Week 7 - Fixed Income Flashcards
What impact would a 10% value tilt have had on returns?
A value tilt would have increased compound annualized returns by 0.19% at the AE portfolio level, and 0.05% at the total portfolio level
• This aligns with the well-known fact that value stocks have outperformed on average over time
What impact would a 10% value tilt have had on portfolio ‘risk’? (Hint: Consider and contrast the various risk measures and holding periods - there is no single, unambiguous answer.)
Standard deviation for both the AE and total portfolio level reduces over 1-month and 12-month holding periods (by 0.07% to 0.19% and 0.02% to 0.03% pa respectively), but …
- Standard deviation for AE portfolio increases over 36-month holding periods (by 0.17%), a small increase of 0.02% for total portfolio.
- Tracking error (i.e. benchmark relative risk) associated with the tilt is 0.94%-1.02% pa at the AE portfolio level, and 0.28%-0.30% pa at the total portfolio level.
−You can think of an AE portfolio with 10% value tilt as comprising
calculation
a 100% long position in the market, a 10% long position in the value index, which is funded by a 10% short position in the growth index.
Thus: Tilted AE Portfolio Return = AE Index Return + 10% * Value Index Return – 10% * Growth Index Return
Tilted Total Portfolio Return =
Total Portfolio Return + 30% * 10% * Value Index Return – 30% * 10% * Growth Index Return.
What type of investor might take a value tilt?
an investor concerned about benchmark or peer relative risk might still adopt a value tilt if they were sufficiently aggressive
• An investor concerned about benchmark or peer relative risk might still adopt a value tilt if they were sufficiently aggressive. For instance, a 10% value tilt would have added 0.19% pa to AE portfolio returns for tracking error (TE) of 0.94%-1.02%, implying a reasonable Information Ratio (= Alpha/TE) of 0.18-0.20. (IRs above 0.30 are considered very good). However, they might want to control the risk by either limiting the size of the position, or perhaps trying to time the exposure if possible.
What type of investor might take a value tilt?
Investors who are primarily focused on overall portfolio performance (AE, or total),
Investors who are primarily focused on overall portfolio performance (AE, or total), and are unconcerned about benchmark or peer relative risk. For these investors, a value tilt provides a meaningful boost to returns, while reducing portfolio standard deviation at shorter horizons (although it adds modesty to standard deviation amount over 36-months).
What type of investor might take a value tilt?
Investors with long horizons
Investors with long horizons, who are more concerned about longer-term returns and relatively unconcerned about shorter-term volatility, e.g. some private investors (note: this point is strengthened from analysis in Part B).
What type of investor might take a value tilt?
- Investors with long horizons
- Investors who are primarily focused on overall portfolio performance
- An investor concerned about benchmark or peer relative risk might still adopt a value tilt if they were sufficiently aggressive
How might you decide how large a tilt is justified?
Depends mainly on tolerance for tracking error risk, given impact on total portfolio risk seems secondary. Investors who expect value to outperform might consider taking a value tilt as big as they can bear
How does the episode-based analysis influence your perception the risks of taking a value tilt? Does it make you more or less willing to adopt a style tilt?
Periods of underperformance seem to be
Periods of underperformance seem to be shorter and sharper for value relative to growth, whereas periods of outperformance by value relative to growth are more extended and gradual.
This comparison suggests negative skewness towards underperformance. Suggests that benchmark or peer relative risk less of a concern for investors with longer time horizon
How does the episode-based analysis influence your perception the risks of taking a value tilt? Does it make you more or less willing to adopt a style tilt?
The episode-based analysis might encourage
The episode-based analysis might encourage tempering the size of any value tilt. This would particularly be the case for a fund manager who was worried about the implications for their business, bonus or even job from possibly underperforming for around 2 years.
(Note: The historical average suggest 10% value tilt might lead to under performance of 1.71% pa (= 17.1% * 10%) during periods when value underperforms. This would probably be sufficient to put the managers in the lower quartile of the performance league table
How does the episode-based analysis influence your perception the risks of taking a value tilt? Does it make you more or less willing to adopt a style tilt?
• The episode-based analysis highlights that value can go through occasional episodes of large and sustained underperformance, averaging -22.3% cumulative (-17.1% pa) over 23 months (range 11 to 33 months).
This kind of underperformance might push a manager to the bottom of the league tables, suggesting the manager would incur meaningful benchmark or peer relative risk for managers with (say) a 1-3 year horizon. Thus a value tilt carries more risk than revealed by analysis of strict holding periods (i.e. 1- or 36-months).
List the key ways in which emerging markets differ from developed equity markets.
Currently, many EMs appear to have less structural problems than some of the major developed markets, e.g. US deficit issues; European problems but
Some argue that the Chinese economy is a risk, particular concerns on its mounting debt level
− Some EMs still have chronic structural issues, e.g. corruption in some EM countries
− The earnings cycle has been weaker in EMs more recently, including greater downward EPS revisions, i.e. earnings momentum is weak
List the key ways in which emerging markets differ from developed equity markets.
structural problems
Currently, many EMs appear to have less structural problems than some of the major developed markets, e.g. US deficit issues; European problems;
List the key ways in which emerging markets differ from developed equity markets.
List 5, 6, 7
5) Less efficient markets, including less information, which implies greater scope for active returns (‘beating the market’, generating alpha)
6) Less regulation
7) Traditionally EMs have traded at a sizable valuation discount - as per chart provided. (However, this has not been so apparent in recent years, raising the question of whether there may have been a permanent ‘revaluation’ due to structural improvements in economies, company management, governance, etc).
List the key ways in which emerging markets differ from developed equity markets.
List 4
1) Higher growth potential of underlying economies
2) Higher risk – more volatile; equity beta greater than 1, larger exposure to global economy and cyclical sectors like commodities; country and political risk (albeit possibly idiosyncratic)
3) Returns have been very episodic – as seen in chart provided
4) Lower liquidity
three main hazards involved in using bond benchmarks as base-case asset class allocations.
Third
The popular bond benchmarks are not representative of the bond markets
so they do not have anything to do investor objectives but instead cater to issuer objectives
three main hazards involved in using bond benchmarks as base-case asset class allocations.
Second
cash bond indexes represent only a fraction of the fixed income markets.
three main hazards involved in using bond benchmarks as base-case asset class allocations.
First
there is significant compositional drift in bond indexes due to their capitalization-weighting schemes —> very broad selection of bonds; and most are poor choices for benchmarks –>
past performance and structure used in asset allocation studies is likely not representational of the future
FI portfolio risk vs total portfolio risk
interest rate fluctuations. interest rate exposure increases risk for FI income managers
equities
credit risk and total portfolio risk
vs FI portfolio level
will increase risk for total portfolio b/c it adds to equity exposure
- returns and yield for lower quality credit are correlated with equity returns (greater credit exposure –)increase risk)
less clear. many cases can reduce risk due to diversification benefits
agency problems arising from differing impact of interate rate and credit exposure
FI managers perceive duration as risky and credit as a diversifying asset (incentive to increase credit exposure to the extent that it reduces overall portfolio variability and offers an expected risk premium)
WHILE end investor views credit as adding to equity risk that dominates portfolio + duration between innocautuious and a diversifying exposure
Active management
equity portfolio managers are assigned to beat a benchmark market index and to beat similar managers’ portfolio
deliberately deviate from the benchmark to enhance return
manager must watch benchmark or competition otherwise client may conclude it is not worth paying management fees
Passive management
equity portfolio managers are assigned to replicate a benchmark market index
