Title LM3 Overview of Equity Portfolio Management IFT Notes.pdf ✅

LM3 Overview of Equity Portfolio Management 2024 Level III Notes © IFT. All rights reserved 1 LM3 Overview of Equity Portfolio Management 1. Introduction and the Role of Equities in a Portfolio...........................................................................2 The Roles of Equities in a Portfolio ..........................................................................................................2 2. Equity Investment Universe.........................................................................................................................5 Segmentation by Size and Style .................................................................................................................5 Segmentation by Geography.......................................................................................................................7 Segmentation by Economic Activity ........................................................................................................8 Segmentation of Equity Indexes and Benchmarks.......................................................................... 10 3. Income Associated with Owning and Managing an Equity Portfolio ........................................ 10 Dividend Income........................................................................................................................................... 10 Securities Lending Income........................................................................................................................ 10 Ancillary Investment Strategies.............................................................................................................. 11 4. Costs Associated with Owning and Managing an Equity Portfolio ............................................ 12 Performance Fees......................................................................................................................................... 12 Administration Fees .................................................................................................................................... 13 Marketing and Distribution Costs.......................................................................................................... 13 Trading Costs ................................................................................................................................................. 13 Investment Approaches and Effects on Costs ................................................................................... 14 5. Shareholder Engagement........................................................................................................................... 14 Benefits of Shareholder Engagement................................................................................................... 15 Disadvantages of Shareholder Engagement ...................................................................................... 15 The Role of an Equity Manager in Shareholder Engagement...................................................... 15 6. Equity Investment Across the Passive–Active Spectrum .............................................................. 17 Summary ............................................................................................................................................................... 19 This document should be read in conjunction with the corresponding reading in the 2024 Level III CFA® Program curriculum. Some of the graphs, charts, tables, examples, and figures are copyright 2023, CFA Institute. Reproduced and republished with permission from CFA Institute. All rights reserved. Required disclaimer: CFA Institute does not endorse, promote, or warrant the accuracy or quality of the products or services offered by IFT. CFA Institute, CFA®, and Chartered Financial Analyst® are trademarks owned by CFA Institute. Ver 1.0
LM3 Overview of Equity Portfolio Management 2024 Level III Notes © IFT. All rights reserved 2 1. Introduction and the Role of Equities in a Portfolio This reading provides an overview of equity portfolio management. Section 1.1 covers the different roles that equities can play in portfolios. Section 2 deals with the equity investment universe, and covers the different ways in which the equity universe can be segmented. Sections 3 and 4 cover the income and costs in an equity portfolio. Section 5 covers shareholder engagement. Finally, Section 6 covers equity investment across the passive-active spectrum. The Roles of Equities in a Portfolio Equities provide four major roles (benefits) in an overall portfolio: • Capital appreciation • Dividend income • Diversification with other asset classes • Hedge against inflation Apart from these benefits, portfolio managers also take into account client investment considerations when deciding to include equities in portfolios. These points are discussed in detail in the following sections. Capital Appreciation Exhibit 1 of the curriculum shows the real annualized returns on equities from 1900-2020. Across the world, equities have outperformed the other asset classes – bonds and bills, during this period. Equities tend to outperform other asset classes during strong economic times, but they tend to underperform other asset classes during weak economic times. They are therefore riskier than bonds and bills. To get capital appreciation we should invest in companies that have strong cash flows that
LM3 Overview of Equity Portfolio Management 2024 Level III Notes © IFT. All rights reserved 3 are expected to grow, as well as in companies that have a competitive advantage. Dividend Income Exhibit 2 of the curriculum shows the dividend contribution of S&P 500 stocks during 1930-2020. Over this period, although the total return has varied a lot, the dividend yield has been fairly consistent. Since 1990, the dividend yield on the S&P 500 has ranged from 1% - 3%. Therefore, such stocks are an attractive option for investors looking for a continuous income stream, regardless of market conditions. Also note that even in periods of severe downturns (for example 2008), there is still positive dividend income. Diversification with Other Asset Classes Exhibit 3 of the curriculum shows a correlation matrix across various global equity indexes and other asset classes using total monthly returns for the twenty years ended 31 October 2021.
LM3 Overview of Equity Portfolio Management 2024 Level III Notes © IFT. All rights reserved 4 Monthly return data cover January 2001 to February 2017 for all indexes except the FTSE EPRA/NAREIT Global Real Estate Index (whose inception date was November 2008). The correlation among different types of equities is quite high. However, the correlation of equities with other asset classes is low. This low correlation indicates that combining equities with other asset classes to construct a portfolio can provide diversification benefits. Hedge against Inflation Some stocks can provide a hedge against inflation. The strength of the inflation hedge depends on the degree to which increases in costs can be passed on to customers. If a company has a high ability to pass on increased costs to customers its stock price will provide a good hedge against inflation. Similarly, companies that produce broad-based commodities (such as industrial metals, or oil) can benefit from an increase in commodity prices and serve as a good inflation hedge. In a statistical sense, we can look at the correlation between equity returns and inflation. This can give us an indication of how well equities provide a hedge against inflation. High correlations indicate good inflation hedging potential; on the other hand, low correlations indicate poor inflation hedging potential. Client Considerations for Equities in a Portfolio There are two broad decisions with respect to the inclusion of equities in a portfolio: 1. What percentage of the portfolio should be invested in equities? 2. What type of equities should be included – for example, large cap, small cap, growth, value, etc.? These decisions are based on the following components of the IPS: • Risk and return objectives • Constraints: Liquidity, time horizon, tax concerns, legal and regulatory factors, and unique circumstances. For example, an investor who is very risk averse will have a small percentage of his portfolio invested in equities, and most of the equity investments will consist of safer large cap value stocks. On the other hand, for an investor who can take on more risk, a larger percentage of his portfolio can be invested in equities and the equity investments can include riskier small cap growth stocks. For several clients’ environmental, social, and governance (ESG) issues are becoming increasingly important. For example, an investor may want to avoid investing in alcohol, tobacco, and firearm companies. Common ESG approaches used by portfolio managers are: • Negative screening: This excludes sectors/companies that do not meet the ESG criteria. • Positive screening: This tries to identify companies that have a favorable ESG score.