1. Capital Appreciation * Driver: Long-term returns are driven predominantly by capital appreciation. * Historical Performance: Historically higher real returns than bonds or bills (1900–2022). * Economic Link: Equities tend to outperform in strong economic growth periods and underperform in weak ones. * Sources: * Growth in earnings, cash flows, and revenues. * Competitive success (e.g., growth companies like small tech, or mature companies maintaining profitability).
2. Dividend Income * Nature: Distribution of free cash flows when reinvestment projects do not meet required rates of return. * Significance: A major component of long-term total returns. In periods of negative price returns (e.g., 2000s), dividends can offset losses. * Variability: Dividend yield varies by sector and over time (S&P 500 yield typically 1%–3% since 1990). * Types: Common dividends and preferred dividends.
3. Diversification with Other Asset Classes * Mechanism: Combining assets with correlations < +1.0 reduces portfolio standard deviation. * Correlations: * Equity indexes (broad and country) are often highly correlated with each other. * Equities have lower correlations with other asset classes (Treasuries, investment-grade bonds, gold). * Risk: Correlations are not constant; they often increase during market crises, reducing diversification benefits when needed most.
4. Hedge against Inflation * Mechanism: Companies may pass higher input costs to customers or benefit from rising commodity prices (e.g., oil producers). * Effectiveness: Mixed. * Positive correlation with inflation over the long term. * Negative correlation during severe inflation (>5%), meaning equities may fail as a hedge when most needed.
5. Client Considerations (Investment Policy Statement) * Risk Objective: Willingness and ability to take risk. * Return Objective: Absolute or relative goals. * Liquidity: Cash needs for anticipated/unanticipated events. * Time Horizon: Short vs. long term. * Taxes: Differential rates for dividends vs. capital gains. * Legal/Regulatory: External constraints. * Unique Circumstances: ESG, religious preferences.
Example: Roles of Equities * Scenario: Three managers with different objectives. * Chang (Income): Focuses on large, established companies with stable dividends. * Choi (Aggressive/Growth): Focuses on companies with earnings growth and competitive success for capital appreciation. * Huber (Inflation Protection): Focuses on companies with pricing power (pass costs to customers) or commodity producers.
1. Segmentation by Size and Style * Size: Measured by market capitalization (Large, Mid, Small). * Style: Value, Growth, or Blend (Core). * Scoring: Uses metrics like P/E, P/B, Dividend Yield, and Earnings Growth to assign a “score” determining style. * Advantages: Straightforward portfolio construction, diversification across sectors, allows construction of specific benchmarks. * Disadvantages: Categories change over time (migration); definitions vary by investor.
2. Segmentation by Geography * Categories: Developed Markets (DM), Emerging Markets (EM), Frontier Markets (FM). * Criteria: Economic development, size/liquidity, market accessibility. * Advantages: Diversification for domestic-focused investors. * Disadvantages: * Currency Risk. * Misleading Exposure: A company listed in a country may derive most revenue elsewhere (e.g., Nestle/Roche in Switzerland).
3. Segmentation by Economic Activity (Sectors/Industries) * Approach: Market-oriented grouping based on how revenue is earned. * Systems: * GICS (Global Industry Classification Standard): 11 Sectors, 24 Industry Groups, 68 Industries, 157 Sub-Industries. * ICB (Industrial Classification Benchmark). * TRBC (Thomson Reuters). * RGS (Russell Global Sectors). * Advantages: Allows sector-specific benchmarks; better industry representation. * Disadvantage: Large companies often have diverse business lines spanning multiple industries.
Example: Segmenting the Equity Investment Universe * Scenario: Manager wants to invest in the Chinese robotics industry (rapidly accelerating earnings). * Recommendation: Segment by Size/Style. * Reasoning: The goal is “rapidly accelerating earnings” (Growth style). Geography (China) and Activity (Robotics) are already defined by the niche, so Size/Style helps select the specific stocks (e.g., small-cap growth) fitting the strategy.
4. Segmentation of Indexes * Can combine approaches (e.g., MSCI World Small Cap Value). * Thematic indexes exist for specific sectors (e.g., Global Natural Resources) or approaches (ESG).
Example: Equity Portfolio Income * Scenario: Isabel Cordova wants to enhance income. * Solution: She can use Securities Lending (fees + collateral interest), Dividend Capture (buy before ex-date), or Write Options (Covered calls/Cash-secured puts).
Effect of Investment Approach on Costs: * Passive: Lower fees, lower turnover (except for reconstitution/rebalancing). * Active: Higher fees, higher trading costs (especially for liquidity-demanding strategies like momentum).
The choice between Active and Passive (Index-based) is a spectrum, not binary.
1. Confidence to Outperform: Requires competitive advantage (information, skill) to generate alpha net of fees. 2. Client Preference: Some clients believe markets are efficient (prefer Index); others want outperformance potential. 3. Suitable Benchmark: Active managers need benchmarks with sufficient liquidity and breadth to allow for alpha generation. 4. Client-Specific Mandates: ESG or religious restrictions (negative screening) often require Active management (indexing is inefficient for custom exclusions). 5. Risks/Costs: Active has higher fees and “Key Person” risk. 6. Taxes: Indexing generally tax-efficient (low turnover). Active strategies can be managed for taxes (tax-loss harvesting) but often have higher turnover.
Example: Active Management Spectrum * Scenario: Client Goudreaux is cost-conscious, believes markets are efficient, but wants specific country/sector exposure. * Position: Index-based approach. * Reasoning: Belief in efficiency + cost consciousness points to passive. Specific sector desires can be met with sector-specific indexes.
Advantages of Index-Based: * Lower fees (primary advantage). * Consistent adherence to style/mandate. * Based on Efficient Market Hypothesis (EMH).
Criteria for a Valid Benchmark: 1. Rules-based: Objective inclusion criteria. 2. Transparent: Constituents and rules are public. 3. Investable: Can be replicated (liquidity, float).
Considerations: * Market Exposure: Geography, Size, Style (matches IPS). * Buffering: Rules to prevent frequent turnover when stocks hover near size cutoffs (e.g., MSCI uses a buffer zone for Large vs. Mid cap migration). * Packeting: Splitting stock weight between two indexes during migration to reduce trading impact.
Weighting Methods: 1. Market-Cap Weighted: * Weight = Market Cap / Total Market Cap. * Pros: Self-adjusting, high capacity/liquidity (Blue chips), consistent with CAPM. * Cons: Concentrated in overvalued stocks (momentum bias). * Free-Float Adjustment: Excludes closely held shares (founders, gov’t) to reflect investable liquidity. 2. Price-Weighted: * Weight = Price / Sum of Prices (e.g., DJIA, Nikkei). * Cons: Arbitrary (stock split changes weight), ignores market cap. 3. Equal-Weighted: * Weight = 1 / N. * Pros: Reduces concentration, small-cap bias (higher potential return). * Cons: High turnover (rebalancing needed), limited capacity (liquidity constraint in small caps). 4. Fundamental Weighted: * Weight based on metrics like sales, dividends, earnings. * Pros: Contrarian (value) bias.
Index Concentration: Herfindahl-Hirschman Index (HHI) * Measure of stock concentration risk. * Formula: \[HHI = \sum_{i=1}^{n} w_i^2\] * Effective Number of Stocks: \[\text{Effective } N = \frac{1}{HHI}\] * Interpretation: An HHI of 1.0 implies single stock concentration. Lower HHI implies greater diversification.
Example: Effective Number of Stocks * Data: 50 stocks. Top 5 weights: 0.089, 0.080, 0.065, 0.059, 0.053. Sum of squares for remaining 45 = 0.01405. * Calculation: * Sum of squares (Top 5) = \(0.00792 + 0.00640 + 0.00423 + 0.00348 + 0.00281 = 0.02484\) * Total HHI = \(0.02484 + 0.01405 = 0.03889\) * Effective \(N = 1 / 0.03889 \approx 25.7\) * Insight: Even with 50 stocks, the concentration makes it equivalent to holding only ~26 equal-weighted stocks.
Rebalancing vs. Reconstitution: * Rebalancing: Adjusting weights to target (frequent). * Reconstitution: Adding/deleting securities (periodic). * Impact: Creates turnover. Arbitrageurs may “front-run” reconstitution trades if rules are transparent (price pressure on adds/deletes).