Portfolio Management in Practice, Volume 3
Description
Part of the CFA Institute's three-volume Portfolio Management in Practice series, Equity Portfolio Management offers a fuller treatment of active versus passive equity investment strategies. This text outlines key topics in the portfolio management process with clear, concise language to serve as an accessible guide for students and current industry professionals.
Building on content in the Investment Management and Equity Valuation volumes in the CFA Institute Investment Series, Equity Portfolio Management provides an in-depth, technical examination of constructing and evaluating active equity methods.
This volume explores:
* An overview of passive versus active equity strategies
* Market efficiency underpinnings of passive equity strategies
* Active equity strategies and developing portfolios to reflect active strategies
* Technical analysis as an additional consideration in executing active equity strategies
To further enhance your understanding of the tools and techniques covered here, don't forget to pick up the Portfolio Management in Practice, Volume 3: Equity Portfolio Management Workbook. The workbook is the perfect companion resource containing Learning Outcomes, Summary Overview sections, and challenging practice questions that align chapter-by-chapter with the main text.
Equity Portfolio Management alongside the other Portfolio Management in Practice volumesdistill the knowledge, skills, and abilities readers need to succeed in today's fast-paced financial world.
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CFA Institute is the global association of investment professionals that sets the standard for professional excellence and credentials. The organization is a champion for ethical behavior in investment markets and a respected source of knowledge in the global financial community. The end goal: to create an environment where investors' interests come first, markets function at their best, and economies grow. CFA Institute has more than 155,000 members in 165 countries and territories, including 150,000 CFA® charterholders, and 148 member societies. For more information, visit www.cfainstitute.org.
Content
Preface xi
Acknowledgments xiii
About the CFA Institute Investment Series xv
Chapter 1 Overview of Equity Securities 1
Learning Outcomes 1
1. Introduction 1
2. Equity Securities in Global Financial Markets 2
3. Types and Characteristics of Equity Securities 6
3.1. Common Shares 7
3.2. Preference Shares 10
4. Private versus Public Equity Securities 12
5. Investing in Non-Domestic Equity Securities 15
5.1. Direct Investing 17
5.2. Depository Receipts 17
6. Risk and Return Characteristics of Equity Securities 20
6.1. Return Characteristics of Equity Securities 20
5.2. Risk of Equity Securities 22
7. Equity Securities and Company Value 23
7.1. Accounting Return on Equity 23
7.2. The Cost of Equity and Investors' Required Rates of Return 28
Summary 29
References 31
Practice Problems 31
Chapter 2 Market Efficiency 35
Learning Outcomes 35
1. Introduction 35
2. The Concept of Market Efficiency 37
2.1. The Description of Efficient Markets 37
2.2. Market Value versus Intrinsic Value 39
2.4. Transaction Costs and Information-Acquisition Costs 43
3. Forms of Market Efficiency 44
3.1. Weak Form 44
3.2. Semi-Strong Form 45
3.3. Strong Form 48
3.4. Implications of the Efficient Market Hypothesis 48
4. Market Pricing Anomalies 50
4.1. Time-Series Anomalies 51
4.2. Cross-Sectional Anomalies 53
4.3. Other Anomalies 54
4.4. Implications for Investment Strategies 56
5. Behavioral Finance 57
5.1. Loss Aversion 57
5.2. Herding 58
5.3. Overconfidence 58
5.4. Information Cascades 58
5.5. Other Behavioral Biases 59
5.6. Behavioral Finance and Investors 60
5.7. Behavioral Finance and Efficient Markets 60
Summary 60
References 61
Practice Problems 63
Chapter 3 Overview of Equity Portfolio Management 67
Learning Outcomes 67
1. Introduction 67
2. The Roles of Equities in a Portfolio 68
2.1. Capital Appreciation 68
2.2. Dividend Income 69
2.3. Diversification with Other Asset Classes 70
2.4. Hedge Against Inflation 71
2.5. Client Considerations for Equities in a Portfolio 71
3. Equity Investment Universe 73
3.1. Segmentation by Size and Style 73
3.2. Segmentation by Geography 75
3.3. Segmentation by Economic Activity 77
3.4. Segmentation of Equity Indexes and Benchmarks 78
4. Income and Costs in an Equity Portfolio 79
4.1. Dividend Income 79
4.2. Securities Lending Income 80
4.3. Ancillary Investment Strategies 80
4.4. Management Fees 81
4.5. Performance Fees 81
4.6. Administration Fees 82
4.7. Marketing and Distribution Costs 82
4.8. Trading Costs 83
4.9. Investment Approaches and Effects on Costs 83
5. Shareholder Engagement 84
5.1. Benefits of Shareholder Engagement 84
5.2. Disadvantages of Shareholder Engagement 85
5.3. The Role of an Equity Manager in Shareholder Engagement 85
6. Equity Investment across the Passive-Active Spectrum 87
6.1. Confidence to Outperform 87
6.2. Client Preference 88
6.3. Suitable Benchmark 89
6.4. Client-Specific Mandates 89
6.5. Risks/Costs of Active Management 89
6.6. Taxes 89
Summary 90
References 91
Practice Problems 92
Chapter 4 Passive Equity Investing 95
Learning Outcomes 95
1. Introduction 95
2. Choosing a Benchmark 97
2.1. Indexes as a Basis for Investment 97
2.2. Considerations When Choosing a Benchmark Index 98
2.3. Index Construction Methodologies 100
2.4. Factor-Based Strategies 106
3. Approaches to Passive Equity Investing 109
3.1. Pooled Investments 110
3.2. Derivatives-Based Approaches 113
3.3. Separately Managed Equity Index-Based Portfolios 140
4. Portfolio Construction 119
4.1. Full Replication 119
4.2. Stratified Sampling 121
4.3. Optimization 122
4.4. Blended Approach 123
5. Tracking Error Management 123
5.1. Tracking Error and Excess Return 124
5.2. Potential Causes of Tracking Error and Excess Return 125
5.3. Controlling Tracking Error 126
6. Sources of Return and Risk in Passive Equity Portfolios 126
6.1. Attribution Analysis 127
6.2. Securities Lending 129
6.3. Investor Activism and Engagement by Passive Managers 131
Summary 132
References 133
Practice Problems 135
Chapter 5 Analysis of Active Portfolio Management 141
Learning Outcomes 141
1. Introduction 141
2. Active Management and Value Added 142
2.1. Choice of Benchmark 143
2.2. Measuring Value Added 143
2.3. Decomposition of Value Added 145
3. Comparing Risk and Return 147
3.1. The Sharpe Ratio 147
3.2. The Information Ratio 150
3.3. Constructing Optimal Portfolios 153
4. The Fundamental Law of Active Management 158
4.1. Active Security Returns 158
4.2. The Basic Fundamental Law 163
4.3. The Expanded Fundamental Law 164
4.4. Ex Post Performance Measurement 167
5. Applications of the Fundamental Law 169
5.1. Global Equity Strategy 169
5.2. Fixed-Income Strategies 177
6. Practical Limitations 183
6.1. Ex Ante Measurement of Skill 183
6.2. Independence of Investment Decisions 184
Summary 185
References 187
Practice Problems 187
Chapter 6 Active Equity Investing: Strategies 197
Learning Outcomes 197
1. Introduction 197
2. Approaches to Active Management 198
2.1. Differences in the Nature of the Information Used 200
2.2. Differences in the Focus of the Analysis 201
2.3. Difference in Orientation to the Data: Forecasting the Future vs. Analyzing the Past 202
2.4. Differences in Portfolio Construction: Judgment vs. Optimization 202
3. Types of Active Management Strategies 204
3.1. Bottom-Up Strategies 204
3.2. Top-Down Strategies 211
3.3. Factor-Based Strategies 214
3.4. Activist Strategies 228
3.5. Other Strategies 235
4. Creating a Fundamental Active Investment Strategy 239
4.1. The Fundamental Active Investment Process 239
4.2. Pitfalls in Fundamental Investing 241
5. Creating a Quantitative Active Investment Strategy 246
5.1. Creating a Quantitative Investment Process 246
5.2. Pitfalls in Quantitative Investment Processes 249
6. Equity Investment Style Classification 253
6.1. Different Approaches to Style Classification 253
6.2. Strengths and Limitations of Style Analysis 260
Summary 262
References 263
Practice Problems 264
Chapter 7 Active Equity Investing: Portfolio Construction 271
Learning Outcomes 271
1. Introduction 271
2. Building Blocks of Active Equity Portfolio Construction 272
2.1. Fundamentals of Portfolio Construction 273
2.2. Building Blocks Used in Portfolio Construction 275
3. Approaches to Portfolio Construction 284
3.1. The Implementation Process: The Choice of Portfolio Management Approaches 285
3.2. The Implementation Process: The Objectives and Constraints 296
4. Allocating the Risk Budget 301
4.1. Absolute vs. Relative Measures of Risk 302
4.2. Determining the Appropriate Level of Risk 307
4.3. Allocating the Risk Budget 310
5. Additional Risk Measures Used in Portfolio Construction and Monitoring 314
5.1. Heuristic Constraints 314
5.2. Formal Constraints 315
5.3. The Risks of Being Wrong 318
6. Implicit Cost-Related Considerations in Portfolio Construction 321
6.1. Implicit Costs-Market Impact and the Relevance of Position Size, Assets under Management, and Turnover 321
6.2. Estimating the Cost of Slippage 324
7. The Well-Constructed Portfolio 328
8. Long/Short, Long Extension, and Market-Neutral Portfolio Construction 332
8.1. The Merits of Long-Only Investing 333
8.2. Long/Short Portfolio Construction 335
8.3. Long Extension Portfolio Construction 336
8.4. Market-Neutral Portfolio Construction 337
8.5. Benefits and Drawbacks of Long/Short Strategies 338
Summary 342
References 345
Practice Problems 346
Chapter 8 Technical Analysis 351
Learning Outcomes 351
1. Introduction 351
2. Technical Analysis: Principles, Assumptions, and Links to Investment Analysis 352
2.1. Principles and Assumptions 353
2.2. Technical Analysis and Behavioral Finance 354
2.3. Technical Analysis and Fundamental Analysis 356
2.4. The Differences in Conducting/Interpreting Technical Analysis in Various Types of Markets 358
3. Charting 360
3.1. Types of Technical Analysis Charts 361
3.2. Trend, Support, and Resistance 372
3.3. Common Chart Patterns 375
4. Technical Indicators 397
4.1. Technical Indicators 398
5. Applications to Portfolio Management 417
5.1. Principles of Intermarket Analysis 418
5.2. Technical Analysis Applications to Portfolio Management 421
Summary 435
Practice Problems 438
Glossary 445
About the Authors 451
About the CFA Program 453
Index 455
CHAPTER 1
OVERVIEW OF EQUITY SECURITIES
Ryan C. Fuhrmann CFA
Asjeet S. Lamba PhD, CFA
LEARNING OUTCOMES
The candidate should be able to:
- describe characteristics of types of equity securities;
- describe differences in voting rights and other ownership characteristics among different equity classes;
- distinguish between public and private equity securities;
- describe methods for investing in non-domestic equity securities;
- compare the risk and return characteristics of different types of equity securities;
- explain the role of equity securities in the financing of a company's assets;
- distinguish between the market value and book value of equity securities;
- compare a company's cost of equity, its (accounting) return on equity, and investors' required rates of return.
1. INTRODUCTION
Equity securities represent ownership claims on a company's net assets. As an asset class, equity plays a fundamental role in investment analysis and portfolio management because it represents a significant portion of many individual and institutional investment portfolios.
The study of equity securities is important for many reasons. First, the decision on how much of a client's portfolio to allocate to equities affects the risk and return characteristics of the entire portfolio. Second, different types of equity securities have different ownership claims on a company's net assets, which affect their risk and return characteristics in different ways. Finally, variations in the features of equity securities are reflected in their market prices, so it is important to understand the valuation implications of these features.
This chapter provides an overview of equity securities and their different features and establishes the background required to analyze and value equity securities in a global context. It addresses the following questions:
- What distinguishes common shares from preference shares, and what purposes do these securities serve in financing a company's operations?
- What are convertible preference shares, and why are they often used to raise equity for unseasoned or highly risky companies?
- What are private equity securities, and how do they differ from public equity securities?
- What are depository receipts and their various types, and what is the rationale for investing in them?
- What are the risk factors involved in investing in equity securities?
- How do equity securities create company value?
- What is the relationship between a company's cost of equity, its return on equity, and investors' required rate of return?
The remainder of this chapter is organized as follows. Section 2 provides an overview of global equity markets and their historical performance. Section 3 examines the different types and characteristics of equity securities, and Section 4 outlines the differences between public and private equity securities. Section 5 provides an overview of the various types of equity securities listed and traded in global markets. Section 6 discusses the risk and return characteristics of equity securities. Section 7 examines the role of equity securities in creating company value and the relationship between a company's cost of equity, its return on equity, and investors' required rate of return. The final section summarizes the chapter.
2. EQUITY SECURITIES IN GLOBAL FINANCIAL MARKETS
This section highlights the relative importance and performance of equity securities as an asset class. We examine the total market capitalization and trading volume of global equity markets and the prevalence of equity ownership across various geographic regions. We also examine historical returns on equities and compare them to the returns on government bonds and bills.
Exhibit 1 summarizes the contributions of selected countries and geographic regions to global gross domestic product (GDP) and global equity market capitalization. Analysts may examine the relationship between equity market capitalization and GDP as a rough indicator of whether the global equity market (or a specific country's or region's equity market) is under, over, or fairly valued, particularly compared to its long-run average.
Exhibit 1 illustrates the significant value that investors attach to publicly traded equities relative to the sum of goods and services produced globally every year. It shows the continued significance, and the potential over-representation, of US equity markets relative to their contribution to global GDP. That is, while US equity markets contribute around 51 percent to the total capitalization of global equity markets, their contribution to the global GDP is only around 25 percent. Following the stock market turmoil in 2008, however, the market capitalization to GDP ratio of the United States fell to 59 percent, which is significantly lower than its long-run average of 79 percent.
As equity markets outside the United States develop and become increasingly global, their total capitalization levels are expected to grow closer to their respective world GDP contributions. Therefore, it is important to understand and analyze equity securities from a global perspective.
EXHIBIT 1 Country and Regional Contributions to Global GDP and Equity Market Capitalization (2017)
Sources: The WorldBank Databank (2017), and Dimson, Marsh, and Staunton (2018).
Exhibit 2 lists the top 10 equity markets at the end of 2017 based on total market capitalization (in billions of US dollars), trading volume, and the number of listed companies.1 Note that the rankings differ based on the criteria used. For example, the top three markets based on total market capitalization are the NYSE Euronext (US), NASDAQ OMX, and the Japan Exchange Group; however, the top three markets based on total US dollar trading volume are the Nasdaq OMX, NYSE Euronext (US), and the Shenzhen Stock Exchange, respectively.2
EXHIBIT 2 Equity Markets Ranked by Total Market Capitalization at the End of 2017 (Billions of US Dollars)
Rank Name of Market Total US Dollar Market Capitalization Total US Dollar Trading Volume Number of Listed Companies 1 NYSE Euronext (US) $22,081.4 $16,140.1 2,286 2 NASDAQ OMX $10,039.4 $33,407.1 2,949 3 Japan Exchange Groupa $6,220.0 $6,612.1 3,604 4 Shanghai Stock Exchange $5,084.4 $7,589.3 1,396 5 Euronextb $4,393.0 $1,981.6 1,255 6 Hong Kong Exchanges $4,350.5 $1,958.8 2,118 7 Shenzhen Stock Exchanges $3,617.9 $9,219.7 2,089 8 National Stock Exchange of India $2,351.5 $1,013.3 1,897 9 BSE Limitedc $2,331.6 $183.0 5,616 10 Deutsche Börse $2,262.2 $1,497.9 499Notes:
aJapan Exchange Group is the merged entity containing the Tokyo Stock Exchange and Osaka Securities Exchange.
bFrom 2001, includes Netherlands, France, England, Belgium, and Portugal.
cBombay Stock Exchange.
Source: Adapted from the World Federation of Exchanges 2017 Report (see http://www.world-exchanges.org). Note that market capitalization by company is calculated by multiplying its stock price by the number of shares outstanding. The market's overall capitalization is the aggregate of the market capitalizations of all companies traded on that market. The number of listed companies includes both domestic and foreign companies whose shares trade on these markets.
Exhibit 3 compares the real (or inflation-adjusted) compounded returns on government bonds, government bills, and equity securities in 21 countries plus the world index ("Wld"), the world ex-US ("WxU"), and Europe ("Eur") during the 118 years 1900-2017.3 In real terms, government bonds and bills have essentially kept pace with the inflation rate, earning annualized real returns of less than 2 percent in most countries.4 By comparison, real returns in equity markets have generally been around 3.5 percent per year in most markets-with a world average return of around 5.2 percent and a world average return excluding the United States just under 5 percent. During this period, South Africa and Australia were the best performing markets followed by the United States, New Zealand, and Sweden.
EXHIBIT 3 Real Returns on Global Equity Securities, Bonds, and Bills During 1900-2017
Source: Dimson, Marsh, and Staunton (2018).
Exhibit 4 shows the annualized real returns on major asset classes for the world index over 1900-2017.
EXHIBIT 4 Annualized Real Returns on Asset Classes for the World Index,...
