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1 INTRODUCTION Equities typically cover a sizable portion of an investor’s portfolio Ownership interest, growth prospects and investment opportunities in various businesses make THE ROLES OF EQUITIES IN A PORTFOLIO Equity investments offer many benefits such as: • • • • 2.1 capital appreciation dividend income diversification inflation hedging 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 2.2 Dividend Income 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 equities attractive to investors Publicly traded securities are considered more liquid than other asset classes 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 (selfimposed) 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) –––––––––––––––––––––––––––––––––––––– Copyright © FinQuiz.com All rights reserved –––––––––––––––––––––––––––––––––––––– FinQuiz Notes Introduction to Equity Portfolio Management Reading 26 Introduction to Equity Portfolio Management Reading 26 o o include certain sectors or companies that perform well with regards to ESG criteria thematic investing – investment in companies that follow some specific themes or overcome some challenges (e.g energy-efficient, climate change) impact investing – is a related approach that seeks to achieve financial returns as well as societal contribution Few segmentation approaches are given below: 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 Practice: Example 1, Volume Reading 26, Curriculum EQUITY INVESTMENT UNIVERSE For effective portfolio evaluation and diversification, portfolio managers divide companies and sectors into various segments based on similar characteristics 3.1 FinQuiz.com 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-thanexpected 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 Introduction to Equity Portfolio Management Reading 26 Disadvantages: One problem with such classification is that business activities of large companies usually incorporate many industries Practice: Example 2, Volume Reading 26, Curriculum 3.4 Segmentation of Equity Indexes and Benchmarks FinQuiz.com 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 Segmentation of equity indexes and benchmarks combine some or all approaches mentioned earlier i.e INCOME AND COSTS IN AN EQUITY PORTFOLIO Primary sources of income and costs for an equity portfolio are given below 4.1 Dividend Income 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 cashcovered 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 Practice: Example 3,Volume Reading 26, Curriculum 4.4 Management Fees 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) Introduction to Equity Portfolio Management Reading 26 Management fee is typically higher for actively managed portfolios as compared to passively managed portfolios 4.5 • • • • Performance Fees 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 4.7 Marketing and Distribution Costs Marketing and distribution costs include costs such as: • • advertising costs sponsorship costs • • Trading Costs 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 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 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: • platform fees for fund services sales commissions for intermediaries costs related to marketing, sales, clientservicing staff costs related to communications with clients and prospects 4.8 4.9 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 FinQuiz.com 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 • • 5.1 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 Benefits of Shareholder Engagement Shareholder engagement may result in effective corporate governance structure and improved company performance Introduction to Equity Portfolio Management Reading 26 Valuable 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 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, nonpublic information may increase likelihood of insider trading Conflict of interest may occur in certain circumstances 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 5.3 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’ 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 FinQuiz.com 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 6.2 Client Preference 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 Introduction to Equity Portfolio Management Reading 26 6.3 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 6.6 Taxes 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 Reading 26, Curriculum Questions & item-sets from FinQuiz Question-bank FinQuiz.com ... Management Reading 26 Disadvantages: One problem with such classification is that business activities of large companies usually incorporate many industries Practice: Example 2, Volume Reading 26, Curriculum. .. country to country Practice: End of Chapter Questions, Volume Reading 26, Curriculum Questions & item-sets from FinQuiz Question-bank FinQuiz. com ... would curb the upside potential from the appreciation of share price Practice: Example 3, Volume Reading 26, Curriculum 4.4 Management Fees Management fees are determined as a percentage of funds
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