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4 implicit managerial incentives
manager may be fired by the board, in a takeover, or in a bankruptcy
4 shortcomings of Boards
boards typically lack independence
Prescriptions for improving director behavior
board should have an independent chairman
Limitations of investor activism
Active investors often unmonitored & are focused on short-term results
Describe debt as a management motivator
debt takes excess cash out of management's hands w/ the pressure to make periodic interest/principal payments
Describe the limitations of debt as a management motivator
threat of illiquidity can also deny the firm investment in new projects
In what situations are passive equity strategies preferrable?
When the investor is: taxable, has an info disadvantage in global markets, is investing in info efficient large cap markets, wants to avoid the high transactions cost of small cap markets
Price vs. Value vs. Equal-Weighted Indexes (And Major Biases)
Price - average of prices of securities in the index
value or growth
Holdings-based style analysis evaluates portfolio characteristics using what attributes?
Opportunity Cost sell discipline
List the 6 different sell disciplines of active investors
IR = IC x (IB)^1/2
Define an investor's information ratio (IR)
True Active Return (Equation)
= manager's total return - manager's normal portfolio return
Misfit Active Return (Equation)
=manager's normal portoflio return - investor's benchmark return
(Rp - Rb) / s(Rp-Rb)
taxable investor preference
returns-based style analysis
returns on a manager's fund are regressed against the returns for various security indicies (e.g., large-cap value, small-cap growth)
the error term in a returns-based style analysis regression, which is the difference between the portfolio return and the returns on the style indicies
the difference between the portfolio weight and the benchmark weights
short extension strategy
the manager shorts an amount of securities equal to a set percentage of his long portfolio and then purchases an equal amount of securities (120/20, 130/30)
net portfolio beta
long positions weighted beta - short positions weighted beta
fundamental law of active management
information ratio = information coefficient * root(investor breadth)
combined with the active portfolio, so that the combined portfolios have a risk exposure similar to the benchmark
misfit active return
measures the part of the manager's return from using a benchmark that is not suited to the manager's style
true active return
what the manager earned relative to the correct benchmark
alpha and beta separation approach
investor gains a systematic risk exposure (beta) through a low-cost index fund or ETF, while adding an alpha through a long-short strategy
Effect of Cross Holdings
Distort the actual index trading volume.
Effect of float adjusted benchmarks on active management
Difficult to easily beat the index as stock prices rise.
Breadth and Investibility
The wider the breadth, the lower investibility. (More illiquid names are in an index with wide breadth.)
3 Characteristics of Popular Indexes
Reconstitution Effects and Alpha
Reconstitution effects do not result in a negative alpha because both the portfolio and index are effected.
How easily index components can be bought and sold.
Problems with International Indices
Developed and emerging market indices can have illiquidity issues due to the presence of small cap stocks and closely held stocks.
Objective index construction
Easy to predict contents.
Subjective index construction
Hard to predict contents
Including an emerging country in a developed country index has these 2 effects.
-When the emerging market economy reaches a significant level of market capitalization, it affects the average size and performance of the developing index.
Explicit and Implicit incentives viewed as complements.
A willingness to accept a high probability of being fired and a willingness to accept a low explicit incentive,
Bonuses and shareholdings are complements or substitutes?
No control rights
Sell stock to a third party.
For compensation to remain an incentive, a manager should not be allowed to...
CEOs and CFOs must give back profits following manipulation.
What % of board must be independent under best practices?
Positive Effects of Product Market Competition
Yardstick against which the firm can be measured against other similar firms.
May encourage excessive risk taking.
Negative Effect of Product Market Competition
Implicit and explicit incentives as substitutes
Stronger implied incentives = lower explicit incentives
Implicit and explicit incentives as compliments
A manager excepts lower probability of keeping their job and lower performance based incentives.
Time of market crises.
The co-operative between directors and managets breaks down during ....
Succesful monetary incentives are...
Systematically related to firm value with a minimum holding of firm shares.
A minority owner who convinces other owners to create an opposition majority.
Real Control depends on
Congruence of interest among owners.
The use of corporate funds by the target's management to purchase the raiders block of the target's stock at a premium.
3 Drawbacks of Active Investing
under-monitoring of those that need to be monitored.
2 Forms of active monitoring
use Private Equity
4 ways to incentivize management to not cash out of their holdings too soon.
ease of communications
3 requirements a minority owner needs to exercise real control.
-Active manager's reputation.
3 requirements of Alliance Building.
over-monitoring by the monitor
3 Side Effects of monitoring on those being monitored
Proponents of the stakeholder society
A firm should ideally internalize all externalities that their decisions impose on the various groups.
4 Duties of the firm in a stakeholder society.
establish Reputation of being a Fair employer.
3 Benefits of living up to stakeholder society expectations
2 Factors of the Stakeholder View
management should maximize the sum of stakeholder surpluses.
Stakeholder Society Regulatory View
Regulatory bodies need to intervene in the contract setting process in the event of imperfect or incomplete contracts between the company and its stakeholders.
Stakeholder maximation is
3 Contrasts between shareholder and stakeholder maximization
Sharing of control between investors and stakeholders results in 2 problems...
Insufficient amount of non-credible income, which can not be pledged to shareholders.
Legal Intervention in the contract setting process amongst stakeholders.
Courts can fill in the details of imprecise contracts as well as Externalities imposed by Corporate action not covered by the contracts.
Stakeholder Society Evidence
There is a lack of evidence to support that the de facto taz imposed on business units by management is superior to the redistribution process handled by the political process.
Shareholder Society View and Contracts
Proponents believe that contracts may be imperfect and legal enforcement may be necessary to substitute for missing or incomplete contracts.
Cadbury - Non-executives
Majority of non-executives should be independent and appointed for specif terms, without automatic reappointment.
Cadbury - Executives
service contracts should not exceed three years without shareholder approval.
Cadbury - Audit Committee
-Should be composed of a minimum of three members which should be non-executives, with a majority of non-executives being independent of the company.
Cadbury - Reporting and controls
directors should explian responsibilities for preparing accounts.
Cadbury - Director compensation
no share option schemes and no pensions.
Cadbury - Audit committee attendance
Common equities have...
Residual Real Claims
Equal Weighted Index
Have a small company bias, may not have sufficient liquidty, have high transactions costs.
Exchange of Futures for Physicals
A transaction which allows a basket of index securities to be traded together, which reduces transactions costs. Used to exchange equity futures for the underlying securities. One party sells futures and buys physicals, the o…
Drawback of using futures to hedge a portfolio indefinately.
The limited life of a futures contract means that a futures position must be rolled over periodically, often at unattractive terms, resulting in a negative roll yield.
Overfitting the Data
Sampling error that results in risk differences among securities, which are not actually true.
Search for companies with high earnings growth. rely on indicators like Relative Strength Indicators.
Premium to growth investors
Dependent on the business cycle.
Market Oriented Investors
May by a stock with either a high or low P/E if it can be justified with expectations.
Market Oriented Style Return Expectations
Return should be greater than the market to offset transaction fees, otherwise might as well invest in a cheaper passive index.
Growth at Reasonable Price Investors
favor companies with above average growth prospects selling at conservative valuation levels.
Coefficient of Determination
Measures Style Fit
Style Analysis Equation =
Portfolio Return - Passive Asset Mix = Selection Return (error term)
Selection Return (error term)
The return from active security selection ability.
Holdings Based Style Analysis
Used to characterize each individual position, not the overall portfolio. Data intensive.
Advantages of Holdings Based Style Analysis
Characterizes each poition in a portfolio.
Disadvantages of Holdings Based Style Analysis
Does not reflect the way portfolio managers pick stocks.
What style analysis is used when there is sufficient length of data?
What style analysis is used when there is not sufficient length of data?
Rolling Style Chart.
What shows the evolution of a portfolio's style exposure over time?
Category or Quanity.
The two ways to determine a stocks style in Holdings Based Style analysis.
Style can be recategorized as Growth or Value with a small change in style characteristics. High transaction costs incurred.
Rules to maintain the style assignment of a stock with a previous assignment when the stock has not clearly moved to a new style. Lowers transaction expenses.
Can test scores be valid but not reliable?
Is there a way to profit from old info?
Disadvantage of Style Drift
Obstacle to investment planning.
When a manager changes his investment style over time.
2 Types of Socially Responsible Investing Screens
Positive - Screen for companies that meet SRI criteria
Risk pf long-short market neutral stategy
Limited to specific company risk. Overall beta = zero.
Alphas earned on a long-short market neutral strategy.
Two alphas are earned, one on the long side and one on the short side.
Pairs Trade Arbitrage
Long position in a stock. Short position on a different stock in the same industry equal in size to the long position.
Best way to equitize a long-short alpha over a long period.
Use ETFs. ETF's are easy to short. ETF's do not need to be rolled over like futures contracts.
gain on long/short Position
Return of an equitized market neutral portfolio =
Leveraged Equity Position
Not market neutral. Beta is not zero.
Market neutral portfolio should be measured against
Nominal risk free rate. Not real risk free rate.
The correlation between actual and forecast returns.
Optimize allocations to a group of managers.
Investor tries to maximize active returns for a given level of active risk determined by his level of risk aversion.
What is the utility of the active return of the manager mix directly related to?
Variance of the active return and investor's risk aversion.
What is the utility of the active return of the manager mix inversely related to?
What happens to diversification as one moves up the effcient frontier assuming more active risk?
Diversification lessons since the portfolio will be concentrated in the hands of the few managers who produce the highest active returns.
Information ratio = True Active Return / True Active Risk
What is the most accurate measure of a managers risk adjusted performance?
Completeness portfolio attributes.
Managed passively or semiactively.
Index provides beta
Alpha and Beta Sepertation
Equitized market neutral long short strategy
Adds beta exposure to a zero beta long-short portfolio.
Index and semiactive managers.
What does core holdings consist of?
Benchmarks for core-satellite portfolio.
Core benchmark = overall asset class benchmark.
Problem with a completeness fund
Seeks to eliminate misfit risk.
Purpose of Fee Cap
Stop manager from taking excessive risks.
Ad valorem fees
Assets under management fees are also called...
Long short market neutral portfolio + Long only equity portfolio Beta =
Long only equity portfolio Beta. The addition of a long short market neutral portfolio strategy to a long only equity portfolio does not change the overall beta of the portfolio.
The short extension strategy because short selling is fixed.
What has better risk control, a Long Short Market Neutral Portfolio or a Short extension Strategy
down from Cost
Rule Driven Sell Disciplines
A market is said to have _______ if the orders that give the market depth exist in significant volume
Common way to equitize cash position.
Derivatives based. Go long on sufficient equity futures contracts to provide equity exposure to the underlying cash investment. Add value by altering the duration of the underlying cash.
Stock Based Enhanced Indexing
Start with an Index then over-weight or under-weight individual stocks based on the portfolio managers return expectations for those stocks.
Short Side Price Inefficiencies
Information Ratio Definition
Represents the Efficiency with which a portfolio's tracking risk delivers active return. It measures the expected active return of the manager's portfolio divided by the amount of risk that the manager takes relative to the benchmark.
Index Weighting Choices
How are Indexes Reconstituted?
by commitee (lower turnover)
2 Techniques to Identifying Investment Styles
Alternate implication of the Information Ratio
IR (active return/active risk) = IC (effectiveness of investment insight) x the square root of Beadth (number of indpendent active decisions made.)