Ch 20 - Portfolio Management (1) Flashcards
The most common investment management styles and stock selection approaches are
Growth
Value
Momentum
Contrarian
Rotational
Top-down
Bottom-up
Passive
Active
When the market is confident and rising - growth stocks tend to
out-perform
When the market is falling - investors prefer
value stocks
Growth stocks
Expected to experience rapid growth of earnings, dividends and hence price
Typically have high price-to-book values
Tend to be more volatile than value stocks
5 growth factors
Sales growth
Earnings growth
Forecast earnings growth
Return on equity
Earnings revisions
Value stocks:
Appear good value in terms of certain accounting ratios, such as P/E ratio or book value per share
Seen to be the safer bet - due to more asset backing and higher cashflow
5 value factors
Book to price
Dividend yield
Earnings yield
Cashflow yield
Sales to price
Momentum
Purchasing (selling) those stocks which have recently risen (fallen) significantly in price on the belief that they will continue to rise (fall) owing to an upward (downward) shift in their demand curves
Contrarian
Doing just the opposite to what most other investors are doing in the market in the belief that investors tend to overreact to news
i.e. Short term markets tend to overreact to news
Aims to take advantage of excessive volatility in investment markets
Rotational
Moving between value and growth depending on which style is believed to be attractive at any particular point in time
This approach requires considerable skill in reading the market
Top-Down
Involves a structured decision-making process which starts by considering the asset allocation at the highest level (between asset classes).
Within each asset class an analysis is then made of how to distribute the available fund between different sectors
and finally the selection of the individual assets to purchase is made.
The top-down approach would usually follows these steps:
Decide upon the long-term benchmark or strategic asset allocation of assets between countries and between the main asset categories
Decide on the short-term tactical split of investments, again between countries and between the main asset categories based on a shorter-term view of global economic and investment issues
Given the chosen tactical asset allocation, decide upon the sector split within each asset category
Finally, within each sector decide which particular stocks are “best value”
Types of data that are important to consider for strategic asset allocation
Inflation (short-term and long-term)
Interest rates (same as above)
Economic growth
Currency movements
Equity and bond market yields
Investment objectives, attitude to risk and/or liabilities of the investor
Investment strategies by peer group
Structural shifts within the economy
Bottom-Up
Seeks to identify the best value individual investments, irrespective of their geographical or sectoral spread
Analyses Used to Aid Stock and Sector Selection:
Fundamental analysis
Quantitative techniques
Technical analysis
Relative merits of Top-down approach
More balanced, diversified portfolio
Argued that the biggest difference in portfolio performance come from differences in asset allocation rather than individual stock selection
Concentrates on the bigger picture
Relative merits of Bottom-up approach
Argue that the whole is always simply the sum of the parts - thus should concentrate on performance of individual assets
Less diversification
Less time spent on the bigger picture (strategic issues)
Approaches to passive management include:
Index tracking
Commercial matching
Immunisation (as a method of passively managing a bond fund)
Advantages of index/passive investments:
Lower dealing and research costs
Risk of under-performing the index in question - and indirectly also your competitors - is greatly reduced
Tracking a well-diversified index will ensure that the fund itself is well-diversified
Appropriate if the particular market is believed to be efficient
Disadvantages of index/passive investments:
Loss of upside potential
Implicit restriction to markets and asset classes where a suitable benchmark exists
Insufficient regard to the investor’s objectives and hence result in unacceptable levels of actuarial risk
A fully replicating index tracker is forced to buy new constituents of an index at inappropriate times (artificially high price as other index-tracking investors are also trying to buy the new share), and also be a forced seller of shares that drop out of an index
The available approaches to index tracking include:
Full replication
Sampling (also called stratified sampling or partial replication)
Synthesizing the index using derivatives
Main advantages of sampling and synthetic replication (compared to full replication):
Management costs ought to be lower
Dealing costs are likely to be lower
Main disadvantages of sampling and synthetic replication (compared to full replication):
Tracking error is likely to be greater
Research costs of deciding which shares or derivatives to hold may be higher
Active investment managers can be divided into two groups:
Multi-asset (balanced) mandates
Specialist mandates
Why actively manage? (Advantages)
Offers the prospect of large returns
Limitation of “peer group” risk
Disadvantages of active management:
Hard to successfully select active managers (past performance does not indicate future performance)
Timing the changes to the line-up of active managers is also very difficult
COSTS!
Anomaly Switching:
Involves moving between bonds with similar volatilities, thereby taking advantage of temporary price anomalies
It is a low-risk strategy
Techniques used to identify possible anomalies include:
Yield differences
Price ratios
Yield models
Price models
Are low-coupon bonds less or more volatile than high-coupon bonds
more
Fixed interest bond volatility
sensitivity of the bond price to a change in its gross redemption yield
5 step guide to a anomaly switch (based on yield difference here):
- Check that the yield is genuinely an anomaly
- Find the stock in our portfolio that has the closest volatility to the target stock
- Simultaneously sell (buy)our similar stock and buy (sell) the anomaly stock
- Wait for the anomaly to disappear (price reverts to normal)
- Switch back (reasons are):
Avoid a more fragmented portfolio
Fund managers like to “crystallise” their profits
Policy Switching:
Involves moving between bonds with different volatilities, to take advantage of predicted changes in the level and/or shape of the yield curve.
This changes the overall characteristics of the portfolio whereas anomaly switching does not
Is a riskier strategy
Policy switching may be aided by the analysis of:
Bond volatilities (and duration)
Reinvestment rates
Spot/forward rates
Alternatives to Government Bonds
CHICAS DAME - sexier than government bonds and thus managers may use these rather than policy and anomaly switching to try and deliver additional returns
Agency bonds
Investment grade corporate bonds
High yield bonds
Convertible bonds
Distressed debt
Event-linked bonds
Interest rate and inflation swaps
Credit default swaps
Mortgage backed securities
Asset backed securities
The additional return (/premium) that a non-government bond offers over a government bond is generally regarded as being made up of two elements:
Credit risk premium
Illiquidity risk premium
Where a bond portfolio is used to match specific liabilities, techniques that may be used to control bond portfolio risk include:
Immunisation
Stochastic ALM
VaR calculations
Multifactor modelling
