CFA Level 3 Book 4
What are the 4 roles of Equities? -CORRECT ANSWER- 1. Capital Appreciation
2. Dividend Income
3. Diversification (equities have less than perfect correlations with other asset classes)
4. Inflation Hedge (studies generally show positive correlation between equity real
returns and inflation)
Thematic Investing -CORRECT ANSWER- Screens equities based on a specific theme
such as climate change
Impact Investing -CORRECT ANSWER- Aims to meet investor objectives by becoming
more actively engaged with company matters and/or directly investing in company
projects
What are the 3 types of approaches to segmenting an equity manager's investment
universe? -CORRECT ANSWER- 1. Size (market cap) and Style (value, growth or mix)
2. Geography
3. Economic Activity
What are the 2 approaches to segmenting by economic activity? -CORRECT ANSWER-
1. Market-Oriented Approach: Segments companies by markets served, how products
are used and how cash flows are generated (GICS)
2. Production-Oriented Approach: Segments companies by products manufactured and
inputs required during the production process
What is the advantage and disadvantage of segmenting the investment universe by
economic activity? -CORRECT ANSWER- Advantage: Diversification benefits are
enhanced when investments span different sectors
Disadvantage: Some larger companies may have operations that are not easily
assigned to one specific sector
Optional Stock Dividend -CORRECT ANSWER- Allows investors to choose between
cash and stock dividends -> Investors are able to sell the "option"
Securities Lending -CORRECT ANSWER- Lender of the security receives a fee and
also receives collateral or cash on which they can earn an additional return
*Borrower must compensate lender for any dividend payment that occurs during period
of loan
*Lender loses the right to vote the shares
Cash-Covered Put -CORRECT ANSWER- Selling a put option on a stock and setting
aside sufficient cash to pay for the stock
,Dividend Capture -CORRECT ANSWER- When an investor buys a stock right before its
ex-dividend date, holds the stock through the ex-dividend date (investor is entitled to the
dividend) and then sells the stock
High Water Mark -CORRECT ANSWER- Manager will only earn an incentive fee on
future appreciation above the previous level that was already compensated for
What are typically discussed at shareholder engagement meetings? -CORRECT
ANSWER- 1. Corporate Strategy (company objectives, constraints, growth opportunities
etc.)
2. Capital Allocation (selection process for new projects)
3. Corporate Governance (internal controls and functions of audit and risk committees)
4. Compensation Structure (executive pay)
5. Composition of BOD
What are the disadvantages of shareholder engagement? -CORRECT ANSWER- 1.
Focusing on short term goals such as increasing cash flow or stock price at the expense
of company's long term goals
2. May lead to insider info (risk of insider trading)
3. Potential conflicts of interest (PM supports company management because
management invests in PM's fund)
What are the 3 considerations in choosing a benchmark? -CORRECT ANSWER- 1.
Rules-Based: Rules for including stocks in the portfolio and rebalancing frequency must
be consistent, objective and predictable
2. Transparent: Rules of index are public and clearly stated
3. Investable: Investors can replicate the return and risk of index
What are the 4 types of weighting methods? -CORRECT ANSWER- 1. Market-Cap
Weighting
2. Price Weighting
3. Equal Weighting
4. Fundamental Weighting (weight stocks by fundamental factors -> sales, income,
dividends)
Herfindahl-Hirschman Index -CORRECT ANSWER- Measures stock concentration ->
As HHI increases, concentration risk increases
*Effective Number of Stocks = 1 / HHI
What type of weighted index has lower effective number of stocks than actual number?
-CORRECT ANSWER- Market-Cap Weighted Index -> Lower effective number reflects
the disproportionate effect of the large cap stocks in the index
Reconstitution -CORRECT ANSWER- Process of removing and replacing stocks that
no longer fit the index market exposure
, What are the most common equity factors? -CORRECT ANSWER- 1. Growth Factor
(stocks with high P/E)
2. Value Factor (mature stocks with low P/E)
3. Size Factor (stocks with low market caps)
4. Yield Factor (high dividend yield stocks)
5. Momentum Factor (stocks with recent above-average returns)
6. Quality Factor (stocks with consistent earnings and dividend growth)
7. Volatility Factor (stocks with low standard deviation of earnings)
What is the advantage to an ETF? -CORRECT ANSWER- Can handle shareholder
redemptions more cheaply and efficiently -> Reduces taxable gains and losses that
would otherwise be passed on to shareholders
Overlay Position -CORRECT ANSWER- Derivative positions used to adjust the existing
portfolio risk and return exposures
What are the 3 types of Overlay Positions? -CORRECT ANSWER- 1. Completion
Overlay: Moves the portfolio back to the risk exposure of the index
2. Rebalancing Overlay: Matches the reconstitution of the index as securities are added
or dropped
3. Currency Overlay: Adjust the FX risk of portfolio holdings
What are the advantages to using Equity Index Derivatives? -CORRECT ANSWER- 1.
Can quickly adjust exposure of the portfolio
2. Trade in liquid markets
3. Make it easy to leverage the portfolio
What are the disadvantages to using Equity Index Derivatives? -CORRECT ANSWER-
1. Derivative positions have finite expirations (have to be rolled over)
2. Some contracts have position limits
3. Special portfolio needs might not be met by the existing derivatives available
4. OTC derivatives introduce counterparty risk
5. Basis risk can increase tracking error
Stratified Sampling -CORRECT ANSWER- Hold a sample of the index stocks, with the
sample selected in a way that replicates the index return/risk characteristics
*Adding to the sample size with liquid stocks first reduces tracking error, but as less
liquid stocks are added, costs and tracking error increases
Optimization -CORRECT ANSWER- Seeks the combination of stocks that minimize
tracking error and maximizes return (based on historical data)
*Exhibits lower tracking error and explicitly accounts for covariance among constituent
stocks
What are the 4 roles of Equities? -CORRECT ANSWER- 1. Capital Appreciation
2. Dividend Income
3. Diversification (equities have less than perfect correlations with other asset classes)
4. Inflation Hedge (studies generally show positive correlation between equity real
returns and inflation)
Thematic Investing -CORRECT ANSWER- Screens equities based on a specific theme
such as climate change
Impact Investing -CORRECT ANSWER- Aims to meet investor objectives by becoming
more actively engaged with company matters and/or directly investing in company
projects
What are the 3 types of approaches to segmenting an equity manager's investment
universe? -CORRECT ANSWER- 1. Size (market cap) and Style (value, growth or mix)
2. Geography
3. Economic Activity
What are the 2 approaches to segmenting by economic activity? -CORRECT ANSWER-
1. Market-Oriented Approach: Segments companies by markets served, how products
are used and how cash flows are generated (GICS)
2. Production-Oriented Approach: Segments companies by products manufactured and
inputs required during the production process
What is the advantage and disadvantage of segmenting the investment universe by
economic activity? -CORRECT ANSWER- Advantage: Diversification benefits are
enhanced when investments span different sectors
Disadvantage: Some larger companies may have operations that are not easily
assigned to one specific sector
Optional Stock Dividend -CORRECT ANSWER- Allows investors to choose between
cash and stock dividends -> Investors are able to sell the "option"
Securities Lending -CORRECT ANSWER- Lender of the security receives a fee and
also receives collateral or cash on which they can earn an additional return
*Borrower must compensate lender for any dividend payment that occurs during period
of loan
*Lender loses the right to vote the shares
Cash-Covered Put -CORRECT ANSWER- Selling a put option on a stock and setting
aside sufficient cash to pay for the stock
,Dividend Capture -CORRECT ANSWER- When an investor buys a stock right before its
ex-dividend date, holds the stock through the ex-dividend date (investor is entitled to the
dividend) and then sells the stock
High Water Mark -CORRECT ANSWER- Manager will only earn an incentive fee on
future appreciation above the previous level that was already compensated for
What are typically discussed at shareholder engagement meetings? -CORRECT
ANSWER- 1. Corporate Strategy (company objectives, constraints, growth opportunities
etc.)
2. Capital Allocation (selection process for new projects)
3. Corporate Governance (internal controls and functions of audit and risk committees)
4. Compensation Structure (executive pay)
5. Composition of BOD
What are the disadvantages of shareholder engagement? -CORRECT ANSWER- 1.
Focusing on short term goals such as increasing cash flow or stock price at the expense
of company's long term goals
2. May lead to insider info (risk of insider trading)
3. Potential conflicts of interest (PM supports company management because
management invests in PM's fund)
What are the 3 considerations in choosing a benchmark? -CORRECT ANSWER- 1.
Rules-Based: Rules for including stocks in the portfolio and rebalancing frequency must
be consistent, objective and predictable
2. Transparent: Rules of index are public and clearly stated
3. Investable: Investors can replicate the return and risk of index
What are the 4 types of weighting methods? -CORRECT ANSWER- 1. Market-Cap
Weighting
2. Price Weighting
3. Equal Weighting
4. Fundamental Weighting (weight stocks by fundamental factors -> sales, income,
dividends)
Herfindahl-Hirschman Index -CORRECT ANSWER- Measures stock concentration ->
As HHI increases, concentration risk increases
*Effective Number of Stocks = 1 / HHI
What type of weighted index has lower effective number of stocks than actual number?
-CORRECT ANSWER- Market-Cap Weighted Index -> Lower effective number reflects
the disproportionate effect of the large cap stocks in the index
Reconstitution -CORRECT ANSWER- Process of removing and replacing stocks that
no longer fit the index market exposure
, What are the most common equity factors? -CORRECT ANSWER- 1. Growth Factor
(stocks with high P/E)
2. Value Factor (mature stocks with low P/E)
3. Size Factor (stocks with low market caps)
4. Yield Factor (high dividend yield stocks)
5. Momentum Factor (stocks with recent above-average returns)
6. Quality Factor (stocks with consistent earnings and dividend growth)
7. Volatility Factor (stocks with low standard deviation of earnings)
What is the advantage to an ETF? -CORRECT ANSWER- Can handle shareholder
redemptions more cheaply and efficiently -> Reduces taxable gains and losses that
would otherwise be passed on to shareholders
Overlay Position -CORRECT ANSWER- Derivative positions used to adjust the existing
portfolio risk and return exposures
What are the 3 types of Overlay Positions? -CORRECT ANSWER- 1. Completion
Overlay: Moves the portfolio back to the risk exposure of the index
2. Rebalancing Overlay: Matches the reconstitution of the index as securities are added
or dropped
3. Currency Overlay: Adjust the FX risk of portfolio holdings
What are the advantages to using Equity Index Derivatives? -CORRECT ANSWER- 1.
Can quickly adjust exposure of the portfolio
2. Trade in liquid markets
3. Make it easy to leverage the portfolio
What are the disadvantages to using Equity Index Derivatives? -CORRECT ANSWER-
1. Derivative positions have finite expirations (have to be rolled over)
2. Some contracts have position limits
3. Special portfolio needs might not be met by the existing derivatives available
4. OTC derivatives introduce counterparty risk
5. Basis risk can increase tracking error
Stratified Sampling -CORRECT ANSWER- Hold a sample of the index stocks, with the
sample selected in a way that replicates the index return/risk characteristics
*Adding to the sample size with liquid stocks first reduces tracking error, but as less
liquid stocks are added, costs and tracking error increases
Optimization -CORRECT ANSWER- Seeks the combination of stocks that minimize
tracking error and maximizes return (based on historical data)
*Exhibits lower tracking error and explicitly accounts for covariance among constituent
stocks
