Security Analysis and Portfolio Management Flashcards
Functions of Portfolio Management.
Types of Client.
Functions:
- Portfolio structuring and analysis
- Adjustment
Performance measurement
Clients:
- Institutional Investor (Banks, investment companies…)
- Individual Investor (High net wealth)
Why passive portfolio management?
For investors willing to accept market returns. Works best in bull markets
What is active portfolio management?
Attempts to meet investment objectives through asset allocation investing and strategies that fit the portfolio owner.
Mixed active/passive portfolio management
i. Security selection style management: certain asset class.
ii. Asset allocation style: mix of assets for optimal risk-return balance.
iii. core-satellite management: minimise cost and volatility while aiming to outperform broad stock market. satellites added to passive portfolio in form of active investments
iv. Contingent immunisation: switch to defensive strategy if returns drop below predetermined point
Continuation strategy
Buying stocks doing well in short period and sell those with poor momentum. Bad in 2000 dot com bubble
Contrarian strategies
Buy bargains.Tries to do opposite of what the ‘herd’ is doing using behaviour science studies measuring technical indicators like consumer sentiment.
Indexation
Technique to adjust income payments by means of a price index, in order to maintain purchasing power
Quantitative investment management
i. AI/Machine learning strategies - algorithms
ii. Factor-investing strategies
iii. Value based quants
Factors Affecting investor objectives
- consumption preference - investment horizon
- Taxation - dividends and capital gains
- Inflation
- Risk tolerance
- Age
Equity passive strategies
Buy and Hold
Index matching - expensive, what do do with income payments.
Might chose to ‘go active’ if clients preferences change, or market risk and return changes
Equity Active strategies
- Security selection - Positive alpha. Higher ERB
- Market timing - buy at ideal moment. Controversial and expensive
- Portfolio Adjustment
Market timing methods
- Trading shares: Increase beta if expecting market to go up. (could lead to bad diversification) Difficult
- Borrowing/Lending and trading shares: Overall beta uses borrowing/lending plus investment in risk (βo = wA(βA) ). reduce beta, invest at Rf more.
- Use futures
Hedging against price falls (equity)
- Sell stock index futures on shares
- Buy stock index put options on shares
- Sell stock index call options on shares
- Synthetic Short future (buy puts and sell calls)
Limitations of hedging with stock index futures - 6
Value locked in at price of futures contract
Only market risk is hedged
Hedge not exact unless basis = 0
Indivisibility of futures contracts
Effect of margin payments
Basis risk
Debt passive management strategies
- Indexation
- Immunisation
Indexation for debt portfolio
Match composition of well diversified bond index.
Problems with bond indexation
Cost.
Thin trading
Income payments
Bond immunisation strategies
Insulate portfolio from interest rate risk.
- classical immunisation= same duration as clients liabilities
- Cash flow matching= match cash flows of portfolio with clients liabilities
Bond immunisation
Each liability is matched with bond with same duration
Eg want 5 years
Focused: Bonds with duration close to liability like 4 and 6
Barbell: Durations far from liability like 1 and 10
Advantages and disadvantages of cash flow matching
A. No need for duration matching
A. no need to rebalance
D. Finding sufficient bonds with appropriate maturities and coupons
What is horizon matching
Combines cash flow matching and immunisation. Near liabilities are cash flow matched and remainder are immunised
Active Bond strategies
Bond picking
Market timing
Portfolio adjustment
Bond picking
High weighting in high alpha bonds.
What is alpha?
Difference between actual return and required return. Remember bonds have different equation (using duration) but both are given
Bond market timing and how
Adjusts relative duration of portfolio over time.
1. Trading bonds= increase D buy buying long D and sell short D
2. Use bond futures= Increase D buy bond futures
Portfolio Adjustment
Purchase and sale of bonds and is known as bond switching
1. Anomaly switching - buy underpriced, sell over priced. take advantage of mispricing
2. Policy switches - changes to client expectations or requirements
Hedge against fall in bond price (due to rise in interest rates
- Sell bond futures
- Buy Put options
- Sell call options
- Synthetic future (Buy puts, Sell calls)
How does buying 50 put contracts hedge against bond prices falling?
Protects against fall in value but preserves the gains from increase in value at the cost of the premium
Objectives of portfolio performance measurement (4)
Assess if objectives of investor have been achieved
Comparison with other portfolios
Assess competency/honesty of managers
Evaluation of investment strategy
Sharpe Ratio
Excess return to volatility. Based on total risk
M squared
Measures return investor would have earned if portfolio was altered by lending or borrowing to match STD of market portfolio
For the same amount of risk as the market, how much more return you get.
Considering total risk.
Treynor measure
Excess return to beta, based on systematic risk, therefore considered more appropriate.
per unit beta, what is the return.
Jensen differential performance index
Rank portfolios based on alpha. Want alpha more than 1.
Excess return over CAPM. Based on specific time period
Information ratio (Appraisal ratio)
Measures amount of abnormal return per unit of non-systematic risk
Excess return to relative duration
Bond version of Treynor measure
Style analysis
Tools for determining investment styles of portfolios and measuring their performance given their style (Style is based on parameters such as risk preference, growth vs. value orientation (Duration for bonds, and/or market cap)
Holdings based style analysis
Analysis of securities held in portfolio
A. Enables analysts to design benchmarks that better fit styles by fund managers
D. Data Problems and costs
Returns based style analysis
identify holdings by identifying what combination of passive holdings across different asset classes would have replicated most closely the performance of the portfolio over a specific time period.
Bond Flat yield
Coupon divided by market price.
Poor measure of return as it ignores maturity value
Bond yield to maturity
Discount rate which equates to PV of future cash flows on its current market price
Return if held to maturity
Limitations of Yield to maturity
- Only provides measure of holding period return if held to maturity and if all coupon payments are reinvested at redemption yield .
- Ignores compounding when converting from semi-annual to annual rate. Convert to true annual effective yield (re) = (1+r/2)^2-1
Holding period yield
Average yield earned over period bond is held.
Affected by price at which bond is bought and sold and reinvestment rate
Factors affecting yields (6)
- Time to maturity
- Default risk
- Coupon rate
- Marketability
- Tax status
- Other eg ‘option’ features
Unbiased Expectations Hypothesis
Long term interest rate is geometric average of future short term rates. Forward rates are unbiased predictors of future spot rates
Liquidity Premium Hypothesis
Lenders prefer to lend short - Borrowers prefer to borrow long, so investors require a liquidity premium. The premium is the difference between forward rate derived from yield curve and expected future spot rate.
- Forward rates are overestimates of future spot rates
- Evidence is most supportive of this
Inflation Premium Hypothesis
Longer maturities pay a premium to compensate for uncertainty about future inflation rates.
- Forward rates are over estimates of future spot rates
Market Segmentation Hypothesis
Separate markets for long, medium and short term bonds with no spillovers between markets. Yield curve depends on demand and supply in each segment.
Preferred Habitat Hypothesis
Moderate version of market segmentation allowing for investors to be tempted out of their preferred habitat if offered a sufficiently great premium
Bond risks (6)
- Default risk
- Event risk
- Inflation risk
- interest rate risk
- Reinvestment risk
- Price risk
Default Risk
Risk borrower will default of some or all coupon payments/principal due.
- measure Promised yield vs expected yield
Interest rate risk
Reinvestment risk: risk that reinvestment rates will differ from those expected
Price risk: Changes in the value of a bond due to changes in interest rates
Factors affecting interest rate risk
- Maturity
- IRR rises with maturity. Less than proportional to bond maturity - Coupon
- IRR inversely related to coupon - YTM
- IRR inversely related to YTM
Duration
Measure of interest rate risk.
Weighted average maturity of a bond using relative discounted cash flows in each period as the weights.
The length of time it takes bond to repay investor
Factors affecting duration
Maturity
- Duration equal or less than maturity
- increases as maturity rises
- increases at decreasing rate
Coupon
- Inversely related
Yield
- Inversely related
If we have two bonds that are identical with the exception on their coupon rates, which bond will have a lower duration?
The bond with higher coupon rate will pay back its original costs faster so lower duration.
Modified duration
Used to estimate bond price changes in response to interest rate changes
Convexity
Degree to which the duration of a bond changes as interest rates change, capturing the curvature in the price-yield relationship.
Characteristics of equities
Nominal value
Voting rights
No maturity
Variable return
Constant dividend growth model
Po = D0(1 + g)/(r - g) = D1/(r - g)
Three stages of super growth firms
- Growth stage
- Transition stage
- Maturity stage
Problems with dividend discount models (5)
- Do not explain why shares are misplaced or when price will be corrected
- Discount rates may change over time
- Results are highly sensitive to input parameters
- Difficulty estimating the input parametres
- Performance of models difficult to assess
What is the free cash flow model for pricing equities
Cash flow remaining after deducting the capital expenditure needed to maintain the firm’s operations at the current level
- estimating free cash can be hard
Valuation multiples
- Price earnings ratio
- Dividend yield
- Tobins Q
- Market to book
- used to generate buy/sell decisions
PE for constant growth firms
Implies increases with increases in the growth rate.
Decreases with increases in risk (bc increasing risk will increase required return )
Dividend yield
Do/Po
- Not a good measure of holding period return since it ignores changes in the value of the share
- Div yield decreases with increase in growth rate
Div yield increases with risk
Tobin’s Q
Ratio of market value of firm to replacement cost of net assets. High values suggest overvaluation
- Of limited use for individual companies
- No info about short term market movements
- Human capital
Growth share characteristics
High market to book values
Relatively expensive. Usually no dividends as more likely to reinvest retained earnings
Equity risk Measures (6)
Total risk (Variability) - σ
Beta
Systematic Variance
Residual variance - unsystematic risk
Specific risk- residual or unsystematic risk of share
R-Squared - proportion of share’s total risk that is accounted for by its market or systematic risk
Fundamental Analysis
Comprehensive approach to evaluating securities by looking at all relevant factors that might affect their value.
Understanding the intrinsic value, investors can make more informed decisions
4 Factors to consider in fundamental analysis
- Global Economy
- National Economy
- Industry
- Individual Companies
- Quantitative - Financial statement analysis
- Qualitative - Market dominance, quality of management
Technical analysis (Based on which trends in market cycle model)
Based on study of past share price data
- Primary Trend (primary tide)
- Intermediate Trend (Secondary Reaction)
- Short term trend (Ripples)
Phases in Primary tides in stock market. In bull tides and Bear tides
Bull tides: Scepticism, Growing Recognition, enthusiasm
Bear tides: Disbelief, Shock and fear, disgust
Tools for technical analysis
- Moving averages, Used to identify trends and as buy/sell signals
- Relative strength test, measured by ratio of stock price to some market index
- Filter rules, Designed to capture a breakout from line.
Limitations of technical analysis (4)
i. imposing of patterns on charts is subjective
ii. Competition between analysts will compete away patterns and trends
iii. Leads to high risk portfolio
iv. high transaction costs
EMH effects on Technical analysis
Weak form: technical analysis will not generate excess returns - cannot beat the market by analysing past pricing data
EMH effects on Fundamental analysis
In semi-strong market, fundamental analysis will not generate excess returns - cannot beat the market by analysing publicly available info
Effect of asymmetric information
Noise traders (uninformed) lead to misplacing which informed investors can exploit to generate excess returns
Total return decomposition TRD (5 Parts)
Risk free rate
Managers risk
Investors risk
Diversification
Net selectivity
Managers risk
Risks taken by fund manager, such as specific bets, stock picking. This component is often evaluated using alpha
r2 - r1
Investors risk
Systematic risk, often measured by beta. represents return associated with market risk or the overall movement of the market.
r1 - r
Return from risk
Managers risk (r2 - r1) + Investors risk (r1 - r)
Return from selectivity
Diversification (r3 -r2) + Net selectivity (rp - r3)
