CFA CFA level 3 CFA level 3 volume III applications of economic analysis and asset allocation finquiz smart summary, study session 12, reading 25

2018 Study Session # 12, Reading # 25

“EQUITY PORTFOLIO MANAGEMENT”
SD = Standard Deviation
ER = Equity Research
MF = Mutual Fund

L/S = Long-Short
IR = Information Ratio
CSP = Core-Satellite Portfolio
IT = Information Technology

1. INTRODUCTION
Decision of how to invest in competing equity investments
ranks second compared to how much to allocate to equities.

2. THE ROLE OF THE EQUITY PORTFOLIO
As an investor’s domestic market‘s global weight increases, so does his domestic market focus.
Investing across countries provides diversification because no one market fully captures all global
economic factors & no exact home-market equivalent.
Equities provide inflation hedge (certain limitations, taxes are not inflation hedged so reduce after
tax real return, price competition may limit price due to inflation).
Equities play growth role in portfolio.
For the above reasons investors are equity biased in their asset allocation.
Both domestic & international equities play an important role in individual/institutional portfolios.

3. APPROACHES TO EQUITY INVESTMENT

Passive Management

Semi Active Management

Active Management

Investor does not reflect his expectations in
security selection.
Dominant passive approach is indexing.
Indexed portfolios are passive in
implementation.

Seeks to outperform benchmark
through security selection.

More concerned about tracking risk
while trying to beat benchmark.

Information ratio ⇒ mean active return / tracking risk
(efficiency with which tracking risk deliver active return).
Efficient markets favor indexing.
Information ratio is higher in enhanced indexing.
Client constraints should also be considered when selecting an appropriate approach.

4. PASSIVE EQUITY INVESTING
Historically before cost avg. active return is approximately equal to index
return (active investment underperform after-cost basis).
Passive investing has tax benefit than active investing (low turnover).
Indexing is appropriate in large cap equity market (informationally efficient),
small cap (heavy transaction cost) & unfamiliar overseas markets.

4.1 Equity Indices
Indexes are used to;

Create index fund.
As benchmark.
To perform technical analysis &β calculation.
Explain factors that influence share prices.
Boundaries of index universe, criteria for inclusion, weighting schemes & how
returns are calculated, determine stock index’s characteristics.

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2018 Study Session # 12, Reading # 25

4.1.1 Index Weighting Choices

Price Weighted

Value Weighted

Weighted according to absolute share
price.
Index = sum of price / adjusted no. of
shares.
Index performance can be matched by
buying one share of each index
component.
Simple to construct & can go back far
into the past.

Equal Weighted

Weighted according to market cap.
Performance can be matched by
investing same proportion as each
index component in index.
Self corrects for stock splits & reverse
stock splits etc.
Float weighted index ⇒ subcategory
⇒ consider investable MV of equity.
Weight of stock in float adjusted index
= market cap weights× adjustment
factor.
Float weighted return represents
return to avg. dollar invested
passively.
Float weighting considered best index
(representative & minimum tracking
error).

Each index stock weighted equally.
Performance can be matched through
equal $ investment in each index
component.
Must be rebalanced periodically.

Weighting Scheme Biases

Price Weighted

Value Weighted

Equal Weighted

Biased towards the highest-priced
stock.
Absolute share price level is arbitrary
(can change through splits, stock
dividends etc.)

Biased towards large market cap
(mature & overvalued companies)
Less diversified.
Not suitable due to regulatory
restriction (e.g. maximum holdings).

Small company bias.
Rebalanced periodically (high
transaction cost).
Illiquid index components.

4.1.2 Equity Indices: Composition & Characteristics of Major Indices
Price weighted & equal weighted indexes are very few in numbers these days.
Indices

Committee-determined indices
Low turnover (low transaction cost & tax).
Not reconstituted regularly and may drift
away from intended segment.

Algorithm (formula based)
High cost & taxes.

Reconstituted regularly (no drift).

Fund must evaluate tradeoff b/w transaction cost & difference in return premiums.

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2018 Study Session # 12, Reading # 25
4.2 Passive Investment Vehicles

4.2.1 Investment in indexed
portfolio

Long position in cash & long
position in futures

Indexed mutual funds

Long position in cash & long
position in Swap

ETFs

Separate or pooled accounts

Difference b/w Indexed Mutual Funds & ETFs

Mutual Funds

Exchange Traded Funds

Trading frequency

Trade at NAV once at market close

Trade in public market anytime during trading day

Index licensing fee

Lower

Higher

Tax efficiency

Lower

Higher

Cost of providing liquidity

Yes

No, due to in-kind creation/redemption

Shareholder accounting expense

Yes

No fund level shareholder accounting

Separate or Pooled Accounts

Indexed institutional portfolios (separate or pooled) are cost efficient than MF & ETFs.
In some cases securities lending revenue can equal or exceed total portfolio management
& custody expense.

Indexing a Portfolio

Full Replication

Stratified Sampling

Suitable when securities in index are less
than 1000 & liquid.
Minimum tracking risk.
Full replication based on value/float
weighted index, is self rebalancing,
trading required only for reinvestment
of dividends & to reflect changes in
index composition.
Return of full replicated fund is less than
return on index (administrative cost,
transaction cost, cash drag).

Divide index along a no. of dimensions
/cells (industry value, growth etc.).
Place each stock into a cell & match cell
weight into portfolio as cell weights in
the index.

Greater the no. of cells lesser the
tracking error.
Stratified sampling can be used to create
index fund from non-diversified index.

Optimization
Use multifactor risk model against which
index & individual securities risk
exposures are measured & minimize the
tracking error.
Optimization considers covariance
among factors (advantage).
Three disadvantages:
Risks change over time & model is
based on historical data.
Sampling error.
Requires periodic rebalancing.
Optimization produces lower tracking
error than stratified sampling when
used in combination with full
replication.

4.2.2 Equity Index Futures

Exchange of future for physicals ⇒ exchange the stock basket for future contract on index (reduce transaction cost).
Facilitate risk management transaction.
Rolling costs (futures position must be rolled over).
Shorting on Basket trades impeded due to Uptick rule (i.e. no short sale on down tick relative to last trade at a different price).
ETFs are better risk management & hedging tools (no uptick rule, lack of expiration date).

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2018 Study Session # 12, Reading # 25
4.2.3 Equity Total Return Swaps
Motivated by different tax treatment of shareholders in different
countries or to acquire exposure to an asset class for strategic/tactical
asset allocation (less cost of rebalancing).

5. ACTIVE EQUITY INVESTING
To outperform benchmark within risk & other constraints.
Range of products from active to passive to satisfy investors’ needs.

5.1 Equity Styles

Value

Growth

Focus is low share price
relative to earnings or BV.

High earning growth
companies are key
considerations.

Market oriented
Intermediate grouping for
investments (neither value
nor growth).

Market cap frequently specified in describing investor’s style.
Styles play a role in risk management & performance evaluation.

5.1.1 Value Investment Styles
Focus on cheap stocks relative to earnings or BV.
Possible arguments:
Earnings have mean reverting tendency so earnings will
causing in multiples & stock prices.
Growth investing contains risk of contraction in earnings &
multiples.
Main risks
Misinterpreting a stock’s cheapness.
Undervaluation may not correct with in investment horizon.
Three substyles
Low P/E ⇒ Invest in stocks with low price hoping industry &
stock will recover & P/E will improve.
Contrarian⇒ investment in very depressed industries usually
P/B < 1.
Yield investor ⇒ focus on high current & future dividend yield
(component of total return).

5.1.2 Growth Investment Styles
Focus on future EPS growth rate & major risk is that growth will not
take place & price will .
Substyles
Consistent growth ⇒ invest in companies with long growth
history.
Earning momentum ⇒ higher quarterly year-over-year
earnings growth but less sustainable.

Growth investors do better in economic contraction than economic
expansion.

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2018 Study Session # 12, Reading # 25
5.1.3 Other Active Management Styles
Market oriented investor buys stocks below its perceived intrinsic value irrespective of where it falls (growth / value).
Drawback ⇒ if portfolio achieves market like return, indexing or enhanced indexing presents a lower cost alternative.
Substyles
Market oriented with value biased (hold well diversified portfolios).
Market oriented with growth biased (hold well diversified portfolios).
Growth-at-reasonable price ⇒ investor favors companies with above avg. growth with conservative valuation
(portfolios are less diversified than other growth investors).
Style rotators ⇒ invest in most favored near term style.

Market Capitalization

Small Cap

Mid Cap

Large Cap

Opportunity for mispriced
stocks (less research).
Better growth prospects.
Micro cap ⇒ smallest part
of small cap.

Less well researched
than large cap
(opportunities exist).
Less volatile than small
cap.

More financial stability.
Add value through
superior analysis.

5.1.4 Techniques for Identifying Investment Styles

Return based style analysis
Regress portfolio return on return series of set
of indices.
Indices should be
Mutually exclusive & exhaustive.
Not be highly correlated.
βs on indices are nonnegative & sum to 1.
Normal benchmark ⇒ benchmark with same
systematic risk exposure as manager’s
portfolio.
R2 determine style fit & 1-style fit = selection.
Error term in regression equation reflects style
return.

Holding based style analysis
Categorize individual securities by their
characteristics & draw overall style conclusion.

Value-oriented portfolio has clear bias towards
low P/E, P/B& high dividend yield (vice versa
for growth) & market oriented has valuation
close to market avg.
Greater earning variability ⇒ value oriented
portfolio⇒ larger weight in utilities & finance
sector.
Growth portfolios ⇒ health care & IT weights
are higher.

Two approaches to style analysis: Advantages and Disadvantages
Advantages
Returns-based style
analysis

Holding-based style
analysis

Characterizes entire portfolio.
Facilitates comparisons of portfolios.
Aggregate the effects of the investment process.
Different models usually give broadly similar results and
portfolio characterizations.
Clear theoretical basis for portfolio categorization.
Requires minimal information.
Can be executed quickly.
Cost effective.
Characterizes each position.
Facilitates comparisons of individual positions.
In looking at present, may capture changes in style more quickly

than returns-based analysis.

Disadvantages
May be ineffective in characterizing current style.
Error in specifying indices in the model may lead to inaccurate
conclusions.

Does not reflect the way many portfolio managers approach
security selection.
Requires specification of classification attributes for style;
different specifications may give different results
More data intensive than returns-based analysis.

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2018 Study Session # 12, Reading # 25
5.1.5 Equity Style Indices
Style indices construction uses multiple variables (price, earnings, book value etc).
Index publishers capture licensing fees from ETF & other investment products.
All style indices use holding-based style analysis.
Overlap ⇒ some securities may be assigned in part to both value & growth.
No overlap ⇒ security is assigned to either value, growth or market oriented.
Buffering ⇒ rules for maintaining the previous stock assignment when stock has not clearly
moved to a new style.
Buffering reduces turnover & transaction expenses.
Index publisher uses growth & value as categories (no overlap) or as quantities (with overlap).

5.1.6 The Style Box
Style box is used for looking at a style.

Style box used by Morningstar divides fund portfolio by market cap (large, mid, small)& style
(value, core & growth).
Categorizing a stock by size is relatively standard technique but techniques used in styles are
diverse across firms.

5.1.7 Style Drift
Inconsistency or straying from stated style.
Two consequences
Investor may lose exposure to desired style.
Manager is operating outside area of expertise.
5.2 Socially Responsible Investing
Consider ethics, social & religious concerns while taking investment decisions.
Negative stocks screens ⇒ reduce investment universe.
Positive SRI Screens ⇒identify companies with ethically desirable characteristics.
SRI often exhibits style bias towards growth investing & market cap bias towards small
cap stocks.
Two benefits of being aware of these biases.
Portfolio manager tries to minimize their biases if inconsistent with client’s
objective & constraints.
Manager can chose appropriate benchmark.
Progress towards style bias issue can be identified & measured through return-based
style analysis.

5.3 Long-Short investing
Style investing focuses on portfolio characteristics while L/S investing
focuses on constraints (short selling).
Long only strategy can hold single alpha while L/S market neutral (zero β)
holds two alphas.
Portable alpha ⇒ added a variety of systematic risk exposures.
Pair trade ⇒ long / short in two single industry firms’ stocks by equal

currency amounts (almost zero β, only firm specific risk).
Leverage used in L/S strategy magnifies risk & return.
If the price of short position tends to rise, loss can be unlimited.

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2018 Study Session # 12, Reading # 25
5.3.1 Price Inefficiency on the Short Side
Four pricing inefficiencies exist on short side (can cause higher short side
alpha than long side).
Short positions difficult to obtain (e.g. find lender).
Management manipulations & window dressing (stock is more likely
to be overvalued rather than undervalued).
More frequent issuance of “buy” recommendations due to greater
commissions & potential buyers > sellers & short sellers.
Fear of management lawsuits & business lost prevent analyst from sell
recommendations [against standard I (B)].

5.3.2 Equitizing a Market-Neutral Long-Short Portfolio
Equitizing⇒ market exposure through futures& Swaps.
Notional value of futures= value of cash position from short position.
Rate of return on total portfolio is sum of;
G/L on L/S securities position.
G/L on long futures position.
Interest earned on cash position.
All above divided by portfolio equity.
ETF is an alternative to futures & cost effective way of equitizing & de-equitizing.
Market neutral L/S should be benchmarked against RFR & equitizing should be
benchmarked against relative index.

5.3.3 The Long-Only Constraint
L/S strategies have advantage of “allowing action on negative
insights” over long only portfolio.
Investor’s opportunity set is not symmetric for long only portfolio
(can not take short position).

5.3.4 Short Extension Strategies
Modify long-only strategy by specifying a stated level of short selling.
Generally designed to have market β of 1.
More efficient use of negative information.
In 130/30 strategy, L/S portfolio decision are coordinated (consider single portfolio) while in
100/0 & 30/30 they are not (consider two portfolios).
Several advantages of short extension.
No need for liquid futures a swap market as in equitizing market natural L/S.
Manager’s investment insight as compared to long only.
Disadvantage
Market return & alpha from same source (less flexible than equitizing market neural L/S).
Market neutral L/S is considered part of alternative investments.
5.4 Sell Disciplines/Trading

Strategy of Substitution

Deteriorating Fundamentals

Replace existing holding with better
opportunity by considering transaction
cost & taxes.
Also known as opportunity cost sell
discipline.

Reduce or eliminate a position if
company’s business prospects are
expected to deteriorate.

These sell disciplines are not mutually exclusive.

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Rule Driven

Valuation level (e.g. if P/E reaches
historical avg.).
Down-from-cost.
Up-from-cost.
Target price sell discipline.


2018 Study Session # 12, Reading # 25
6. SEMIACTIVE EQUITY INVESTING
Designed to outperform benchmark while carefully
managing portfolio risk exposure.
Highest IR as compared to indexing & active
management.

Basic Forms

Derivative-Based

Stock Based

Achieve desired equity exposure through derivatives& enhanced
return through something other than equity investments.
Most common strategy ⇒ equitize a cash portfolio & add value
through duration management.
Low investment breadth.
Straight forward strategy.

Identify overvalued & undervalued stocks & outperform through stock
selection.
Risk is controlled through factor exposure & industry concentration.
If manager has no opinion on stock, hold it at benchmark weight.
Limitations
Positive alpha may disappear as other mangers try to exploit it.
Quantitative & mathematical models, based on historical data,
will not work if economy changes.

Fundamental Law of Active Management
IR ≈ IC√Breadth
Where IC = information coefficient (effectiveness of
investment insight).
Breadth = no. of independent active investment
decisions.
Higher the ratio, the better it is.

7. MANAGING A PORTFOLIO OF MANAGERS
When investing a pool of assets, determine overall asset allocation i.e. which classes to
use & how to invest within each asset class.
Allocation should maximize expected total return at a given level to total risk.
‫ܿݕܾ(݁ݖ݅݉݅ݔܽܯ‬ℎ‫ܷ)ݏݎ݂݁݃ܽ݊ܽ݉݋݁ܿ݅݋‬஺ = ‫ݎ‬஺ −⋌஺ ߜ஺ଶ

Where
ܷ஺ = expected utility of active return of manager mix.
‫ݎ‬஺ = expected active return.
⋌஺ = active risk aversion.
ߜ஺ଶ = variance of active return.
How much active risk an investor assumes determines mix of managers.
Investors are more averse to active risk than total risk, because;
They believe that successful active management is possible & that they have the
skill to select outperforming managers.
Answerable to someone i.e. institutional conservatism, where overall performance
is judged relative to benchmark, which is difficult to outperform.
More active risk less manager diversification on efficient frontier (active risk
limitation by institutional investors).
ܲ‫∑ = ݊ݎݑݐ݁ݎ݁ݒ݅ݐܿܽ݋݈݅݋݂ݐݎ݋‬௡௜ୀଵ ℎ஺௜ ߜ஺௜
Where
ℎ஺௜ = weight assigned to ith manager.
ߜ஺௜ = active return of ith manager.
ଶ
ଶ
Portfolio active risk (active returns are uncorrelated);ඥ∑௡௜ୀଵ ℎ஺௜
ߜ஺௜
if returns are
correlated include covariance term under square root sign.

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2018 Study Session # 12, Reading # 25
7.1 Core-Satellite
Core-satellite portfolio ⇒ consists of a core holding (index & semi active) &

satellite (active managers).
CSP is a result of optimization applied to a group of equity mangers or some
other heuristic.
Objective is to achieve passive as well as active exposure.
Core should closely resemble investor’s benchmark while satellite portfolios
may have different benchmarks.

Decomposition of Active Return

True Active Return

Misfit Active Return

Manager’s return-manager’s normal
benchmark.

Manager’s normal benchmarkinvestor’s benchmark.

Decomposition of Active Risk

True Active Risk
SD of true active return.

Misfit Active Risk
SD of misfit active return.

Total active risk = ඥሾሺ݉ܽ݊ܽ݃݁‫ ݎ‬ᇱ ‫݇ݏ݅ݎ݁ݒ݅ݐܿܽ݁ݑݎݐݏ‬ሻଶ + ሺ݉ܽ݊ܽ݃݁‫ ݎ‬ᇱ ‫݇ݏ݅ݎݐ݂݅ݏ݅݉ݏ‬ሻଶ ሿ
Most accurate risk-adjusted performance measure is;
ܶ‫݊ݎݑݐ݁ݎ݁ݒ݅ݐܿܽ݁ݑݎ‬
ܶ‫ = ܴܫ݁ݑݎ‬

ܶ‫݇ݏ݅ݎ݁ݒ݅ݐܿܽ݁ݑݎ‬
Two main uses of true / misfit distinction.
Performance appraisal.
Optimization (allow optimal level of “misfit” risk).

7.2 Completeness Fund
Active managers’ portfolios have number of risk exposures or biases in CSP.
Bottom-up stock picker’s portfolios reflect industry concentrations.
Completeness fund ⇒ when added to active managers’ positions, establishes an overall
portfolio with same risk exposure as investor’s overall equity benchmark.
Value added through stock selection.
Can be managed passively or semi actively &re-estimated periodically.
Drawback ⇒eliminates misfit risk where non-zero misfit risk may be optimal, hence
losing part of true active return.

7.3 Other Approaches: Alpha & Beta Separation
Long active equity portfolio ⇒ provides both α&β exposure.
Market neutral L/S ⇒ can better manage α&β (can use portable α in asset class outside
β asset class).
Risks to market neutral L/S ⇒ short positions are difficult to construct or portfolio may
not really be market neutral.
Portable alpha can be used even without investing on a L/S basis e.g.
ߚ
[ long on S & P 500 future]
LongonJapanesemanagerportfolioሺTOPIXindexሻ
∝ ቂ
ቃ
ܽ݊݀‫ݏ‬ℎ‫ݐݎ݋‬onTOPIXfuture

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2018 Study Session # 12, Reading # 25
8. IDENTIFYTING, SELECTING, AND CONTRACTING WITH EQUITY PORTFOLIO MANAGERS
When funds are delegated to outside management a
consultant is required for investment manager search.

8.1 Developing a Universe of Suitable Manager Candidates
Consultants use research staff to determine which
managers are talented & truly add value.
Use both qualitative (people, investment philosophy
etc.) & quantitative (comparison with peers, style
orientation etc.) factors.

8.2 The Predictive Power of Past Performance
Legally “past performance is no guarantee of future
result”.
Past performance must be examined (e.g. active
manager exhibiting consistent underperformance
from benchmark not likely to be selected).

8.3 Fee Structures

Ad Valorem Fees

Performance-Based Fees

Calculated by multiplying a % by value of assets managed.
Advantage ⇒ simple & predictable.
Also called assets under management fees.

Base fee plus sharing %.
Fee cap ⇒ upper limit to total fee (limit manager from high risk).
High water mark ⇒ provision requiring cumulatively generated
outperformance since last performance-based fee paid.
Symmetric incentives fees ⇒ reduce (poor performance) as well as
increase (good performance) compensation (better align manager &
plan sponsor interest). manager’s revenue volatility.
One-sided performance based fee ⇒ conveys a call option to
investment manager & value is determined through option pricing
model.

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2018 Study Session # 12, Reading # 25

8.4 The Equity Manager Questionnaire

Five Sections

First Section

Second Section

Organization / people.
Questions include vision of firm, competitive advantage, role of
portfolio managers, length of time the team has together etc.

Philosophy / process.

Questions about how equity portfolio will be managed (e.g. research
process, risk management function, stock selection process etc.).

Third Section

Fourth Section

Focus is on research process, how it is conducted and communicated
etc.
Allocation of resources within organization (investment in technology,
portfolio construction etc.).

Performance.
Appropriate benchmark & level of appropriate excess return.
Firms submit monthly or quarterly returns & holdings for evaluators.

Fifth Section
Fees.
Type of fees (ad valorem or performance based) & terms& conditions
related to fees.

9. STRUCTURING EQUITY RESEARCH AND SECURITY SELECTION

ER is a necessary component of active & semi active
investing.

9.1 Top-Down versus Bottom-Up Approaches

Top-Down

Bottom-Up

Focuses on macroeconomic factors.
Build portfolio of individual stocks with
macro insights.

Focuses on company-specific fundamentals.

9.2 Buy-Side versus Sell-Side Research

Buy-Side

Sell-Side

Research with intent of building a portfolio
(investment management firms).
Decisions are made through committee
structure (analyst prepares report, presents
to committee that reviews & decides upon
the conclusion).

Independent researchers (who sell their
work) or investment banks / brokerage to
generate business.
Analysts work either in teams or themselves
& produce reports on companies &
industries.

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2018 Study Session # 12, Reading # 25

9.3 Industry Classification
Equity research departments organized along
industry or sector lines.
Company is categorized into sector, industry group,
industry & sub-industry.

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