Preface xi
Acknowledgments xiii
About the CFA Institute Investment Series xv
Chapter 1 Overview of Equity Securities 1
Learning Outcomes 1
1. Introduction 1
2. Equity Securities in Global Financial Markets 2
3. Types and Characteristics of Equity Securities 6
3.1. Common Shares 7
3.2. Preference Shares 10
4. Private versus Public Equity Securities 12
5. Investing in Non-Domestic Equity Securities 15
5.1. Direct Investing 17
5.2. Depository Receipts 17
6. Risk and Return Characteristics of Equity Securities 20
6.1. Return Characteristics of Equity Securities 20
5.2. Risk of Equity Securities 22
7. Equity Securities and Company Value 23
7.1. Accounting Return on Equity 23
7.2. The Cost of Equity and Investors' Required Rates of Return 28
Summary 29
References 31
Practice Problems 31
Chapter 2 Market Efficiency 35
Learning Outcomes 35
1. Introduction 35
2. The Concept of Market Efficiency 37
2.1. The Description of Efficient Markets 37
2.2. Market Value versus Intrinsic Value 39
2.4. Transaction Costs and Information-Acquisition Costs 43
3. Forms of Market Efficiency 44
3.1. Weak Form 44
3.2. Semi-Strong Form 45
3.3. Strong Form 48
3.4. Implications of the Efficient Market Hypothesis 48
4. Market Pricing Anomalies 50
4.1. Time-Series Anomalies 51
4.2. Cross-Sectional Anomalies 53
4.3. Other Anomalies 54
4.4. Implications for Investment Strategies 56
5. Behavioral Finance 57
5.1. Loss Aversion 57
5.2. Herding 58
5.3. Overconfidence 58
5.4. Information Cascades 58
5.5. Other Behavioral Biases 59
5.6. Behavioral Finance and Investors 60
5.7. Behavioral Finance and Efficient Markets 60
Summary 60
References 61
Practice Problems 63
Chapter 3 Overview of Equity Portfolio Management 67
Learning Outcomes 67
1. Introduction 67
2. The Roles of Equities in a Portfolio 68
2.1. Capital Appreciation 68
2.2. Dividend Income 69
2.3. Diversification with Other Asset Classes 70
2.4. Hedge Against Inflation 71
2.5. Client Considerations for Equities in a Portfolio 71
3. Equity Investment Universe 73
3.1. Segmentation by Size and Style 73
3.2. Segmentation by Geography 75
3.3. Segmentation by Economic Activity 77
3.4. Segmentation of Equity Indexes and Benchmarks 78
4. Income and Costs in an Equity Portfolio 79
4.1. Dividend Income 79
4.2. Securities Lending Income 80
4.3. Ancillary Investment Strategies 80
4.4. Management Fees 81
4.5. Performance Fees 81
4.6. Administration Fees 82
4.7. Marketing and Distribution Costs 82
4.8. Trading Costs 83
4.9. Investment Approaches and Effects on Costs 83
5. Shareholder Engagement 84
5.1. Benefits of Shareholder Engagement 84
5.2. Disadvantages of Shareholder Engagement 85
5.3. The Role of an Equity Manager in Shareholder Engagement 85
6. Equity Investment across the Passive-Active Spectrum 87
6.1. Confidence to Outperform 87
6.2. Client Preference 88
6.3. Suitable Benchmark 89
6.4. Client-Specific Mandates 89
6.5. Risks/Costs of Active Management 89
6.6. Taxes 89
Summary 90
References 91
Practice Problems 92
Chapter 4 Passive Equity Investing 95
Learning Outcomes 95
1. Introduction 95
2. Choosing a Benchmark 97
2.1. Indexes as a Basis for Investment 97
2.2. Considerations When Choosing a Benchmark Index 98
2.3. Index Construction Methodologies 100
2.4. Factor-Based Strategies 106
3. Approaches to Passive Equity Investing 109
3.1. Pooled Investments 110
3.2. Derivatives-Based Approaches 113
3.3. Separately Managed Equity Index-Based Portfolios 140
4. Portfolio Construction 119
4.1. Full Replication 119
4.2. Stratified Sampling 121
4.3. Optimization 122
4.4. Blended Approach 123
5. Tracking Error Management 123
5.1. Tracking Error and Excess Return 124
5.2. Potential Causes of Tracking Error and Excess Return 125
5.3. Controlling Tracking Error 126
6. Sources of Return and Risk in Passive Equity Portfolios 126
6.1. Attribution Analysis 127
6.2. Securities Lending 129
6.3. Investor Activism and Engagement by Passive Managers 131
Summary 132
References 133
Practice Problems 135
Chapter 5 Analysis of Active Portfolio Management 141
Learning Outcomes 141
1. Introduction 141
2. Active Management and Value Added 142
2.1. Choice of Benchmark 143
2.2. Measuring Value Added 143
2.3. Decomposition of Value Added 145
3. Comparing Risk and Return 147
3.1. The Sharpe Ratio 147
3.2. The Information Ratio 150
3.3. Constructing Optimal Portfolios 153
4. The Fundamental Law of Active Management 158
4.1. Active Security Returns 158
4.2. The Basic Fundamental Law 163
4.3. The Expanded Fundamental Law 164
4.4. Ex Post Performance Measurement 167
5. Applications of the Fundamental Law 169
5.1. Global Equity Strategy 169
5.2. Fixed-Income Strategies 177
6. Practical Limitations 183
6.1. Ex Ante Measurement of Skill 183
6.2. Independence of Investment Decisions 184
Summary 185
References 187
Practice Problems 187
Chapter 6 Active Equity Investing: Strategies 197
Learning Outcomes 197
1. Introduction 197
2. Approaches to Active Management 198
2.1. Differences in the Nature of the Information Used 200
2.2. Differences in the Focus of the Analysis 201
2.3. Difference in Orientation to the Data: Forecasting the Future vs. Analyzing the Past 202
2.4. Differences in Portfolio Construction: Judgment vs. Optimization 202
3. Types of Active Management Strategies 204
3.1. Bottom-Up Strategies 204
3.2. Top-Down Strategies 211
3.3. Factor-Based Strategies 214
3.4. Activist Strategies 228
3.5. Other Strategies 235
4. Creating a Fundamental Active Investment Strategy 239
4.1. The Fundamental Active Investment Process 239
4.2. Pitfalls in Fundamental Investing 241
5. Creating a Quantitative Active Investment Strategy 246
5.1. Creating a Quantitative Investment Process 246
5.2. Pitfalls in Quantitative Investment Processes 249
6. Equity Investment Style Classification 253
6.1. Different Approaches to Style Classification 253
6.2. Strengths and Limitations of Style Analysis 260
Summary 262
References 263
Practice Problems 264
Chapter 7 Active Equity Investing: Portfolio Construction 271
Learning Outcomes 271
1. Introduction 271
2. Building Blocks of Active Equity Portfolio Construction 272
2.1. Fundamentals of Portfolio Construction 273
2.2. Building Blocks Used in Portfolio Construction 275
3. Approaches to Portfolio Construction 284
3.1. The Implementation Process: The Choice of Portfolio Management Approaches 285
3.2. The Implementation Process: The Objectives and Constraints 296
4. Allocating the Risk Budget 301
4.1. Absolute vs. Relative Measures of Risk 302
4.2. Determining the Appropriate Level of Risk 307
4.3. Allocating the Risk Budget 310
5. Additional Risk Measures Used in Portfolio Construction and Monitoring 314
5.1. Heuristic Constraints 314
5.2. Formal Constraints 315
5.3. The Risks of Being Wrong 318
6. Implicit Cost-Related Considerations in Portfolio Construction 321
6.1. Implicit Costs-Market Impact and the Relevance of Position Size, Assets under Management, and Turnover 321
6.2. Estimating the Cost of Slippage 324
7. The Well-Constructed Portfolio 328
8. Long/Short, Long Extension, and Market-Neutral Portfolio Construction 332
8.1. The Merits of Long-Only Investing 333
8.2. Long/Short Portfolio Construction 335
8.3. Long Extension Portfolio Construction 336
8.4. Market-Neutral Portfolio Construction 337
8.5. Benefits and Drawbacks of Long/Short Strategies 338
Summary 342
References 345
Practice Problems 346
Chapter 8 Technical Analysis 351
Learning Outcomes 351
1. Introduction 351
2. Technical Analysis: Principles, Assumptions, and Links to Investment Analysis 352
2.1. Principles and Assumptions 353
2.2. Technical Analysis and Behavioral Finance 354
2.3. Technical Analysis and Fundamental Analysis 356
2.4. The Differences in Conducting/Interpreting Technical Analysis in Various Types of Markets 358
3. Charting 360
3.1. Types of Technical Analysis Charts 361
3.2. Trend, Support, and Resistance 372
3.3. Common Chart Patterns 375
4. Technical Indicators 397
4.1. Technical Indicators 398
5. Applications to Portfolio Management 417
5.1. Principles of Intermarket Analysis 418
5.2. Technical Analysis Applications to Portfolio Management 421
Summary 435
Practice Problems 438
Glossary 445
About the Authors 451
About the CFA Program 453
Index 455
