Chapter 21: Portfolio management (1) Flashcards
Most common investment management styles and stock selection approaches
Investment management styles:
- growth
- value
- momentum
- contrarian
- rotational
- active
- passive
Stock selection approaches:
- top-down
- bottom-up
Growth managers
Managers that specialise in managing portfolios of growth stocks - broadly stocks that are expected to experience rapid growth of earnings and hence share price
5 growth factors
- Sales growth
- Earnings growth
- Forecast earnings growth
- Return on equity
- Earnings revision
Value managers
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
5 value factors
- Book to price
- Dividend yield
- Earnings yield
- Cashflow yield
- Sales to price
Long-term forecast earnings growth
(forecast EPS over next 3-4 years - previous years’ EPS)/(previous years’ EPS)
Short-term forecast earnings growth
(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
Current internal growth rate
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
Long-term historical earnings growth
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
Long-term historical sales growth
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
Book value to price
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
Forward earnings to price
(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
Dividend yield
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
Momentum style
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
Contrarian
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
Rotational
Moving between countries, sectors, industries or value and growth depending on which style is believed to be attractive at any point in time
Top-down approach
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.
Types of data important to consider within the strategic asset allocation
- 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
Strategic investment decision
Determines the long-term investment strategy of the fund that’s structured to best meet the investment objectives of the fund
Tactical investment decision
Short-term divergence from the long-term strategic asset allocation to make additional investment returns
Bottom-up approach
Starts by identifying the most attractive individual securities, irrespective of their geographical or sectoral spread
Merits of the top-down approach
- 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
Relative merits of the bottom-up approach
- 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
Analysis used for asset allocations and individual stock selection
- fundamental analysis
- quantitative techniques (e.g. multifactor models)
- technical analysis - aims to predict future market movements by analysing past market data
Passive managers
- 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
Advantages of index tracking
- 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
Disadvantages of index tracking
- 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
Approaches to index tracking
- Full replication
- Sampling (aka stratified sampling or partial replication)
- Synthesizing the index using derivatives
Main advantages of sampling and synthetic replication compared to full replication:
- 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
Main disadvantages of sampling and synthetic replication compared to full replication:
- 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
Active managers
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
Multi-asset mandates
- 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
Specialist mandates
- 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
Relative merits of active management
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
‘Active over passive’ or core/satellite management
- 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
Bond indices
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
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
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
Switching
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
Anomaly switching
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
Techniques used to identify anomaly switches
- Yield differences and position relative to yield curve
- Price ratios
- Price models
- Yield models
Policy switching
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
Techniques for identifying policy switches
- Volatility and duration
- Reinvestment rates
- Spot rates and forward rates
Spot rates and forward rates
Techniques for identifying policy switches
- 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
Alternatives to government bonds
- 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
Difference between a credit crunch and a recession
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
Where a bond portfolio is held to match specific liabilities, techniques that may be used to control bond portfolio risk include:
- immunisation
- stochastic asset laibility modelling
- VaR
- multifactor modelling
Use of repos in bond portfolios
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
