unit 16 | the portfolio management process Flashcards
Asset Allocation
An investor’s money can be distributed amongst 3 broad categories of assets:
Cash → no expected return, no expected risk
Fixed income → low expected return, low expected risk
Equities → high expected return, high expected risk
Active vs Passive Asset Allocation
Asset Allocation can be fixed over the life of an investor (passive), or can change with market cycles (active)
Markets (eg. economy) can alternate between:
Expansion → economic & profit growth
Peak → maximum economic activity/profit in a cycle
Contraction → economic & profit decline
Trough → minimum economic activity/profit in a cycle
Goal of active asset allocation
To be more invested in equities between the trough & the peak (pick them at the bottom, sell them at the top), & less between the peak & the trough
Active Asset Allocation Strategies
- High level asset allocation is called “Strategic”
> Generally fixed, but may change with changing characteristics of an investor (eg. age) - Tactical/Dynamic/Integrated Asset Allocation
> Different names for the same thing
> Shift the asset allocation based on short-term expectations for different asset classes
> May be based on macro, price, political, or other trends
- Manager charge fees
Passive Asset Allocation Strategies
- Does not attempt to time the market; holds one set of assets for a long period of time
- 2 types:
- Buy & hold limited # of individual stocks, similar to Warren Buffet
- Invest in a market index, like the S&P500, as exemplified by Vanguard & Jack Bogle
- Evidence that passive investing (at least the index version) performs better over time
Industry (Sector) Rotation
In addition to asset allocation, a portfolio manager may shift money between industries or sectors:
- Cyclical stocks grow/decline with the economy
- Defensive stocks are stable regardless of economic conditions
- Some stocks/bonds may be “interest rate sensitive” meaning they are directly impacted by changing interest rates
> Banks & life insurers
> Floating rate bonds/debentures
Equity Manager Styles
- Growth
> Focus on companies with high revenue growth
> May pay high P/E for exposure to high growth
> Price earnings ratio → share price/earnings per share - Value
> Focus on mature companies with stable revenue
> Pay low P/E - Sector Rotation
> Macro driven industry selection (eg. oil vs industrial vs consumer discretionary)
Bond Manager Styles
- Interest Rate Anticipators
> Bet on interest rates rising or falling - Term to maturity
> Restricted to specific maturities (3-5 year bonds) - Credit Quality
> Identify the best yields for a given credit quality; may bet on credit upgrades/downgrades
> Economic turmoil → sell company bonds w poor quality (likely to bankrupt) → buy gov’t bonds instead (buy quality) - Spread Traders
> Long-short bond strategy betting on yield spreads between bonds to rise/fall (eg. corporate vs government spread)
Evaluating Performance
- Compare the Total Return of your investments to an alternative benchmark
> Total Return formula is the same, but now applied to a portfolio instead of an individual security
> The benchmark must be investible, meaning an investor would invest in the benchmark - Benchmark may blend different asset classes to reflect the investor’s asset allocation
> Could be 50% bond index, 50% stock index - Absolute relative return
> Absolute nominal return
Sharpe Ratio formula
portfolio_return - risk_free_rate / sd
Sharpe Ratio definition
- Commonly used metric for evaluation of a portfolio’s risk-adjusted return → takes into account of risk
- Measures unit of return per unit of risk
> Return = Total Return
> Risk = Standard Deviation - Risk-Free rate (Rf) is subtracted from Return as anyone can earn Rf (buying government bonds)
> Only get credit for “excess” return above the risk-free rate
