Common Behavioral Biases
Mnemonic Devices for Easy Recall Cognitive: The cognitive biases can be remembered with... Read More
Dividend income arises from companies that generate surplus cash flows beyond their operational needs. Dividends reflect financial responsibility, significantly when firms increase these payments. Dividend income is commonly associated with value stocks and appeals to investors seeking passive cash flows.
Special dividends resemble regular dividends but are typically nonrecurring. While firms aren't legally obligated to pay dividends, they may do so to attract investors for future financing.
An optional stock dividend refers to payments like special dividends. However, optional stock dividends are made in company stock rather than cash.
Investors who own equities may lend them out to other investors. This is the process by which short-selling becomes possible, as the shares must first be borrowed before they can be sold. Interest earned from securities lending tends to be modest in developed markets, usually no more than 3% annually. However, certain stocks which are in higher demand will have higher yields.
Index funds tend to be large lenders of securities as they have extensive inventories of stocks. Since their only goal is to replicate the performance of an index, they're not worried about the ‘short squeeze’ pressure that may be put on lent securities. Pension funds, endowments, and institutional investors also frequently lend shares. Even then, these large investors are often more concerned about the potential downward pricing pressure that securities lending can create.
Covered call writing refers to owning an optionable number of shares (usually lots of 100) and using those as ‘collateral’ against which to sell call options. These short calls are known as covered calls because the underlying shares will satisfy the obligation of the short call if it is to finish in the money.
The primary draw of the covered call strategy is the income that call premiums generate. This can be earned in addition to dividends and any room for capital gains that are left between the call strike price and the current market price of the shares.
Another lure of covered call writing is that it allows an investor to adjust a position from ‘decidedly bullish’ to ‘mildly bullish.’ This adjustment happens due to the reduction in dollar delta exposure of the position. In other words, rather than relying solely on the stock to increase in price over time, an investor can profit when markets are only slightly bullish or flat.
Like covered call writing, a cash-secured put involves selling options. A cash-secured put entails selling a put option while having the cash on hand to purchase the underlying stock if the put option is exercised. In this strategy, the investor receives a premium for selling the put option. If the stock's price decreases and the buyer exercises the put option, the investor uses the reserved cash to buy the stock at the predetermined strike price. This approach can be used by investors willing to buy the stock at a specific price and want to generate income from selling the put option. It's called “cash-secured” because the investor sets aside the necessary cash to fulfill the potential purchase obligation.
Dividend capture is a strategy to earn dividend income while avoiding the risk of a long-term buy-and-hold approach. In this strategy, an investor waits until just before a stock goes ex-dividend (without the right to the upcoming dividend) and then buys the shares. Once the investor secures the dividend rights by owning the stock, they sell it.
Theoretically, this strategy should not yield profits. When a company pays dividends, its market value tends to decrease by the same amount. However, market dynamics often enable this strategy to work. If the stock price drops by an amount less than the dividend on the ex-dividend date, a profit can be earned through this strategy (accounting for commission costs).
Management fees compensate portfolio managers for their professional services, including research, software, and trade processing. These fees are usually a percentage of the assets under management.
Performance fees come into play when portfolio managers achieve exceptional results. A good case in point is when their annual yield surpasses a benchmark like the Dow Jones Industrial Average. To prevent double charging, a high-water mark is often used. This means that if a portfolio's value once reached $1,000,000 but dropped to $800,000, performance fees won't apply until it surpasses the $1,000,000 high-water mark again. This protects investors.
Administrative fees are associated with asset custody, portfolio asset segregation, and ensuring compliance with investment regulations or mutual fund share ownership registration.
Marketing and distribution fees encompass expenses related to promoting portfolio management services. This category covers website costs, brochures, conferences, and sales efforts.
Trading costs encompass expenses incurred when purchasing and selling securities. These costs are divided into implicit costs (hard dollars) and explicit costs (missed opportunities). Each commission paid for a trade contributes to implicit trading costs, which the investor eventually bears.
Question
A high-water mark most likely refers to?
- Administrative costs.
- Performance fees.
- Implicit transaction costs.
Solution
The correct answer is B:
A high-water mark refers to performance fees.
A high-water mark is a minimum portfolio value under which performance fees cannot be assessed to an account. This high watermark protects investors so they do not pay for the same growth multiple times.
A is incorrect. Administrative costs are the expenses associated with running and maintaining an investment fund. They are not related to the concept of a high-water mark.
C is incorrect. Implicit transaction costs refer to the hidden costs associated with trading securities within a portfolio, such as bid-ask spreads and market impact costs. While these costs are relevant to investment management, they are not what a high-water mark refers to.
Reading 23: Overview of Equity Portfolio Management
Los 23 (c) Describe the types of income and costs associated with owning and managing an equity portfolio and their potential effects on portfolio performance