Equity

What is model overfitting?

model overfitting occurs when the model fits the past data by finding a pre-conceived relationship (i.e., making the model specifications biased toward the pre-conceived relationship) or when the model is biased toward patterns that are specific only to the past data.

What are the components of active return?

(alpha + epsilon) - the part of the return that cannot be explained by exposure to rewarded factors

What are the factors for consideration with regards to collateral for stock lending?

- Additional income may be earned by reinvesting the cash collateral received given that interest rates are rising. - The cash collateral is subject to market risk (the value of the posted collateral may fall) if the cash collateral is invested in long-term and/or risky securities. - The cash collateral is subject to credit risk (the credit quality of the borrower may decline). - The administrative costs of a securities lending program would reduce total income earned.

What are some of the differences between ETFs and mutual funds?

- ETFs can be sold short, but mutual funds cannot - only ETF investors can purchase shares on margin - mutual funds and ETFs do not have the same degree of liquidity. Although ETFs allow for inter-day trading they could experience periods of market illiquidity. Mutual fund units are redeemed directly from the mutual fund and may be subject to redemption terms - ETFs have smaller taxable events than mutual funds because of the in-kind transfer of securities between an authorized participant and the fund when redemptions occur - Disadvantages of using ETFs include the need to buy at the offer and sell at the bid price, paying commissions, and possibly facing illiquid markets at either purchase or sale

What are the differences between a factor weighted and cap weighted index?

- Relative to cap weighting, single-factor funds concentrate risk exposure to the characteristics of the factor used - Value factor funds focus on valuation measures, not volatility - Fundamental weighting's intended advantage is overweighting stocks priced below intrinsic value and underweighting overpriced stocks Factor-weighted portfolios are passively managed with active elements. Thus, they are classified as a hybrid investment style.

What are the roles of equity in a portfolio?

- capital appreciation - dividend income - diversification with other asset classes - hedge against inflation: if it's a company that commodity-related or is good at passing higher input costs to consumers

What is hedged portfolio approach to factor-based portfolios?

- choose the factor to be scrutinized and rank the investable stock universe by that factor - divide the universe into groups referred to as quantiles (typically quintiles or deciles) to form quantile portfolios - stocks are either equally weighted or capitalization weighted within each quantile - a long/short hedged portfolio is typically formed by going long the best quantile and shorting the worst quantile - the performance of the hedged long/short portfolio is then tracked over time.

What are the common behavioral biases in fundamental investing?

- confirmation bias - illusion of control - availability bias - loss aversion - overconfidence bias - regret aversion bias

What are top down strategies?

- country and geographic allocation - sector and industry rotation - volatility based strategies - thematic investing

What are the characteristics of most multi-factor products?

- diversified across factors - high active share - low active risk (tracking error), ~3% - low concentration among securities to balance exposure to risk factors and minimize idiosyncratic risks

What are the core aspects of portfolio construction?

- factor exposures - timing - position sizing - breadth or depth - systematic or discretionary - bottom up or top down - benchmark aware or benchmark agnostic

What are the building blocks of portfolio construction?

- factor weightings - alpha skills - position sizing

What are the causes for tracking error and excess return in a passive portfolio?

- fees charged - # of securities held vs index - intra-day trading of constituent stock - trading commissions paid to brokers - cash drag - effects of temporarily uninvested cash - an index that contains a large number of constituents will tend to create higher tracking error than one with fewer constituents

What are the characteristics of a diversified stock picking strategy portfolio?

- high active share (indicates that a manager's holdings differ substantially from the benchmark) - low active risk (low idiosyncratic risk resulting from diversification)

What are the approaches to passive equity investing?

- pooled investing (ETFs) - derivative-based approaches (involves completion overlay, rebalancing overlay, currency overlay)

What are the bottom up value-based investment strategies?

- relative value (low valuation relative to industry peers) - contrarian investing - high quality value (low valuation relative to attractive metrics) - income investing - deep value investing (low valuation relative to company's own assets) - restructuring and distressed investing - special situations

What are things to consider when deciding to include equities in a client portfolio?

- risk objective - return objective - liquidity requirement - time horizon - tax concerns - legal and regulatory factors - unique circumstance

What are the disadvantages of shareholder engagement?

- shareholder engagement is time consuming and can be costly for both shareholders and companies - pressure on company management to meet near-term share price or earnings targets could be made at the expense of long-term corporate decisions - engagement can result in selective disclosure of important information to a certain subset of shareholders, which could lead to a breach of insider trading rules while in possession of specific, material, non-public information about a company - conflicts of interest can result for a company: for example, a portfolio manager could engage with a company that also happens to be an investor in the manager's portfolio. In such a situation, a portfolio manager may be unduly influenced to support the company's management so as not to jeopardize the company's investment mandate with the portfolio manager.

What are the common behavioral biases in quantitative investing?

- survivorship bias - look-ahead bias - data mining - overfitting

What are the drawbacks of the hedged portfolio approach?

- the information contained in the middle quantiles is not utilized, as only the top and bottom quantiles are used in forming the hedged portfolio. - it is implicitly assumed that the relationship between the factor and future stock returns is linear (or at least monotonic), which may not be the case - portfolios built using this approach tend to be concentrated, and if many managers use similar factors, the resulting portfolios will be concentrated in specific stocks - the hedged portfolio requires managers to short stocks, but shorting may not be possible in some markets and may be overly expensive in others. - the hedged portfolio is not a "pure" factor portfolio because it has significant exposures to other risk factors.

What are the style factors?

- value - price momentum - growth - quality

what are the two frameworks of active equity investing and their objectives?

1. Absolute framework: maximize sharpe ratio 2. Relative framework: maximize information ratio

How to calculate excess return arising from active factor weights?

1. Calculate attribution for the portfolio and benchmark for each factor (factor return x factor weight), then calculate the difference (portfolio attribution - benchmark attribution) and sum it up - this is the total effect 2. Calculate active factor weights and sum the products of active weights and factor potrfolio returns across all factors - this is factor over/underweight 3. % of Excess return = factor over/underweight / total effect

What does investment process look like in a fundamental strategy?

1. Define the investment universe and the market opportunity—the perceived opportunity to earn a positive risk-adjusted return to active investing, net of costs—in accordance with the investment mandate. The market opportunity is also known as the investment thesis. 2. Prescreen the investment universe to obtain a manageable set of securities for further, more detailed analysis. 3. Understand the industry and business for this screened set by performing industry and competitive analysis and analyzing financial reports. 4. Forecast company performance, most commonly in terms of cash flows or earnings. 5. Convert forecasts to valuations and identify ex ante profitable investments. 6. Construct a portfolio of these investments with the desired risk profile. 7. Rebalance the portfolio with buy and sell disciplines.

What are the advantages of holdings-based style analysis vs returns-based style analysis?

1. HBS characterizes each position rather than looking only at the portfolio as a whole. 2. HBS facilitates the comparison of individual positions. 3. HBS is likely to capture changes in style more quickly.

What are the four main building blocks of portfolio construction?

1. Overweight, underweight or neutralize rewarded factors: The four most recognized factors known to offer a persistent return premium are Market, Size, Value, and Momentum. 2. Alpha skills: Timing factors, securities, and markets. Finding new factors and enhancing existing factors. 3. Sizing positions to account for risk and active weights. 4. Breadth of expertise: A manager's ability to consistently outperform his benchmark increases when that performance can be attributed to a larger sample of independent decisions. Independent decisions are uncorrelated decisions.

What does investment process look like in a quantitative strategy?

1. The first step in creating a quantitative, active strategy is to define the market opportunity or investment thesis. 2. Then, relevant data is acquired, processed, and transformed into a usable format. 3. This step is followed by back-testing the strategy, which involves identifying the factors to include as well as their weights. The purpose of back-testing is to identify correlations between the current period's factor scores and the next period's holding period strategy returns (the Information Coefficient). 4. Finally, the strategy performance should be evaluated using an out-of-sample back-test.

What are growth based approaches?

A bottom up approach. Growth-based investment approaches focus on companies that are expected to grow faster than their industry or faster than the overall market, as measured by revenues, earnings, or cash flow. Growth investors usually look for high-quality companies with consistent growth or companies with strong earnings momentum.

What are the characteristics of a closet indexer portfolio?

A closet index would exhibit both low Active Share and low active risk, because such funds make few active bets.

What is free-float adjusted index?

A common version of capitalization weighting is the free-float weighting. With this method a float factor is assigned to each stock to account for the proportion of outstanding shares that are held by the general public, as opposed to "closely held" shares owned by the government, royalty, or company insiders (see float). Thus a free-float adjustment to a market index more accurately reflects its actual liquidity (not lowers liquidity) and makes the index benchmark more investable. For example, if for some stock 15% of shares are closely held, and the other 85% are publicly held, the float factor will be 0.85, by which the company's market capitalization will be multiplied before weighting its value against the rest of the index. In other words, the number of shares used for calculation is the number of shares "floating", rather than outstanding.

What is a limit order book and how it is used in equity investing?

A limit order book is a record of outstanding limit orders maintained by the security specialist who works at the exchange. A limit order is a type of order to buy or sell a security at a specific price or better. In the United States, many market microstructure-based arbitrage strategies take advantage of the NYSE Trade and Quote (TAQ) database and often involve extensive analysis of the limit order book to identify very short-term mispricing opportunities. For example, a temporary imbalance between buy and sell orders may trigger a spike in share price that lasts for only a few milliseconds. Only those investors with the analytical tools and trading capabilities for high-frequency trading are in a position to capture such opportunities, usually within a portfolio of many stocks designed to take advantage of very short-term discrepancies.

What is active share?

A measure of how similar the portfolio is to its benchmark. High active share implies that manger's portfolio differs substantially from the benchmark.

What are the characteristics of a sector rotator portfolio?

A sector rotator typically has high active risk, high tolerance for sector deviations and could have either high or low Active Share, depending on whether a concentrated or diversified portfolio approach was followed.

What is high water mark?

A specified net asset value level that a fund must exceed before performance fees are paid to the hedge fund manager. A high-water mark is the highest value, net of fees, that the fund has reached. The use of high-water marks protects clients from paying twice for the same performance. For example, if a fund performed well in a given year, it might earn a performance fee. If the value of the same fund fell the following year, no performance fee would be payable. Then, if the fund's value increased in the third year to a point just below the value achieved at the end of the first year, no performance fee would be earned because the fund's value did not exceed the high-water mark.

What is Size factor?

A tilt toward smaller size involves buying stocks with low float-adjusted market capitalization.

What is dividend capture?

A trading strategy whereby an equity portfolio manager purchases stocks just before their ex-dividend dates, holds these stocks through the ex-dividend date to earn the right to receive the dividend, and subsequently sells the shares. Dividend capture works best in a scenario when the stock's price rises or at least falls less than the amount of the dividend paid. A growth stock in a range-bound market could potentially satisfy this need.

What is the value trap?

A value trap is a stock that appears to be attractively valued—with a low P/E multiple (and/or low price-to-book-value or price-to-cash-flow multiples)—because of a significant price fall but that may still be overpriced given its worsening future prospects.

What is active return?

Active (excess return) of an actively managed portfolio is driven by the difference in weights between the active portfolio and the benchmark.

What happens to active risk with an increase in factor and idiosyncratic volatility?

Active risk does rise with an increase in factor and idiosyncratic volatility.

Consider two pair trades: (1) two automobile stocks, and (2) an energy and a financial stock. Both trades implemented as an overweight and underweight, with the second trade coming as a replacement for the first one. What was the net impact on active risk?

Active risk is affected by the degree of cross-correlation. The correlation of two stocks in different sectors is most likely lower than the correlation of two stocks in the same sector. Therefore, the correlation of the energy/financial pair is most likely lower than that of the automobile/automobile pair. Because both positions were implemented as an overweight and underweight, the lower correlation of the two stocks in the second position should contribute more to active risk than the two-stock position that it replaced.

What are activist strategies?

Activist investors specialize in taking stakes in listed companies and advocating changes for the purpose of producing a gain on the investment. The investor may wish to obtain representation on the company's board of directors or use other measures in an effort to initiate strategic, operational, or financial structure changes.

What is a distinct feature of a well constructed portfolio?

Assuming similar costs, fees, alpha skills, similar active and absolute risks, and comparable factor exposures, a well constructed portfolio will have: - low idiosyncratic (unexplained) risk relative to total risk - lower absolute volatility and lower active risk - higher active share

What is the obligation for passive and active investors to engage in shareholder proxy voting?

Both active and passive managers have a fiduciary duty to vote proxy shares in the best interests of their investors. The active managers will usually do so directly. Due to the expense and time, however, most passive investors will usually do so indirectly through proxy-voting services. In both cases, however, the duty to vote proxy shares for their investors has been performed.

What are Pearson and Spearman Rank coefficients?

Both are used in backtesting of quantitative strategies. Pearson IC = correlation between factor exposure and subsequent period returns, high correlation means factor is good signal for predicting future returns. Disadvantage, Pearson IC is sensitive to outliers. Spearman Rank IC is correlation coefficient of factor score rank against stock returns rank, better predictor than Pearson IC because less sensitive to outliers. The Spearman Rank information coefficient is more robust to the nonlinear relationship because it is only measuring the correlation between rankings and not the raw data. Thus, in situations where nonlinear relationships exist, Spearman Rank IC will likely be higher than Pearson. Generally, an IC of over 0.05 is deemed to be strong. Pearson IC and Spearman Rank IC can contradict each other b/c of outliers affecting Pearson score.

How does a factor-based strategy compares to a broad-market-cap strategy in terms of risk exposure?

Compared with broad-market-cap weighting, passive factor-based strategies tend to concentrate risk exposure, leaving investors vulnerable during periods when the risk factor (e.g., momentum) is out of favor.

What is a characteristic of writing covered calls as a means of income enhancement?

Covered call is selling a call while owning the underlying. Writing covered calls would generate income, but doing so would limit the upside share price appreciation for the underlying shares.

What are the different types of administration fees?

Custody fees paid for the safekeeping of assets by a custodian (often a subsidiary of a large bank) that is independent of the investment manager. Depository fees paid to help ensure that custodians segregate the assets of the portfolio and that the portfolio complies with any investment limits, leverage requirements, and limits on cash holdings. Registration fees that are associated with the registration of ownership of units in a mutual fund.

What is the evidence of impact of activist investors on company financial metrics?

Data for US companies subject to activist investing show that on average fundamentals of a company such as revenue growth, EPS growth, return on equity and corporate governance indicators improve in the years after activist investing. Price momentum also significantly improves. The data also show that on average these improvements come at the cost of higher debt/equity ratios.

What is the largest component of equity total return over long period of time?

Dividends have comprised a significant component of long-term total returns for equity investors, but over shorter periods of time, the proportion of equity returns from dividends can vary considerably.

What are the differences between fundamental and quantitative strategy in terms of evaluating investment's growth prospects?

Fundamental analysis (not quantitative analysis) emphasizes forecasting future prospects, including the future earnings and cash flows of a company. Quantitative analysis focuses on historical performance.

What are the two main approaches to active equity investing?

Fundamental and quantitative

What is full replication?

Full replication in index investing occurs when a manager holds all securities represented by the index in weightings that closely match the actual index weightings. Advantages: - it usually accomplishes the primary goal of matching the index performance - it is easy to comprehend Full replication, however, requires that the asset size of the mandate is sufficient and that the index constituents are available for trading

What is buffering?

Establishing ranges around breakpoints that define whether a stock belongs in one index or another. Some index providers have adopted policies intended to limit stock migration problems and keep trading costs low for investors who replicate indexes. Size rankings may change daily with market price movements, so buffering makes index transitions a more gradual and orderly process. As long as stocks remain within the buffer zone, they stay in the current index, and as a result, the holdings of the fund may exceed the holdings of the index. Buffering makes index benchmarks more investable by making index transitions a more gradual and orderly process.

How to mitigate loss aversion bias?

Establishing stop-loss rules is most likely to address loss aversion bias, which is an emotional bias whereby investors tend to prefer avoiding losses over achieving gains. Stop-loss rules do not address illusion of control or confirmation bias.

What are event-driven equity strategies?

Event-driven strategies exploit market inefficiencies that may occur around corporate events such as mergers and acquisitions, earnings or restructuring announcements, share buybacks, special dividends, and spinoffs. Funds can hold either long or short positions in the acquiring and target companies as appropriate to produce a profitable position. This would be true even in consolidating industries as long as it believed that a market inefficiency existed.

What is exhaustive vs selective stock inclusion?

Exhaustive stock inclusion strategies are those that select every constituent of a universe, while selective approaches target only those securities with certain characteristics.

What are factor mimicking portfolios?

Factor mimicking portfolios are dollar neutral long/short portfolios that aim to generate a unit exposure to a single factor. As such they invest in very many positions without regard to short selling constraints and transaction costs. This can make them very expensive to construct. Factor tilting portfolios are not constructed using factor mimicking portfolios - they are portfolios designed to track a benchmark with small tilts towards factors that the manager expects to outperform.

True or false? Adding investment grade bonds to a passive equity index fund would reduce the portfolio's short term risk.

False. Predictability of correlations is uncertain.

What type of risk constraints (formal vs heuristic) is more appropriate for fundamental vs quantitative managers?

Fundamental managers are likely to run more concentrated portfolios and hold fewer positions - this increases the estimation errors for return distributions and makes the use of formal risk constraints that directly relate to estimate return distributions less useful. Hence fundamental managers are more likely to find heuristic risk constraints more appropriate. Conversely, quantitative active equity managers are likely to integrate formal risk constraint measures into portfolio optimizers when constructing their portfolios.

What is GARP investment strategy?

GARP (growth at a reasonable price) strategy seeks out companies with above-average growth that trade at reasonable valuation multiples. Many investors who use GARP rely on the P/E-to-growth (PEG) ratio. Most attractive candidates have low PEG ratios (on absolute basis, not relative to sector) and long-term growth forecasts exceeding industry average. PEG is calculated with the growth rate expressed as a percentage (i.e. if growth rate is 20%, we use 20 for the calculation).

How to calculate contribution of an asset to portfolio variance?

Given assets A, B, C: weight_A x weight_A x Cov(A,A) + weight_A x weight_B x Cov(A, B) + weight_A x weight_C x Cov(A,C) = Asset A'c contribution to total portfolio variance % of portfolio variance = Asset A's contribution / Total portfolio variance Total portfolio variance - STD^2 This calculation can also be performed with weights replaced by factor coefficients to determine contribution to total portfolio variance by a factor.

What is Growth factor?

Growth stocks are generally associated with high-performing companies with an above-average net income growth rate and high P/Es.

What are the characteristics of growth vs value stocks?

Growth stocks: high price momentum, high P/Es, and high EPS growth. Value stocks: high dividend yields, low P/Es, and low price-to-book value ratios.

What are the common risk factors?

Growth, Value, Yield, Momentum, Volatility, Quality, Size

How to calculate the Herfindahl-Hirschman Index?

HHI = Sum of portfolio constituent weightings squared Effective number of stocks = 1/HHI This is an estimate of effective number of stocks held in equal weights that would mimic the concentration level of the chosen index.

What are heuristic risk constraints?

Heuristic risk constraints are based on experience and deemed good practise without rigorous backing of empirical evidence. Example of a heuristic constraint: Liquidity constraint: It should always be possible to liquidate 85% of the portfolio in 10 trading days or less without suffering significant market impact costs Alternatively - the constraint "The 1 % Conditional VaR should not exceed 3%" is a formal constraint in that it is statistical in nature and directly linked to the distribution of the returns of the portfolio.

Summarize the combinations of active share and active risk and the strategy they indicate.

High active share / high active risk: stock picking (inc. pairs trading) Low active share / low active risk: indexing Anything in between is often indicative of factor investing.

How does an addition of a manager with a high/low covariance with the existing portfolio affect active risk and volatility of the portfolio?

High covariance - minimize active risk, but heighten overall volatility of the portfolio Low covariance - reduce overall portfolio volatility but increase active risk

Are factor based strategies transparent?

Passive factor-based strategies tend to be transparent in terms of factor selection, weighting, and rebalancing. The strategies can be easily replicated by other investors which can produce overcrowding and reduce the realized advantages of a strategy.

What is the Fundamental Law of Active Management?

IC - expected information coefficient, the extent to which a manager's forecasted active returns correspond to the realized active returns BR - breadth, the number of truly independent decisions made each year TC - transfer coefficient, or the ability to translate portfolio insights into investment decisions without constraint (TC = 1 in a unconstrained portfolio) sigma(R_a) - manager's active risk

What happens to portfolio risk if an asset is added with a higher covariance with the portfolio than current securities, or if such asset replaces an existing lower-covariance asset?

If a manager adds a new asset to his portfolio that has a higher covariance with the portfolio than most current securities, total portfolio risk will rise. (A high covariance with the existing portfolio can be driven by a high variance or a higher correlation of the new security with the portfolio.)

How to calculate manager return that is unexplained by rewarded factors (i.e. alpha)?

Return from unrewarded factors = Actual monthly performance - Return from rewarded factors

What are implicit costs of trading?

Implicit costs include delay and slippage. Characteristics that increase market impact of trades are large AUM but focus on small cap stocks, small numbers of securities in portfolio and large trade preference. Market impact is a function of the security's liquidity and trade size. The larger a trade size relative to a stock's average daily volume, the more likely it is that the trade will affect prices. The relatively low level of trading volume of small-cap stocks can be a significant implementation hurdle for a manager running a strategy with significant assets under management and significant positive active weights on smaller companies.

What is the mechanics of the M&A arbitrage strategy?

In a cash-only transaction, the acquirer proposes to purchase the shares of the target company for a given price. The stock price of the target company typically remains below the offered price until the transaction is completed. Therefore, an arbitrageur could buy the stock of the target company and earn a profit if and when the acquisition closes. In a share-for-share exchange transaction, the acquirer uses its own shares to purchase the target company at a given exchange ratio. A risk arbitrage trader normally purchases the target share and simultaneously short-sells the acquirer's stock at the same exchange ratio. Once the acquisition is closed, the arbitrageur uses his or her long positions in the target company to exchange for the acquirer's stocks, which are further used to cover the arbitrageur's short positions.

what is a price weighted vs equally weighted index?

In a price-weighted index, the weight of each stock is its price per share divided by the sum of all share prices in the index. A price-weighted index can be interpreted as a portfolio that consists of one share of each constituent company. Equally weighted indexes produce the least-concentrated portfolios. Such indexes have constituent weights of 1/n, where n represents the number of stocks in the index. Equal weighting of stocks within an index is considered a naive strategy because it does not show preference toward any single stock. The reduction of single stock concentration risk and slow changing sector exposures make equal weighting attractive to many investors.

What happens to active share and active risk if factor exposure is fully neutralized in a single-factor model?

In a single-factor model, if the factor exposure is neutralized, the active risk will be entirely attributable to the Active Share—a consequence of the manager deviating from benchmark weights.

What are the three features of independent variables used in a returns-based analysis?

Independent variables should: - be mutually exclusive - be exhaustive - represent distinct sources of risk.

What would be a relationship between a fund's active share and mgmt fees?

Investors are more likely to be willing to pay higher fees for higher Active Share as an indicator of greater active management

What is the growth trap?

Investors in growth stocks do so with the expectation that the share price will appreciate when the company experiences above-average earnings (or cash flow) growth in the future. However, if the company's results fall short of these expectations, stock performance is affected negatively. The stock may also turn out to have been overpriced at the time of the purchase. The company may deliver above-average earnings or cash flow growth, in line with expectations, but the share price may not move any higher due to its already high starting level.

What is data mining bias?

It arises due to the misuse of the sample data and refers to automated computational procedures for discovering patterns in large datasets, which can introduce a bias known as overfitting. The analyst searches through a dataset for a statistically significant pattern by repeatedly drilling into the same data until a pattern is found, which may be misleading. Quantitative strategies are prone to data mining bias.

What is look ahead bias?

Look-ahead bias is a type of bias that occurs when a study or simulation relies on data or information that was not yet available or known during the time period being studied. It generally leads to inaccurate results from a study or simulation. An example of this bias is using financial accounting data for a company at a point before the data were actually released by the company. Quantitative strategies are prone to this bias when back testing is implemented.

what is the look ahead bias?

Look-ahead bias occurs by using information or data in a study or simulation that would not have been known or available during the period being analyzed. This will usually lead to inaccurate results in the study or simulation.

What are the features of a diversified multi-factor approach?

Low single-security risk and modest overall portfolio risk, combined with flexibility on sector risk, demonstrate a highly diversified portfolio that primarily emphasizes factor exposures.

What is Volatility factor?

Low volatility is generally desired by investors seeking to lower their downside risk. Volatility is often measured as the standard deviation of stock returns.

What fund manager needs to be added to an indexed portfolio in order to minimize active risk?

Manager that has high covariance with the existing portfolio. Active risk is a measure of the volatility of portfolio returns relative to the volatility of benchmark returns. Given an existing portfolio that tracks an index, current portfolio active risk is likely low. Thus, in order to minimize active risk, we want to add a manager having high covariance with the present portfolio. The low-covariance funds may reduce overall portfolio volatility but not active risk.

What are the differences between fundamental and quantitative strategy in terms of portfolio risk?

Managers following a fundamental approach typically select stocks by performing extensive research on individual companies; thus, fundamental investors see risk at the company level. In contrast, with a quantitative approach, the risk is that factor returns will not perform as expected. Because the quantitative approach invests in baskets of stocks, the risks lie at the portfolio level rather than at the level of specific stocks (company level).

What is Momentum factor?

Momentum attempts to capture further returns from stocks that have experienced an above-average increase in price during the prior period. It is usually defined as amount of stock's excess return relative to market over a specified period.

What is Morningstar's style classification system?

Morningstar classifies securities as either value, growth or core, and funds as either value, growth or blend. Morningstar calculates a score for value and growth on a scale of 0 to 100 using five proxy measures for each. The value score is subtracted from the growth score. A strongly positive net score leads to a growth classification, and a strongly negative score leads to a value classification. A score relatively close to zero indicates a core classification. To achieve a blend classification, the portfolio must have a balanced exposure to stocks classified as value and growth, a dominant exposure to stocks classified as core, or a combination of both.

What are the characteristics of a multi-factor manager?

Most multi-factor products are diversified across factors and securities and typically have high active share but have reasonably low active risk (tracking error), often in the range of 3%. Most multi-factor products have a low concentration among securities in order to achieve a balanced exposure to risk factors and minimize idiosyncratic risks.

What are the ESG approaches to equity investing?

Negative screening: practice of excluding certain sectors or companies that deviate from accepted standards in areas such as human rights or environmental concerns Positive screening/best-in-class: identify companies or sectors that score most favorable with regard to ESG-related risks and opportunities Thematic investing: investing in companies within a specific sector or following a specific theme such as energy efficiency or climate change Impact investing: seeking to achieve targeted social or environmental objectives along with measurable financial returns through engagement with a company or by direct investment in projects or companies

How to calculate gross and net exposure?

Net = Long - Short Gross = Long + |Short| A long short portfolio can be structured to have 100% gross exposure.

Does currency overlay lever returns of securities held in foreign currency?

No. A currency overlay assists a portfolio manager in hedging (not levering) the returns of securities that are held in foreign currency back to the home country's currency.

What is optimization?

Optimization typically involves maximizing a desirable characteristic or minimizing an undesirable characteristic, subject to one or more constraints. For an indexed portfolio, the optimization process could account explicitly for the covariances in the portfolio constituents and involve minimizing index tracking error, subject to the constraint that the portfolio holds 50 constituent securities or fewer.

How do factors such as volatility, momentum and # of stocks correspond to different investing approaches?

Overweight low volatility - risk reduction approach Overweight momentum - return-oriented approach # of stocks higher than benchmark - diversification approach

What is pairs trading?

Pairs trading uses statistical techniques to identify two securities that are historically highly correlated with each other. When the price relationship of these two securities deviates from its long-term average, managers that expect the deviation to be temporary go long the underperforming stock and simultaneously short the outperforming stock. If the prices do converge to the long-term average as forecasted, the investors close the trade and realize a profit. Two stocks thus make for an ideal pairs trade if (1) the current price ratio differs from its long-term average and shows historical mean reversion and (2) the two stocks' returns are highly correlated

What is smart beta?

Portfolio returns can be explained by factor models, so one way to replicate the return/risk characteristics of an index is to create a portfolio with the same exposures to a set of risk factors as the index. This strategy is often referred to as a passive factor-based strategy (also known as smart beta).

What are the differences between fundamental and quantitative strategy in terms of rebalancing?

Portfolios managed using a quantitative approach are usually rebalanced at regular intervals, such as monthly or quarterly. In contrast, portfolios managed using a fundamental approach usually monitor the portfolio's holdings continuously and may increase, decrease, or eliminate positions at any time.

What is Quality factor?

Quality stocks might include those with consistent earnings and dividend growth, high cash flow to earnings, and low debt-to-equity ratios.

What is a returns-base style analysis and how does it compare with holdings-based analysis?

Regressing a fund's past returns against the past returns from a number of style indexes is a returns-based style analysis. Returns-based analysis is easier to implement than holdings-based analysis because data are more readily available. Holdings-based analysis allows for a deeper level of analysis when compared with returns-based analysis because holdings-based analysis uses the actual portfolio holdings. The analysis is more accurate and generates more information for making style allocation decisions.

What is the difference between factor based and market cap weighted strategies in terms of risk exposure?

Relative to broad-market-cap-weighting, passive factor-based strategies tend to concentrate risk exposures, leaving investors exposed during periods when a chosen risk factor is out of favor.

How to determine if returns of a manager pursuing an index replication strategy are a matter of luck vs skill?

Replication managers attempt to create a portfolio that tracks the performance and the volatility of the underlying index as closely as possible. The proper measure of skill is the tracking error: the manager with the highest tracking error may outperform the benchmark by luck.

Given two funds A and B, with fund A having higher active risk indicator, which one of them would be expected to have higher number of sector bets?

Sector bets are likely to affect active risk; therefore, Fund A is more likely to be using sector bets, not Fund B.

What is stock lending?

Securities lending involving the transfer of equities. Stock lenders generally receive a fee from the stock borrower as compensation for the loaned shares, including compensation for any stock dividends that the lender would have received had the stock not been lent. Additionally, lenders can generate income by investing the cash collateral. Income generated by lending securities provides income to a passive portfolio, which can be used to offset expenses, including management fees.

What is skewness?

Skewness measures the degree to which return expectations are non-normally distributed. If a distribution is positively skewed, the mean of the distribution is greater than its median—more than half of the deviations from the mean are negative and less than half are positive—and the average magnitude of positive deviations is larger than the average magnitude of negative deviations. Negative skew indicates that that the mean of the distribution lies below its median, and the average magnitude of negative deviations is larger than the average magnitude of positive deviations.

What are special dividends and optional stock dividends?

Special dividends occur when companies decide to distribute excess cash to shareholders, but the payments may not be maintained over time. Optional stock dividends occur when shareholders may elect receive either cash or new shares.

What is packeting?

Splitting stock positions into multiple parts. Let us say that a stock is currently in a mid-cap index. If its capitalization increases and breaches the breakpoint between mid-cap and large-cap indexes, a portion of the total holding is transferred to the large-cap index but the rest stays in the mid-cap index. On the next reconstitution date, if the stock value remains large-cap and all other qualifications are met, the remainder of the shares are moved out of the mid-cap and into the large-cap index.

What are statistical arbitrage strategies?

Statistical arbitrage (or "stat arb") strategies use statistical and technical analysis to exploit pricing anomalies. Statistical arbitrage makes extensive use of data such as stock price, dividend, trading volume, and the limit order book for this purpose. The analytical tools used include (1) traditional technical analysis, (2) sophisticated time-series analysis and econometric models, and (3) machine-learning techniques. Portfolio managers typically take advantage of either mean reversion in share prices or opportunities created by market microstructure issues. Pairs trading is an example of a popular and simple statistical arbitrage strategy.

What is style fit?

Style fit reflects how well the actual portfolio fits with its stated objectives in relation to style (e.g. large cap value, small cap growth, etc.). Style analysis techniques (Returns based, Holdings based, or Equity Style Box) are used to identify the portfolios styles and can detect style drift. Style fit can be charted as a plot of R-squared over time (R-squared from returns based regression analysis to style indices). The difference 1-R-squared denotes % of returns derived from stock selection (i.e. active management). Thus, an increase in R-squared over time suggests that active management is falling.

How to determine the number of futures required to be added to the portfolio, given futures price and subject to an asset allocation?

Suppose the amount to be received in one month (USD5,750,000) needs to be invested passively based upon the strategic allocation. Using the strategic allocation of the portfolio, 15% (USD862,500.00) should be allocated to US equity exposure using the S&P 500 E-mini contract, which trades in US dollars. Because the futures price is 2,464.29 and the S&P 500 E-mini multiplier is 50, the contract unit value is USD123,214.50 (2,464.29 × 50). The correct number of futures contracts is (5,750,000.00 × 0.15)/123,214.50 = 7.00. Therefore, investor will buy seven S&P 500 E-mini futures contracts.

What is survivorship bias?

Survivorship bias or survival bias is the logical error of concentrating on the people, things or companies that made it past some selection process and overlooking those that did not, typically because of their lack of visibility (since they haven't survived). Survivorship bias occurs when back-testing uses companies that are in business today but ignores companies that have left the investment universe. This can lead to false conclusions. Quantitative strategies are prone to this bias.

When a benchmark security held in an active portfolio is replaced with a similar security that is not held in the benchmark, what would happen to Active Share and active risk?

Swapping a security that is in the benchmark for a security that is not in the benchmark will certainly increase Active Share because Active Share is a direct measure of the amount of the portfolio that is not included in the benchmark. Active risk however will not necessarily increase since it is a measure of the volatility of relative returns - this is unlikely to increase if the new security that is introduced in to the portfolio behaves in a similar way to the benchmark security that was originally held in the portfolio.

Targeting low concentration and low idiosyncratic risk indicates a fundamental or systematic approach?

Targeting low idiosyncratic risk along with low concentrations indicates a systematic approach, not a discretionary approach.

What is a differentiating factor of active risk attributed to active share in a diversified portfolio?

The active risk attributed to Active Share will be smaller for more diversified portfolios with lower idiosyncratic risk.

What is the primary risk in pairs trading strategy and how to mitigate it?

The biggest risk in pairs trading is that the observed price divergence is not temporary and could be due to structural reasons. Frequent use of stop-loss rules, which are set to exit trades when a loss limit is reached, addresses this risk.

What is the difference between discretionary and systematic investment approach in terms of the process of arriving to an investment decision?

The discretionary investment process searches for active returns from firm-specific factors, such as pricing power and the competitive landscape. This process results in more concentrated portfolios reflecting the depth of the manager's insights on firm characteristics and the competitive landscape. A discretionary approach will involve managerial judgments on a smaller subset of securities. A systematic investment approach is likely to be designed around extracting premiums from a balanced exposure to known, rewarded factors and typically incorporates research-based rules across a broad universe of securities. Manager discretion has a minimal role in quantitative approaches and such funds' investment processes will rely heavily on software and technology. Fundamental approaches stress the use of human judgment in arriving at an investment decision, whereas quantitative approaches stress the use of rules-based, quantitative models to arrive at a decision.

Which index type (price-weighted, value-weighted, equal-weighted) will have bias to small cap stocks?

The equal-weighted index is biased towards small-cap companies because they will have the same weight as large-cap firms even though they have less liquidity. Many equal-weighted indices also have more small companies in them than large firms, creating a further bias towards small companies. Value-weighted indices are biased towards large cap stocks and price-weighted indices are biased towards high priced stocks.

What are the differences between fundamental and quantitative strategy in terms of size of investment universe?

The focus of a quantitative approach is on factors across a potentially large group of stocks, whereas fundamental strategies focus on a relatively small group of stocks.

What is the most cost efficient strategy to rebalance the portfolio to IPS prescribed allocations, following an equity market correction?

The most cost efficient rebalancing strategy is to implement an overlay using equity index futures. This approach can get the equity exposure up to at least the guideline range without impacting the active managers. Equity index futures will very likely have less tracking error than the active managers. Simply buying equities and selling bonds will incur trading costs and disrupt the present active managers' execution. This is not the most cost-effective solution compared with a derivatives overlay.

How to determine if a manager uses stratified sampling blended with optimization approach?

The optimization process accounts explicitly for the covariances in the portfolio constituents and results in lowering tracking error when compared with stratified sampling alone. So we look for (1) a materially lower number of portfolio holdings compared to the benchmark as indication of stratified sampling, and (2) low tracking error to demonstrate optimization

What is turnover ratio?

The portfolio turnover ratio measures its trading activity. It is calculated as the lower of purchases and sales divided by average monthly net asset. Example: A portfolio had beginning, ending, and average net assets of $120 million, $145 million, and $130 million, respectively. During that month, the portfolio had purchases of $18 million and sales of $25 million. TR = $18 million / $130 million = 13.8%

What is a short term reversal strategy?

The short-term reversal factor risk premium is earned by selling recent outperformers and buying recent underperformers on a short-term investment horizon. This is likely to have a relatively high turnover compared to other more passive factor strategies and as such will likely have higher slippage costs as the manager's assets under management increase.

What is equity universe segmentation by geography?

This approach is typically based on the stage of markets' macroeconomic development and wealth. Common geographic categories are developed markets, emerging markets, and frontier markets. - useful for global diversification by investing - a key weakness is that investing in a specific market (e.g., market index) may provide lower-than-expected exposure to that market (e.g. many large companies domiciled in the United States, Europe, or Asia may be global in nature as opposed to considerable focus on their domicile) - another key weakness is potential currency risk

What is Yield factor?

Yield is identified as dividend yield relative to other stocks. High dividend-yielding stocks may provide excess returns in low interest rate environments.

Does tracking error measures volatility of the portfolio?

Tracking error does not measure volatility of the portfolio; rather, it measures the volatility of the excess return between the index and the portfolio

Which manager will likely have the largest tracking error?

Tracking error indicates how closely the portfolio behaves like its benchmark and measures a manager's ability to replicate the benchmark return. Manager C is most likely to have the largest tracking error for three reasons: - The portfolio contains a smaller number of the index holdings than the other two portfolios, resulting in a lower level of replication. - Dividends are reinvested the day following receipt rather than the same day, which would cause cash drag relative to Manager B. - The portfolio is reconstituted less frequently than the other two portfolios. Although Manager C has a slightly lower management fee, which would result in a lower tracking error, the benefit is unlikely to offset the combined higher tracking error related to the other portfolio characteristics.

True or false? Long only portfolio generally allows for greater investment capacity than other approaches, particularly when using strategies that focus on large cap stocks.

True

What are the two main approaches in style analysis?

Two main approaches are often used in style analysis: a returns-based approach and a holdings-based approach. - Holdings-based approaches aggregate the style scores of individual holdings - Returns-based approaches analyze the investment style of portfolio managers by comparing the returns of the strategy to those of a set of style indexes

What is the Information Coefficient calculated as part of back testing performance of a quantitative strategy?

Under the assumption that expected returns are linearly related to factor exposures, the correlation between factor exposures and their holding period returns for a cross section of securities has been used as a measure of factor performance in quantitative back-tests. This correlation for a factor is known in this context as the factor's information coefficient (IC).

What are the different VaR risk measures?

VaR measures how much a portfolio might lose with a given probability under normal market conditions. CVaR measures the average loss that would occur if the VaR threshold is surpassed (i.e., expected tail loss). IVaR is the impact on portfolio VaR if a new position is added to a portfolio (and existing positions are reduced). MVaR measures the impact of a very small change in the position size. In a diversified portfolio, MVaR is appropriate to calculate the contribution of each asset to the total portfolio VaR.

What is deep value investing?

Value based approach. A value investor with a deep-value orientation focuses on undervalued companies that are available at extremely low valuation relative to their assets (e.g., low P/B). Such companies are often those in financial distress.

What is special situations investing?

Value based approach. Focuses on the identification and exploitation of mispricings that may arise as a result of corporate events such as divestitures or spinoffs of assets or divisions or mergers with other entities.

What is restructuring and distressed investing approach?

Value based approach. Opportunities in restructuring and distressed investing are generally counter cyclical relative to the overall economy or to the business cycle of a particular sector. A weak economy generates increased incidence of companies facing financial distress. When a company is having difficulty meeting its short-term liabilities, it will often propose to restructure its financial obligations or change its capital structure.

What is high quality value strategy?

Value based approach. Some value-based strategies give valuation close attention but place at least equal emphasis on financial strength and demonstrated profitability. High quality managers believe investors sometimes behave irrationally, making stocks trade at prices very different from intrinsic value based on company fundamentals.

What is income investing strategy?

Value based approach. The income investing approach focuses on shares that offer relatively high dividend yields and positive dividend growth rates.

What is contrarian investment approach?

Value based strategy. Contrarian investors purchase and sell shares against prevailing market sentiment. Their investment strategy is to go against the crowd by buying poorly performing stocks at valuations they find attractive and then selling them at a later time, following what they expect to be a recovery in the share price. Companies in which contrarian managers invest are frequently depressed cyclical stocks with low or even negative earnings or low dividend payments. Contrarians expect these stocks to rebound once the company's earnings have turned around, resulting in substantial price appreciation.

What is Value factor?

Value stocks are generally associated with mature companies that have stable net incomes or are experiencing a cyclical downturn. Value stocks frequently have low price-to-book and price-to-earnings ratios as well as high dividend yields.

What is a relative value strategy?

Value-based approach. Investors who pursue a relative value strategy evaluate companies by comparing their value indicators (e.g., P/E or P/B multiples) to the average valuation of companies in the same industry sector with the aim of identifying stocks that offer value relative to their sector peers. As different sectors face different market structures and different competitive and regulatory conditions, average sector multiples vary.

What is stratified sampling?

When investor selectively chooses index constituents instead of fully replicating the index. In equity indexing, stratified sampling is most frequently used when the portfolio manager wants to track indexes that have many constituents or when dealing with a relatively low level of assets under management. Brokerage fees and trading and rebalancing fees can be expensive.

How could stock lending interfere with the goal of investor participation in corporate governance (e.g. proxy voting)?

When using security lending, the voting rights are transferred to the borrower of the securities. Thus, investor would not be able to exercise his voting rights through proxy on those shares.

What is a covered put?

Writing covered puts is a bearish options trading strategy involving the writing of put options while shorting the obligated shares of the underlying stock. A cash-covered put could be a good option in a range-bound or a slight downtrend, but in a deep downtrend, the investor could be forced to purchase shares at a strike price that is considerably higher than the current market price at the time of exercise.

What are factor based strategies?

a factor-based strategy aims to identify significant factors that can predict future stock returns and to construct a portfolio that tilts towards such factors

What is program trading?

a strategy of buying or selling many stocks simultaneously

How to mitigate confirmation bias?

confirmation bias is the tendency of investors to look for information that confirms their existing beliefs about their favorite companies and ignore or undervalue any information that contradicts their existing beliefs. The consequences of confirmation bias are a poorly diversified portfolio, excessive risk exposure, and holdings in poorly performing securities. Actively seeking the opinions of other team members or other information to challenge existing beliefs will help mitigate this bias.

What are the features of an approach focused on stock picking?

high exposure to risk from a single security, low sector deviations and could have high or low active risk, depending on whether concentrated or diversified approach was selected

When will an active manager generate positive active returns?

if the gains generated by - overweighting securities that outperform the benchmark underweighting the securities that underperform it are on average greater than the losses generated by - underweighting the securities that outperform the benchmark and overweighting securities that underperform it

How to mitigate illusion of control bias?

illusion of control refers to the human tendency to overestimate one's ability to select stocks, influence outcomes, and outperform the market. An illusion of control could lead to excessive trading and heavy weighting on a few stocks. Investors should enforce proper trading and portfolio diversification rules to try to avoid this problem.

What is the segmentation by economic activity?

production-oriented: groups companies that manufacture similar products or use similar inputs in their manufacturing process - ICB, TRBC, RGS market-oriented: groups companies based on the markets they serve, the way revenue is earned and the way customers use companies' products - GICS classification The key disadvantage of segmentation by economic activity is that the business activities of companies—particularly large ones—may include more than one industry or sub-industry.

What is reconstitution?

reconstitution involves deleting names that are no longer in the index and adding names that have been approved as new index members

What is the segmentation by size and style?

size: small, mid and large cap style: value, core, growth

What is tracking error?

standard deviation of active return (portfolio return - benchmark return)