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F105 Finance & Investment > Chapter 21: Portfolio management (1) > Flashcards

Chapter 21: Portfolio management (1) Flashcards

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1
Q

Most common investment management styles and stock selection approaches

A

Investment management styles:

  • growth
  • value
  • momentum
  • contrarian
  • rational
  • active
  • passive

Stock selection approaches:

  • top-down
  • bottom-up
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2
Q

Growth stocks

A
  • Stocks from companies that are expected to grow faster than average when compared to the market or industry
  • Trading on higher than average multiples (price is relatively expensive)
  • Growth investors believe these stocks will grow more rapidly or subject to positive earnings revision in near term
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3
Q

5 growth factors

A
  • Sales growth
  • Earnings growth
  • Forecast earnings growth
  • Return on equity
  • Earnings revision
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4
Q

Value stocks

A
  • stocks that the investor believes are underpriced by some form of fundamental analysis
  • historically had a low price-to-book ratio
  • seen to have more asset backing and higher cashflows and therefore will be a safer bet
  • value investors believe market overreacts to good and bad news, resulting in stock movements that don’t correspond to the company’s fundamentals
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5
Q

5 value factors

A
  • Book to price
  • Dividend yield
  • Earnings yield
  • Cashflow yield
  • Sales to price
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6
Q

When do investors prefer growth stocks?

A

When the market is confident and rising

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7
Q

When do investors prefer value stocks?

A

When the market is falling

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8
Q

MSCI Growth indices

A

Consider 5 variables when categorising index members:

  • long-term forecast earnings growth
  • short-term forecast earnings growth
  • current internal growth rate
  • long-term historical earnings growth
  • long-term historical sales growth
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9
Q

MSCI Value indices

A

Consider 3 variables when categorising index members:

  • book value to price
  • forward earnings to price
  • dividend yield
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10
Q

Long-term forecast earnings growth

A

(forecast EPS over next 3-4 years - previous years’ EPS)/(previous years’ EPS)

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11
Q

Short-term forecast earnings growth

A

(forecast EPS over next year - previous years’ EPS)/(previous years’ EPS)

  • Stocks in the growth markets would be associated with high short and long terms forecast earnings growth
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12
Q

Current internal growth rate

A

Maximum rate of growth in sales and assets a company can achieve using only retained earnings. Stocks in growth markets would be associated with a high internal growth rate

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13
Q

Long-term historical earnings growth

A

The average annual percentage growth in EPS over the last 5 years. Stocks in growth markets would be associated with high long-term historical earnings growth

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14
Q

Long-term historical sales growth

A

The average annual growth rate in turnover over the last 5 years. Stocks that claim to be in growth markets should be able to demonstrate high historical growth in turnover and earnings

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15
Q

Book value to price

A

NAV per share / market price per share

Value stocks would be expected to have high book to price ratios - indeed some stocks actually have market caps below their accounting values and hence have ratios more than one

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16
Q

Forward earnings to price

A

(estimated EPS) / (market price per share) x 100%

Would expect value stocks to have high forward earnings to price because we would not expect a value stock to have a high price relative to its current earnings or dividends

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17
Q

Dividend yield

A

dividend per share / market price per share x 100%

Value stock would not be expected to have a high price relative to its current earnings or dividends. Therefore we would expect the dividend yield of such a stock to be high

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18
Q

Momentum style

A

Purchasing (selling) those stocks which have recently risen (fallen) significantly in price on belief that they’ll continue to rise (fall) owning an upward (downward) shift in their demand curves or due to behavioural finance aspects

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19
Q

Contrarian

A

Doing opposite to what most other investors are doing in market – especially at market ‘extremes’ – in the belief that investors tend to overreact to news

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20
Q

Rational

A

Moving between countries, sectors, industries or value and growth depending on which style is believed to be attractive at any point in time

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21
Q

Top-down approach

A

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.

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22
Q

Types of data important to consider within the strategic asset allocation

A
  • economic growth
  • short-term and long-term inflation
  • short-term and long-term interest rates
  • structural shifts within the economy
  • currency movements
  • bond and equity market yields
  • investment objectives, attitude to risk and/or liabilities of the investor
  • investment strategies pursued by the investor’s peer group
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23
Q

Strategic investment decision

A

Determines the long-term investment strategy of the fund that’s structured to best meet the investment objectives of the fund

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24
Q

Tactical investment decision

A

Short-term divergence from the long-term strategic asset allocation to make additional investment returns

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25
Q

Steps involved in the top-down approach

A
  1. Decide upon the long-term benchmark or strategic asset allocation of assets between countries and between the main asset categories
  2. 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
  3. Given the chosen tactical asset allocation, decide upon the sector split within each asset category
  4. Finally, within each sector decide which particular stocks are “best value”
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26
Q

Bottom-up approach

A

Starts by identifying the most attractive individual securities, irrespective of their geographical or sectoral spread

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27
Q

Merits of the top-down approach

A
  • Argued that the biggest difference in portfolio performance come from differences in asset allocation rather than individual stock selection
  • Concentration on the bigger picture
  • More balance diversified portfolio
28
Q

Relative merits of the bottom-up approach

A
  • starting with asset allocation between sectors ignores that all investment performance starts with performance of individual assets held & analysis should be concentrated here
  • more difficult to attain good diversification
  • less time spent on the bigger picture = strategic issues
29
Q

Analysis used for asset allocations and individual stock selection

A
  • fundamental analysis
  • quantitative techniques
  • technical analysis
30
Q

Approaches to passive management

A
  • Index tracking
  • Tracking competitors
  • Immunisation as a method of passively managing a bond fund
31
Q

Passive managers

A
  • Typically index trackers
  • Manage assets without attempting to generate outperformance from making superior investment decisions
  • Objective to to closely track the performance of a specified index
  • May be appropriate f particular market is efficient
32
Q

Advantages of index tracking

A
  • Risk of underperforming index & competitors reduced
  • Lower portfolio management costs
  • Appropriate if market is believed to be efficient
  • Well-diversified index = fund itself is well diversified
33
Q

Disadvantages of index tracking

A
  • Risk of overperforming index & competitors reduced
  • Could be forced to buy/sell new constituents at inappropriate times = price artificially high/low
  • Resulting strategy may pay insufficient regard to investors’ objectives & result in unacceptable actuarial risk
  • Difficult to find appropriate index/track chosen index
34
Q

Approaches to index tracking

A
  • Full replication
  • Sampling (aka stratified sampling or partial replication)
  • Synthesizing the index using derivatives
35
Q

Main advantages of sampling and synthetic replication compared to full replication:

A
  • avoiding a more fragmented portfolio means management costs should be lower
  • dealing costs likely to be lower as the fund isn’t committed to trading whenever an index constituent changes
36
Q

Main disadvantages of sampling and synthetic replication compared to full replication:

A
  • tracking error is likely greater - though expenses mean that exact replication of index performance will in any case never be possible
  • research costs of deciding exactly which shares or derivatives to hold may be higher
37
Q

Active managers

A

Involves actively seeking out under-priced or over-priced assets which can be traded in an attempt to enhance investment returns via short term deviations from the benchmark strategic position

38
Q

Groups of active managers

A
  • Multi-asset (balanced) mandates
  • Specialist mandates
39
Q

Multi-asset mandates

A
  • Invest across a variety of different asset categories
  • take decisions on the weightings in each asset category and decisions on the type of stocks purchased in each category
  • try to outperform managers that operate funds with similar mandates, constraints and tax treatments
40
Q

Specialist mandates

A
  • Each investment manager specialises in particular asset category and is employed to manage the funds invested in that asset category only
  • Each manager attempts to outperform the relevant benchmark
  • Appropriate where fund trustees want to make own decisions on amount to be invested in each of the various asset categories and possibly the type of investment to make in each category
41
Q

Relative merits of active management

A

Advantage

  • Offers the prospect of superior returns
  • Essential for a proper functioning market as without it, there would be no relative adjustment of prices in response to news or company fundamentals

Disadvantage

  • Risk of underperformance against the benchmark or a peer group if the portfolio selected is deficient
  • Difficult to successfully select active managers (past performance isn’t indicative of future performance)
  • Management and admin costs
  • Timing the changes to the line-up of active managers is difficult
42
Q

‘Active over passive’ or core/satellite management

A
  • A portfolio where the majority of the fund (the ‘core portfolio) is managed on a passive, low-cost basis
  • Specialist satelite managers are then employed to seek increase performance (in excess of fees paid) in respect of the remainder of the fund
  • May extend to employing a number of competing managers across specialist asset classes, if size of overall fund warrents this
  • Satelite managers could include hedge fund and private equity specialists
43
Q

Advantages of employing asset class specialists as satelite managers

A
  • possibility of higher investment returns
  • increased diversification, with a consequent reduction in market risk
44
Q

Passive bond management

A

Comparable in certain aspects to passive equity management, bond potfolio can be managed in line with a bond market index.

Important differences compared with equity indices:

  • bond market trading is often less transparent which make accurate and objective determination of an index value more difficult
  • concept of market cap is less well understood in the bond market:
  • -> issuers may have similar, often overlapping bonds outstanding at any one time
  • -> using the total value of outstanding bonds would mean the index overweights the most indebted issuers which may be undesirable

Often used in market segments where trading is transparent (gov bonds)

Index providers may design rules for index inclusion so as to avoid duplication of exposure to individual issuers, e.g. by including only the largest or most liquid bond issued and ignoring the remainder

45
Q

Distribution of returns on a bond

A

The return on a bond will have a pronounced negative skew because the are suceptable to negative shocks.

E.g. substantially downgraded or suffering a partial or complete default.

46
Q

Circumstances in which an individual bond will outperform its peers and provide a higher return than its yield-to-maturity at the point of purchase

A
  • Issuers perceived creditworthiness being upgraded or corrected relative to other issuers which may result in an adjustment on the bond’s price (downgrades may be equally profitable for investors with the short position)
  • Issuer’s terms, liquidity or other trading aspects improving relative to other bonds, resulting in excess demand for the security
  • Current supply/demand imbalance causing the bond to trade away from its fair value

Bond prices are affected by change in the shape or level of the yield curve which creates opportunities for outperformance by investors enetering and exiting the market tactically, or by altering their portfolio duration to profit from the movement in the curve.

Having a lower than average credit rating than the benchmark or peer group (resulting in higher yield which hopefully not negated by higher defaults), or seeking yield inhancement by identifying cheapest bond from group of similar bonds

47
Q

How is the outperformance of a specific bond bounded?

A
  • credit ratings can only take the bond to the highest credit rating
  • yield curve movements are limited to ‘realistic’ interest rate levels (e.g. negatie interest rates - while in existence - are uncommon)
48
Q

Switching

A

Selling one stock and buying another, in the hope of achieving a higher return. Returns are only enhanced in this way in markets where there’s a variety of highly marketable bonds available.

Classified into:

  • anomaly switching
  • policy switching
49
Q

Anomaly switching

A

Involves moving between stocks with similar volatility, thereby taking advantage of temporary anomalies in price.

  • Relatively low risk strategy, but widespread use of computer-based analysis limits opportunities for significant anomalies between similar bonds
50
Q

Why would a fund manager switch back to the original stock after performing an anomaly switch?

A
  • Like to crystallise their profits from switching activities as it’s much easier to show a client that some profit has been generated
  • If didn’t switch back, the portfolio could end up being very fragmented. Switching back to a few core holdings is better
51
Q

Techniques used to identify anomaly switches

A
  • Yield differences and position relative to yield curve
  • Price ratios
  • Price models
  • Yield models
52
Q

Yield differences and position on the yield curve

Technique for identifying anomaly switches

A

Yield differences are used to identify individual bonds which seem cheap or dear in reltion to other bonds.

  • High coupon bonds are likely to have higher yields than low coupons, a high gross yield does not in itself indicate that a bond is cheap
  • Investor must examine whether yield difference is greater or less than it has been in the past
  • Problem with evaluation of individual bonds in relation to a fitted yield curve has been the stability of the method used to fit the curve
  • Now more usual to review a computer-generated history of yield spreads between actual pairs of bonds
53
Q

Price ratios

Techinique for identifying anomaly switches

A

Ideally a switch under consideration is attractive in relation to both yield and price histories

Practical problem in using price ratios: do not allow for the fact that two bonds may have different coupons; they will have different prices but will both be redeemed at par. Ratio of prices will thus display a trend.

  • History of price ratios may be adjusted by this trend to produce what are often known as ‘stabilised’ price ratios
54
Q

Price models

Techniques for identifying anomaly switches

A

Analysts have devised price models which try to assess the ‘correct price’ for a stock, given the key variables. Stock’s price is considered anomalous if actual price differs from the price derived from the model

55
Q

Yield models

Techniques for identifying anomaly switches

A

Rather than compare bond’s yield with a redemption yield curve it can be compared with one of the alternatives such as a yield surface or par yield curve

56
Q

Policy switching

A

A more risky approach that involves taking a view on future changes in the shape or level of the yield curve and moving into bonds with quite different terms to maturity and/or coupons.

Example: If yield generally were expected to fall, the portfolio might be switched into longer-dated, more volatile stocks

57
Q

Techniques for identifying policy switches

A
  • Volatility and duration
  • Reinvestment rates
  • Spot rates and forward rates
58
Q

Voltility and duration

Techniques for identifying policy switches

A

Switches based on changes in the level of the yield curve

  • calculations of volatility/duration together with forecasts for changes in the yield at different point along the yield curve can be used to estimate percentage changes in value and so to determine the area of the market that’ll give the best returns, if forecasts prove accurate

Switches based on pure changes in the yield curve

  • The shape of the yield curve (normal, steep, flat, or inverted) influences the expected total return of a bond. Switch might occur to capture a more favorable risk-return profile.
  • Example: If the yield curve is flat or inverted, shorter maturities might be preferred to avoid the additional risk of long-term bonds without sufficient yield compensation.
59
Q

Reinvestment rates

Techniques for identifying policy switches

A
  • Comparing two bonds, one with a long term to maturity and the other with a short term to maturity.
  • Knowing their yields to maturity, its possible to compute a rate at which the proceeds from the short term bond would have to be reinvested, up to maturity of the long-term bond, to match its total return.
  • If reinvestment rate is particularly high, it may be considered unattainable, leading to the conclusion that the long term bond is better value

Can select representative bonds at various points along maturity range and compute reinvestment rates between each bond to the next - help identify areas which seem cheap/dear in relation to neighboring areas

60
Q

Spot rates and forward rates

Techniques for identifying policy switches

A
  • Similar techniques to using reinvestment rates is to derive forward and/or spot rates from the yield curve
  • This may reveal oddities in term structure of interest rates which give rise to a policy switching opportunity
61
Q

Alternatives to government bonds

A
  • Agency bonds – issued by US government sponsored agencies
  • Investment grade corporate bonds
  • High yield (“junk”) corporate bonds
  • Convertible bonds – bonds that can be converted to equities at later date
  • Distressed bonds – securities of companies/government entities that are either in default, under bankruptcy protection/in distress and heading towards bankruptcy
  • Event-linked bonds – bonds with coupons and redemption payments conditional on non-occurrence of defined event (e.g. earthquake)
  • Interest rate and inflation swaps
  • Credit default swaps (CDS)
  • Mortgage-backed securities (MBS)
  • Asset-backed securities (ABS)
  • Green bonds – funding projects with environmental and/or climate benefits
62
Q

The additional return or yield premium that a non-government bond offers over a government bond is usually made up of:

A
  • An additional yield to compensate for the risk that the bond issuer will default (and thus fail to meet their obligations) - credit risk premium
  • an illiquidity premium to reflect the typically weaker marketability of non-government bonds to government bonds
  • some additional structural factors, especially with swaps which are also factored into the price

Investors purchase bonds where they believe the yield pick-up is greater than the additional risk of holding the bond

63
Q

Difference between a credit crunch and a recession

A

A recession is usually take as two (or more) successive quarters of negative economic growth.

A credit crunch can be seperate to, or part of a recession. It is where there is a sudden and severe reduction in the availability of credit or loans from banks and other financial institutions

64
Q

Where a bond portfolio is held to match specific liabilities, techniques that may be used to control bond portfolio risk include:

A
  • immunisation
  • stochastic asset laibility modelling
  • VaR
  • multifactor modelling
65
Q

Use of repos in bond portfolios

A

Increased demand for cash from investors to fund initial and variation margin payments due to move toward central clearing for OTC derivatives.

  • Investors who don’t have large allocation to cash use bond repos and securities lending to generate the cash collateral required

F105 Finance & Investment (21 decks)

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