Pooled Investment Vehicles
An investment vehicle refers to the type of account(s) used to hold an... Read More
One of the primary sources of equity return is capital appreciation. This happens when an investor buys a stock and sells it for a higher price, making a profit. Capital appreciation often receives favorable tax treatment in many jurisdictions compared to other forms of income. While growth stocks are known for emphasizing capital appreciation, it's a significant driver of returns for most equities. Equities generally offer higher returns than fixed-income investments.
Rising equity prices are tied to companies' improved prospects. The dividend growth model, such as the Gordon Growth Model, values a company's shares based on upcoming dividends (D1). This shows that the equity market looks ahead. Companies expected to experience growth in revenue, cash flows, and earnings will see their share prices rise. This trend is especially pronounced during periods of economic expansion. Equities typically underperform other assets when an economic downturn is imminent.
Dividends are payments made by companies that have generated surplus profits, which they choose to distribute to shareholders rather than reinvest. Unlike interest payments in fixed income, dividends are not guaranteed or legally mandated.
While dividends are a way for companies to attract investors and potentially boost share prices, they are not as prominent a source of return for equities as capital appreciation. Dividend yields for established firms typically range from 1% to 3% annually. Companies with a consistent track record of paying growing dividends are seen as financially responsible, enhancing their stock value. Dividend yields are generally higher for larger, more mature companies and are often associated with value stocks rather than growth stocks.
Equities tend to show less than perfect correlation with other major asset classes. This brings about a diversification benefit, improving the risk-adjusted return of a portfolio. It's important to note that correlations between major asset classes, including equities, tend to increase during market crises. This means that diversification is less effective precisely when it's most needed.
Equities provide the opportunity to hedge a portfolio against inflation. The degree of this protection is somewhat uncertain and varies across different periods and countries.
Companies that can raise their product prices in response to rising input costs offer the most substantial hedge against inflation. Additionally, commodities producers, such as oil and gas companies, often benefit when the prices of their products rise. Companies with price-sensitive customers and numerous substitutes have less pricing power and therefore offer a weaker inflation hedge. Equities can generally equities can be considered a superior inflation hedge compared to fixed-rate bonds.
The investment policy statement outlines the types of securities that can be included in a portfolio. Besides, it determines the extent to which the securities can run. Managers might need to include specific sectors or types of companies to balance a client's risk exposure (positive screening) or exclude certain equity types (negative screening). Environmental, Social, and Governance (ESG) considerations are increasingly important to clients and may lead to additional restrictions on the equities that can be included in a portfolio.
In summary, when wealth managers and financial advisers are determining whether to incorporate equities or other asset classes into a client’s portfolio, they typically take into account the following investment goals and limitations:
Client requests often drive ESG considerations due to the increasing interest in sustainable investing. Specifically regarding equities, these considerations frequently influence the appropriateness of particular sectors or individual company stocks within designated investor portfolios.
Some ESG approaches that portfolio managers can apply to include:
Question
Which of the following is least likely a benefit of including equities in a portfolio?
- Capital appreciation.
- Inflationary hedge.
- Diversification.
Solution
The correct answer is B.
Equities' ability to act as an inflationary hedge depends on the company's capability to align revenue with rising input costs, which varies among firms.
A and C are incorrect. Equities are generally expected to provide diversification benefits and a portfolio’s potential for capital appreciation.
Portfolio Construction: Learning Module 1: Overview of Equity Portfolio Management; Los 1(a) Describe the roles of equities in the overall portfolio