Chapter 21: Portfolio Management (1) Flashcards
o.i) principal pf management and risk control (active management styles)
List nine management styles
Active management styles
- Active
- Passive
- Growth
- Value
- Momentum
- Contrarian
- top-down
- bottom up
- rotational
- Strictly speaking, top-down and bottom-up are approaches to pf management
- Momentum, contrarian, rotational are all active management styles, whereas value and growth can be applied either actively or passively.
o.i) principal pf management and risk control (active management styles)
Describe the general characteristics of growth stocks, and list five factors that you might use to identify them.
Active management styles
Growth stocks
- Are stocks which are expected to growth faster than average compared to the market orr industry where they operate.
- Investors believe that the stocks will growth rapidly or will be subject to positive earnings revisions in the near future.
Five factors used to identify growth stocks:
1. long-term forecast earnings growth (Forecast EPS over next 3-5 years - previous year’s EPS)/previous year’s EPS
2. short-term forecast earnings growth (Forecast EPS over next year - previous year’s EPS)/previous year’s EPS
3. current internal growth rate (Max growth in sales and assets a company can achieve using only retained)
4. long-term historical earnings growth Average annual percentage growth in earnigs per share over the last five years.
high
5. long-term historical sales growth
Other features :
- higher P/E ratio
- high sales growth rate
- May not pay dividends (investors expecte high earnings in future)
- may not be making profit so sales used to measure profits
o.i) principal pf management and risk control (active management styles)
Describe the general characteristics of value stocks, and list three factors that you might use to identify them.
Active management styles
Value stocks
- Are stocks that seem underpriced by some form of fundamental analysis
- Investors believe that the market overreacts to bad or good news resulting in stock prices that do not correspond to the companies fundamentals.
Three factors used to identify value stocks:
1. low price to earnings ratio
2. forward earnings price ratio = (forecasted) ESP/SP
3. (high) dividend yield = DPS/SP
Other features:
1. (high) book to price = NAV PS/share price
2. Slow or stable growth (focus is on operational efficiency and stable profits)
3. Sales to price = turnover/market capital
4. Cashlow price = CF PS/SP
5. Out-of-Favour industries (sometime found in ‘out of fashion’ industries could be due to temporary economic downturns or shift in market sentiment)
(BEDS Company)
o.i) principal pf management and risk control (active management styles)
Outline conditions in which value stocks and growth stocks will outperform respectively.
Give reaons why we might analyse investment styles.
Active management styles
- Growth stocks will outperform when the market is confident and rising
- when the market is nervous and falling investors will prefer value stocks…
-…as they are seen as having more asset backing and CF and therefore a safer bet
-…they will at least be worth the accounting value of their assets
Why analyse investment styles
1. may be misleaing to compare performance of two equity fund managers if one has been following a growth strategy and the other a value strategy –> success of picking stocks not identifiable
2. Investors can select an appropriate manager for their fund
o.i) principal pf management and risk control (active management styles)
Explain brief waht is meant by of the following investment management syles:
- momentum
- contrarian
- rotational
Active management stylesActive management styles
Momentum
Momentum investors purchase (sell) stocks that have recently risen (fallen) in significantly in price on belief that they will continue to rise (fall) owing to an upward (downward) shift in their demand curves or due to behavioural finance aspects, thereby taking advantage of their momentum effects.
Contrarian
Contrarian investors do opposite to most investors in belief that investors, and hence share prices, tend to overreact to news.
Rotation
Rotational investors move between countries, sectors, industries, value and growth stocks depending on which is believed to be attractive at any particular point in time, i.e., growth stocks when the market is rising, value stocks when the market is falling.
o.i) principal pf management and risk
Outline the top-down and bottom-up approaches.
Equity pf management techniques
Top-down approach
- First considers asset allocation between different asset classes.
- And then if considers split the fund between different sectors (e.g., different industries of equities) of each asset class.
- lastly individual assets will be seleled within each sector
- provides better control of risk, as it ensures diversifed pf and matching of liabilities
- Focuses more on asset allocation choice, which has greatest overall impact on investment performance…
-…biggest differences in performance comes from differences in asset allocation rather than individual stock selection.
Bottom-up approach
- selects the most attractive individual securities, irrespective of geographical or sectoral spread.
- Focuses on choice of individual securities, whose performance actually dictates that of the pf as a whole…
-…stock pickers argue allocation between sectors ignore the fact that peformance starts with the performance of the individual assets held.
o.i) principal pf management and risk
List the data required/considered for strategic allocation in the top-down approach.
Equity pf management techniques
- Economic growth
- ST and LT inflation
- ST and LT interest rates
- structural shifts within economy
- currency movements
- bond and equity market yields
- investment objs, attitude to risk and/or liabilities of the investor
- investment strategies pursued by investor’s peer group
o.i) principal pf management and risk
Distinguish between active and passive investment management and describe a popular management style.
Equity pf management techniques
Active management
- Seeks to actively identify mispriced assets which can the be traded to generate large returns (in excess of fees paid) e.g., via stock selection, sector selection, switching, market timing
- requires an efficient market
Passive management
- Involves selecting securities that meet the investor’s objective and/or make up a benchmark pf.
- the securties are then held passively and changed only when there is a change in objectives and/or benchmark pf.
- Appropriate when the market is efficient and the outpeformance by managment does not justify the increased costs.
Popular managment style
- Manage the majority of the fund (‘core pf’) on a passive basis and hire specialist managements to increase returns with the remainder of the fund via the short-term
o.i) principal pf management and risk
Define the following types of analysis (used to aid stock and sector selection):
- fundamental analysis
- quantitative analysis
- technical analysis.
Equity pf management techniques
Fundamental analysis
The analysis of a copmany’s share value and future profits and dividends based on accounting and economic information.
Quantitative analysis
The use of modern mathematical techniques used to aid in stock and sector selection, e., asset pricing models.
Technical analysis
Analysis of historical market data on prices, yields and/trading volumes to predict future market movements.
NB: these can all be used to activelu identify mispriced securities. Quantitiative analysis is used for index tracking via sampling
o.i) principal pf management and risk
List three ways of tracking an index.
Equity pf management techniques
1.Full replication - holding all securities in the index in proportion to index weighting
- requires a large fund
- investment fund closely mirrors that of the index reducing tracking error (at least before tax and expenses)
2.Partial replication or sampling
- hold a representative sample of securities, which behave in the same way as the index.
3.Synthetically replicating index using derivatives (by using Total return swaps and a basket of options)
o.i) principal pf management and risk
Outline four potential advantages and five potential disadvantages of index tracking compared to active pf management.
Equity pf (passive) management techniques
Advantages:
1. Risk of underpeforming index (and indirectly competitiors) reduced.
2. Lower transactional and research costs
3. if investing or following a diverisfied index, then pf will be diversified, reducing specific risk and volatilty.
4. appropriate when market is believed to be efficient
Disadvantages:
1. Chance of over-performing the index (and indirectly competitiors) reduced.
2. Full replication requireds buying/selling when index constituents changed and fragmented pf (resulting in tracking error and dealing costs)
3. Resulting strategy may pay little regard to the investor’s objectives (resulting in unacceptable levels of actuarial risk)
4. May prove to be difficult to find an appropriate index.
5. May prove difficult to track accurately the index chosen.
o.i) principal pf management and risk
State:
- the two conditions required in order for active investment management to be appropriate
- noe potential advantage adn two difficulties with active management
Equity pf (active) management techniques
Two conditions for active management
1. Market needs to be inefficient
2. possible to identify skilled investment managers who can exploit market inefficiencies.
Advantages
1. Potentially offers possibility of higher returns
Difficulties
1. Selecting out-performing investment managers
2. Timing changes to line-up of active managers.
o.i) principal pf management and risk
Outline the two types of mandates under which active investment managers typicall operate.
Equity pf (active) management techniques
-
Specilist mandate - specialist in a particular asset category and employed to manage funds invested in that particular category only.
- Each specialist manager will attempt to out-perform the relevant benchmark.
- Trustees can choose to invest fund directly in a chosen asset category via specialist funds. -
Multi-asset or Balanced or mandate - Manage funds invested across a variety of different asset categories and will make decisions on:
- weightings across asset categories
- and stocks within each asset category
o.i) principal pf management and risk
Describe the core-satellite approach to pf management.
Equity pf (active vs passive) management techniques
- Majority of the fund (‘core’ pf) managed on a passive, low-cost basis.
- Speciliast ‘satellite’, active managers emplyed to provide increased returns (in excess of fees) in respect of the balance of the fund.
- Number of competing managers may be employed in respect of the specialist asset classes.
- Specialist managers may include hedge fund and private equity specialist.
o.i) principal pf management and risk
Explain the difference between passive management of bonds and equities.
Bond pf management techniques
- Bond market trading less transparent (OTC) –> accurate and objective determination of index value difficult
- Concept of ‘market cap’ is less understood in the bond market
- issues may have several similar, possibly overlapping bonds outstanding at one time
- using total value of outstanding bonds would mean the index overweights the most indebted issues which may be undesirable
Passive management used often in transparent market segments where trading is transparent, such gov bonds.
Alternatively index providers will design rules for inclusion in the index to avoid double exposure to a particular issuer.
Bond pf (passive) management techniques
