Reading 24 - Equity Portfolio Management

Another characteristic often used in describing the style of equity investors is the typical market capitalization of the issues they hold *MID CAP*

*Focusing on middle-capitalization equities*

5.1. *Equity Styles* 5.1.2. *Growth* Investment Styles e. *Explain the rationales and primary concerns of growth investors*

*PAY ABOVE-market earnings multiples* for companies that *have superior growth rates* *Invest in companies in growth industries*, such as *TECH, HEALTHCARE, & CONSUMER PRODUCTS* GROWTH STOCKS have *HIGH SALES GROWTH relative to the overall market* & *tend to trade at HIGH P/E, P/B, & P/S*

Where is Passive (indexing) most appropriate? Answer: Three common options 2. Overseas Markets (Unfamiliar markets)

3. INDEXING is also a good choice in MARKETS WITH WHICH AN INVESTOR MAY BE UNFAMILIAR (OVERSEAS MARKET)

At least FOUR economically significant differences separate INDEX MUTUAL FUNDS vs INDEXED ETFs

4. Users of *ETFs pay transaction costs including COMMISSIONS to trade them* *But for their ONGOING shareholders*: ETFs provide better protection from the cost of providing LIQUIDITY to shareholders who are SELLING fund shares

These different weighting schemes can lead to a NUMBER OF BIASES PRICE WEIGHTED: MAIN ADVANTAGE

ADVANTAGE: 1. *SIMPLICITY of its construction* 2. *STOCK PRICE data series are also EASIER to obtain* historically than MARKET VALUE series. Consequently, *price-weighted index series can go back far into the past

Other issues with MARKET CAP weighted index construction

Another criticism of value-weighted/float-weighted indices is that: 1. *Portfolios based on such an INDEX* may be *concentrated in relatively FEW ISSUES* and, hence,*LESS DIVERSIFIED* THAN most actively managed portfolios

a. *Discuss the role of equities in the overall portfolio* Primary Role in the portfolio: 1. *Inflation Hedge* Are equities better than bonds to hedge inflation? Why?

As *residual real claims on businesses*, EQUITIES should offer *superior protection against UNANTICIPATED inflation* compared with conventional BONDS *Companies' EARNINGS TEND TO INCREASE WITH INFLATION* *Payments on CONVENTIONAL BONDS are FIXED* in nominal terms

*Relative strength indicators*:

Compare a *stock's performance during a specific period* either to its *own past performance*or *to the performance of some group of stocks*

3. *ETFs are often MUCH MORE TAX-efficient* than CONVENTIONAL FUNDS in many markets

EXCHANGE-TRADED FUNDS are less likely than mutual funds to *MAKE TAXABLE CAPITAL GAINS DISTRIBUTIONS* At the investor level, MUTUAL FUND buyers are affected by a fund's COST BASIS for its positions, which may differ quite a bit from the positions' CURRENT VALUE. At the time of purchase an investor may *buy into a potential tax liability* if the positions show a gain Unlike a traditional mutual fund that will ordinarily sell stocks inside the fund and pay cash to a fund shareholder who is redeeming shares, the redemption mechanism for an exchange-traded fund is usually "in kind" in the sense of being an exchange of shares. The FUND (ETF FUND) typically delivers a basket of the fund's portfolio stocks to a redeeming DEALER who has turned in shares of the fund for this exchange In the US, this transaction is NOT TAXABLE from the FUNDS's perspective, and there is no distributable GAIN on the redemption.

Second main ROLE of Equities: 2. *Growth*

Equities' relative HIGH historical *LONG TERM REAL RATES OF RETURN* help support the belief that it *PLAYS A GROWTH ROLE IN A PORTFOLIO*

4.1.2. Equity Indices: Composition and Characteristics of Major Indices

In choosing the INDEX TO REPLICATE, a fund must evaluate the TRADE-OFF between differences in *TRANSACTION COSTS & differences in return PREMIUM among the indices*

Continued

In some cases, the *preferred method* depends on *PORTFOLIO SIZE & the AVAILABILITY OF ACTIVE TRADING in an index basket* by means of PORTFOLIO TRADES For example: An INDEXER may use FULL replication for a LARGE FUND (e.g., an ETF) tracking the Russell 2000, making use of standard Russell 2000 basket trades, but may choose OPTIMIZATION for SMALLER, separately managed accounts indexed to the same index

4.2.2. Equity Index Futures Mental Map: 4.1.1. Index Weighting Choices 4.1.2. Equity Indices: Composition & Characteristics of Major Indices 4.2. Passive Investment Vehicles: 4.2.1. Indexed Portfolios 4.2.2. Equity Index Futures 4.2.3. Equity Total Return Swaps

In the 80s TWO additional indexing products arrived: 1. PORTFOLIO TRADES (also known as BASKET TRADES or PROGRAM trades) Portfolio trade = *basket of securities* traded as a BASKET or UNIT Traditional security trade = done one share issue at a time Made when all of the stocks in the basket are traded together under relatively standardized terms) 2. STOCK INDEX FUTURES

5.1. *Equity Styles* 5.1.1. *Value* Investment Styles e. *Explain the rationales and primary concerns of value investors*

MAIN IDEA: Concerned about *buying a stock that looks relatively CHEAP in terms of the purchase price of earnings OR assets * *RATIONALE*: Companies' earnings may have a tendency to *REVERT TO A MEAN VALUE* IF *valuation multiples for a set of stocks are depressed* because of *recent earnings problems*, an investor in those stocks may benefit from *reversion to the mean* in earnings *accompanied by expansion in P/Es* *The flip side of the argument* is that investments in *stocks that are RELATIVELY EXPENSIVE* expose the investor to the *RISK OF CONTRACTION in multiples & in earnings*

5.1. *Equity Styles* 5.1.2. *Growth* Investment Styles e. *Explain the rationales and primary concerns of growth investors*

MAIN IDEA: More *concerned with earnings* *RATIONALE*: Assumption is that *if a company can deliver future growth in EPS* and *its P/E DOES NOT DECLINE*, then its *SHARE PRICE will APPRECIATE at LEAST at the RATE of EPS GROWTH*

Why use the Equity Total Return Swaps?

Most equity swap applications are motivated: By differences in the *TAX TREATMENT of shareholders domiciled in different COUNTRIES* or By the desire to *GAIN EXPOSURE to an ASSET CLASS in asset allocation*

What are some reasons companies *cannot cope with increase in inflation*?

Nevertheless, companies do face challenges in coping with inflation *REPORTED EARNINGS* often *OVERSTATE THEIR REAL economic value* to varying degrees 1. *CORPORATE INCOME TAXES & CAPITAL GAINS TAX* rates are typically *NOT INFLATION INDEXED*, so inflation can *cut into investors' after-tax real returns* UNLESS share prices fully reflect the interaction of inflation & taxation

Drawback of OPTIMIZATION over INDEXING Important for morning section....

OPTIMIZATION has several DRAWBACKS as an approach to INDEXATION 1. IMPERFECTLY SPECIFIED: *Impossible to create a RISK MODEL that EXACTLY captures the RISK associated with a give STOCK*, if only because *RISKS CHANGE OVER TIME & RISK MODELS are based on HISTORICAL DATA*

Drawback of OPTIMIZATION over INDEXING Important for morning section....

OPTIMIZATION has several DRAWBACKS as an approach to INDEXATION 2. The optimization procedure *seeks to maximally exploit any risk differences among securities*, even if they *just REFLECT SAMPLING ERROR* (problem known as *OVERFITTING THE DATA*)

4. Users of ETFs pay transaction costs including COMMISSIONS to trade them, but for their ONGOING shareholders, ETFs provide better protection from the cost of providing LIQUIDITY to shareholders who are SELLING fund shares

Occasionally, a conventional fund—particularly a non-index fund—will deliver stock in kind to a large redeeming shareholder; but most conventional funds offer limited opportunities to redeem fund shares by delivering portfolio stock in kind The in-kind creation and redemption process of ETFs also insulates long-term ETF shareholders from the costs of supplying LIQUIDITY to traders, a persistent problem with mutual funds in a number of markets

Optimization (multi factor risk model)

Optimization is a *MATHEMATICAL APPROACH* to index fund construction involving the use of: • a MULTI-FACTOR RISK MODEL, against which the risk exposures of the INDEX and INDIVIDUAL SECURITIES are measured • an *OBJECTIVE FUNCTION* that specifies that securities be held in proportions that *MINIMIZE EXPECTED TRACKING RISK relative to the INDEX* subject to *APPROPRIATE CONSTRAINTS* Factors might include: 1. MARKET CAPITALIZATION 2. BETA 3. INDUSTRY MEMBERSHIP 4. MACROECONOMIC FACTORS such as IR levels Objective function seeks to *MATCH the PORTFOLIO'S RISK EXPOSURES to those of the index* being tracked

Other issues with MARKET CAP weighted index construction

Other issues: BECAUSE of REGULATORY or other restrictions on maximum holdings, *indexing to some concentrated indices may be infeasible*

These different weighting schemes can lead to a NUMBER OF BIASES PRICE WEIGHTED: BIAS

PRICE WEIGHTED: BIASED: 1. *HIGHEST-PRICE share*

*MID CAP* Rationale

RATIONALE: *LESS well researched than the LARGE-CAP* companies but *financially STRONGER* and *LESS VOLATILE* than SMALL-cap companies

*SMALL CAP* Rationale

RATIONALE: 1. *MORE OPPORTUNITY exists to find MISPRICED stocks via research in the SMALL-CAP universe* than in the less numerous and *more intensely researched universe of LARGE-CAP firms* 2. Smaller companies tend to have *BETTER GROWTH PROSPECTS* because their business is *starting from a smaller base* & their product line tends to be more focused Also, the *chance of earning a very high rate of return on one's money is much better* if the starting market capitalization is small Small-cap investors can also *focus on VALUE, GROWTH, or MARKET-orientation* within the SMALL-CAP universe

4.2.3. Equity Total Return Swaps

Resemble the more widely known fixed-income and currency swaps The distinct feature of an EQUITY SWAP is that at least ONE SIDE of the transaction receives the *TOTAL RETURN of either an EQUITY instrument or, more commonly, an EQUITY INDEX portfolio* The OTHER SIDE can be either another *EQUITY instrument or INDEX or an INTEREST payment* The most common *NON-EQUITY* swap counter payments are *USD LIBOR for equity swaps* based on US securities, or LIBOR in the appropriate currency for equity swaps based on non-US stocks

3. Approaches to Equity Investment *PASSIVE* b. Discuss the rationales for *passive equity investment* approaches and distinguish among those approaches with respect to expected active return and tracking risk;

The investor *DOES NOT ATTEMPT TO REFLECT HIS INVESTMENT EXPECTATIONS* through changes in security holdings The dominant passive approach is *INDEXING* (attempts to match the performance of some specified benchmark)

4.2. Passive Investment Vehicles 4.2.1. Indexed Portfolios 4.2.2. Equity Index Futures 4.2.3. Equity Total Return Swaps

The major choices are: 1. Investment in an *INDEXED portfolio* 2. *LONG position in CASH* plus a *LONG position in FUTURES contracts* on the underlying INDEX, when such markets are available & liquid 3. *LONG position in CASH* plus a *LONG position in a SWAP on the INDEX*

Differences between: Index Mutual Funds & ETFs vs Indexed Institutional portfolios

The principal difference is *COST* *Indexed institutional portfolios* managed as separate accounts with a single shareholder or, increasingly, as pooled accounts, are extremely *LOW-COST PRODUCTS* Occasionally, *where securities with an active lending market are involved*, the *revenue from securities lending* can equal or exceed *total portfolio management and custody expenses*

4.2. Passive Investment Vehicles 4.2.1. Indexed Portfolios 1. Conventional Index Mutual Funds 2. Exchange-traded funds (ETFs) 3. SEPARATE accounts or POOLED accounts

The three most important categories of INDEXED portfolios are: 1. *Conventional index MUTUAL FUNDS* 2. *Exchange-traded funds (ETFs)* Based on benchmark index portfolios 3. *SEPARATE accounts or POOLED accounts* *Mostly for INSTITUTIONAL investors*, designed to track a benchmark index

4.2. Passive Investment Vehicles 4.2.1. Indexed Portfolios 1. INDEX MUTUAL FUNDS 2. Exchange-traded funds (ETFs) 3. SEPARATE accounts or POOLED accounts

Turning to INDEXED INSTITUTIONAL PORTFOLIOS, a relatively *small number of quantitatively oriented investment management organizations* manage the majority of the money in such indexed accounts The same organization may manage *INSTITUTIONAL PORTFOLIOS, CONVENTIONAL FUNDS, and ETFs* Management of these different portfolios may be assigned to separate groups of managers or integrated, with the portfolio management and trading functions consolidated in a single indexing group Investment management firms' aggressiveness in implementing index composition changes varies, and in fact may vary from one type of account to another within the same firm

2. STOCK INDEX FUTURES Exchange for physicals (EFP)

Using an EFP, a *futures position* can be translated into a *portfolio position* The product interchangeability through the EFP process facilitates risk-management transactions for many participants in the securities markets *The limited life of a futures contract* and the fact that the *most active trading in the futures market is in the nearest expiration contract* means that a *futures position must be rolled over periodically* to maintain appropriate market exposure.

These different weighting schemes can lead to a NUMBER OF BIASES VALUE WEIGHTED: BIAS

VALUE WEIGHTED: BIASED: 1. Companies with the *LARGEST MARKET CAPITALIZATION* The bias toward large market cap issues in value-weighted/float-weighted indices, however, means that such indices will tend to be BIASED toward: 1. *LARGE & probably MATURE COMPANIES* 2. *OVERVALUED companies*, whose share prices have already risen the most

3. Approaches to Equity Investment *SEMI-ACTIVE* (ENHANCED INDEXING or RISK-CONTROLLED) b. Discuss the rationales *semi-active (enhanced index)* equity investment approaches and distinguish among those approach with respect to expected active return and tracking risk;

Variant of active management The manager SEEKS TO OUTPERFORM A GIVEN BENCHMARK, as do active managers in general A semi-active PM, however, *worries MORE about TRACKING RISK* than an ACTIVE manager does and Manager will tend to build a portfolio whose performance will have *VERY LIMITED VOLATILITY around the benchmark's returns*

INDEXED PORTFOLIOS are *NOT PASSIVE IN IMPLEMENTATION*

When a stock is ADDED to or DROPPED from an index, or when the WEIGHT of a given stock CHANGES because of a corporate action (share buyback, or secondary offering), the *PORTFOLIO MUST BE ADJUSTED* Today, INDEXED portfolios often function as the *CORE HOLDING* in an investor's overall equity allocation

The *value investing style* has at least *three SUB-STYLES* 2. *High yield*

o Focuses on stocks that *offer high dividend yield with prospects of MAINTAINING or INCREASING the dividend* JUSTIFICATION: Knowing that in the long run, *dividend yield has generally constituted a major portion of the TOTAL RETURN on equities*

Other issues with MARKET CAP weighted index construction

*Largest-cap stocks are more likely to incorporate positive pricing errors* than negative pricing errors (2005) SOLUTION: *Adjusting the MARKET CAP DOWNWARD when P/E are high* *Adjusting the MARKET CAP UPWARD when P/E are low*

Where is Passive (indexing) most appropriate? Answer: Three common options 2. Large Cap Equity markets

2. LARGE-CAP EQUITY MARKETS favors INDEXING In typically *less efficient market segments, such as SMALL CAP*, the *supply of active investment opportunities may be larger* but *transaction costs are higher*

Advantages of over OPTIMIZATION over STRATIFIED sampling

An ADVANTAGE of OPTIMIZATION compared with stratified sampling is that optimization *takes into account the COVARIANCES* among the factors used to explain the return on stocks The STRATIFIED sampling approach implicitly assumes the factors are *MUTUALLY UNCORRELATED*

2. *ETFs generally PAY MICH HIGHER INDEX LICENSE FEES* than CONVENTIONAL FUNDS

EXCHANGE-TRADED FUNDS have *NO SHAREHOLDER ACCOUNTING at the FUND LEVEL*, so *THEIR EXPENSE RATIOS are typically LOWER* THAN CONVENTIONAL MUTUAL FUND EXPENSE RATIOS FOR FUNDS linked to comparable indices Brokers who carry these shares for investors may levy *inactivity fees on ETF shareholders* if they trade rarely, and of course there are transaction costs associated with buying & selling ETF shares in the marketplace At the fund level, the most significant *tax difference between conventional funds and ETFs* is in the process by which *fund shares are redeemed*. A traditional MUTUAL FUND will usually experience a TAX EVENT from SELLING PORTFOLIO securities when holders of a significant number of shares redeem their positions for cash.

Why use the Equity Total Return Swaps? 2. Rebalance to SAA

Equity swaps have another important application: ASSET ALLOCATION TRANSACTIONS A manager can use equity swaps to *REBALANCE portfolios to the SAA* *Total costs to rebalance by trading the underlying* securities *may EXCEED the cost of an EQUITY SWAP* Consequently, effecting the asset allocation change with a SWAP is *often more EFFICIENT* Equity swaps are used in *tactical asset allocation* for similar reasons

4.1.2. Equity Indices: Composition and Characteristics of Major Indices

The indexer should also be aware of *liquidity differences* among the *component securities* of the various indices that cover the same market segment E.g.: LIQUIDITY & relatively ADEQUATE FLOAT are criteria for selection to the S&P SmallCap 600 Index but not the Russell 2000 Index The downside, investing in *LESS LIQUID shares* may allow the *indexer to capture an ILLIQUIDITY PREMIUM*

1. *SHAREHOLDER ACCOUNTING* at the fund level can be a *significant expense for conventional MUTUAL FUNDS* in some markets, but *ETFs DO NOT have fund level shareholder accounting*

To the extent that a fund has a LARGE NUMBER of SMALL shareholders, shareholder record-keeping will be a SIGNIFICANT COST reflected in the FUND'S EXPENSE RATIO Some funds attempt to cope with this cost & to allocate it to the shareholders who are responsible for it by charging a MAINTENANCE FEE for accounts below a CERTAIN SIZE and by offering funds with a LOWER EXPENSE RATIO to VERY LARGE INVESTORS

Why would an index fund underperform the index (eg. S&P500) even if it did the full replication method?

*Attempting to fully replicate an index containing a large proportion of ILLIQUID STOCKS* will usually result in an index portfolio that *UNDERPERFORMS the index* This phenomenon occurs because indices DO NOT have to bear *transaction costs* but a real portfolio does These transaction costs include brokerage commissions, bid-offer spreads, taxes, and the market impact of trades

*The GROWTH style* has at *least TWO substyles*: 1. *Consistent growth* 2. Earnings momentum

*CONSISTENT GROWTH*: Companies have a *LONG HISTORY* of: 1. *Unit-sales growth* 2. *Superior profitability* 3. *Predictable earnings* They tend to *trade at HIGH P/Es* and be the *LEADERS in CONSUMER-ORIENTED BUSINESSES* (think of Starbucks)

4. *Passive Equity Investing* Major advantage over active investments

*Compared to ACTIVELY managed fund*, a well-run *INDEXED fund's MAJOR ADVANTAGE* is: *EXPECTED SUPERIOR long-term net-of-fees performance* Reason: *LOW TURNOVER & LOW MANAGEMENT FEES* (often 0.10% of assets or less)

1. Tax efficiency for cross boarder investors

*Dividend withholding taxes*, and an often *cumbersome process for obtaining appropriate relief from part of the withholding tax*, give many cross-border investors an *incentive to use an equity total return swap* They receive the *total return of a international equity index* in return for an *interest payment to a counter party* that holds the underlying equities more tax-efficiently

The growth style has at least two substyles: 1. Consistent growth 2. *Earnings momentum*

*EARNINGS MOMENTUM*: *Companies may have HIGHER POTENTIAL EARNINGS GROWTH RATES* than *CONSISTENT growth companies*, but such *GROWTH IS LIKELY to be LESS SUSTAINABLE*(think of solar stocks) Some growth investors also *include PRICE MOMENTUM INDICATORS such as RELATIVE STRENGTH indicators* in their investment disciplines They *rely on possible patterns of price persistence for certain time horizons* (usually relatively short)

These different weighting schemes can lead to a NUMBER OF BIASES EQUAL WEIGHTED: BIAS

*EQUAL WEIGHTED* BIASED: *SMALL-company bias* because such indices *include MANY MORE SMALL companies* than large ones Moreover, to *maintain equal weighting*, this type of index *must be REBALANCED PERIODICALLY* Frequent rebalancing can lead to *HIGH TRANSACTIONS COST* in a portfolio tracking such an index Another limitation of EQUAL-weighted indices as INDEXING BENCHMARK is that NOT ALL COMPONENTS in such an INDEX may have sufficiently LIQUID markets to absorb the demand of indexers

4.1.1. Index Weighting Choices b. Distinguish among the predominant weighting schemes used in the construction of major equity market indices and evaluate the biases of each; EQUAL WEIGHTED: Mental Map: 4.1.1. Index Weighting Choices 4.1.2. Equity Indices:Composition & Characteristics of Major Indices 4.2. Passive Investment Vehicles: 4.2.1. Indexed Portfolios 4.2.2. Equity Index Futures 4.2.3. Equity Total Return Swaps

*EQUAL WEIGHTED* Each stock in the index is *WEIGHTED EQUALLY* *The PERFORMANCE of an equal-weighted index* represents the performance of a portfolio in which the *SAME AMOUNT OF MONEY is invested in the shares of each index component* Equal-weighted indices must be *rebalanced periodically* (e.g., monthly, quarterly, or annually) to reestablish the equal weighting, because varying individual stock returns will cause stock weights to drift from equal weights

Equities are appropriate for both individual and institutional investors

*EQUITIES would be appropriate not only for *INDIVIDUAL investors* with inflation concerns but also for *INSTITUTIONAL investors* such as *DEFINED-BENEFIT PLAN SPONSORS*, which may be exposed through the terms of the pension benefit formula to INCREASING NOMINAL WAGE & SALARY COSTS

5.1.3. Other Active Management Styles *MARKET ORIENTED* or *BLEND or CORE* (neither growth nor value)

*Market-oriented investors* DO NOT restrict themselves to either the *VALUE or GROWTH* *The valuation metrics* of market-oriented portfolios *resemble those of a BROAD MARKET INDEX* more than those of a VALUE or GROWTH index RATIONALE: Market-oriented investors *may be WILLING TO BUY stocks NO MATTER where they fall on the GROWTH/VALUE spectrum*, provided they can buy a stock below its *PERCEIVED INTRINSIC VALUE* They might use a *DISCOUNTED CASH model or other discipline to estimate INTRINSIC VALUE*

Differences between: Index Mutual Funds vs ETFs

*Mutual funds shareholders* usually BUYS & SELL SHARES in the fund at a *NAV* determined *ONCE A DAY* at the *market CLOSE* *ETF shareholders* BUY & SELL shares in public markets *anytime during the trading day* DEALERS can create & redeem ETF shares with in-kind deposits and withdrawals at *each day's market close*

4.1.1. Index Weighting Choices b. *Distinguish among the predominant weighting schemes used in the construction of major equity market indices and evaluate the biases of each* *PRICE WEIGHTED* Mental Map: 4.1.1. *Index Weighting Choices* 4.1.2. Equity Indices: Composition & Characteristics of Major Indices 4.2. Passive Investment Vehicles: 4.2.1. Indexed Portfolios 4.2.2. Equity Index Futures 4.2.3. Equity Total Return Swaps

*PRICE WEIGHTED* Each stock is WEIGHTED by its *ABSOLUTE share price* *The INDEX* is simply the *SUM of the share PRICES divided by the *ADJUSTED number* of shares in the index *Adjustments* are for the purpose of making sure that the *index value does not change just because of stock splits or changes in index components* since launch date of the index *The PERFORMANCE of a price-weighted index* represents the performance of a portfolio that simply *BOUGHT & HELD ONE SHARE of each index component*

Stratified sampling

*Stratified sampling* allows the manager to build a portfolio that retains the basic characteristics of the index *without having to buy all of the stocks in the index* The *greater the number of dimensions and the finer the divisions* = *the more closely the portfolio will resemble the index*

When do growth investors do well or not....which economic environments Slow Economy or Expanding Economy? Counter intuitive

*The GROWTH INVESTOR who buys a stock at a premium to the overall market* is counting on the market to *CONTINUE PAYING A PREMIUM for the earnings growth that a company has been providing and may continue to deliver* *During an economic EXPANSION*, earnings growth is ABUNDANT (even in the depressed stocks preferred by a value investor) which *may cause this PREMIUM to ABOVE-AVERAGE GROWTH to SHRINK or VANISH* By contrast, *when companies with positive earnings momentum become SCARCE*, as in a *SLOWING ECONOMY*, *EARNINGS GROWTH becomes a SCARCE resource commanding a HIGHER PRICE, and GROWTH INVESTORS may do relatively well*

5. *Active Equity Investing*

*The active equity PM's PRIMARY JOB* is to *deliver the best possible performance relative to the benchmark's performance* working *within the risk & other constraints* specified in the client's mandate *To add value*, the active manager must *sharpen information, investment insights, and investment tools* (VALUATION MODELS) to the point at which he has a distinct competitive advantage over peers

e. *Discuss the key risks of each investment style* KEY RISKS FOR MARKET ORIENTED INVESTORS

*The potential drawback of a market-oriented active style* is that if the portfolio achieves only *MARKET-LIKE returns* *INDEXING (PASSIVE)* or *ENHANCED INDEXING* based on a *BROAD equity market index* will likely be *the LOWER-COST and thus MORE EFFECTIVE choice*

2. STOCK INDEX FUTURES Exchange for physicals (EFP)

*Trading a basket of stocks* can be relatively cumbersome at times, *particularly on the short side* where any uptick rule historically *impeded basket transactions in US markets* UPTICK RULES = require that a short sale must not be on a downtick relative to the last trade at a different price *EXCHANGE-traded funds* historically have been *EXEMPT from the UPTICK RULE for SHORT SALES* This fact, and their lack of an expiration date, has made *ETFs instruments of choice for many indefinite-term portfolio hedging and risk management applications*

Among the recognized subcategories of market-oriented investors are: 1. *Market-oriented with a VALUE bias* 2. *Market-oriented with a GROWTH bias* 3. Growth-at-a-reasonable-price 4. Style rotators

*VALUE BIAS & GROWTH BIAS investors* TILT their portfolios toward VALUE and GROWTH respectively, but *NOT SO distinctively as to clearly identify them as VALUE or GROWTH investors* They typically *hold WELL-DIVERSIFIED portfolios*

5.1. *Equity Styles* 5.1.1. *Value* Investment Styles e. *Explain the rationales and primary concerns of value investors*

*VALUE INVESTORS* often believe that investors inherently overpay for "GLAMOUR" stocks while *neglecting those with less favorable prospects* Value investors think that some investors *OVERREACT TO BAD NEWS* & thus provide *opportunities for VALUE INVESTORS*

4.1.1. Index Weighting Choices b. Distinguish among the predominant weighting schemes used in the construction of major equity market indices and evaluate the biases of each; *VALUE WEIGHTED* Mental Map: 4.1.1. Index Weighting Choices 4.1.2. Equity Indices: Composition & Characteristics of Major Indices 4.2. Passive Investment Vehicles: 4.2.1. Indexed Portfolios 4.2.2. Equity Index Futures 4.2.3. Equity Total Return Swaps

*VALUE WEIGHTED* (or market-capitalization weighted) Each stock is WEIGHTED by to its *MARKET CAPITALIZATION* *The PERFORMANCE of a value-weighted index* would represent the performance of a portfolio that owns *ALL the outstanding SHARES of each index component* *A given % change in a value-weighted index* is equal to *the change in the TOTAL VALUE of ALL included companies* A value-weighted index *SELF-CORRECTS* for *STOCK SPLITS, reverse stock splits, and DIVIDENDS* because such actions are directly reflected in the number of SHARES outstanding & PRICE per share for the company affected

4.1.1. Index Weighting Choices b. Distinguish among the predominant weighting schemes used in the construction of major equity market indices and evaluate the biases of each; *VALUE WEIGHTED: FLOAT ADJUSTED*

*VALUE WEIGHTED: FLOAT ADJUSTED* *The PERFORMANCE of a float-weighted index* represents the *performance of a portfolio that BUYS & HOLDS ALL the shares of each index component that are AVAILABLE FOR TRADING* Thus, *the (total) return of a float-weighted index* will represent the *return to the average dollar invested passively in the index's securities* (ignoring costs) If the index securities are the manager's investment universe, such a float-weighted index represents a PLAUSIBLE performance BENCHMARK for him

4.1.1. Index Weighting Choices b. Distinguish among the predominant weighting schemes used in the construction of major equity market indices and evaluate the biases of each; *VALUE WEIGHTED: FLOAT ADJUSTED* Mental Map: 4.1.1. Index Weighting Choices 4.1.2. Equity Indices: Composition & Characteristics of Major Indices 4.2. Passive Investment Vehicles: 4.2.1. Indexed Portfolios 4.2.2. Equity Index Futures 4.2.3. Equity Total Return Swaps

*VALUE WEIGHTED: FLOAT ADJUSTED* A *subcategory of the value-weighted method* involves *adjustment of market cap weights for each issue's FREE FLOAT* (# of shares outstanding that are actually available to investors) Index also called a *FREE FLOAT-ADJUSTED* market capitalization index, or *FLOAT-WEIGHTED index*

4.1.1. Index Weighting Choices b. Distinguish among the predominant weighting schemes used in the construction of major equity market indices and evaluate the biases of each; *VALUE WEIGHTED: FLOAT ADJUSTED* Mental Map: 4.1.1. Index Weighting Choices 4.1.2. Equity Indices: Composition & Characteristics of Major Indices 4.2. Passive Investment Vehicles: 4.2.1. Indexed Portfolios 4.2.2. Equity Index Futures 4.2.3. Equity Total Return Swaps

*VALUE WEIGHTED: FLOAT ADJUSTED* The *WEIGHT of a STOCK* in a float-weighted index equals its *MARKET-CAP WEIGHT x FREE-float adjustment FACTOR ( between 0 & 1 representing the fraction of shares that float freely)

At least FOUR economically significant differences separate INDEX MUTUAL FUNDS vs INDEXED ETFs

1. *SHAREHOLDER ACCOUNTING* at the fund level can be a *significant expense for conventional MUTUAL FUNDS* in some markets, but *ETFs DO NOT have fund level shareholder accounting*

Where is Passive (indexing) most appropriate? Answer: Three common options 1. Tax Sensitive Investors

1. For TAX-SENSITIVE INVESTORS, *indexing's often relatively HIGH TAX EFFICIENCY* is appealing. That tax efficiency comes from *TURNOVER that is usually LOW* compared with *ACTIVE investing* Tax Efficiency: POST-TAX returns that are close to PRE-TAX RETURNS

b. *Recommend an equity investment approach when given an investor's IPS and beliefs concerning market efficiency* 1. Belief in Efficient market = Passive

1. Investors *who BELIEVE that an equity market is EFFICIENT* will usually favor *INDEXING* because they think that *equity research will not provide a sufficient increment in return* to overcome their research and transaction costs

FULL REPLICATION ADVANTAGES

1. Should result in *MINIMAL TRACKING RISK* A FULL REPLICATION portfolio based on a *VALUE-weighted or FLOAT-weighted index* has the ADVANTAGE of being: *SELF REBALANCING* Because the stock weights in the portfolio will mirror changes in the index weights resulting from constantly changing stock prices (implies that trading is needed only for the reinvestment of dividends and to reflect changes in index composition)

b. *Recommend an equity investment approach when given an investor's IPS and beliefs concerning market efficiency* 2. Belief in Inefficient market = Active

2. *ACTIVE investors believe that the equity market is often INEFFICIENT* and that *good research will allow them to outperform the market net of all costs*

At least FOUR economically significant differences separate INDEX MUTUAL FUNDS vs INDEXED ETFs

2. *ETFs generally PAY MICH HIGHER INDEX LICENSE FEES* than CONVENTIONAL FUNDS

What are some reasons companies cannot cope with increase in inflation?

2. INDIVIDUAL EQUITIES *differ in their sensitivities to inflation because of INDUSTRY, COMPETITIVE, and OTHER TYPES OF FACTORS*

b. *Recommend an equity investment approach when given an investor's IPS and beliefs concerning market efficiency* 3. In between = Enhanced (limit tracking risk goal)

3. *ENHANCED indexers FALL somewhere BETWEEN the two*, believing that they can extract information about companies that has not been embedded in stock prices, but *attempting to do so in a way that LIMITS TRACKING RISK*

At least FOUR economically significant differences separate INDEX MUTUAL FUNDS vs INDEXED ETFs

3. *ETFs are often MUCH MORE TAX-efficient* than CONVENTIONAL FUNDS in many markets

What are some reasons companies cannot cope with increase in inflation?

3. Companies' abilities to RAISE OUTPUT PRICES and REVENUES to keep pace with increases in input prices vary INVERSELY with the amount of PRICE COMPETITION in their markets

3. Approaches to Equity Investment *ACTIVE* b. Discuss the rationales for *active equity investment* approach and distinguish among those approach with respect to expected active return and tracking risk

An active manager *SEEKS TO OUTPERFORM a given BENCHMARK portfolio* Manager tries to identify which STOCKS WILL PERFORM WELL vs THE BENCHMARK PORTFOLIO *AVOID STOCKS believes will underperform* the BENCHMARK

4.1.2. Equity Indices: Composition and Characteristics of Major Indices c. *Compare alternative methods for establishing passive exposure to an equity market*, including: 1. Indexed separate or pooled accounts 2. Index mutual funds 3. Exchange-traded funds (ETFs) 4. Equity index futures 5. Equity total return swaps

An indexer's choice of index to track has important consequences COMMITTEE-determined INDICES tend to have *LOWER TURNOVER* than those reconstituted regularly according to an ALGORITHM (you saw that on index reading) Thus indexing on the former type (COMMITTEE) of index may have *TRANSACTION COSTS & TAX advantages* The downside is that INDICES that are not reconstituted regularly may DRIFT away from the MARKET SEGMENT they are intended to cover

Conclusion

As a result of these limitations, the *PREDICTED TRACKING RISK of an OPTIMIZATION-based portfolio* will typically *UNDERSTATE* the ACTUAL TRACKING RISK With either STRATIFIED SAMPLING or OPTIMIZATION, the INDEXER MAY *FULLY REPLICATE (purchase in index-weight proportions) THE LARGEST STOCKS* and create an *OPTIMIZED/sampled portfolio for the REST*

Historical records back up the inflation hedge properties of equities

Evidence from many markets indicates that *using long measurement periods* (*longer than annual*), *EQUITIES* on average *DO HAVE VALUE AS AN INFLATION HEDGE*

FLOAT WEIGHTING is generally regarded as today's *GOLD STANDARD*

FLOAT WEIGHTING is generally regarded as today's *GOLD STANDARD* for INDEXING PORTFOLIOS Because it facilitates the *MINIMIZATION of TRACKING RISK* & *PORTFOLIO TURNOVER* and Because it results in indices that *well represent asset-class performance*

Among the recognized subcategories of market-oriented investors are: 1. Market-oriented with a value bias 2. Market-oriented with a growth bias 3. *Growth-at-a-reasonable-price* 4. Style rotators

Favor companies with *ABOVE-AVERAGE GROWTH prospects that are selling at relatively CONSERVATIVE VALUATION levels* compared with other growth companies Their portfolios are typically somewhat *LESS WELL DIVERSIFIED* than those of other growth investors

Float adjustments usually exclude:

Float adjustments usually exclude: 1. *Corporate CROSS-holdings* 2. *Large holdings by FOUNDING SHAREHOLDERS* 3. *GOVERNMENT HOLDINGS* holdings of shares in partly privatized companies

Another *characteristic often used in describing the style* of equity investors is the typical market capitalization of the issues they hold *SMALL CAP*

Focus on the *LOWEST market-capitalization stocks* in the countries in which they invest

5.1. *Equity Styles* e. *Discuss the key risks of each investment style* Key risks for Growth Investors

Forecasted *EPS growth DOES NOT MATERIALIZE* as expected In that event, *P/E MULTIPLES may CONTRACT at the same time as EPS*, amplifying the investor's losses

Historical records back up the inflation hedge properties of equities

Historical records indicates that the *VERY LONG-RUN REAL RETURN on stocks in the US has been relatively INSENSITIVE to REALIZED INFLATION RATES*, in contrast to *BONDS, whose RETURNS have been NEGATIVELY related to inflation*

d. As approaches to constructing an indexed portfolio compare: 1. Full replication (X) 2. Stratified sampling 3. Optimization *Recommend an approach* when given a description of the investment vehicle and the index to be tracked

If an index contains *LESS than, say, 1,000 stocks*, and the stocks are *LIQUID*, the index fund MANAGER will usually try to manage the portfolio with FULL REPLICATION—every issue in the index will be bought in the portfolio, and each position will have about the same weight in the FUND as in the INDEX As the number of issues in the index *MORE THAN 1,000*, it is increasingly likely that the manager will construct the portfolio using either: 1. STRATIFIED SAMPLING (Representative sampling) or 2. OPTIMIZATION

Tricky multiple choice question (quick review)

In the Elton et al. study the difference between the best-performing S&P 500 fund and the worst-performing fund for that six-year period was an average of 209 bps (2.09%) a year Clearly, *S&P 500 index funds and index portfolio managers* are sometimes not the "commodities" they are often thought to be

Tracking risk and index reconstitution

Indeed, index fund managers have sometimes come under pressure for failing to implement anticipated index composition changes aggressively because of *their concern for minimizing tracking risk* The issue arises *because changes to indices are often predictable or announced in advance of the effective date*, but index funds may not effect these changes as soon as they are foreseeable because of a *concern with minimizing tracking risk* relative to the current index components In the interim, *arbitrageurs may trade on the basis of the anticipated changes*, affecting prices and causing an implicit LOSS to index fund INVESTORS

Other differences between different types of index funds

Index *MUTUAL FUNDS* can *vary greatly in their COST STRUCTURE & RETURNS* A large part of the difference in performance among these funds came from differences in the *funds' EXPENSE RATIOS* Different funds *use SECURITIES LENDING as a source of INCOME* to varying degrees

Among the recognized subcategories of market-oriented investors are: 1. Market-oriented with a value bias 2. Market-oriented with a growth bias 3. Growth-at-a-reasonable-price 4. *Style rotators*

Invest according to the *STYLE THAT THEY BELIEVE WILL BE FAVORED IN THE MARKETPLACE* in the relatively *NEAR TERM*

MARKET ORIENTED or BLEND or CORE Continued

Market-oriented style investors *might buy a stock with a HIGH P/E* provided the price can be justified through *FUTURE GROWTH expected in EPS* They might also buy a *DEPRESSED CYCLICAL issue* provided that they *foresee some recovery in product pricing in the future*

2. The *Role of the Equity Portfolio* Background of what is an asset that hedges against inflation

Most INVESTORS WORRY ABOUT INFLATION, and inflation hedging ability is a big desire among investors *INFORMALLY*: An asset is an inflation hedge if *its returns are sufficient on average to preserve purchasing power during periods of inflation* *FORMALLY*: An asset is an inflation hedge if its *NOMINAL RETURNS* tend to be *HIGHLY CORRELATED with INFLATION RATES*

Drawback of OPTIMIZATION over INDEXING Important for morning section....

OPTIMIZATION has several DRAWBACKS as an approach to INDEXATION 3. Even in the absence of index changes & dividend flows, *optimization requires PERIODIC TRADING to keep the risk characteristics of the portfolio lined up with those of the index being tracked*

There are TWO WAYS to build an INDEX-TRACKING PORTFOLIO using a *SUBSET* OF STOCKS IN THE INDEX: 1. Stratified sampling 2. Optimization

Should permit a PM to INDEX successfully to even a very broad index containing ILLIQUID securities STRATIFIED SAMPLING: 1. PM divides the INDEX along a number of DIMENSIONS (e.g., Mkt cap, industry, value, and growth), creating multidimensional cells 2. Then characterize all stocks in the index in this way and determine the weight of each cell in the index by SUMMING the market cap for all stocks in that cell 3. Build a portfolio by selecting a *RANDOM* sample of STOCKS from EACH CELL and ensuring that the sum of the weights of the stocks purchased from each cell corresponds to the cell's weight in the index

Issues with U.S Regulations & European Regulations Not very important

Sometimes an INDEX with relatively few components or with a few heavily weighted components is not naturally COMPLIANT with REGULATORY REQUIREMENTS for fund DIVERSIFICATION In such cases, STRATIFIED SAMPLING techniques may be used to create an INDEX fund variation loosely based on the non-diversification-compliant index In the US, the diversification requirements are the rules for Regulated Investment Company diversification in Sub-Chapter M of the IRS. In Europe, the appropriate rules cover Undertakings for Collective Investment in Transferable Securities, which was passed in 2009 for implementation in 2011. UCITS rules allow index funds with an EU passport to hold up to 20% of assets in one security if the index called for such. Increasingly, ETF issuers and index publishers who develop indices specifically for the ETF market are designing indices to be inherently RIC-compliant in the USand UCITS-compliant in Europe. If the fund can replicate the index & comply with local diversification requirements simultaneously, a fund analyst can better evaluate the fund's portfolio manager and the fund management process

e. &Discuss the key risks of each investment style& Key *Risk for Value Investors*

The MAIN RISK: 1. *Misinterpreted a stock's cheapness* (cheap for a very good economic reason) 2. Undervaluation will *not be corrected within the investor's investment time horizon*

2. STOCK INDEX FUTURES

Trading index securities as a *BASKET and EXCHANGING the STOCK BASKET for the FUTURES contract on the INDEX* A transaction called an *Exchange of Futures for Physicals* Permits sharp *REDUCTIONS IN TRANSACTIONS COSTS *

Why would an index fund underperform the index (eg. S&P500) even if it did the full replication method?

Typically, the return on a full replication index fund may be LESS than the index return by an amount equal to the sum of: 1. *Cost of managing & administering the fund* 2. Transaction costs of portfolio adjustments* to reflect *changes in index composition* 3. Transaction costs of *investing and disinvesting cash flows* 4. In upward-trending equity markets, the *DRAG on performance from any CASH POSITIONS*

The *value investing style* has at least *three SUB-STYLES* 2. *Contrarian*

o Will *look for stocks that have been MARKED BY PROBLEMS* & are generally *selling at LOW P/Bs, frequently BELOW 1* Such stocks are found in *very DEPRESSED INDUSTRIES that may have virtually NO CURRENT EARNINGS* JUSTIFICATION: The investor buys on the *expectation of a CYCLICAL REBOUND that drives up product PRICES & DEMAND* How to identity contrarian investor in the exam. Look for: 1. Low P/B = Below 1 2. Almost no earnings EPS = $0.00

The *value investing style* has at least *three SUB-STYLES* 1. *Low P/E*

o Will *look for stocks that sell at LOW PRICES to current or normal earnings* o Such stocks are generally found in industries categorized as *DEFENSIVE, CYCLICAL, or simply OUT-of-FAVOR* JUSTIFICATION: o The investor buys on the *expectation that the P/E will rise as the STOCK or INDUSTRY RECOVERS* How to identity contrarian investor in the exam. Look for: 1. Low P/E in out of favor sectors, defensive or cyclical