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 :
- Earnings revisions
- Return on equity
- 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.
Value stocks may include stocks of companies:
- which are out of favour due to the economic cycle,
- or company fundamentals,
- or may even have become oversold;
- at mature stages,
- or in in relatively stable industries.
A value stock will have a higher than average ratio (i.e. appear relatively cheap) for either all or for the majority of the following ratios
Three factors used to identify value stocks:
- (High) book value to price = NAV PS/share price
- forward earnings to price ratio = (forecasted) ESP/SP
- (high) dividend yield = DPS/SP
Other features:
- Slow or stable growth (focus is on operational efficiency and stable profits)
- Sales to price = turnover/market capital
- Cashflow to price = CF PS/SP
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. Aims to take advantage of excessive volatility in investment market.
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.
Outline the top-down and bottom-up approaches.
Top-down approach
- Give consideration to macroeconomic expectations
- Consider asset allocation between different asset classes.
- Split the fund between different sectors (e.g., different industries of equities) of each asset class.
- Lastly, individual securities will be selected within each sector
Bottom-up approach
- Selects the most attractive individual securities, irrespective of geographical or sectoral spread.
- Perform valuation techniques (undertaken FA) to identify these stocks and add them to the portfolio
- 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 performance starts with the performance of the individual assets held.
o.i) principal pf management and risk
Outline the relative merits of the Top-down approach and Bottom-up approach
Equity pf management techniques
Top-down approach
+Better control of risk: by considering spread across countries and asset allocation etc, ensures diversified pf, reduces specific risk and also enables better matching of liabilities
+Focus on asset allocation choice: which has greatest overall impact on investment performance…
- …this is if the view is that stocks within a sector are correlated and that the biggest difference in performance comes from asset allocation, industry or country allocation
+Less time consuming
-limits performance in sectors chosen even if asset class is sound
-May over look undervalued stocks
-requires strong understanding of macroeconomic factors and their impact on investment
Bottom-up approach
+ Outperformance if can correctly identify undervalued securities
+ Focus on fundamentals: emphasis depth of company analysis leading to deeper understanding of company
+ Allows greater flexibility to adjust pf based on individual stock opportunities regardless of market trends
+ reduces dependence on accurately predicting macroeconomic conditions, which can be challenging
-requires greater expertise if securities are across countries/industry/asset classes
-requires time and effort to research individual companies thoroughly
-high risk
-potential bias as easy to emotion attach to certain companies
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. with regard to:
- …market weights in each of the main sectors
- …size of companies
- …exposure to overseas earnings
3.Synthetically replicating index using cash and derivatives (by using Total return swaps and a basket of options) and creating a synthetic fund
In either case, a multifactor model might be used to help construct a suitable pf so to replicate as closely as possible the characteristics of the index
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:
- Risk of underpeforming index (and indirectly competitiors) reduced.
- Lower transactional and research costs
- if investing or following a diverisfied index, then pf will be diversified, reducing specific risk and volatilty.
- appropriate when market is believed to be efficient
Disadvantages:
- Chance of over-performing the index (and indirectly competitiors) reduced.
- Full replication requires buying/selling when index constituents changed
- Trading Costs: Frequent buying and selling incur brokerage fees and other transaction costs, which eat into returns.
- Market Impact: Simultaneous buying or selling by multiple index trackers can artificially inflate or deflate prices, leading to less efficient execution.
- Tracking Error: The portfolio might deviate slightly from the index due to these adjustments, resulting in tracking error.
- Resulting strategy may pay little regard to the investor’s objectives (resulting in unacceptable levels of actuarial risk)
- May prove to be difficult to find an appropriate index
- May prove difficult to track accurately the index chosen (transactional costs, timing of trade, differences in dividend policies)
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 superior returns
Difficulties
1. Selecting out-performing investment managers
2. Timing changes to line-up of active managers.
3. risk of underperformance of benchmark or peer group if pf selected is deficient
4. Good past performance not guarantee of future out-performance (investment conditions continually change)
5. Requires manager to have superior data, analysis or execution compared to other participants. Achieving this is very difficult particularly in efficient markets
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
- Involves active management focused on a specific asset category.
- employed to manage funds invested in that particular category only.
- Each specialist manager will attempt to out-perform the relevant benchmark (e.g., ALSI40).
- Trustees can choose to invest fund directly in a chosen asset category via specialist funds.
- Rationale: Belief that managers possess specialized skills in specific asset classes, not necessarily in all or asset allocation decision itself.
- Extends to different investment styles/philosophies (e.g., growth-style equity funds). -
Multi-asset or Balanced or mandate
- Involves active management of funds across various asset categories (equities, bonds, property, overseas).
- Manager decides on asset category weightings and specific stock types within each category (e.g., value or growth)
- the manager’s goal is to outperform similar funds with comparable mandates, constraints, and tax treatments.
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.
