Equity Portfolio Management (Skipped)

https://study.cfainstitute.org/app/cfa-institute-program-level-iii-for-august-2024#read/study_task/2563733/introduction-and-the-role-of-equities-in-a-portfolio-1

INTRODUCTION AND THE ROLE OF EQUITIES IN A PORTFOLIO

Learning Outcome

• describe the roles of equities in the overall portfolio

Equities represent a sizable portion of the global investment universe and thus often represent a primary component of investors’ portfolios. Rationales for investing in equities include potential participation in the growth and earnings prospects of an economy’s corporate sector as well as an ownership interest in a range of business entities by size, economic activity, and geographical scope. Publicly traded equities are generally more liquid than other asset classes and thus may enable investors to more easily monitor price trends and purchase or sell securities with low transaction costs.

This reading provides an overview of equity portfolio management. Section 1.1 discusses the roles of equities in a portfolio. Section 2 discusses the equity investment universe, including several ways the universe can be segmented. Sections 3 and 4 cover the income and costs in an equity portfolio. Section 5 discusses shareholder engagement between equity investors and the companies in which they invest. Section 6 discusses equity investment across the passive–active investment spectrum. A summary of key points completes the reading.

The Roles of Equities in a Portfolio

Equities provide several roles in (or benefits to) an overall portfolio, such as capital appreciation, dividend income, diversification with other asset classes, and a potential hedge against inflation. In addition to these benefits, client investment considerations play an important role for portfolio managers when deciding to include equities in portfolios.

Capital Appreciation

Long-term returns on equities, driven predominantly by capital appreciation, have historically been among the highest among major asset classes. Exhibit 1 demonstrates the average annual real returns on equities versus bonds and bills—both globally and within various countries—from 1900–2020. With a few exceptions, equities outperformed both bonds and bills, in particular, during this period across the world.

Exhibit 1:

Real Returns on Equities (1900–2020)

Source: Credit Suisse Global Investment Returns Yearbook 2021, Summary Edition.

Equities tend to outperform other asset classes during periods of strong economic growth, and they tend to underperform other asset classes during weaker economic periods. Capital (or price) appreciation of equities often occurs when investing in companies with growth in earnings, cash flows, and/or revenues—as well as in companies with competitive success. Capital appreciation can occur, for example, in such growth-oriented companies as small technology companies as well as in large, mature companies where management successfully reduces costs or engages in value-added acquisitions.

Dividend Income

The most common sources of income for an equity portfolio are dividends. Companies may choose to distribute internally generated cash flows as common dividends rather than reinvest the cash flows in projects, particularly when suitable projects do not exist or available projects have a high cost of equity or a low probability of future value creation. Large, well-established corporations often provide dividend payments that increase in value over time, although there are no assurances that common dividend payments from these corporations will grow or even be maintained. In addition to common dividends, preferred dividends can provide dividend income to those shareholders owning preferred shares.

Dividends have comprised a significant component of long-term total returns for equity investors. Over shorter periods of time, however, the proportion of equity returns from dividends (reflected as dividend yield) can vary considerably relative to capital gains or losses. Exhibit 2 illustrates this effect of dividend returns relative to annual total returns on the S&P 500 Index from 1930 through 2020. Since 1990, the dividend yield on the S&P 500 has been in the 1–3% range; thus, the effect of dividends can clearly be significant during periods of weak equity market performance, like during the 2000s when price returns were negative. Also note that the dividend yield may vary considerably by sector within the S&P 500.

Exhibit 2:

 S&P 500 Dividend Contribution (1930–2020)

Source: Hartford Funds.

Diversification with Other Asset Classes

Individual equities clearly have unique characteristics, although the correlation of returns among equities is often high. In a portfolio context, however, equities can provide meaningful diversification benefits when combined with other asset classes (assuming less than perfect correlation). Recall that a major reason why portfolios can effectively reduce risk (typically expressed as standard deviation of returns) is that combining securities whose returns are less than perfectly correlated reduces the standard deviation of the diversified portfolio below the weighted average of the standard deviations of the individual investments. The challenge in diversifying risk is to find assets that have a correlation that is much lower than +1.0.

Exhibit 3 provides a correlation matrix across various global equity indexes and other asset classes using total monthly returns for the twenty years ended 31 October 2021.1 The correlation matrix shows that during this period, various broad equity indexes and, to a lesser extent, country equity indexes were highly correlated with each other. Conversely, both the broad and country equity indexes were considerably less correlated with indexes in other asset classes, notably Treasury bonds, investment grade bonds, and gold. Overall, Exhibit 3 indicates that combining equities with other asset classes can result in portfolio diversification benefits.

It is important to note that correlations are not constant over time. During a long historical period, the correlation of returns between two asset classes may be low, but in any given period, the correlation can differ from the long term. Correlation estimates can vary based on the capital market dynamics during the period when the correlations are measured. During periods of market crisis, correlations across asset classes and among equities themselves often increase and reduce the benefit of diversification. As with correlations, volatility (standard deviation) of asset class returns may also vary over time.

Exhibit 3:

Correlation Matrix, 20 Years Ended 31 October 2021

Source: Morningstar Direct.

Hedge Against Inflation

Some individual equities or sectors can provide some protection against inflation, although the ability to do so varies. For example, certain companies may be successful at passing along higher input costs (such as raw materials, energy, or wages) to customers. This ability to pass along costs to customers can protect a company’s or industry’s profit margin and cash flow and can be reflected in their stock prices. As another example, companies within sectors that produce broad-based commodities (e.g., oil or industrial metals producers) can more directly benefit from increases in commodity prices. Although individual equities or sectors can protect against inflation, the success of equities as an asset class in hedging inflation has been mixed. Certain empirical studies have indeed shown that real returns on equities and inflation have positive correlation over the long-term, thus in theory forming a hedge. However, the degree of correlation typically varies by country and is dependent on the time period assessed. In fact, for severe inflationary periods, some studies have shown that real returns on equities and inflation have been negatively correlated. When assessing the relationship between equity returns and inflation, investors should be aware that inflation is typically a lagging indicator of the business cycle, while equity prices are often a leading indicator.

Client Considerations for Equities in a Portfolio

The inclusion of equities in a portfolio can be driven by a client’s goals or needs. A client’s investment considerations are typically described in an investment policy statement (IPS), which establishes, among other things, a client’s return objectives, risk tolerance, constraints, and unique circumstances. By understanding these client considerations, a financial adviser or wealth manager can determine whether—and how much—equities should be in a client’s portfolio.

Equity investments are often characterized by such attributes as growth potential, income generation, risk and return volatility, and sensitivity to various macro-economic variables (e.g., energy prices, GDP growth, interest rates, and inflation). As a result, a portfolio manager can adapt such specific factors to an equity investor’s investment goals and risk tolerance. For example, a risk-averse and conservative investor may prefer some exposure to well-established companies with strong and stable cash flow that pay meaningful dividends. Conversely, a growth-oriented investor with an aggressive risk tolerance may prefer small or large growth-oriented companies (e.g., those in the social media or alternative energy sectors).

Wealth managers and financial advisers often consider the following investment objectives and constraints when deciding to include equities (or asset classes in general, for that matter) in a client’s portfolio:

• Risk objective addresses how risk is measured (e.g., in absolute or relative terms); the investor’s willingness to take risk; the investor’s ability to take risk; and the investor’s specific risk objectives.

• Return objective addresses how returns are measured (e.g., in absolute or relative terms); stated return objectives.

• Liquidity requirement is a constraint in which cash is needed for anticipated or unanticipated events.

• Time horizon is the time period associated with an investment objective (e.g., short term, long term, or some combination of the two).

• Tax concerns include tax policies that can affect investor returns; for example, dividends may be taxed at a different rate than capital gains.

• Legal and regulatory factors are external factors imposed by governmental, regulatory, or oversight authorities.

• Unique circumstances are an investor’s considerations other than liquidity requirements, time horizon, or tax concerns that may constrain portfolio choices. These considerations may include environmental, social, and governance (ESG) issues or religious preferences.

ESG considerations often occur at the request of clients because interest in sustainable investing has grown. With regard to equities, these considerations often determine the suitability of certain sectors or individual company stocks for designated investor portfolios. Historically, ESG approaches used by portfolio managers have largely represented negative screening (or exclusionary screening), which refers to the practice of excluding certain sectors or companies that deviate from accepted standards in such areas as human rights or environmental concerns. More recently, portfolio managers have increasingly focused on positive screening or best-in-class approaches, which attempt to identify companies or sectors that score most favorably with regard to ESG-related risks and/or opportunities. Thematic investing is another approach that focuses on investing in companies within a specific sector or following a specific theme, such as energy efficiency or climate change. Impact investing is a related approach that seeks to achieve targeted social or environmental objectives along with measurable financial returns through engagement with a company or by direct investment in projects or companies.

EXAMPLE 1

Roles of Equities

1. Alex Chang, Lin Choi, and Frank Huber manage separate equity portfolios for the same investment firm. Chang’s portfolio objective is conservative in nature, with a regular stream of income as the primary investment objective. Choi’s portfolio is more aggressive in nature, with a long-term horizon and with growth as the primary objective. Finally, Huber’s portfolio consists of wealthy entrepreneurs who are concerned about rising inflation and wish to preserve the purchasing power of their wealth.

   Discuss the investment approach that each portfolio manager would likely use to achieve his or her portfolio objectives.

   Solution:

   Given that his portfolio is focused on a regular stream of income, Chang is likely to focus on companies with regular dividend income. More specifically, Chang is likely to invest in large, well-established companies with stable or growing dividend payments. With a long-term horizon, Choi is most interested in capital appreciation of her portfolio, so she is likely to focus on companies with earnings growth and competitive success. Finally, Huber’s clients are concerned about the effects of inflation, so he will likely seek to invest in shares of companies that can provide an inflation hedge. Huber would likely seek companies that can successfully pass on higher input costs to their customers, and he may also seek commodity producers that may benefit from rising commodity prices.

https://study.cfainstitute.org/app/cfa-institute-program-level-iii-for-august-2024#read/study_task/2563743/equity-investment-universe-1

EQUITY INVESTMENT UNIVERSE

Learning Outcome

• describe how an equity manager’s investment universe can be segmented

Given the extensive range of companies in which an equity portfolio manager may invest, an important task for the manager is to segment companies or sectors according to similar characteristics. This segmentation enables portfolio managers to better evaluate and analyze their equity investment universe, and it can help with portfolio diversification. Several approaches to segmenting the equity investment universe are discussed in the following sections.

Segmentation by Size and Style

A popular approach to segmenting the equity universe incorporates two factors: (1) size and (2) style. Size is typically measured by market capitalization and often categorized by large cap, mid cap, and small cap. Style is typically classified as value, growth, or a combination of value and growth (typically termed “blend” or “core”). In addition, style is often determined through a “scoring” system that incorporates multiple metrics or ratios, such as price-to-book ratios, price-to-earnings ratios, earnings growth, dividend yield, and book value growth. These metrics are then typically “scored” individually for each company, assigned certain weights, and then aggregated. The result is a composite score that determines where the company’s stock is positioned along the value–growth spectrum. A combination of growth and value style is not uncommon, particularly for large corporations that have both mature and higher growth business lines.

Exhibit 4 illustrates a common matrix that reflects size and style dimensions. Each category in the matrix can be represented by companies with considerably different business activities. For example, both a small, mature metal fabricating business and a small health care services provider may fall in the Small Cap Value category. In practice, individual stocks may not clearly fall into one of the size/style categories. As a result, the size/style matrix tends to be more of a scatter plot than a simple set of nine categories. An example of a scatter plot is demonstrated in Exhibit 5, which includes all listed equities on the New York Stock Exchange as of March 2017. Each company represents a single dot in Exhibit 5. This more granular representation enables the expansion of size and style categories, such as blue chip and micro-cap companies in size and deep value and high growth in style. It should be noted that Morningstar applies the term “core” for those stocks in which neither value nor growth characteristics dominate, and the term “blend” for those funds with a combination of both growth and value stocks or mostly core stocks.

Exhibit 4:

Equity Size and Style Matrix

Source: Morningstar.

Exhibit 5:

Equity Size and Style Scatter Plot

Source: Morningstar Direct.

Segmentation by size/style can provide several advantages for portfolio managers. First, portfolio managers can construct an overall equity portfolio that reflects desired risk, return, and income characteristics in a relatively straightforward and manageable way. Second, given the broad range of companies within each segment, segmentation by size/style results in diversification across economic sectors or industries. Third, active equity managers—that is, those seeking to outperform a given benchmark portfolio—can construct performance benchmarks for specific size/style segments. Generally, large investment management firms may have sizable teams dedicated toward specific size/style categories, while small firms may specialize in a specific size/style category, particularly mid-cap and small-cap companies, seeking to outperform a standard benchmark or comparable peer group.

The final advantage of segmentation by size/style is that it allows a portfolio to reflect a company’s maturity and potentially changing growth/value orientation. Specifically, many companies that undertake an IPO (initial public offering) are small and in a growth phase, and thus they may fall in the small-cap growth category. If these companies can successfully grow, their size may ultimately move to mid cap or even large cap, while their style may conceivably shift from high growth to value or a combination of growth and value (e.g., a growth and income stock). Accordingly, over the life cycle of companies, investor preferences for these companies may shift increasingly from capital appreciation to dividend income. In addition, segmentation also helps fund managers adjust holdings over time—for example, when stocks that were previously considered to be in the growth category mature and possibly become value stocks. The key disadvantages of segmentation by size/style are that the categories may change over time and may be defined differently among investors.

Segmentation by Geography

Another common approach to equity universe segmentation is by geography. This approach is typically based on the stage of markets’ macroeconomic development and wealth. Common geographic categories are developed markets, emerging markets, and frontier markets. Exhibit 6 demonstrates the commonly used geographic segmentation of international equity indexes according to MSCI. MSCI classifies countries as developed, emerging, or frontier according to a holistic framework that considers economic development, size and liquidity, and accessibility criteria like openness to foreign equity ownership. Other major index providers—such as FTSE, Standard & Poor’s, and Russell—also provide similar types of international equity indexes.

Geographic segmentation is useful to equity investors who have considerable exposure to their domestic market and want to diversify by investing in global equities. A key weakness of geographic segmentation is that investing in a specific market (e.g., market index) may provide lower-than-expected exposure to that market. As an example, many large companies domiciled in the United States, Europe, or Asia may be global in nature as opposed to considerable focus on their domicile. Another key weakness of geographic segmentation is potential currency risk when investing in different global equity markets.

Exhibit 6:

MSCI International Equity Indexes (as of November 2021)

Developed Markets
Americas	Europe and Middle East	Pacific
Canada United States	Austria Belgium Denmark Finland France Germany Ireland Israel Italy Netherlands Norway Portugal Spain Sweden Switzerland United Kingdom	Australia Hong Kong SAR Japan New Zealand Singapore

Emerging Markets
Americas	Europe, Middle East, and Africa	Asia Pacific
Argentina Brazil Chile Colombia Mexico Peru	Czech Republic Egypt Greece Hungary Kuwait Poland Qatar Russia Saudi Arabia South Africa Turkey United Arab Emirates	Chinese mainland India Indonesia Korea Malaysia Pakistan Philippines Taiwan Region Thailand

Frontier Markets
Europe and CIS 2	Africa	Middle East	Asia
Croatia Estonia Iceland Lithuania Kazakhstan Romania Serbia Slovenia	Kenya Mauritius Morocco Nigeria Tunisia WAEMU3	Bahrain Jordan Oman	Bangladesh Sri Lanka Vietnam

Notes:

1. The following markets are not included in the developed, emerging, or MSCI frontier indexes but have their own market-specific indexes: Jamaica, Panama, Trinidad and Tobago, Bosnia Herzegovina, Bulgaria, Malta, Ukraine, Botswana, Zimbabwe, Lebanon, and Palestine.

2. CIS: Commonwealth of Independent States (formerly the USSR).

3. WAEMU: West African Economic and Monetary Union, also known by its French acronym UEMOA, which consists of the following countries: Benin, Burkina Faso, Ivory Coast, Guinea-Bissau, Mali, Niger, Senegal, and Togo.

Segmentation by Economic Activity

Economic activity is another approach that portfolio managers may use to segment the equity universe. Most commonly used equity classification systems group companies into industries/sectors using either a production-oriented approach or a market-oriented approach. The production-oriented approach groups companies that manufacture similar products or use similar inputs in their manufacturing processes. The market-oriented approach groups companies based on the markets they serve, the way revenue is earned, and the way customers use companies’ products. For example, using a production-oriented approach, a coal company may be classified in the basic materials or mining sector. However, using a market-oriented approach, this same coal company may be classified in the energy sector given the primary market (heating) for the use of coal. As another example, a commercial airline carrier may be classified in the transportation sector using the production-oriented approach, while the same company may be classified in the travel and leisure sector using the market-oriented approach.

Four main global classification systems segment the equity universe by economic activity: (1) the Global Industry Classification Standard (GICS); (2) the Industrial Classification Benchmark (ICB); (3) the Thomson Reuters Business Classification (TRBC); and (4) the Russell Global Sectors Classification (RGS). The GICS uses a market-oriented approach, while the ICB, TRBC, and RGS all use a production-oriented approach. These classification systems help standardize industry definitions so that portfolio managers can compare and analyze companies and industries/sectors. In addition, the classification systems are useful in the creation of industry performance benchmarks.

Exhibit 7 compares the four primary classification systems mentioned. Each system is classified broadly and then increasingly more granular to compare companies and their underlying businesses.

Exhibit 7:

Primary Sector Classification Systems

Level/System	GICS	ICB	TRBC	RGS
1st	11 Sectors	10 Industries	10 Economic Sectors	9 Economic Sectors
2nd	24 Industry Groups	19 Super Sectors	28 Business Sectors	33 Sub-Sectors
3rd	68 Industries	41 Sectors	54 Industry Groups	157 Industries
4th	157 Sub-Industries	114 Sub-Sectors	136 Industries	Not Applicable

Source: Thomson Reuters, S&P/MSCI, FTSE/Dow Jones.

To illustrate how segmentation of the classification systems may be used in practice, Exhibit 8 demonstrates how GICS, perhaps the most prominent classification system, sub-divides selected sectors—in this case, Consumer Discretionary, Consumer Staples, and Information Technology—into certain industry group, industry, and sub-industry levels.

Exhibit 8:

GICS Classification Examples

Sector	Consumer Discretionary	Consumer Staples	Information Technology
Industry Group Example	Automobiles & Components	Food, Beverage & Tobacco	Technology Hardware & Equipment
Industry Example	Automobiles	Beverages	Electronic Equipment, Instruments & Components
Sub-Industry Example	Motorcycle Manufacturers	Soft Drinks	Electronic Manufacturing Services

Source: MSCI.

As with other segmentation approaches mentioned previously, segmentation by economic activity enables equity portfolio managers to construct performance benchmarks for specific sectors or industries. Portfolio managers may also obtain better industry representation (diversification) by segmenting their equity universe according to economic activity. The key disadvantage of segmentation by economic activity is that the business activities of companies—particularly large ones—may include more than one industry or sub-industry.

EXAMPLE 2

Segmenting the Equity Investment Universe

1. A portfolio manager is initiating a new fund that seeks to invest in the Chinese robotics industry, which is experiencing rapidly accelerating earnings. To help identify appropriate company stocks, the portfolio manager wants to select an approach to segment the equity universe.

   Recommend which segmentation approach would be most appropriate for the portfolio manager.

   Solution:

   Based on his desired strategy to invest in companies with rapidly accelerating (growing) earnings, the portfolio manager would most likely segment his equity universe by size/style. The portfolio manager would most likely use an investment style that reflects growth, with size (large cap, mid cap, or small cap) depending on the company being analyzed. Other segmentation approaches, including those according to geography and economic activity, would be less appropriate for the portfolio manager given the similar geographic and industry composition of the Chinese robotics industry.

Segmentation of Equity Indexes and Benchmarks

Segmentation of equity indexes or benchmarks reflects some of or all the approaches previously discussed in this section. For example, the MSCI Europe Large Cap Growth Index, the MSCI World Small Cap Value Index, the MSCI Emerging Markets Large Cap Growth Index, or the MSCI Latin America Midcap Index combine various geographic, size, and style dimensions. This combination of geography, size, and style also sometimes applies to individual countries—particularly those in large, developed markets.

A more focused approach to segmentation of equity indexes uses industries or sectors. Because many industries and sectors are global in scope, the most common types of these indexes are comprised of companies in different countries. A few examples include the following:

• Global Natural Resources—the S&P Global Natural Resources Index includes 90 of the largest publicly traded companies in natural resources and commodities businesses across three primary commodity-related sectors: agribusiness; energy; and metals and mining.

• Worldwide Oil and Natural Gas—the MSCI World Energy Index includes the large-cap and mid-cap segments of publicly traded oil and natural gas companies within the developed markets.

• Multinational Financials—the Thomson Reuters Global Financials Index includes the 100 largest publicly traded companies within the global financial services sector as defined by the TRBC classification system.

Finally, some indexes reflect specific investment approaches, such as ESG. Such ESG indexes are comprised of companies that reflect certain considerations, such as sustainability or impact investing.

https://study.cfainstitute.org/app/cfa-institute-program-level-iii-for-august-2024#read/study_task/2563753/income-associated-with-owning-and-managing-an-equity-portfolio-1 INCOME ASSOCIATED WITH OWNING AND MANAGING AN EQUITY PORTFOLIO

Learning Outcome

• describe the types of income and costs associated with owning and managing an equity portfolio and their potential effects on portfolio performance

Dividends are the primary source of income for equity portfolios. In addition, some portfolio managers may use securities lending or option-writing strategies to generate income. On the cost side, equity portfolios incur various fees and trading costs that adversely affect portfolio returns. The primary types of income and costs are discussed in this section.

Dividend Income

Investors requiring regular income may prefer to invest in stocks with large or frequent dividend payments, whereas growth-oriented investors may have little interest in dividends. Taxation is an important consideration for dividend income received, particularly for individuals. Depending on the country where the investor is domiciled, where dividends are issued, and the type of investor, dividends may be subject to withholding tax and/or income tax.

Beyond regular dividends, equity portfolios may receive special dividends from certain companies. Special dividends occur when companies decide to distribute excess cash to shareholders, but the payments may not be maintained over time. Optional stock dividends are another type of dividend in which shareholders may elect to receive either cash or new shares. When the share price used to calculate the number of stock dividend shares is established before the shareholder’s election date, the choice between a cash or stock dividend may be important. This choice represents “optionality” for the shareholder, and the optionality has value. Some market participants, typically investment banks, may offer to purchase this “option,” providing an additional, if modest, source of income to an equity investor.

Securities Lending Income

For some investors, securities lending—a form of collateralized lending—may be used to generate income for portfolios. Securities lending can facilitate short sales, which involve the sale of securities the seller does not own. When a securities lending transaction involves the transfer of equities, the transaction is generally known as stock lending and the securities are generally known as stock loans. Stock loans are collateralized with either cash or other high-quality securities to provide some financial protection to the lender. Stock loans are usually open-ended in duration, but the borrower must return the shares to the lender on demand.

Stock lenders generally receive a fee from the stock borrower as compensation for the loaned shares. Most stock loans in developed markets earn a modest fee, approximately 0.2–0.5% on an annualized basis. In emerging markets, fees are typically higher, often 1–2% annualized for large-cap stocks. In many equity markets, certain stocks—called “specials”—are in high demand for borrowing. These specials can earn fees that are substantially higher than average (typically 5–15% annualized), and in cases of extreme demand, they could be as high as 25–100% annually. However, such high fees do not normally persist for long periods of time.

In addition to fees earned, stock lenders can generate further income by reinvesting the cash collateral received (assuming a favorable interest rate environment). However, as with virtually any other investment, the collateral would be subject to market risk, credit risk, liquidity risk, and operational risk. The administrative costs of a securities lending program, in turn, will reduce the collateral income generated. Dividends on loaned stock are “manufactured” by the stock borrower for the stock lender—that is, the stock borrower ensures that the stock lender is compensated for any dividends that the lender would have received had the stock not been loaned.

Index funds are frequent stock lenders because of their large, long-term holdings in stocks. In addition, because index funds merely seek to replicate the performance of an index, portfolio managers of these funds are normally not concerned that borrowed stock used for short-selling purposes might decrease the prices of the corresponding equities. Large, actively managed pension funds, endowments, and institutional investors are also frequent stock lenders, although these investors are likely more concerned with the effect on their returns if the loaned shares are used to facilitate short-selling. The evidence on the impact of stock lending on asset prices has, however, been mixed (see, for example, Kaplan, Moskowitz, and Sensoy 2013).

Ancillary Investment Strategies

Additional income can be generated for an equity portfolio through a trading strategy known as dividend capture. Under this strategy, an equity portfolio manager purchases stocks just before their ex-dividend dates, holds these stocks through the ex-dividend date to earn the right to receive the dividend, and subsequently sells the shares. Once a stock goes ex-dividend, the share price should, in theory, decrease by the value of the dividend. In this way, capturing dividends would increase portfolio income, although the portfolio would, again in theory, experience capital losses of similar magnitude. However, the share price movement could vary from this theoretical assumption given income tax considerations, stock-specific supply/demand conditions, and general stock market moves around the ex-dividend date.

Selling (writing) options can also generate additional income for an equity portfolio. One such options strategy is writing a covered call, whereby the portfolio manager already owns the underlying stock and sells a call option on that stock. Another options strategy is writing a cash-covered put (also called a cash-secured put), whereby the portfolio manager writes a put option on a stock and simultaneously deposits money equal to the exercise price into a designated account. Under both covered calls and cash-covered puts, income is generated through the writing of options, but clearly the risk profile of the portfolio would be altered. For example, writing a covered call would limit the upside from share price appreciation of the underlying shares.

EXAMPLE 3

Equity Portfolio Income

1. Isabel Cordova is an equity portfolio manager for a large multinational investment firm. Her portfolio consists of several dividend-paying stocks, and she is interested in generating additional income to enhance the portfolio’s total return. Describe potential sources of additional income for Cordova’s equity portfolio.

   Solution:

   Cordova’s primary source of income for her portfolio would likely be “regular” and, in some cases, special dividends from those companies that pay them. Another potential source of income for Cordova is securities (stock) lending, whereby eligible equities in her portfolio can be loaned to other market participants, including those seeking to sell short securities. In this case, income would be generated from fees received from the stock borrower as well as from reinvesting the cash collateral received. Another potential income-generating strategy available to Cordova is dividend capture, which entails purchasing stocks just before their ex-dividend dates, holding the stocks through the ex-dividend date to earn the right to receive the dividend, and subsequently selling the shares. Selling (writing) options, including covered call and cash-covered put (cash-secured put) strategies, is another way Cordova can generate additional income for her equity portfolio.

https://study.cfainstitute.org/app/cfa-institute-program-level-iii-for-august-2024#read/study_task/2563763/costs-associated-with-owning-and-managing-an-equity-portfolio-1 COSTS ASSOCIATED WITH OWNING AND MANAGING AN EQUITY PORTFOLIO

Learning Outcome

• describe the types of income and costs associated with owning and managing an equity portfolio and their potential effects on portfolio performance

Management fees are typically determined as a percentage of the funds under management (an ad-valorem fee) at regular intervals. For actively managed portfolios, the level of management fees involves a balance between fees that are high enough to fund investment research but low enough to avoid detracting too much from investor returns. Management fees for actively managed portfolios include direct costs of research (e.g., remuneration and expenses for investment analysts and portfolio managers) and the direct costs of portfolio management (e.g., software, trade processing costs, and compliance). For passively managed portfolios, management fees are typically low because of lower direct costs of research and portfolio management relative to actively managed portfolios.

Investment managers typically present a standard schedule of fees to a prospective client, although actual fees can be negotiated between the manager and investors. For a fund, fees are established in the prospectus, although investors could negotiate special terms (e.g., a discount for being an early investor in a fund).

Performance Fees

In addition to management fees, portfolio managers sometimes earn performance fees (also known as incentive fees) on their portfolios. Performance fees are generally associated with hedge funds and long/short equity portfolios, rather than long-only portfolios. These fees are an incentive for portfolio managers to achieve or outperform return objectives, to the benefit of both the manager and investors. As an example, a performance fee might represent 10–20% of any capital appreciation in a portfolio that exceeds some stated annual absolute return threshold (e.g., 8%). Several performance fee structures exist, although performance fees tend to be “upwards only”—that is, fees are earned by the manager when performance objectives are met, but fund investors are not reimbursed when performance is negative. However, performance fees could be reduced following a period of poor performance. Fee calculations also reflect high-water marks. A high-water mark is the highest value, net of fees, that the fund has reached. The use of high-water marks protects clients from paying twice for the same performance. For example, if a fund performed well in a given year, it might earn a performance fee. If the value of the same fund fell the following year, no performance fee would be payable. Then, if the fund’s value increased in the third year to a point just below the value achieved at the end of the first year, no performance fee would be earned because the fund’s value did not exceed the high-water mark. This basic fee structure is used by many alternative investment funds and partnerships, including hedge funds.

Administration Fees

Equity portfolios are subject to administration fees. These fees include the processing of corporate actions, such as rights issues; the measurement of performance and risk of a portfolio; and voting at company meetings. Generally, these functions are provided by an investment management firm itself and are included as part of the management fee.

Some functions, however, are provided by external parties, with the fees charged to the client in addition to management fees. These externally provided functions include:

• Custody fees paid for the safekeeping of assets by a custodian (often a subsidiary of a large bank) that is independent of the investment manager.

• Depository fees paid to help ensure that custodians segregate the assets of the portfolio and that the portfolio complies with any investment limits, leverage requirements, and limits on cash holdings.

• Registration fees that are associated with the registration of ownership of units in a mutual fund.

Marketing and Distribution Costs

Most investment management firms market and distribute their services to some degree. Marketing and distribution costs typically include the following:

• Costs of employing marketing, sales, and client servicing staff

• Advertising costs

• Sponsorship costs, including costs associated with sponsoring or presenting at conferences

• Costs of producing and distributing brochures or other communications to financial intermediaries or prospective clients

• “Platform” fees, which are costs incurred when an intermediary offers an investment management firm fund services on the intermediary’s platform of funds (e.g., a “funds supermarket”)

• Sales commissions paid to such financial intermediaries as financial planners, independent financial advisers, and brokers to facilitate the distribution of funds or investment services

When marketing and distribution services are performed by an investment management firm, the costs are likely included as part of the management fee. However, those marketing and distribution services that are performed by external parties (e.g., consultants) typically incur additional costs to the investor.

Trading Costs

Buying and selling equities incurs a series of trading (or transaction) costs. Some of these trading costs are explicit, including brokerage commission costs, taxes, stamp duties, and stock exchange fees. In addition, many countries charge a modest regulatory fee for certain types of equity trading.

In contrast to explicit costs, some trading costs are implicit in nature. These implicit costs include the following:

• Bid–offer spread

• Market impact (also called price impact), which measures the effect of the trade on transaction prices

• Delay costs (also called slippage), which arise from the inability to complete desired trades immediately because of order size or lack of market liquidity

In an equity portfolio, total trading costs are a function of the size of trades, the frequency of trading, and the degree to which trades demand liquidity from the market. Unlike many other equity portfolio costs, such as management fees, the total cost of trading is generally not revealed to the investor. Rather, trading costs are incorporated into a portfolio’s total return and presented as overall performance data. One final trading cost relates to stock lending transactions that were previously discussed. Equity portfolio managers who borrow shares in these transactions must pay fees on shares borrowed.

Investment Approaches and Effects on Costs

Equity portfolio costs tend to vary depending on their underlying strategy or approach. As mentioned previously, passively managed strategies tend to charge lower management fees than active strategies primarily because of lower research costs to manage the portfolios. Passively managed equity portfolios also tend to trade less frequently than actively managed equity portfolios, with trading in passive portfolios typically involving rebalancing or changes to index constituents. Index funds, however, do face a “hidden” cost from potential predatory trading. As an illustration, a predatory trader may purchase (or sell short) shares prior to their effective inclusion (or deletion) from an index, resulting in price movement and potential profit for a predatory trader. Such predatory trading strategies can be regarded as a cost to investors in index funds, albeit a cost that is not necessarily evident to a portfolio manager or investor.

Some active investing approaches “demand liquidity” from the market. For example, in a momentum strategy, the investor seeks to buy shares that are already rising in price (or sell those that are already falling). In contrast, some active investing approaches are more likely to “provide liquidity” to the market, such as deep value strategies (i.e., those involving stocks that are deemed to be significantly undervalued). Investment strategies that involve frequent trading and demand liquidity are, unsurprisingly, likely to have higher trading costs than long-term, buy-and-hold investment strategies.

https://study.cfainstitute.org/app/cfa-institute-program-level-iii-for-august-2024#read/study_task/2563773/shareholder-engagement-1 SHAREHOLDER ENGAGEMENT

Learning Outcome

• describe the potential benefits of shareholder engagement and the role an equity manager might play in shareholder engagement

Shareholder engagement refers to the process whereby investors actively interact with companies. Shareholder engagement often includes voting on corporate matters at general meetings as well as other forms of communication (e.g., quarterly investor calls or in-person meetings) between shareholders and representatives of a company. Generally, shareholder engagement concerns issues that can affect the value of a company and, by extension, an investor’s shares.

When shareholders engage with companies, several issues may be discussed. Some of these issues include the following:

• Strategy—a company’s strategic goals, resources, plans for growth, and constraints. Also of interest may be a company’s research, product development, culture, sustainability and corporate responsibility, and industry and competitor developments. Shareholders may ask the company how it balances short-term requirements and long-term goals and how it prioritizes the interests of its various stakeholders.

• Allocation of capital—a company’s process for selecting new projects as well as its mergers and acquisitions strategy. Shareholders may be interested to learn about policies on dividends, financial leverage, equity raising, and capital expenditures.

• Corporate governance and regulatory and political risk—including internal controls and the operation of its audit and risk committees.

• Remuneration—compensation structures for directors and senior management, incentives for certain behaviors, and alignment of interests between directors and shareholders. In some cases, investors may be able to influence future remuneration structures. Such influence, especially regarding larger companies, often involves the use of remuneration consultants and an iterative process with large, long-term shareholders.

• Composition of the board of directors—succession planning, director expertise and competence, culture, diversity, and board effectiveness.

Benefits of Shareholder Engagement

Shareholder engagement can provide benefits for both shareholders and companies. From a company’s perspective, shareholder engagement can assist in developing a more effective corporate governance culture. In turn, shareholder engagement may lead to better company performance to the benefit of shareholders (as well as other stakeholders).

Investors may also benefit from engagement because they will have more information about companies or the sectors in which companies operate. Such information may include a company’s strategy, culture, and competitive environment within an industry. Shareholder engagement is particularly relevant for active portfolio managers given their objective to outperform a benchmark portfolio. By contrast, passive (or index) fund managers are primarily focused on tracking a given benchmark or index while minimizing costs to do so. Any process, such as shareholder engagement, that takes up management time (and adds to cost) would detract from the primary goal of a passive manager. This would be less of an issue for very large passively managed portfolios, where any engagement costs could be spread over a sizable asset base.

In theory, some investors could benefit from the shareholder engagement of others under the so-called “free rider problem.” Specifically, assume that a portfolio manager using an active strategy actively engages with a company to improve its operations and was successful in increasing the company’s stock price. The manager’s actions in this case improved the value of his portfolio and also benefitted other investors who own the same stock in their portfolios. Investors who did not participate in shareholder engagement benefitted from improved performance but without the costs necessary for engagement.

In addition to shareholders, other stakeholders of a company may also have an interest in the process and outcomes of shareholder engagement. These stakeholders may include creditors, customers, employees, regulators, governmental bodies, and certain other members of society (e.g., community organizations and citizen groups). These other stakeholders can gain or lose influence with companies depending on the outcomes of shareholder engagement. For example, employees can be affected by cost reduction programs requested by shareholders. Another example is when creditors of a company are affected by a change in a company’s vendor payment terms, which can impact the company’s working capital and cash flow. Such external forces as the media, the academic community, corporate governance consultants, and proxy voting advisers can also influence the process of shareholder engagement.

Shareholders that also have non-financial interests, such as ESG considerations, may also benefit from shareholder engagement. However, these benefits are difficult to quantify. Empirical evidence relating shareholder returns to a company’s adherence to corporate governance and ESG practices is mixed. This mixed evidence could be partly attributable to the fact that a company’s management quality and effective ESG practices may be correlated with one another. As a result, it is often difficult to isolate non-financial factors and measure the direct effects of shareholder engagement.

Disadvantages of Shareholder Engagement

Shareholder engagement also has several disadvantages. First, shareholder engagement is time consuming and can be costly for both shareholders and companies. Second, pressure on company management to meet near-term share price or earnings targets could be made at the expense of long-term corporate decisions. Third, engagement can result in selective disclosure of important information to a certain subset of shareholders, which could lead to a breach of insider trading rules while in possession of specific, material, non-public information about a company. Finally, conflicts of interest can result for a company. For example, a portfolio manager could engage with a company that also happens to be an investor in the manager’s portfolio. In such a situation, a portfolio manager may be unduly influenced to support the company’s management so as not to jeopardize the company’s investment mandate with the portfolio manager.

The Role of an Equity Manager in Shareholder Engagement

Active managers of equity portfolios typically engage, to some degree, with companies in which they currently (or potentially) invest. In fact, investment firms in some countries have legal or regulatory responsibilities to establish written policies on stewardship and/or shareholder engagement. Engagement activities for equity portfolio managers often include regular meetings with company management or investor relations teams. Such meetings can occur at any time but are often held after annual, semi-annual, or quarterly company results have been published.

For such non-financial issues as ESG, large investment firms, in particular, sometimes employ an analyst (or team of analysts) who focuses on ESG issues. These ESG-focused analysts normally work in conjunction with traditional fundamental investment analysts, with primary responsibility for shareholder voting decisions or environmental or social issues that affect equity investments. In lieu of—or in addition to—dedicated ESG analyst teams, some institutional investors have retained outside experts to assist with corporate governance monitoring and proxy voting. In response to this demand, an industry that provides corporate governance services, including governance ratings and proxy advice, has developed.

Activist Investing

A distinct and specialized version of engagement is known as activist investing. Activist investors (or activists) specialize in taking stakes in companies and creating change to generate a gain on the investment. Hedge funds are among the most common activists, possibly because of the potential for, in many cases, high performance fees. In addition, because hedge funds are subject to limited regulation, have fewer investment constraints, and can often leverage positions, these investors often have more flexibility as activists.

Engagement through activist investing can include meetings with management as well as shareholder resolutions, letters to management, presentations to other investors, and media campaigns. Activists may also seek representation on a company’s board of directors as a way of exerting influence. Proxy contests are one method used to obtain board representation. These contests represent corporate takeover mechanisms in which shareholders are persuaded to vote for a group seeking a controlling position on a company’s board of directors. Social media and other communication tools can help activists coordinate the actions of other shareholders.

Voting

The participation of shareholders in general meetings, also known as general assemblies, and the exercise of their voting rights are among the most influential tools available for shareholder engagement. General meetings enable shareholders to participate in discussions and to vote on major corporate matters and transactions that are not delegated to the board of directors. By engaging in general meetings, shareholders can exercise their voting rights on major corporate issues and better monitor the performance of the board and senior management.

Proxy voting enables shareholders who are unable to attend a meeting to authorize another individual (e.g., another shareholder or director) to vote on their behalf. Proxy voting is the most common form of investor participation in general meetings. Although most resolutions pass without controversy, sometimes minority shareholders attempt to strengthen their influence at companies via proxy voting. Occasionally, multiple shareholders may use this process to collectively vote their shares in favor of or in opposition to a certain resolution.

Some investors use external proxy advisory firms that provide voting recommendations and reduce research efforts by investors. Portfolio managers need not follow the recommendations of proxy advisory firms, but these external parties can highlight potential controversial issues. An investor’s voting instructions are typically processed electronically via third-party proxy voting agents.

When an investor loans shares, the transaction is technically an assignment of title with a repurchase option; that is, the voting rights are transferred to the borrower. The transfer of voting rights with stock lending could potentially result in the borrower having different voting opinions from the lending investor. To mitigate this problem, some stock lenders recall shares ahead of voting resolutions to enable exercise of their voting rights. The downside of this action would be the loss of stock lending revenue during the period of stock loan recall and potential reputation risk as an attractive lender. Investors, in some cases, may borrow shares explicitly to exercise the voting rights attached. This process is called empty voting, whereby no capital is invested in the voted shares.

EXAMPLE 4

Shareholder Engagement

1. An investor manages a fund with a sizable concentration in the transportation sector and is interested in meeting with senior management of a small aircraft manufacturer. Discuss how the investor may benefit from his/her shareholder engagement activities, as well as from the shareholder engagement of other investors, with this manufacturer.

   Solution:

   The investor may benefit from information obtained about the aircraft manufacturer, such as its strategy, allocation of capital, corporate governance, remuneration of directors and senior management, culture, and competitive environment within the aerospace industry. The investor may also benefit as a “free rider,” whereby other investors may improve the manufacturer’s operating performance through shareholder engagement—to the benefit of all shareholders. Finally, if the investor has non-financial interests, such as ESG, he or she may address these considerations as part of shareholder engagement.

EQUITY INVESTMENT ACROSS THE PASSIVE–ACTIVE SPECTRUM

Learning Outcome

• describe rationales for equity investment across the passive–active spectrum

The debate between passive management and active management of equity portfolios has been a longstanding one in the investment community. In reality, the decision between passive management and active management is not an “either/or” (binary) alternative. Instead, equity portfolios tend to exist across a passive–active spectrum, ranging from portfolios that closely track an equity market index or benchmark to unconstrained portfolios that are not subject to any benchmark or index. In some cases, portfolios may resemble a “closet index” in which the portfolio is advertised as actively managed but essentially resembles a passively managed fund. For an equity manager (or investment firm), several rationales exist for positioning a portfolio along the passive–active spectrum. Each of these rationales is discussed further.

Confidence to Outperform

An active investment manager typically needs to be confident that she can adequately outperform her benchmark. This determination requires an understanding of the manager’s equity investment universe as well as a competitive analysis of other managers that have a similar investment universe.

Client Preference

For equity portfolio managers, client preference is a primary consideration when deciding between passive or active investing. Portfolio managers must assess whether their passive or active investment strategies will attract sufficient funds from clients to make the initiatives viable. Another consideration reflects investors’ beliefs regarding the potential for active strategies to generate positive alpha. For example, in some equity market categories, such as large-cap/developed markets, companies are widely known and have considerable equity analyst coverage. For such categories as these, investors often believe that potential alpha is substantially reduced because all publicly available information is efficiently disseminated, analyzed, and reflected in stock prices.

A comparison of passive and active equities is illustrated in Exhibit 9. The exhibit demonstrates the relative proportion of investment passive and active equities in US open-ended mutual funds and exchange-traded funds (ETFs) by Morningstar equity category. Nearly all equities in some categories, such as foreign small/mid-cap growth, are managed on an active basis. Conversely, equities in other categories, such as large-cap blend, are predominantly managed on a passive basis.

Exhibit 9:

Passive versus Active Equities in US Open-Ended Mutual Funds and ETFs

Source: Morningstar Direct. Data as of 31 October 2021.

Suitable Benchmark

An investor or equity manager’s choice of benchmark can play a meaningful role in the ability to attract new funds. This choice is particularly relevant in the institutional equity market, where asset owners (and their consultants) regularly screen new managers in desired equity segments. As part of the selection process in desired equity segments, active managers normally must have benchmarks with sufficient liquidity of underlying securities (thus maintaining a reasonable cost of trading). In addition, the number of securities underlying the benchmark typically must be broad enough to generate sufficient alpha. For this reason, many country or sector-specific investment strategies (e.g., consumer defensive companies) are managed passively rather than actively.

Client-Specific Mandates

Client-specific investment mandates, such as those related to ESG considerations, are typically managed actively rather than passively. This active approach occurs because passive management may not be particularly efficient or cost effective when managers must meet a client’s desired holdings (or holdings to avoid). For example, a mandate to avoid investments in companies involved in certain “unacceptable” activities (e.g., the sale of military technology or weapons, tobacco/alcohol, or gambling) requires ongoing monitoring and management. As part of this exclusionary (or negative) screening process, managers need to determine those companies that are directly, as well as indirectly, involved in such “unacceptable” industries. Although ESG investing is typically more active than passive, several investment vehicles enable a portfolio manager to invest passively according to ESG-related considerations.

Risks/Costs of Active Management

As mentioned previously, active equity management is typically more expensive to implement than passive management. Additionally, “key person” risk is relevant for active managers if the success of an investment manager’s firm is dependent on one or a few individuals (“star managers”) who may potentially leave the firm.

Taxes

Compared with active strategies, passive strategies generally have lower turnover and generate a higher percentage of long-term gains. An index fund that replicates its benchmark can have minimal rebalancing. In turn, active strategies can be designed to minimize tax consequences of gains/income at the expense of higher trading costs. One overall challenge is that tax legislation differs widely across countries.

EXAMPLE 5

Passive–Active Spectrum

1. James Drummond, an equity portfolio manager, is meeting with Marie Goudreaux, a wealthy client of his investment firm. Goudreaux is very cost conscious and believes that equity markets are highly efficient. Goudreaux also has a narrow investment focus, seeking stocks in specific country and industry sectors.

   Discuss where Goudreaux’s portfolio is likely to be positioned across the passive–active spectrum.

   Solution:

   Goudreaux’s portfolio is likely to be managed passively. Because she believes in market efficiency, Goudreaux likely believes that Drummond’s ability to generate alpha is limited. Goudreaux’s cost consciousness also supports passive management, which is typically less expensive to implement than active management. Finally, Goudreaux’s stated desire to invest in specific countries and sectors would likely be better managed passively.