Chapter 21: Portfolio management (1)

Question 1

Most common investment management styles and stock selection approaches

Answer 1

Investment management styles:

• growth
• value
• momentum
• contrarian
• rotational
• active
• passive

Stock selection approaches:

• top-down
• bottom-up

Question 2

Growth managers

Answer 2

Managers that specialise in managing portfolios of growth stocks - broadly stocks that are expected to experience rapid growth of earnings and hence share price

Question 3

5 growth factors

Answer 3

• Sales growth
• Earnings growth
• Forecast earnings growth
• Return on equity
• Earnings revision

Question 4

Value managers

Answer 4

Managers that specialise in managing portfolios of value stocks - stocks that appear good value in terms of certain accounting ratios, such as the forward earnings to price ratio or book value to price ratio

Question 5

5 value factors

Answer 5

• Book to price
• Dividend yield
• Earnings yield
• Cashflow yield
• Sales to price

Question 6

Long-term forecast earnings growth

Answer 6

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

Question 7

Short-term forecast earnings growth

Answer 7

(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

Question 8

Current internal growth rate

Answer 8

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

Question 9

Long-term historical earnings growth

Answer 9

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

Question 10

Long-term historical sales growth

Answer 10

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

Question 11

Book value to price

Answer 11

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

Question 12

Forward earnings to price

Answer 12

(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

Question 13

Dividend yield

Answer 13

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

Question 14

Momentum style

Answer 14

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

Question 15

Contrarian

Answer 15

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

Question 16

Rotational

Answer 16

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

Question 17

Top-down approach

Answer 17

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.

Question 18

Types of data important to consider within the strategic asset allocation

Answer 18

• 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

Question 19

Strategic investment decision

Answer 19

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

Question 20

Tactical investment decision

Answer 20

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

Question 21

Bottom-up approach

Answer 21

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

Question 22

Merits of the top-down approach

Answer 22

• 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

Question 23

Relative merits of the bottom-up approach

Answer 23

• 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

Question 24

Analysis used for asset allocations and individual stock selection

Answer 24

• fundamental analysis
• quantitative techniques (e.g. multifactor models)
• technical analysis - aims to predict future market movements by analysing past market data

Question 25

Passive managers

Answer 25

- 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

Question 26

Advantages of index tracking

Answer 26

- 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

Question 27

Disadvantages of index tracking

Answer 27

- 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

Question 28

Approaches to index tracking

Answer 28

- Full replication - Sampling (aka stratified sampling or partial replication) - Synthesizing the index using derivatives

Question 29

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

Answer 29

- 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

Question 30

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

Answer 30

- 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

Question 31

Active managers

Answer 31

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

Question 32

Multi-asset mandates

Answer 32

- 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

Question 33

Specialist mandates

Answer 33

- 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

Question 34

Relative merits of active management

Answer 34

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

Question 35

'Active over passive' or core/satellite management

Answer 35

- 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

Question 36

Bond indices

Answer 36

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 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

Question 37

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

Answer 37

Scope for active returns on bonds is limited. Active bond management is therefore more concerned with loss avoidance. Generated from changes in the bond's: - perceived creditworthiness - issue's terms, liquidity or other trading aspects - supply/demand imbalances - shape/level of the yield curve

Question 38

Switching

Answer 38

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

Question 39

Anomaly switching

Answer 39

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

Question 40

Techniques used to identify anomaly switches

Answer 40

- Yield differences and position relative to yield curve - Price ratios - Price models - Yield models

Question 41

Policy switching

Answer 41

A more risky approach that involves taking a view on future changes in the shape or level of the yield curve and moving between stocks with different volatilities. Example: If yield generally were expected to fall, the portfolio might be switched into longer-dated, more volatile stocks

Question 42

Techniques for identifying policy switches

Answer 42

- Volatility and duration - Reinvestment rates - Spot rates and forward rates

Question 43

Spot rates and forward rates | Techniques for identifying policy switches

Answer 43

- 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

Question 44

Alternatives to government bonds

Answer 44

- 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

Question 45

Difference between a credit crunch and a recession

Answer 45

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

Question 46

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

Answer 46

- immunisation - stochastic asset laibility modelling - VaR - multifactor modelling

Question 47

Use of repos in bond portfolios

Answer 47

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