Equity

Question 1

What are the roles of equity in a portfolio?

Answer 1

1. Capital Appreciation
2. Dividend Income
3. Diversification - although correlation increases in time of crisis
4. Inflation hedge - this does not apply to equities as a whole, but applies to certain sectors or stocks depending on the ability to pass on increases in input costs.

Question 2

What are the pros and cons of segmenting equities based on size and style characteristics?

Answer 2

Pros:
1. Simplifies portfolio management
2. Helps define a benchmark
3. Keeps managers within a style
Cons:
1. No clear category definitions

Question 3

What are the pros and cons of segmenting equities by geography?

Answer 3

Pros:
1. increase global diversification
Cons:
1. Country domicile does not mean you only capture that economy's risk
2. Currency risk

Question 4

What is the difference between a market oriented and production oriented sector classification?

Answer 4

Market oriented is based on the way revenue is earned and the way customers use their products. Production oriented is about manufacturing process (inputs and outputs). For example, airlines could be classified as transportation or travel and leisure depending on how you view it.

Question 5

What are the types of income and costs of an equity portfolio?

Answer 5

Income:
1. Dividends
2. Securities lending income
3. Ancillary investment strategies
This includes dividend capture (buy before divided and sell after), covered calls, cash covered puts.
Fees:
1. Management fees
2. Performance fees
3. Administrative fees
4. External fees (custody, registration)
5. Marketing and distribution
6. Trading costs (explicit and implicit)

Question 6

What is shareholder engagement? What are the benefits and drawbacks?

Answer 6

This is the process of investors actively interact with companies (voting for example).
Benefits:
1. Potential to gain more information
2. Chance to add value
Costs:
1. Time consuming and costly
2. Pressures companies to reach ST targets
3. Potential conflicts of interest

Question 7

Why would you engage in active investing?

Answer 7

1. You have confidence to outperform
2. Your clients prefer active management
3. Unique client circumstances or preferences

Question 8

Why would you engage in passive investing?

Answer 8

1. You do not have confidence to outperform
2. Your client prefers
3. You don’t want to incur the risks and costs of active management
4. You want to be very tax efficient

Question 9

What are the key three requirements for selecting a benchmark for a passive investing strategy?

Answer 9

1. It must be rules based (criteria for inclusion, rebalancing rules, consistent, predictable)
2. It must be transparent - disclosure of rules and constituents
3. It must be investable - performance can be replicated in the market

Question 10

What is buffering? What is packeting?

Answer 10

This is the process of defining the ranges where stocks move across different classifications. For example, when does a small cap move to mid cap? Packeting is when you split stock positions into multiple parts. For example, you could include a stock in both indices and different weightings.

Question 11

How do you find the effective number of stocks (after considering concentration) of an index?

Answer 11

Take the 1 /HHI (squared summed weights of constituents)

Question 12

What are the basic three types of factor based strategies?

Answer 12

1. Return oriented - yield, value, momentum
2. Risk oriented - minimum variance, volatility weighted
3. Diversification oriented - equally weighted, maximum diversification strategies

Question 13

What causes tracking error?

Answer 13

1. Fees
2. Securities lending
3. Intraday trading
4. Cash balances
5. Sampling

Question 14

What are the key differences between fundamental and quantitative investing?

Answer 14

Fundamental is subjective and discretionary, whereas quant is objective and systematic.
Fundamental is based on bottom up research on companies whereas quants is about statistics and modelling. Risk is at the company level in fundamental but is at the portfolio/model level in quant

Question 15

What are value based investing approaches?

Answer 15

1. Relative value - price vs peers
2. Contrarian investing - depressed cyclical names
3. high quality value - strong ROE, growth,
4. income investing - high yields and yield growth
5. Deep value - could indicate inefficient pricing
6. Restructuring
7. Special situations

Question 16

What are some basic top down investing strategies?

Answer 16

1. Country and geographic
2. Sector and indsutry
3. Volatility based
4. Thematic investors

Question 17

What are some of the potential reasons for the existence of the value factor?

Answer 17

1. Premium for financial distress

2. Behavioural biases - overselling, less attention

Question 18

What are common tactics used by activists?

Answer 18

1. Seeking board representation
2. Proxy contests
3. Talking to management
4. Proposing changes in annual meetings
5. Reduce management compensation
6. Lawsuits against management
7. Breaking up conglomerates

Question 19

How does a company defend against activist investors?

Answer 19

1. Dual Class
2. Poison Pills
3. Staggered boards

Question 20

What are characteristics of a company activists would target?

Answer 20

1. Slower revenue and earnings growth
2. Negative share momentum
3. Weaker corporate governance

Question 21

What is statistical arbitrage?

Answer 21

This is when you try to take advantage of mean reversion or long term relationships. An example if pairs trading. This strategy can become risky if there is a structural change that means the historical relationship no longer holds.

Question 22

What are the basic steps to take when you’re developing a fundamental equity portfolio management approach?

Answer 22

1. Define the universe and potential opportunity
2. Pre-screen the universe
3. Understand
4. Forecast company performance
5. Convert forecasts into valuations
6. Construct
7. Rebalance

Question 23

What are some of the common pitfalls of fundamental equity management?

Answer 23

1. Behavioural biases
2. Value traps
3. Growth traps

Question 24

How do you create a quant portfolio management strategy?

Answer 24

1. Define market opportunity
2. Acquire and process data
3. Back test - take factor performance vs one period ahead performance

Question 25

What is the difference between the Pearson IC and Spearman IC?

Answer 25

Pearson is the correlation using factor score and one period ahead return Spearman is the correlation between factor rank and performance one period ahead rank.

Question 26

What are some of the pitfalls of backtesting quant strategies?

Answer 26

1. Survivorship bias 2. Look-ahead bias - using information that was unavailable in the original time period 3. Data mining 4. Turnover, transaction costs, short availability

Question 27

What is the difference between a holdings based and return based style classification system?

Answer 27

A holdings based takes each holding and classifies based on active weightings. Return based uses regression to determine source of returns.

Question 28

What are the three sources of active return?

Answer 28

1. Exposure to rewarded factors - OW vs UW 2. Alpha 3. Luck

Question 29

What is alternative beta and how is it related to alpha?

Answer 29

Alternative beta is exposure to a rewarded factor. This is not alpha, but is still active return. The idea behind this is that you could have achieved exposure through a passive product.

Question 30

What is factor timing?

Answer 30

This is generated through shifting beta exposures over time and is considered a source of alpha.

Question 31

What are two ways to size positions?

Answer 31

1. Manage factor exposure | 2. Stock picks - higher idiosyncratic risk

Question 32

What is the significance of "breadth" of experience? How does it convert to expected returns?

Answer 32

Success if a function of breadth of experience. If you are confident in each of your decisions, and expect uncorrelated decisions to each pay off, more decisions are diversifying. This is related to expected return = IC * sqrt breadth * SD of active return * TC. Basically, confidence in outperformance increases when it can be attributed to a larger sample size of decisions

Question 33

What does active share measure? How do you calculate it?

Answer 33

This measures the extend to which number and sizing of positions differ from the benchmark. This is the absolute value of the differences, summed, and divided by 2.

Question 34

What is the difference between active share and active risk?

Answer 34

Active share measures similarity the a benchmark which is controllable, whereas active risk measures the deviation of returns from benchmark.

Question 35

What is active risk a function of?

Answer 35

1. Increases in factor risk volatility 2. Idiosyncratic volatility Essentially, it is attributed to factor exposure or active share

Question 36

What are the steps in an effective risk budgeting process?

Answer 36

1. Determine the best type of risk measure for your goals 2. Understand how each aspect of the strategy contributes to its overall risk 3. Determine the appropriate level of risk 4. Allocate risk among factors and positions

Question 37

How is it possible to add active risk when adding a low volatility asset?

Answer 37

If your benchmark if very volatile and you add an uncorrelated asset, you have lower explained return and therefore have higher active risk.

Question 38

What are some common limitations to the level of risk you aim to take?

Answer 38

1. Implementation issues (no leverage, shorts) 2. Limited diversification opportunities 3. Leverage levels reduce compounded returns in a multi period setting

Question 39

What are common heuristics used in risk management?

Answer 39

1. Exposure concentration 2. Net factor exposures 3. Net currency exposures 4. Degree of leverage 5. Turnover

Question 40

What are the common formal measures of portfolio risk?

Answer 40

VaR, CVar, IVar, MVar, skewness, active risk, volatility

Question 41

How does AUM affect portfolio management?

Answer 41

The larger the AUM, the lower the explicit costs. However, implicit costs will go up. This is the opposite for small funds that lack scale. Higher AUM increases position size in general.

Question 42

How do larger position sizes affect the ability to manage an equity portfolio?

Answer 42

Bigger positions make turnover very hard to manage and impact markets more when trading.

Question 43

What are the characteristics of a well constructed portfolio?

Answer 43

1. Clear philosophy 2. Consistent process 3. Risk & structural process as promised 4. Risk and cost efficient

Question 44

Explain the features of a long/short portfolio:

Answer 44

1. You are able to express negative views 2. You can extract pure factor exposures 3. You can reduce market exposure

Question 45

What is the difference between a long short portfolio and a long extension portfolio?

Answer 45

A long short portfolio is unconstrained in net and gross exposure. A long extension is an enhanced equity portfolio where net exposure will always be 100%. For example, 130/30 portfolios.

Question 46

Explain the features of a market neutral fund

Answer 46

The purpose is to hedge out all or most market risk (beta). This is typically less volatile.

Question 47

What is the difference between pairs trading and stat. arbitrage?

Answer 47

Pairs trades go long strong performers and short weak. Stat. arb is a mean reversion trend that goes long underperformer and short outperformer. Pairs trading is about spreads widening, stat arb is about convergence

Question 48

What are the benefits and costs of long/short strategies?

Answer 48

``` Benefits: 1. Reduce market risk 2. Alpha opportunity 3. Diversification Costs: 1. Leverage 2. Higher active risk 3. Borrowing costs 4. Complexity 5. Lose market premium ```

Question 49

What is the difference between a systematic portfolio and a discretionary portfolio?

Answer 49

1. Systematic is generally more diversified whereas discretionary has less positions 2. Systematic is generally a quantitative strategy whereas discretionary is a fundamental strategy

Question 50

What is the difference between a top down and bottom up portfolio?

Answer 50

1. Top down managers are concerned with macro factors and factor timing, sectors and sector rotation, volatility, themes, and events. 2. Bottom up strategies are concerned with individual company business models, competitive advantages, relative value.

Question 51

What are the benefits and drawbacks of return based style analysis?

Answer 51

Benefits: Can be more widely applied as you do not need to know all of the holdings of a portfolio This can accommodate alternative return sources like derivatives. Costs: Make it difficult to detect aggressive positions due to unnecessary constraints Generally less accurate than holdings based

Question 52

What are the benefits and drawbacks of holdings based style analysis?

Answer 52

Benefits: Generally more accurate Can detect more aggressive positions and analyze deeper Costs: You need all holdings and the attributes of those holdings Limited data on derivatives

Question 53

How can a large fund reduce the implicit costs of trading?

Answer 53

1. Reduce turnover 2. Use a trading strategy that moves the markets less 3. Gate the fund or return capital 4. Expand number of holdings

Question 54

How do you calculate the contribution to total portfolio risk?

Answer 54

Sum of... | Weight A * Weight holding * Covariance, done for each holding