Portfolio Management in Practice, Volume 3

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.

• Preface xiAcknowledgments xiiiAbout the CFA Institute Investment Series xvChapter 1 Overview of Equity Securities 1Learning Outcomes 11. Introduction 12. Equity Securities in Global Financial Markets 23. Types and Characteristics of Equity Securities 63.1. Common Shares 73.2. Preference Shares 104. Private versus Public Equity Securities 125. Investing in Non-Domestic Equity Securities 155.1. Direct Investing 175.2. Depository Receipts 176. Risk and Return Characteristics of Equity Securities 206.1. Return Characteristics of Equity Securities 205.2. Risk of Equity Securities 227. Equity Securities and Company Value 237.1. Accounting Return on Equity 237.2. The Cost of Equity and Investors’ Required Rates of Return 28Summary 29References 31Practice Problems 31Chapter 2 Market Efficiency 35Learning Outcomes 351. Introduction 352. The Concept of Market Efficiency 372.1. The Description of Efficient Markets 372.2. Market Value versus Intrinsic Value 392.4. Transaction Costs and Information-Acquisition Costs 433. Forms of Market Efficiency 443.1. Weak Form 443.2. Semi-Strong Form 453.3. Strong Form 483.4. Implications of the Efficient Market Hypothesis 484. Market Pricing Anomalies 504.1. Time-Series Anomalies 514.2. Cross-Sectional Anomalies 534.3. Other Anomalies 544.4. Implications for Investment Strategies 565. Behavioral Finance 575.1. Loss Aversion 575.2. Herding 585.3. Overconfidence 585.4. Information Cascades 585.5. Other Behavioral Biases 595.6. Behavioral Finance and Investors 605.7. Behavioral Finance and Efficient Markets 60Summary 60References 61Practice Problems 63Chapter 3 Overview of Equity Portfolio Management 67Learning Outcomes 671. Introduction 672. The Roles of Equities in a Portfolio 682.1. Capital Appreciation 682.2. Dividend Income 692.3. Diversification with Other Asset Classes 702.4. Hedge Against Inflation 712.5. Client Considerations for Equities in a Portfolio 713. Equity Investment Universe 733.1. Segmentation by Size and Style 733.2. Segmentation by Geography 753.3. Segmentation by Economic Activity 773.4. Segmentation of Equity Indexes and Benchmarks 784. Income and Costs in an Equity Portfolio 794.1. Dividend Income 794.2. Securities Lending Income 804.3. Ancillary Investment Strategies 804.4. Management Fees 814.5. Performance Fees 814.6. Administration Fees 824.7. Marketing and Distribution Costs 824.8. Trading Costs 834.9. Investment Approaches and Effects on Costs 835. Shareholder Engagement 845.1. Benefits of Shareholder Engagement 845.2. Disadvantages of Shareholder Engagement 855.3. The Role of an Equity Manager in Shareholder Engagement 856. Equity Investment across the Passive–Active Spectrum 876.1. Confidence to Outperform 876.2. Client Preference 886.3. Suitable Benchmark 896.4. Client-Specific Mandates 896.5. Risks/Costs of Active Management 896.6. Taxes 89Summary 90References 91Practice Problems 92Chapter 4 Passive Equity Investing 95Learning Outcomes 951. Introduction 952. Choosing a Benchmark 972.1. Indexes as a Basis for Investment 972.2. Considerations When Choosing a Benchmark Index 982.3. Index Construction Methodologies 1002.4. Factor-Based Strategies 1063. Approaches to Passive Equity Investing 1093.1. Pooled Investments 1103.2. Derivatives-Based Approaches 1133.3. Separately Managed Equity Index-Based Portfolios 1404. Portfolio Construction 1194.1. Full Replication 1194.2. Stratified Sampling 1214.3. Optimization 1224.4. Blended Approach 1235. Tracking Error Management 1235.1. Tracking Error and Excess Return 1245.2. Potential Causes of Tracking Error and Excess Return 1255.3. Controlling Tracking Error 1266. Sources of Return and Risk in Passive Equity Portfolios 1266.1. Attribution Analysis 1276.2. Securities Lending 1296.3. Investor Activism and Engagement by Passive Managers 131Summary 132References 133Practice Problems 135Chapter 5 Analysis of Active Portfolio Management 141Learning Outcomes 1411. Introduction 1412. Active Management and Value Added 1422.1. Choice of Benchmark 1432.2. Measuring Value Added 1432.3. Decomposition of Value Added 1453. Comparing Risk and Return 1473.1. The Sharpe Ratio 1473.2. The Information Ratio 1503.3. Constructing Optimal Portfolios 1534. The Fundamental Law of Active Management 1584.1. Active Security Returns 1584.2. The Basic Fundamental Law 1634.3. The Expanded Fundamental Law 1644.4. Ex Post Performance Measurement 1675. Applications of the Fundamental Law 1695.1. Global Equity Strategy 1695.2. Fixed-Income Strategies 1776. Practical Limitations 1836.1. Ex Ante Measurement of Skill 1836.2. Independence of Investment Decisions 184Summary 185References 187Practice Problems 187Chapter 6 Active Equity Investing: Strategies 197Learning Outcomes 1971. Introduction 1972. Approaches to Active Management 1982.1. Differences in the Nature of the Information Used 2002.2. Differences in the Focus of the Analysis 2012.3. Difference in Orientation to the Data: Forecasting the Future vs. Analyzing the Past 2022.4. Differences in Portfolio Construction: Judgment vs. Optimization 2023. Types of Active Management Strategies 2043.1. Bottom-Up Strategies 2043.2. Top-Down Strategies 2113.3. Factor-Based Strategies 2143.4. Activist Strategies 2283.5. Other Strategies 2354. Creating a Fundamental Active Investment Strategy 2394.1. The Fundamental Active Investment Process 2394.2. Pitfalls in Fundamental Investing 2415. Creating a Quantitative Active Investment Strategy 2465.1. Creating a Quantitative Investment Process 2465.2. Pitfalls in Quantitative Investment Processes 2496. Equity Investment Style Classification 2536.1. Different Approaches to Style Classification 2536.2. Strengths and Limitations of Style Analysis 260Summary 262References 263Practice Problems 264Chapter 7 Active Equity Investing: Portfolio Construction 271Learning Outcomes 2711. Introduction 2712. Building Blocks of Active Equity Portfolio Construction 2722.1. Fundamentals of Portfolio Construction 2732.2. Building Blocks Used in Portfolio Construction 2753. Approaches to Portfolio Construction 2843.1. The Implementation Process: The Choice of Portfolio Management Approaches 2853.2. The Implementation Process: The Objectives and Constraints 2964. Allocating the Risk Budget 3014.1. Absolute vs. Relative Measures of Risk 3024.2. Determining the Appropriate Level of Risk 3074.3. Allocating the Risk Budget 3105. Additional Risk Measures Used in Portfolio Construction and Monitoring 3145.1. Heuristic Constraints 3145.2. Formal Constraints 3155.3. The Risks of Being Wrong 3186. Implicit Cost-Related Considerations in Portfolio Construction 3216.1. Implicit Costs—Market Impact and the Relevance of Position Size, Assets under Management, and Turnover 3216.2. Estimating the Cost of Slippage 3247. The Well-Constructed Portfolio 3288. Long/Short, Long Extension, and Market-Neutral Portfolio Construction 3328.1. The Merits of Long-Only Investing 3338.2. Long/Short Portfolio Construction 3358.3. Long Extension Portfolio Construction 3368.4. Market-Neutral Portfolio Construction 3378.5. Benefits and Drawbacks of Long/Short Strategies 338Summary 342References 345Practice Problems 346Chapter 8 Technical Analysis 351Learning Outcomes 3511. Introduction 3512. Technical Analysis: Principles, Assumptions, and Links to Investment Analysis 3522.1. Principles and Assumptions 3532.2. Technical Analysis and Behavioral Finance 3542.3. Technical Analysis and Fundamental Analysis 3562.4. The Differences in Conducting/Interpreting Technical Analysis in Various Types of Markets 3583. Charting 3603.1. Types of Technical Analysis Charts 3613.2. Trend, Support, and Resistance 3723.3. Common Chart Patterns 3754. Technical Indicators 3974.1. Technical Indicators 3985. Applications to Portfolio Management 4175.1. Principles of Intermarket Analysis 4185.2. Technical Analysis Applications to Portfolio Management 421Summary 435Practice Problems 438Glossary 445About the Authors 451About the CFA Program 453Index 455