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Overview

Portfolio Management
Spring Term Lecture 20+21
ActEd Chapter 20

Management styles
Tells you how the manager will run the
fund.
 Helps distinguish between different asset
managers.


Management styles.
Top-down and bottom-up approaches.
 Active and passive management.



Growth style.
Manager invests mainly in growth stocks.
Style of investing that emphasizes capital
appreciation.
 Growth stocks:



Growth.
 Value.
 Momentum.
 Contrarian.
 Rotational.


Value style.



Manager invests mainly in value stocks.


Seeks out stocks that are considered to be
undervalued based on certain accounting
ratios:




PER
Price-to-book ratio
Dividend yields.

Less volatile than growth stocks.


 Value stocks often outperform the rest of the
market during recovery stages of the general
economic cycle.


Index-tracking.

Bond portfolio management.





Earnings expected to grow at an above average


rate relative to the market.
Pay low dividends (earnings reinvested in
company).
Higher price to earnings ratio than other
companies.
E.g. technology companies.

Growth and value styles.


There are growth and value variants of
indices for benchmarking purposes.
 E.g. consider S&P 500.
 All the 500 companies are ranked by
their Price-to-Book ratios.
 Resulting list is then divided in half by
market capitalisation.


Growth and value styles.


Those companies with half of the market
cap of S&P 500 and having lower PBR
are included in the value index.
 The remaining companies are added to
the growth index.


Growth and value styles.




An alternative method identifies 5


growth factors:
1.
2.
3.
4.
5.

Growth and value styles.




The 5 value factors are:


1.
2.
3.
4.
5.

Price-to-book ratio (PBR)


Dividend yield
Earnings yield
Cashflow yield
Sales to price

These factors are used to distinguish


between growth and value securities.

Other management styles.




Rotational moving between value and


growth depending on which style is
believed to be attractive at a particular
point in time.

Sales growth
Earnings growth
Forecast earnings growth
Return on equity
Earnings revisions

And 5 value factors

Other management styles.


Momentum buying (selling) stocks that
have recently risen (fallen) significantly in
price on the belief that they will continue
to rise (fall) owing to an upward
(downward) shift in their demand curves.
 Contrarian going against market
sentiment in the belief that investors in
the market over-react to news.


Top-down and bottom-up




How do you start assembling a


portfolio?

Top-down and bottom-up approaches


are the two widely used.

Top-down approach


Begins with the `big picture - of studying the


macro-economic environment.




Rate of economic growth.


Political conditions.
Regulatory environment.

This will help the manager decide the


region/country.
 Within the region, consider the industries that
offer the best investment opportunities.


Bottom-up approach
Starts with micro-analysis at the
company level.
 Analyse various factors like:


Management quality + track record


Market share
 Business plans for the future
 Etc.


Top-down approach
For example, during periods of low
inflation, consumer spending increases,
which might be a good time to buy
automobile stocks or retail stocks.
 Finally select individual stocks, based on
fundamental share analysis.


Bottom-up approach
Next consider forecasts for the industry
prospects.
 Finally consider the general (macro)
economic conditions.


Top-down and bottom-up

As long as the company's future


prospects look strong, the economic,
market or industry cycles are of no
concern.

Top-down is better because


Better risk control, because you build a
balanced, well-diversified portfolio.
 Argument: it is asset allocation that
matters, not stock selection.
 Dont lose out on industries/regions that
have a promising outlook this is a risk
with bottom-up approach.


Bottom-up is better because


Investment performance depends on individual
asset performance this is where you should
concentrate your analysis.
 Even if its industry is doing poorly, a strong
company may still outperform the market.
 Argue: macroeconomic forecasts are actually
major distractions for investors as the
projections might turn out to be wrong.
 Warren Buffet used bottom-up approach!


Active management
All the techniques we have seen so far
are examples of active management.
 It is an attempt to outperform





the market
the funds peers (where appropriate).

The verdict


An investment style that combines the


two approaches is better.

Passive management
Makes no attempt to distinguish attractive from
unattractive securities, or forecast securities
prices, or market sectors.
 Investors willing to accept average returns.
 Makes little or no use of the information active
investors seek out.


Mandates:

Multi-asset or balanced.
 Specialist.

Active or passive?


Advantages of active management:


Expert analysis experienced investment
managers making decisions based on
market trends, economic factors, own
judgement, etc.
 Possibility of higher than average returns.
 Managers can take action if they believe the
market may take a downturn.


E.g.




Index-tracking
Liability hedging
Immunisation
Matching.

Active or passive?


Disadvantages of active management:


Higher expenses fees, transaction costs.
No guarantee of higher returns riskier
strategy than passive investment.
 Style may conflict with current market
conditions, leading to lower returns.



Active or passive?


Advantages of passive management:

Active or passive?


Lower expenses.
 Lower volatility.
 Will at least make average returns for each
asset class.


Active vs passive: returns

Disadvantages of passive management:





Loss of upside potential.


Investment restricted to markets and
sectors where suitable benchmarks exist.

Index-tracking: Definition


Attempt to replicate the performance of a


market index, either by:
holding all the shares in the index in the
appropriate proportions;
 hold some shares (sample);
 synthesising the index using derivatives a
complicated way of saying use index
futures.


Index-tracking - Assumptions



Markets are relatively efficient.


Any out-performance via active
management is not worth the extra
costs.

Full replication
Use this strategy if the investment fund is
large.
 Aim is to minimise tracking error (gross
of tax and expenses).


Tracking error divergence between the


performance of the fund and the
performance of the index.

Sampling or Partial Replication









Hold a stratified sample of the index.


Involves dividing up the stocks in the index by
size and sector and just buying samples of each
group, where the chosen assets perform closely
in line with the sector as a whole.
Lower transaction costs than full replication.
Why?
Assets chosen based on statistical analysis.
If analysis is incorrect, this technique will
produce a higher tracking error than full
replication.

Index-tracking in practice


Applied at an asset class level




actively select asset allocation, then within


each asset class, use index-tracking.

Applied to certain sectors:





Where there is less scope for active style.


Where there is greater risk or less
information about a market/sector.

Synthesising using derivatives


Same as hedging using a combination of
cash and index futures.
 See ActEd example in Chapter 20.
 See other examples we worked through
in class + home exercises.


Active or passive? Verdict


Manage core portfolio on a passively.
 Appoint specialist satellite managers for
the remaining portfolio to try and achieve
better returns.
 Increasingly satellite managers are
hedge fund and private equity
specialists.


Switching

Bond Portfolio Management

Active bond portfolio management


achieved by switching.
 Selling one bond and buying another,
hoping to achieve a higher return.
 You need a market with a variety of
highly liquid, marketable bonds.
 Two types: anomaly and policy
switching.


Switching


Three types of trends in bond markets:


Permanent trend the effect of passage of
time.
 Temporary trends changes in the general
level of interest rates and changes in the
shape of the yield curve.
 Fluctuations fluctuations around the yield
curve.

Switching


Policy switch


Take advantage of expected temporary trends.


Risk of loss incurred if trend takes place in the
opposite directions to that expected.

Anomaly switch a.k.a Jobbing switch





Take advantage of fluctuations.


Risk incurred if:



Anomaly Switching


Involves moving between stocks with


similar volatility, thereby taking
advantage of temporary anomalies in
price.





Glossary


4 ways to identify anomalies:






yield differences
price ratios
price models
yield models.

measures sensitivity of the price of the


bond to change in yields.

V =

Low-risk strategy, but


the use of computer-based analysis
limits opportunities for significant
anomalies.

Volatility of a fixed-interest bond:

Define volatility of a fixed interest bond.

Anomaly Switching

fluctuation does not reverse soon enough, or


unfavourable temporary trend develops.

1 dP
P dy

where P is the price and y is the bond yield.

Anomaly Switching
Yield differences are usually used to
identify cheap and dear bonds.
 High gross redemption yield usually
means the bond is cheap.
 However, this is may be misleading,
especially if there are tax-related
preferences.
 So analyse carefully before making a
decision to switch.


Anomaly Switching
Price ratios can also be used, but
 For two bonds A and B, keep a historical
record of the values of the price ratio
PA/PB.
 When the ratio reaches an extreme high
or low point, then it usually indicates an
opportunity for a switch.
 Problems?


Anomaly Switching


Solution?


Adjusted the prices used in the calculation


of the ratios e.g. allow for accrued
interest.

However, price ratios will still be


influenced by changes in general level of
interest rates.
 Need to consider whether anomaly is
suitable for the fund to exploit.


Policy Switching
Entails taking a view on future changes
in shape or level of the yield curve and
moving into gilts with quite different
terms to maturity and/or coupon.
 More risky
 involves taking a view on future
changes to shape and level of yield
curve.


Anomaly Switching


Price ratios have trends, due to the


following reasons:
The price of a low-coupon bond accrues
faster than that of a high-coupon bond as
maturity is approached.
 Even if coupons are the same, the price of a
shorter bond tends to accrue faster than the
price of a longer bond.
 Short-term bonds are less volatile than longterm bonds.


Anomaly Switching
Price models can be built to assess the
theoretically correct price of a bond. A
bonds price is anomalous if the actual
price differs from the price derived from
the model.
 Yield models that compare a bonds
yield with the par yield curve can also be
used.


Policy Switching
E.g., if yields in general are expected to
fall, the portfolio may be switched into
longer-dated more volatile stocks.
 3 methods for identifying policy switches:


Volatility (or duration).


Reinvestment rates.
 Spot rates and forward rates.



Spotting a Policy Switch Volatility


Calculate volatility (or duration) and look
at forecast changes at different points in
the yield curve.
 Gives an idea of the area of the market
that will give the best returns if the
forecasts prove accurate.


Spotting a Policy Switch


Reinvestment Rates Example
Consider 2 bonds A and B.
B has longer term to maturity.
 So we can calculate the rate at which
proceeds of A have to be re-invested, up
to the maturity of B, to match Bs total
return.
 If reinvestment rates are particularly high
or unattainable, then B offers better
value.



Spotting a Policy Switch


Reinvestment Rates
Method involves selecting representative
bonds at various points along the
maturity range.
 Then work out the reinvestment rates
between each bond and the next.
 Examining the series of reinvestment
rates can identify areas that are
cheap/dear in relation to neighbouring
areas.


Spotting a Policy Switch Spot


rates and forward rates
Derive spot rates and forward rates from
the yield curve.
 This may reveal unusual features in the
term structure of interest rates which
give rise to a policy switch opportunity.


Reminder
Portfolio management could involve
using other assets like interest rate
swaps instead of direct bond investment.
 When using such alternatives, check
whether you are rewarded adequately for
the risks taken:





Marketability and liquidity risks.


Credit risks.