Manager A holds 400 stocks with weights near the index and charges 15 bps. Manager B holds 35 high-conviction positions and charges 85 bps. Manager A outperforms by 40 bps. Manager B outperforms by 190 bps, but with 7.2% tracking error. Which one fits a pension that already has $2 billion in passive equity?
Before choosing a strategy, an asset owner needs to know why they hold equities at all. CFA® Institute curriculum identifies five distinct roles, and most allocations use equities for more than one.
- Capital appreciation. Equities have historically delivered the highest long-run real returns of any major asset class.
- Dividend income. A meaningful share of long-run equity total return comes from dividends and reinvested dividends. Retirees and income-focused mandates often tilt toward high-yield or dividend-growth strategies.
- Inflation hedge. Corporate earnings tend to rise with prices over long horizons, giving equities a partial real-asset character.
- Diversification. Within a multi-asset portfolio, equities diversify against bonds, cash, and many alternatives. Across regions and sectors, equities diversify against one another.
Common mistakes
- Describing covered calls as "hedged" equity positions. Covered calls cap upside but do not limit downside beyond the premium cushion. They are yield enhancement strategies, not hedges. Candidates who call them hedged lose marks.
- Equating differentiation with skill. Departing sharply from the benchmark is necessary for potential outperformance but does not guarantee it. A manager who overlaps the benchmark by only 10% and has no skill just generates high tracking error with zero alpha.
- Assuming passive ownership means passive governance. Passive managers cannot sell a benchmark constituent, which makes voting and engagement their only levers for protecting value. Treating engagement as optional for index portfolios inverts the actual incentive.
Bottom line
- Passive replicates the benchmark at minimum tracking error and cost; active seeks alpha above the benchmark.
- Fundamental active applies deep insight across few positions; quantitative applies modest systematic edges across many; factor-based captures systematic premiums more cheaply than traditional active.
- RBSA infers style from returns while HBSA uses holdings; closet indexers pair benchmark-hugging portfolios with active-level fees.
- Enhanced indexing targets 20-80 bps alpha at 0.5-2.0% tracking error through systematic tilts.
Exam shortcut
When the vignette shows a benchmark-hugging portfolio with high fees, the answer is "closet indexer (replace with passive)." When it asks which active approach fits a given mandate, check: is the market efficient or inefficient? Large-cap efficient = quant or enhanced index. Small-cap inefficient = fundamental. When the vignette asks why an investor holds equities, map the answer to one of five roles. Retirees and income mandates emphasize dividend income.
The full lesson (about 4,412 words, 29 min read) adds 2 worked examples, all 11 common mistakes, a self-check, free in the app.
Learning objectives
- equity pm overview
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