Week 11 Flashcards

1
Q

Calculate what percentage of each of these companies that the manager would need to purchase to achieve a standard 4% position at 5 levels of funds under management (FUM): $250 million, $500 million, $1 billion, $2 billion and $4 billion.

A

Capacity is obviously a significant consideration for this manager and investors in this fund. The manager may have difficulty investing in companies towards the lowest quarter of the investment universe (i.e. stocks ranked 150-200) once FUM gets much above (say) $1 billion, as they would need to purchase over 5% of these companies to establish a standard 4% position.

Similar problems would arise if FUM rises to over $2 billion for companies around the middle the universe (i.e. stocks ranked near 100). This fund may have a capacity of something like $1-$2 billion.

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
2
Q

by restraining FUM, the manager would be able to

A

effectively implement their current investment process, and avoid any fade in returns

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
3
Q

Effects as FUM increase:

increasing need

A

(b) There would be an increasing need to be sure of companies purchased, as bad positions may become very difficult to reverse at reasonable prices.
(c) A longer investment time horizon may become necessary.
(d) Increasingly the manager would be forced to hold either: (a) more stocks, or (b) larger stocks. This could dilute the effectiveness of the manager’s skill.

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
4
Q

Effects as FUM increase:

trade

A

) Ability to trade small-medium sized companies quickly without moving the market is much diminished. Manager would face an increasingly difficult trade-off between potential market impact from trading, and the speed at which a position can be accumulated or exited at attractive prices.

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
5
Q

Do these processes rely on high breath or high skill for success?

Private equity fund

A

More skill, but some breadth (number of companies held)

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
6
Q

Do these processes rely on high breath or high skill for success?

Fund of hedge funds

A

More breadth, but some skill (selecting funds)

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
7
Q

Do these processes rely on high breath or high skill for success?

Fixed income manager that forms their portfolio around a view on interest rates

A

skill

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
8
Q

Do these processes rely on high breath or high skill for success?

Quant equity fund that holds 50-60 stocks which are turned over often

A

Breadth

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
9
Q

Do these processes rely on high breath or high skill for success?

Stock picker with a high tracking error of 7%-10% that holds 10-15 stocks

A

Skill (mainly – even though stock picker, TE and # stocks implies very concentrated portfolio)

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
10
Q

Do these processes rely on high breath or high skill for success?

(a) Asset allocator that engages in strategic tilting or dynamic strategic asset allocation (DSAA), i.e. occasional shifts away from SAA when markets appear to be at some extreme

A

Skill (almost exclusively)

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
11
Q

in what way might an existing capital gains tax liability (or asset) influence the decision to trade?

A

An existing CGT liability (asset) means that the investor requires a higher (lower) rate of return from a new asset in order to justify trading.

This is because paying CGT decreases the amount of funds invested, and therefore the new stock needs to work harder to make up the gap.

Alternatively, getting a tax deduction for capital losses increases the amount of funds invested, and therefore the stock needs to work less hard to make up the gap.

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
12
Q

general guidelines for how a portfolio manager could manage their portfolio to maximize after-tax value for their investors?

A

Know your tax parcels

  • Realize losses (called ‘tax loss harvesting’)
  • Before selling a stock with a large CGT liability, ask whether the replacement asset generates a sufficient expected return to justify the transaction.
  • Be aware of differences between short-term and long-term CGT rates.
How well did you know this?
1
Not at all
2
3
4
5
Perfectly
13
Q

how inflation might influence how portfolios are managed in a tax-effective manner? (Hint: Think about how inflation interacts with returns and hence CGT over the long run.

A

Inflation generally raises the level of nominal returns over the long run

This can have the effect of reducing the justifiable level of turnover in portfolios that are managed to minimize tax, as tax liabilities become larger as they build up over time, i.e. the hurdle to justify switching will tend to increase.

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
14
Q

Significance of tax to portfolio outcomes

A

When both the existing and new stock have the same E[R] of 10.0%, the value difference at the end of year 10 is -6.8% for a cost base of $0.50 and +11.7% for a cost base of $2.00. These are economically meaningful differences in value, equating to differences in annualized return of about -0.7% and +1.1%.

ignoring tax may be quite costly for accumulated portfolio value and after-tax returns over time.

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
15
Q

past performance is a ___ basis for assessing investment skill.

A

considered in isolation, past performance is a poor basis for assessing investment skill.

b.c there is a high degree of randomness in relative investment returns and that to be statistically signi cant a performance record should be intact for nearly 15 years; differentiate luck from skill

it is possible that a skilled manager will generate poor returns for an uncomfortably long time before his skill again manifests itself.

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
16
Q

Explicit determination of investment skill in an equity fund manager is complicated.

should focus on

A

A focus on the long term is particularly important, as some asset managers appear to rely on the randomness of returns in markets to produce a positive short-term track record, which is then used to market products to advisors and clients who are attracted by short-term performance.

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
17
Q

An investment philosophy is important

A

An investment philosophy is important because no one knows what a business will earn or what equity risk premium should be applied in the future.

Consequently, investment managers need
a relatively constant framework of beliefs to guide them in the formulation and execution of their process.

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
18
Q

The role of investment philosophy

A

manager’s beliefs about what creates investment opportunities, how a process can be constructed which enables the manager to capture sustainably such opportunities, what competitive advantage the manager may have and how this process can be expected to evolve.

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
19
Q

Assessing whether the portfolio will deliver the expected alpha

equity managers

A

starts with a detailed examination of the investments within the portfolio for any obvious inconsistencies with the process.

If there are investments which appear to contradict the process then these may be prioritisedfor discussion.

Examining such exceptions deepens our understanding of the process and the manager.

Alternatively, poorly performing investments may be selected on the basis that we are likely to learn more from a manager’s mistakes than from his successes.

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
20
Q

Our sole objective in discussing investments is to

A

ather evidence to support an opinion of the manager’s investment skill and ability to generate alpha

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
21
Q

Critics of multi-manager investing sometimes assert that combining multiple investment managers

A

results in lower returns than investing with individual managers. They ascribe this to ‘over-diversification’

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
22
Q

combining managers with positive alpha

A

reduces tracking error (assuming the managers are not perfectly correlated), but does not, of itself, reduce returns

. Since each manager is expected to outperform the market, so should any combination of these managers. Adding more managers, as long as they also outperform the market, does not change this result.

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
23
Q

The lower tracking error we observe in multi-manager portfolios is due to

A

reduced style and manager risk. Lower tracking error is attractive to investors since it results in more certain performance outcomes.

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
24
Q

Benefits of multi-managers

A

these manager mixes were derived randomly; skilful combination of the managers would result in even greater diversification benefits

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
25
for Single manager there is a positive relationship multi-managers
between alpha and tracking error Again, while excess returns remain unchanged when combining managers, tracking error falls dramatically.
26
Why do people think that multi-managers lead to lower alpha but
due to lower active bets active bets are not the only factor that drive alpha. alpha is generated not only by the size of active bets but how many of these bets turn out to be corret (manager skill)
27
. It is certainly true that for a given level of skill, decreasing active bets will
reduce alpha
28
when managers with positive alpha are combined.
is that the level of ‘skill’ that increases each manager brings some unique skill (however small) to the portfolio less active bets but are more likely to be accurate So the decline in alpha one might expect from smaller active bets is offset by an increase in the success ratio.
29
There are two key factors that may lead to higher costs for multi-managers
■ Additional custody and administration costs for each manager’s mandate. ■ Higher manager fees
30
what offsets higher management fees from multi-managers
weighed against the benefits of lower tracking error and improved performance outcomes. In trying to identify outperforming managers a multi-manager should look at net performance; that is, performance after all costs have been paid.
31
combinations of high risk managers can
result in significant outperformance, with only moderate tracking error. Such a multi-manager portfolio, comprised as it is of high risk strategies, may have higher costs than a low risk single manager, but the alpha potential is far greater and so should more than compensate for the added costs
32
Investment processes
Procedure that fund manager puts together so everyone is working towards one objective within the defined boundaries of fund mandate. That defines what we do in fund, objectives and how take people into responsiblites Converting an investment philosophy into a portfolio –Processes offer hope that performance is repeatable
33
The investment process
34
Review
Review of whole investment process: refine investment philosophy. Refine the signal creation or signal acpture or improve efficiency in implementation process. How portfolio managers performance is going to be evaluated? Attribute the excess return over the benchmark as driven by skill or luck. Feedback process
35
Implementation
buying or selling a particular stock. Will that transaction move the market price? not relevant for individual, but for institutional investors esp within a very small equity market in austraia, the fund managers need to consider whether buy or sell orders will move the market price They have to evaluate the trade of of potential benefits and costs of doing the trade then ask the broker to buy or sell on their behalf
36
Signal capture:
Everyday new info comes into market of a particular company, asset so signal capture process will calculate. Try to create summary statistics or ranking info of all of listed au companies. Through this process, we may distinguish firms that are more likely to be undervalued that of good quality from the rest of the firm. These firms will become candidate to be included in portfolio.
37
Signal creation:
Dfnie kind of measures we will create signal. E.g. selecting value au stocks, going to use the signal of value measures e.g. PE ratio or other alternative measures of value These bench of measures help us to create signal. During process, set a hurdle so that only stocks that exceed this hurdle may become cadidate to be icluded in portfolio.
38
Investment philosophy
ideas, concepts e.g. actively select undervalued stocks on a group of measures and tries to achieve absolute return of ceretain perentage over investment horizon
39
Skills versus breadth
How active managers generate excess return
40
Who cares about tracking error/information ratio or how they are going to generate positive alpha or beat the benchmark:
Mutual fund manager given a well defined benchmark to outperform.
41
Info ratio
which Is portfolio excess return over benchmark for every unit of peer risk Info ratio provide insight into how well my investment idea will generate excess return for me but not deviating too much from the benchmark.
42
Sometimes fund managers may decide willingly deviate from benchmark allocation.
Willingly take tracking error risk in the hope to generate larger excess return. Active managers like to achieve in portfolio tilting, underweighting or overweighting
43
breadth
On average, over the process, I am going to refine investment process, my signal creation and signal capture process, eventually I believe on average I am going to make corrected bets i.e. out of the large number of bets I make in investment process, **I make the right course more than the wrong course.**
44
With managers that are heavily relying on info content,
they believe they have superior info inside experience and can make better choices than average investor, these managers, don’t trade that often as managers relying on bredth. hey make discreet or few bets. They make every bet very large to generate significant positive alpha or info ratio.
45
•A fund manager can outperform through either:
1. Small number of large and correct bets (skill focus), or 2. Large number of small (and independent) bets that are correct on average (breath focus); keep info ratio constant Note: to outperform, some skills are always required
46
Active managers relying on breadth
lots of trading, fine tuning their investment process and trying to have on average correct bets, t Every bet is much smaller even if they make a wrong call, the impact on the portfolio can be quite benefited. There can be a disadvantage if they trade a lot: buy and sell security a lot.
47
active managers relying on breadth and cost
, one single trade has small impact on total portfolio, because thy trade frequntly, they incur a large cost.
48
Breadth ## Footnote –Disadvantages
1. Higher transaction costs 2. Large outperformance often requires large bets
49
Breadth ## Footnote –Advantages
1. Easier to establish skill from a statistical perspective (with a large number of bets, success rate looks more like skill than luck) 2. Lower ‘risk’ from not relying on big bets to pay off
50
Tracking error vs benchmark actiev quity funds, tracking error below
2% considered to be rasonable. Level of tracking error that you may have a chance. High tracking error cloes to 5% or above - You have to generate enough excess return to justify that additional peer risk you are taking on in the portfolio.
51
investment style
Investors can benefit by diverisfying their exposure to a particular investment style in a particular asset class Allocate all to one manager, subject to concentrate investment style risk
52
When you include 3 investment styles within your equity portfoio, you benefit from
diversification benefits of different styles of managers. At the same time, you maintain reasonable level of equity returns and very reasonalbe level of peer risk.
53
Investment style
54
Do not select managers based on best historical return understand the sources of the active returns
Try to disentangle alpha from total return and beta exposure. Existence of an estalished track record. How long they have been in industry. Their performane in the past several years, with different funds.
55
Fund size: capacity level
When the size of the funds under management is close to the hurdle, alpha will be diminishih Funds under managemnt of australian value manager is growing and growing because of stellar performance in past quarters. Up to a limit, they will put a cap. no more new investors because, the larger the funds under management, any buyer is sell order from fund will more liklely move market price, that will erode opporutnity for manager to generate alpha.
56
Institutional investors with more resources in their discretion
they care more about return than the fees. don’t really choose the cheapest managers due to the sheer size of funds under management are more concerened with expected performance of the funds.
57
active v passive active argument
We have superior info, superior skills and we are able to generate a. market is not always efficient and we are able to identify that temporary mispricing to generate active return. Even after fees, we are able to genreate positive apha for managers.
58
Framework for choosing an alternative to replicating a passive cap-weighted index Active management is expected to outperform the index
Investment environment favors active management in general 5. Skilled managers can be identified active managers are better placed than other investors to exploit any mis-pricing. Competitive advantages of active managers: information advantage (EM and small cap); preferential access to desirable assets (IPOs, unlisted markets); partially segmented markets (Em, global property); economic value-add (PE, private real eastate)
59
Framework for choosing an alternative to replicating a passive cap-weighted index 2. Suitability of passive alternative - The passive or cap-weighted index is unsuitable for investor’s objectives DB Funds
FI index have their own particular traits or profiles. E.g. duration of one particular FI index is 4 years, the other is 6 years **FI index is not appropriate for DB funds when they have particular need of duration of FI portfolio** DB funds has 5 years of duration from estimated libailitis, the passive index of 6 years duration is not appropriate. They want to match duration of portfolio (esp FI securiites) to duration of projected liabilites They usually require customised management of FI portfolio instead of going to buy a passive index. Even though thy may have passive index, they still have specialisd team to manage total exposure of FI seucrities.
60
Framework for choosing an alternative to replicating a passive cap-weighted index 2. Suitability of passive alternative
Passive or cap-weighted index is not suitable for the investor’s objectives The standard cap-weighted index is inefficiently constructed Fixed income index is constructed through sampling, and the portfolio composition is dynamic due to maturity, new issues of debt. Therefore it is not representative of the whole universe. Another example is commodity ind
61
Framework for choosing an alternative to replicating a passive cap-weighted index Availability of passive alternative As a result,
No readily replicable index is available e.g. Unlisted properties (No way you can hold portion of all of the direct prperties In the world) and PE don't have passive index if investors would like to have expsure on direct property, PE hedge funds, they have to go to alternative or active product
62
Investors passive investment option will provide the
the best option at low cost. But there are some situations where passive is not an option at all
63
when to go with active.
When active management is expected to outperform the nindex Have assets that have potential to generate positive a. emerging market equities is more likely to generate A. these products are temporarily inefficiently priced. May have potential to generate a or active return. need to understand Companies in emerging market behave, what are the differences in terms of business environemnt, reporting, accounting. And you do have particular expertise to identify these investment opportunities
64
example of CGT implication in a diversified portfolio
Currently there is 30% dxposure ot australian equity, if you want to increase that, have to sell the direct properties. Have to pay tax, realised CGT if you sell the direct properties. You may decide I don’t want to pay CGT\> I am going to stick with suboptimal asset allocation.
65
Relevance of CGT in asset allocation
affects after-tax returns b/c * effective impact depends on timing and circumstances of realization * differential rates per holding period, e.g. concessional rate for \>12 monthsl 50% concession on realised capital gains for investments held for at least 12 months. * CGT/availability of offsetting losses depends on tax parcels, market movements
66
what tax might not be considered in strategic asset allocation and why
Accounting and calculation of Capital gain tax is particualry tricky for investors. Not going to be considered when doing strategic asset allocaiton
67
when is CGT considered
when implementing asset allocation
68
for investors when they cosider the tax implication, important that they
capture the tax parcel: do the accounting of the shares, make sure you maximise the tax benefit. Individual is easy, identify the inventory of shares and decide which inventory you want to sell to make most of the tax concession or capital loss.
69
What about institutional investors Capture tax parcel
Requires overlay of management in the top level for institutional investor to identify most benefical tax parcel
70
Transaction cost, if you are changing asset allocation
a) Commissions (i.e. brokerage) b) Bid-ask spread c) Market impact: For some institutional investors, esp want to buy or sell some small and medium size, the buy or sell order will impact market price. This could be countered as cost of trade. d) Tax impact e) Opp cost: sometimes atuck with illiquid assets or have to live with sup optimal asset allocation Comment: Hopefully all turnover costs are offset by expected benefits
71
Opportunity costs:
• (unfortunate) deviations from target portfolio; sup optimal asset allocation –Decision not to trade due to costs, taxes, etc –Inability to trade due to illiquidity or constraints; cannot sell to rebalance portfolio to long term strategic asset allocation –Failure to rebalance –Cash drag
72
Cash need
Spending program to spend. Pensioners in db funds, need to pay cash to meet liability requirement
73
•Typical turnover rates
–10%: index fund; .whenver there is change in index, there will be buy and sell in vanguard australian share index. –40%: active manager with 2-3 year investment horizon, e.g. long term value fund –80%: average turnover for active managers –150%: a very active trader or momentum investors, or a quant fund: extremely active,making a lot of buy and sells,
74
Info ratio can be decomposed in a way that will help us to gauge the skill of the fund managers.
Going to be a product of information content and the number of trades involved in the investment process. Separating the skills that info content and the number of trades and bets made by the fund manager. If we keep number of bets constant, the higher info content you have i.e. the more skills you have in selecting the undervalued stocks
75
With managers that are heavily relying on info content, they believe they have superior info inside experience and can make better choices than average investor, these managers, don’t trade that often as managers relying on bredth. They make discreet or few bets. They make every bet very large to generate significant positive alpha or info ratio. Disadvanage of these active managers
if they make a call, the impact on portfolio performance can be quite significant. If they are right with one particular large bet, they are going to reap benefits of outperformance and bonus
76
If we keep number of bets constant,
the higher info content you have i.e. the more skills you have in selecting the undervalued stocks
77
Keep info content constant
large number of bets indicates active manager relying on breadth to generate alpha
78
Fund size: capacity level For most of investment process and investment philosphy, the ability to generate alpha is
limited esp for upper limit.