CFA Level III - Equity
Equity segmentation methods (3) - correct answer ✔- provides
understanding of overall portfolio and diversification
(1) size and style
- size: large-cap, mid-cap, small-cap
- style: growth, value, or a mix (aka blend or core) - determined by looking at
P/E, P/B, div yield, earnings or book value growth - stable net income and
high div yields are characteristics of value
- PROS - better address client risk/return characteristics, greater ability to
diversify across different sectors (can target exposure to meet specific
objectives), construct relevant benchmark (beyond just S&P 500), analyze
how company characteristics change over time
- CONS: categories are not stable over time (this is the last pro as well)
(2) geography - by stage of economic development
- developed mkts (e.g US, UK, Germany, Australia, Japan)
- emerging (e.g. Brazil, Russia, India, China, South Africa) -> ie BRIC + S
Africa
- frontier (e.g. Argentina, Estonia, Nigeria, Jordan, Vietnam)
- ADV: can better understand how to diversify across mkts
- DISADV: currency risk; may overestimate diversification benefit as
companies themselves may already be diversified across geos
(3) economic activity - companies grouped into sectors / industries
- mkt-oriented approach - segments companies by markets served, how
products are used by consumers, how cash is generated
,- production-oriented approach - segments companies by products
manufactured and inputs required during the production process
-> companies may land in different buckets depending on which method was
used
- ADV: analyze / benchmark based on specific sectors; diversification benefit
across sectors
- DISADV: some companies not easily assigned to one specific sector
Benefits to overall portfolio of equity (4) - correct answer ✔(1) capital
appreciation - the main driver of LT equity returns (i.e. price returns) - equities
on average have higher returns than debt during periods of strong growth but
underperform in weak economies
(2) dividend income - dividend yields are more stable than return due to price
change
(3) diversification - less than perfect correlation with other asset classes
(causing port SD to be less than wtd sum of individual asset SDs)
- but in crisis, correlations tend to increase, reducing benefit; also, standard
deviations could increase, further reducing expected reduction in portfolio risk
(4) potential to hedge inflation - company may be able to charge customers
more when input costs rise due to inflation
- most equities are positively correlated with inflation, but in hyperinflation
negative correlations are observed
Addressing client constraints through negative screening, positive screening,
thematic / impact investing - correct answer ✔- negative screening -
exclusionary screening - exclude companies / sectors that don't meet client
standards (e.g. excluding coal cos that don't meet ESG standards)
- positive screening - best in class screening - uncover companies / sectors
that are most favorable to client (eg finding cos that score best on ESG)
- thematic investing - screen equities based on a certain theme or sector, e.g
climate change or clean energy
,- impact investing - meet investor objectives by becoming more actively
engaged with company matters or directly investing in company projects
Shareholder engagement - what it is and costs - correct answer ✔- investors
interacting with companies to potentially favorably impact stock price
- includes participating in calls with the company and voting on corporate
issues - would involve corporate strategy, capital allocation, corporate
governance, mgmt comp, board composition
- free riders who don't incur the costs of engagement still benefit
- costs:
(1) requires an investment of time and resources - active mgrs will do so to
improve performance, passive mgrs will look to reduce these costs (passive
managers, like index funds, try to minimize costs, so SH engagement will
likely increase costs and lower returns); larger investors can more easily
absorb these costs as they can spread it out over more assets
(2) focus on ST goals like increasing stock price at expense of LT goals
(3) acquisition of MNPI, increasing risk of insider trading
(4) potential conflicts of interest
Active vs. passive investing; rationale for shifting to active and costs of active -
correct answer ✔PASSIVE: try to replicate index or benchmark
ACTIVE: seek to outperform benchmark and add value
- riskier as you may underperform benchmark; also has higher turnover, which
can lead to higher tax burden
- rationale:
(1) confidence mgr has expert knowledge and skill
(2) client preferences - need enough investors to give you money to cover
costs of investing (but too much capital can make it hard to find opps to add
value)
, - benchmark should contain a broad range of underlying equities with
sufficient liquidity to support active mgmt -> narrow limited benchmarks don't
give the active mgr much room to deviate while keeping trading costs
reasonable and passive approach would be better -> country and sector
specific equity funds (e.g. US consumer defensive companies) tend to be
passively managed
(3) mandates to invest in certain companies (e.g. ESG) may require a more
active approach
- results are less certain and costs are higher
- other risks:
(1) reputation risk - from violations to rules, regulations, client agreements, or
moral principles
(2) key man risk - individuals who are essential leave the fund
(3) higher turnover - leads to higher transaction costs
Types of equity income (dividends, securities lending, writing options, dividend
capture) - correct answer ✔- dividend income:
- optional stock dividend - investor can choose b/w cash pmt or stock dividend
(i.e. additional shares)
- special dividend - one-time cash pmt
- securities lending - lending a security to a short seller in return for a fee and
collateral / cash that can be invested (short seller has to borrow a security to
deliver it to the buyer when the short is made)
- CONS: short selling drives down price of underlying (which you are
ultimately getting back); must be concerned with credit worthiness of borrower
(to return security and to compensate for any dividends received during loan
period); lender loses right to vote; administrative costs of securities lending
program would reduce total income earned
- index funds and large institutional portfolios are best situated for it
