2 Chapter II EQUITY INVESTMENTS AND FACTOR

ATTRIBUTION.

2.1 Introduction
There is an extensive range of companies in which an equity portfolio manager may
invest, and one 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.

2.2 Segmentation by Size and Style

A popular approach to segmenting the equity universe incorporates two factors:
Size and 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.
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.
 2.2.1 Benefits of Segmentation by size/style.
1. First, portfolio managers can construct an overall equity portfolio that reflects
desired risk, return, and income characteristics in a relatively straightforward and
manageable way.
2. Second, given the broad range of companies within each segment, segmentation
by size/style results in diversification across economic sectors or industries.
3. Third, active equity managers 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.
4. 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.

2.3 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.
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 may
provide lower- than- expected exposure to that market. Another key weakness of
geographic segmentation is potential currency risk when investing in different global
equity markets.

2.4 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 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 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.

A factor is a variable or a characteristic with which individual asset returns are

correlated. In comparison to single- factor models (typically based on a market risk
factor), multifactor models offer increased explanatory power and flexibility.

2.5 Index Construction

2.5.1 Indexes as a Basis for Investment
For an index to become the basis for an equity investment strategy, it must meet three
initial requirements. It must be rules- based, transparent, and investable.
Examples of rules include criteria for including a constituent stock and the frequency with
which weights are rebalanced.
Transparency may be the most important requirement because passive investors expect
to understand the rules underlying their investment choices.
Equity index benchmarks are investable when their performance can be replicated in the
market. For example, the FTSE 100 Index is an investable index because its constituent
securities can be purchased easily on the London Stock Exchange.
2.5.2 Index Construction Methodologies
A security market index is a method of calculating a single number which represents the value,
at a particular point in time, of a large number of securities. It is comprised of a group of securities
known as the constituent securities. An index value only has meaning relative to its own past
values
Equity index providers differ in their stock inclusion methods, ranging from exhaustive
to selective in their investment universes. Exhaustive stock inclusion strategies are those
that select every constituent of a universe, while selective approaches target only those
securities with certain characteristics..
The weighting method used in constructing an index influences its performance.
2.5.2.1 Market- cap weighting
One of the most common weighting methods is market- cap weighting. The equity market
cap of a constituent company is its stock price multiplied by the number of shares
outstanding. Each constituent company’s weight in the index is calculated as its market
capitalization divided by the total market capitalization of all constituents of the index.
An advantage of the capitalization- weighted approach is that it reflects a strategy’s
investment capacity. A cap- weighted index can be thought of as a liquidity weighted
index because the largest- cap stocks tend to have the highest liquidity and the greatest
capacity to handle investor flows at a manageable cost.

The advantages of a market-cap-weighted index relative to a price-weighted or equal-

weighted index are that:
 Constituent securities are held in proportion to their value in the target market.
  It self-corrects for stock splits, reverse stock splits, and dividends because such
actions are directly reflected in the number of shares outstanding and price per
share for the company affected .

The disadvantages are that:

 Securities whose prices increase will have a greater weight in the index. Those
whose prices decrease will have a lower weight in the index.
 It is biased towards companies with the largest market capitalizations. In effect,
this means that the index will be biased towards large, and probably mature,
companies and companies that are overvalued.
2.5.2.2 Fundamental-weighted index
In a fundamental-weighted index, the weight of each security is determined based on
some fundamental factor that is independent of its market price. Examples of
fundamental factors include: book value, cash flow, revenues, earnings, dividends, and
number of employees .
2.5.2.3 Price- weighted index
In a price- weighted index, the weight of each stock is its price per share divided by the
sum of all share prices in the index. A price- weighted index can be interpreted as a
portfolio that consists of one share of each constituent company. Although some price-
weighted indexes, such as the Dow Jones Industrial Average and the Nikkei 225, have high
visibility as indicators of day- to- day market movements, price- weighted investment
approaches are not commonly used by portfolio managers.
2.5.2.4 Equally weighted indexes
They produce the least- concentrated portfolios. Such indexes have constituent weights
of 1/n, where n represents the number of stocks in the index. The advantages of an equal-
weighted index relative to a price-weighted or market-cap weighted index are that all
that all constituent securities impact the index equally, irrespective of their share price
or market value.
The disadvantages are that:
 After one period has passed the index will no longer be equally weighted and will
need to be rebalanced to become equally-weighted again.
 An equal-weighted index cannot be exactly replicated by an indexed portfolio, due to
fractional constituents.
 Since an equal-weighted index will include a greater weight of small cap
constituents, there may not be sufficient liquidity in these small capitalization
constituent securities for portfolios to effectively track the index.

2.6 Active vs Passive Portfolio Management.

The objective of active management is to add value in the investment process by doing
better than a benchmark portfolio. Value added is a relative performance comparison to
investing in the benchmark portfolio, often called passive investing. If the investor
outperforms the benchmark portfolio, value added is positive. If the investor
underperforms the benchmark portfolio, value added is negative and in such a case, the
investor would have been better off by simply holding the benchmark portfolio.
2.6.1 Active Risk and Return
The value added or “active return” of an actively managed portfolio is typically calculated
as the simple difference between the return on that portfolio and the return on the
benchmark portfolio. 𝑅𝐴 = 𝑅𝑃 − 𝑅𝐵
Portfolio’s Alpha; This is a risk- adjusted calculation of value added, it incorporates some
estimate of the managed portfolio’s risk relative to the benchmark, often captured by the
portfolio’s beta.
𝛼𝐴 = 𝑅𝑃 − 𝛽𝑅𝐵
In practice, the term alpha is also often used to refer to active return, which implicitly
assumes that the beta of the managed portfolio relative to the benchmark is 1.
Active Weights;
Active return is ultimately driven by the differences in managed portfolio weights and
benchmark weights.
∆𝑤𝑖 = 𝑤𝑃,𝑖 − 𝑤𝐵,𝑖
Thus active return can be computed as;
𝑅𝐴 = ∑𝑁 𝑖=1 ∆𝑤𝑖 𝑅𝑖
The sum of the active weights is zero, this means that we can also write the value added
as the sum product of active weights and active security returns: 𝑅𝐴 = ∑𝑁 𝑖=1 ∆𝑤𝑖 𝑅𝐴
Example; Suppose the benchmark is a 60/40 weighted composite portfolio of
stocks/bonds. The investor is optimistic on Stock performance and holds a portfolio that
is weighted 70% stocks and 30% bonds. Assume the ex-post return on the stock market
turned out to be 14.0% and the return on the bond market turned out to be just 2.0%.
Compute the Active return.
The return on the managed portfolio is 0.70(14.0) + 0.30(2.0) = 10.4% and the return on
the benchmark 0.60(14.0) + 0.40(2.0) = 9.2%. Active return =10.4 – 9.2 = 1.2%.
A more informative calculation is to use 𝑅𝐴 = ∑𝑁 𝑖=1 ∆𝑤𝑖 𝑅𝐴
Which shows the contributions from each segment is
RA = 0.10(14.0 – 9.2) – 0.10(2.0 – 9.2) = 0.5 + 0.7 = 1.2%.
This suggests that a 0.5% return relative to the benchmark was generated by being
overweight stocks and a 0.7% return was generated by being underweight bonds.
2.6.2 Sharpe ratio
The Sharpe ratio is a measure for comparing the performance of portfolios. The Sharpe
ratio for a particular portfolio is calculated with the following equation:
𝐸𝑟𝑝 − 𝑟𝑓
𝜎𝑝
𝐸(𝑅𝑝)= expected portfolio return; or portfolio return in a past period
𝑅𝑓= the rate of return on the risk-free asset
𝜎𝑝= the volatility of portfolio returns.
The most attractive portfolio amongst a choice of portfolios will be the one with the
highest Sharpe ratio, as it will have the highest return for the risk taken.
The Sharpe ratio uses the total risk of the portfolio, whereas only systematic risk is priced.
This is a limitation.
An important property is that the Sharpe ratio is unaffected by the addition of cash or
leverage in a portfolio
Adjusting Risk and Return Using the Sharpe Ratio
Consider two risky portfolios: a large- cap stock portfolio and a small- cap stock portfolio.
Suppose for simplicity that the current risk- free rate is 2.8%. The forecasted Sharpe ratio
of the small- cap portfolio is 0.5 higher than the 0.47 ratio of the large- cap portfolio.
Suppose the investor does not want the high 21.1% volatility associated with the small-
cap stocks.
Qtn; How much would an investor need to hold in to reduce the risk of a portfolio invested
in the small- cap portfolio and cash to the same risk level as that of the large- cap
portfolio?

2.6.3 The Information Ratio

Information ratio compares the active return from a portfolio relative to a benchmark
with the volatility of the active return (“active risk” or “benchmark tracking risk.”) The
information ratio can be thought of as a way to measure the consistency of active return,
as most investors would prefer a more consistently generated value added (low active
risk) rather than a lumpy active return pattern. The information ratio tells the investor
how much active return has been earned, or is expected to be earned.
𝑅𝐴
𝐼𝑅 =
𝜎(𝑅𝐴 )
Unlike the Sharpe ratio, the information ratio is affected by the addition of cash or the use
of leverage. For example, if the investor adds cash to a portfolio of risky assets, the
information ratio for the combined portfolio will generally shrink. However, the
information ratio of an unconstrained portfolio is unaffected by the aggressiveness of
active weights.
Specifically, if the active security weights, Δwi, defined as deviations from the benchmark
portfolio weights, are all multiplied by some constant, c, the information ratio of an
actively managed portfolio will remain unchanged
2.6.4 The fundamental law of active management
It is a mathematical relationship that relates the expected information ratio of an actively
managed portfolio to a few key parameters like forecasted active returns, μi; active
portfolio weights, Δwi; and realized active returns, RAi.

The arrow at the base of the triangle reflects value added

Vertical right-there is little hope of adding value if the investor’s forecasts of active
returns do not correspond to the realized active returns. Signal quality is measured by
the correlation between the forecasted active returns, μi, and the realized active returns,
RAi,. This is known as Information coefficient(IC). Investors with higher IC, or ability to
forecast returns, will add more value over time
Vertical Left- The correlation between any set of active weights, Δwi, and forecasted
active returns, μi, measures the degree to which the investor’s forecasts are translated
into active weights, called the transfer coefficient (TC).
The fundamental law generally assume that active return forecasts are scaled prior to as:
μi = ICσiSi
where IC is the expected information coefficient and Si represents a set of standardized
forecasts of expected returns across securities, sometime called “scores.”
The mean–variance optimal active weights are
𝜇 𝜎𝐴
∆𝑤𝑖∗ = 𝜎2𝑖 𝐼𝐶√𝐵𝑅 BR stands for breadth,
𝑖
BR, or breadth, conceptually equal to the number of independent decisions made per year
by the investor in constructing the portfolio.
Example; Consider the simple case of four individual securities whose active returns are
defined to be uncorrelated with each other and have active return volatilities as shown
in table below. An active investor believes the first two securities will outperform the
other two over the next year, and thus assigns scores of +1 and –1 to the first and second
groups, respectively

Assume that the anticipated accuracy of the investor’s ranking of securities is measured
by an information coefficient of IC = 0.20.
1) What are the forecasted active returns to each of the four securities
2) Given the assumption that the four securities’ active returns are uncorrelated with
each other, and forecasts are independent from year to year, what is the breadth
of the investor’s forecasts?
3) Suppose the investor wants to maximize the expected active return of the
portfolio subject to an active risk constraint of 9.0%. Calculate the active weights
that should be assigned to each of these securities.

Consider the simple case of four individual securities whose active returns are
uncorrelated with each other and forecasts are independent from year to year. The active
return forecasts, active risks, and the active weights for each security are shown below;

1. Suppose that the benchmark portfolio for these four securities is equally weighted
(i.e., wB,i = 25% for each security) and that the forecasted return on the benchmark
 portfolio is 10.0%. What are the portfolio weights and the total expected returns
for each of the four securities?
2. Calculate the forecasted total return and active return of the managed portfolio.
3. Calculate the active risk of the managed portfolio.
4. Verify the basic fundamental law of active management using the expected active
return and active risk of the managed portfolio. The individual security active
return forecasts and active weights were sized using an information coefficient of
IC = 0.20, breadth of BR = 4, and active risk of σA = 9.0%.

2.7 Factor Models in Return and Risk Attribution

Factors can be viewed as the mean return to a zero- net investment, long– short portfolio.
In the Fama-French model, SMB represents the mean return to shorting large- cap shares
and investing the proceeds in small- cap shares; HML is the mean return from shorting
low book- to- market (high P/B) shares and investing the proceeds in high book- to-
market shares.

A High price to Book ratio indicates a growth stock while a low price to book indicate a
value stock. So for an investment that has a tilt towards Value will have a positive
coefficient for the HML factor in the FF Model, the opposite is true for growth.
A positive co-efficient for SMB indicates a tilt towards small cap stocks and negative co-
coe-eficient indicate a tilt towards large cap.

2.7.1 Decomposing Active Return;

Performance attribution systems often attempt to decompose the value added into
multiple sources. The most common decomposition is between value added due to asset
allocation and value added due to security selection.
Consider a composite portfolio of stocks and bonds where the asset allocation weights
differ from a composite benchmark and each asset class is actively managed by selecting
individual securities. Active return can be decomposed into asset allocation and security
selection as follows;
𝑅𝐴 = (∆𝑤𝑠𝑡𝑜𝑐𝑘𝑠 𝑅𝐵_𝑠𝑡𝑜𝑐𝑘𝑠 +∆𝑤𝑏𝑜𝑛𝑑𝑠 𝑅𝐵_𝑏𝑜𝑛𝑑𝑠 ) + (𝑤𝑃_𝑠𝑡𝑜𝑐𝑘𝑠 𝑅𝐴_𝑠𝑡𝑜𝑐𝑘𝑠 +𝑤𝑃_𝑏𝑜𝑛𝑑𝑠 𝑅𝐴_𝑏𝑜𝑛𝑑𝑠 )
Example, the long- term policy portfolio might be 60/40 stocks versus bonds, and the
investor deviates from this policy portfolio from year to year based on beliefs about the
returns to each asset class.
Fund Fund Benchmark Value
Return(%) Return(%) Added(%)
Stocks 35.3 32.3 3.0
Bonds -1.9 -2.0 0.1
Portfolio Return 23.4 18.613 4.8

Consider an investor who invested in both actively managed funds, with 68% of the total
portfolio in Stock Fund and 32% in Bond Fund. Assume that the investor’s policy portfolio
(strategic asset allocation) specifies weights of 60% for equities and 40% for bonds.
Using the given information, decompose the Active return into asset allocation and
security selection.

Factor Return Attribution.

Analysts often favor fundamental multifactor models in decomposing the sources of
returns. In contrast to statistical factor models, fundamental factor models allow the
sources of portfolio performance to be described using commonly understood terms.
Also, in contrast to macroeconomic factor models, fundamental models express
investment style choices and security characteristics more directly and often in greater
detail.
With the help of a factor model, we can analyze a portfolio manager’s active return as the
sum of two components. The first component is the product of the portfolio manager’s
factor tilts and the factor returns; we call that component the return from factor tilts.
The second component of active return reflects the manager’s skill in individual asset
selection we call that component security selection.

𝑅𝐴 = ∑[(𝑃𝑜𝑟𝑡𝑓 𝑆𝑒𝑛𝑠𝑖𝑡𝑖𝑣𝑖𝑡𝑦)𝑘 − (𝐵𝑒𝑛𝑐ℎ𝑚 𝑆𝑒𝑠𝑖𝑡𝑖𝑣𝑖𝑡𝑦)] × (𝐹𝑎𝑐𝑡𝑜𝑟 𝑟𝑒𝑡)𝑘

𝑘=1
+ 𝑆𝑒𝑐 𝑆𝑒𝑙𝑒𝑐𝑐𝑡𝑖𝑜𝑛
Example;
An equity analyst at a pension fund uses the Carhart multifactor model to evaluate Zim
equity portfolios. The Analyst describes himself as a “stock picker” and points to his
performance in beating the benchmark as evidence that he is successful. The active
return for the portfolio he manages is 2.0741%.

You are also given the following information on factor return and sensitivities;
Factor Sensitivity
Factor Portfolio Benchmark Factor Return
RMRF 0.95 1 5.52%
SMB -1.05 -1 -3.35%
HML 0.40 0.00 5.10%
WML 0.05 0.03 9.63%

i. Compute the return from security selection

ii. Evaluate the sources of the Analyst’s active return for the year.
iii. Verify the statement that the Analyst is a stock picker.
 2.7.2 Factor Models in Risk Attribution
A few key terms are important to the understanding of how factor models
are used to build an understanding of a portfolio manager’s risk exposures.
Active risk -can be represented by the standard deviation of active returns. A traditional
term for that standard deviation is tracking error (TE)/Tracking.
TE = s(Rp – RB)
Setting guidelines for acceptable active risk or tracking error is one of the methods that
some investors use to ensure that the overall risk and style characteristics of their
investments are in line with their chosen benchmark.
Multifactor models can also be used to decompose and attribute sources of total risk. By
decomposing active risk, the analyst’s objective is to measure the portfolio’s active
exposure along each dimension of risk.
In analyzing risk, it is more convenient to use variances rather than standard deviations
because the variances of uncorrelated variables are additive. We refer to the variance of
active return as active risk squared.
Active risk squared = s2(Rp – RB)
A portfolio’s active risk squared can be divided into two components:
■ Active factor risk is the contribution to active risk squared resulting from the portfolio’s

different- from- benchmark exposures relative to factors specified in the risk model.
■ Active specific risk or security selection risk measures the active non-factor or residual

risk assumed by the manager. Portfolio managers attempt to provide a positive average
return from security selection as compensation for assuming active specific risk..
Active risk squared = Active factor risk + Active specific risk
Active factor risk represents the part of active risk squared explained by the portfolio’s
active factor exposures. Active factor risk can be found indirectly as the risk remaining
after active specific risk is deducted from active risk squared.
𝑛

𝐴𝑐𝑡𝑖𝑣𝑒 𝑠𝑝𝑒𝑐𝑖𝑓𝑖𝑐 𝑟𝑖𝑠𝑘 = ∑(∆𝑤𝑖 )2 𝜎𝜀𝑖2

𝑖=1
where ∆𝑤𝑖 is the ith asset’s active weight in the portfolio
and 𝜎𝜀𝑖2 is the residual risk of the ith asset (the variance of the ith asset’s returns left
unexplained by the factors).
Example; Consider the following information;

i. Contrast the active risk decomposition of Portfolios A and B.

ii. Contrast the active risk decomposition of Portfolios B and C.