding (index & semi active) & satellite (active managers) CSP is a result of optimization applied to a group of equity mangers or some other heuristic Objective is to achieve passive as well as active exposure Core should closely resemble investor’s benchmark while satellite portfolios may have different benchmarks Decomposition of Active Return True Active Return Misfit Active Return Manager’s return-manager’s normal benchmark Manager’s normal benchmarkinvestor’s benchmark Decomposition of Active Risk True Active Risk SD of true active return Misfit Active Risk SD of misfit active return Total active risk = ඥሾሺ݉ܽ݊ܽ݃݁ ݎᇱ ݇ݏ݅ݎ ݁ݒ݅ݐܿܽ ݁ݑݎݐ ݏሻଶ + ሺ݉ܽ݊ܽ݃݁ ݎᇱ ݇ݏ݅ݎ ݐ݂݅ݏ݅݉ ݏሻଶ ሿ Most accurate risk-adjusted performance measure is; ܶ݊ݎݑݐ݁ݎ ݁ݒ݅ݐܿܽ ݁ݑݎ ܶ = ܴܫ ݁ݑݎ ܶ݇ݏ݅ݎ ݁ݒ݅ݐܿܽ ݁ݑݎ Two main uses of true / misfit distinction Performance appraisal Optimization (allow optimal level of “misfit” risk) 7.2 Completeness Fund Active managers’ portfolios have number of risk exposures or biases in CSP Bottom-up stock picker’s portfolios reflect industry concentrations Completeness fund ⇒ when added to active managers’ positions, establishes an overall portfolio with same risk exposure as investor’s overall equity benchmark Value added through stock selection Can be managed passively or semi actively &re-estimated periodically Drawback ⇒eliminates misfit risk where non-zero misfit risk may be optimal, hence losing part of true active return 7.3 Other Approaches: Alpha & Beta Separation Long active equity portfolio ⇒ provides both α&β exposure Market neutral L/S ⇒ can better manage α&β (can use portable α in asset class outside β asset class) Risks to market neutral L/S ⇒ short positions are difficult to construct or portfolio may not really be market neutral Portable alpha can be used even without investing on a L/S basis e.g ߚ [ long on S & P 500 future] Long on Japanese manager portfolio ሺTOPIX indexሻ ∝ ቂ ቃ ܽ݊݀ ݏℎ ݐݎon TOPIX future Copyright © FinQuiz.com All rights reserved 2018 Study Session # 12, Reading # 25 IDENTIFYTING, SELECTING, AND CONTRACTING WITH EQUITY PORTFOLIO MANAGERS When funds are delegated to outside management a consultant is required for investment manager search 8.1 Developing a Universe of Suitable Manager Candidates Consultants use research staff to determine which managers are talented & truly add value Use both qualitative (people, investment philosophy etc.) & quantitative (comparison with peers, style orientation etc.) factors 8.2 The Predictive Power of Past Performance Legally “past performance is no guarantee of future result” Past performance must be examined (e.g active manager exhibiting consistent underperformance from benchmark not likely to be selected) 8.3 Fee Structures Ad Valorem Fees Performance-Based Fees Calculated by multiplying a % by value of assets managed Advantage ⇒ simple & predictable Also called assets under management fees Base fee plus sharing % Fee cap ⇒ upper limit to total fee (limit manager from high risk) High water mark ⇒ provision requiring cumulatively generated outperformance since last performance-based fee paid Symmetric incentives fees ⇒ reduce (poor performance) as well as increase (good performance) compensation (better align manager & plan sponsor interest) manager’s revenue volatility One-sided performance based fee ⇒ conveys a call option to investment manager & value is determined through option pricing model Copyright © FinQuiz.com All rights reserved 2018 Study Session # 12, Reading # 25 8.4 The Equity Manager Questionnaire Five Sections First Section Second Section Organization / people Questions include vision of firm, competitive advantage, role of portfolio managers, length of time the team has together etc Philosophy / process Questions about how equity portfolio will be managed (e.g research process, risk management function, stock selection process etc.) Third Section Fourth Section Focus is on research process, how it is conducted and communicated etc Allocation of resources within organization (investment in technology, portfolio construction etc.) Performance Appropriate benchmark & level of appropriate excess return Firms submit monthly or quarterly returns & holdings for evaluators Fifth Section Fees Type of fees (ad valorem or performance based) & terms& conditions related to fees STRUCTURING EQUITY RESEARCH AND SECURITY SELECTION ER is a necessary component of active & semi active investing 9.1 Top-Down versus Bottom-Up Approaches Top-Down Bottom-Up Focuses on macroeconomic factors Build portfolio of individual stocks with macro insights Focuses on company-specific fundamentals 9.2 Buy-Side versus Sell-Side Research Buy-Side Sell-Side Research with intent of building a portfolio (investment management firms) Decisions are made through committee structure (analyst prepares report, presents to committee that reviews & decides upon the conclusion) Independent researchers (who sell their work) or investment banks / brokerage to generate business Analysts work either in teams or themselves & produce reports on companies & industries Copyright © FinQuiz.com All rights reserved 2018 Study Session # 12, Reading # 25 9.3 Industry Classification Equity research departments organized along industry or sector lines Company is categorized into sector, industry group, industry & sub-industry Copyright © FinQuiz.com All rights reserved ... rule, lack of expiration date) Copyright © FinQuiz. com All rights reserved 2018 Study Session # 12, Reading # 25 4.2 .3 Equity Total Return Swaps Motivated by different tax treatment of shareholders... sustainable Growth investors better in economic contraction than economic expansion Copyright © FinQuiz. com All rights reserved 2018 Study Session # 12, Reading # 25 5.1 .3 Other Active Management Styles... risk & return If the price of short position tends to rise, loss can be unlimited Copyright © FinQuiz. com All rights reserved 2018 Study Session # 12, Reading # 25 5 .3. 1 Price Inefficiency on