Reading 31: Equity Portfolio Management－LOS m market, contrast, potential, including, investment

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CFA Institute Area 8-11, 13: Asset Valuation
Session 10: Equity Portfolio Management
Reading 31: Equity Portfolio Management
LOS m: Compare and contrast long-short versus long-only investment strategies, including their risks and potential alphas, and explain why greater pricing inefficiency may exist on the short side of the market.

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Which of the following is characteristic of a long-short trade? A long-short trade has the potential to earn:

A) two alphas and eliminate unsystematic risk.

B) two alphas and eliminate systematic risk.

C) one alpha and eliminate systematic risk.

D) one alpha and eliminate unsystematic risk.

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Answer and Explanation

Long-short strategies can buy undervalued stocks and short overvalued stocks, earning two alphas. A long-only strategy can only earn the long alpha. Long-short strategies can eliminate expected systematic risk by buying one stock and shorting another in the same industry. The investor however still has unsystematic risk if the short position rises while the long falls.

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Which of the following are advantages of a long-short trade? A long-short trade focuses on:

A) exploiting constraints and can generate an asymmetric distribution of active returns.

B) fundamental valuation and can generate a symmetric distribution of active returns.

C) exploiting constraints and can generate a symmetric distribution of active returns.

D) fundamental valuation and can generate an asymmetric distribution of active returns.

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Answer and Explanation

Long-only strategies are focused on using fundamental analysis to find undervalued stocks. In contrast, long-short strategies focus on exploiting the constraints many investors face. For example, institutions are unable to short a stock. If an investor would like to express a negative view of an index security in a long-only strategy, he is limited to avoidance of the stock. The distribution of potential active weights in a long-only portfolio is asymmetric. A long-short investor can create a symmetric distribution of active weights by taking either long or short positions.

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Which of the following is least likely to be a reason pricing inefficiencies exist on the short-side?

A) There are barriers to short sales that do not exist for long trades.

B) Management has options in firms stock.

C) The securities exchanges in the developed world prohibit short sales.

D) There are more potential buyers than sellers of stock.

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Answer and Explanation

Although there may be limitations on short sales, they are not prohibited by securities exchanges. There are more potential buyers than sellers of stock so analysts are reluctant to lose these potential customers with a sell recommendation. Also management may hold their firms stock and options and put pressure on analysts to not issue sell recommendations.

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A recession is expected in an economy within the next year. Portfolio Manager A has shifted more of their stocks from the financial industry to the health care industry. Portfolio Manager B has shifted more of their stocks from the technology industry to the utility industry. Which of the following statements is most accurate regarding the performance of each manager?

A) Portfolio Manager A is expected to outperform the broad market and Portfolio Manager B is expected to outperform the broad market.

B) Portfolio Manager A is expected to underperform the broad market and Portfolio Manager B is expected to underperform the broad market.

C) Portfolio Manager A is expected to outperform the broad market while Portfolio Manager B is expected to underperform the broad market.

D) Portfolio Manager A is expected to underperform the broad market while Portfolio Manager B is expected to outperform the broad market.

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Answer and Explanation

Both managers are exhibiting style drift. Manager As drift is actually beneficial to performance while Bs is not. Value managers tend to have greater representation in the utility and financial industries whereas growth managers tend to have higher weights in the technology and health care industries. Growth stocks are more likely to outperform during a recession as there are few other firms with growth prospects and a premium would be placed on growth stocks valuation.