BFC5935 Portfolio Management

and Theory

Lecture 9 – Portfolio Management I

Lecturer: Dr. Manapon Limkriangkrai, CFA

Learning Outcomes
▪ Managed Fund Industry & Managed Fund Products

Equity Portfolio Management Strategies

▪ Passive Strategies
▪ Active Strategies

Bond Portfolio Management Strategies

▪ Passive Strategies
▪ Active Strategies
▪ Matching Strategies

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Managed Fund Products
Capital Stable
▪ Large investments in defensive asset classes
▪ Long term stability with low risk

Balanced
▪ Balanced investments in different asset classes
▪ Medium risk with medium returns

Growth
▪ Attain capital growth and reinvest earnings
▪ High risk position
▪ Active management and longer term horizon
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Managed Fund Products

Source: https://russellinvestments.com/us/solutions/financial-professionals/lifepoints 4
Equity Portfolio Management

Passive equity portfolio management

▪ Long-term buy-and-hold strategy
▪ Usually tracks an index over time
Active equity portfolio management
▪ Attempts to outperform a passive benchmark portfolio
on a risk-adjusted basis by seeking the “alpha” value

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Portfolio Management
Passive Strategies
Equal Weighting
▪ diversification
▪ equal investment
Minimum Variance
▪ least variance
Minimum risk given expected return
▪ lies on the mean-variance efficient set
Index Tracking
▪ match the expected return and risk characteristics

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Portfolio Management
Passive Strategies
Index Tracking: Tracks a designated index

Indexing Strategies
[1] Full Replication
▪ All securities in the index are purchased in proportion to
weights in the index
▪ < 1000 (liquid) Stocks
▪ Low tracking risk
▪ High transaction costs
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Portfolio Management
Passive Strategies
Indexing Strategies
[2] Stratified Sampling
▪ Buys a representative sample of stocks in the benchmark
index according to their weights in the index
▪ Dividing stocks using dimensions & Random samples
▪ Low cost & High tracking error
[3] Quadratic Optimization
▪ Use of programming to minimize tracking error
▪ Complex
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Managed Fund Products
Passive Strategies

Exchange Traded Funds (ETFs) / Index Funds

▪ Explicit objective and benchmark

▪ Listed on the stock market

▪ Ease of access and low costs of entry and exit

▪ Provide investors a pro rata claim on the capital gains

and cash flows of the securities that are held
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Managed Fund Products
Passive Strategies: Index Funds

▪The goal of the passive manager should be to minimize

tracking error

▪Tracking Error Measure

Δt =Rpt – Rbt
where Rpt= return to the managed portfolio in Period t
Rbt= return to the benchmark portfolio in Period t
Tracking error is measured as the standard deviation of Δt ,
normally annualized (TE)
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Portfolio Management
Passive Strategies
Index Funds

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Equity Portfolio Management
Active Strategies: Fundamental Strategies

▪ Market Timing: Shifting funds between asset classes

depending on broad market forecasts

▪ Sector Rotation: Shift funds among different equity

sectors and industries or among investment styles

▪ Security Selection: Identifying mispriced securities

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Equity Portfolio Management
Active Strategies: Fundamental Strategies

The 130/30 Strategy

▪ Long positions up to 130 percent of the portfolio’s
original capital and short positions up to 30 percent
▪ The use of the short positions creates the leverage
needed, increasing both risk and expected returns
compared to the fund’s benchmark
▪ Enable managers to make full use of their fundamental
research to buy stocks they identify as undervalued as
well as short those that are overvalued

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Equity Portfolio Management
Management Approaches

Passive Semi-Active Active

Low Exp. Return/Active Return High

Low Risk/Active Risk High

Information Ratio

(approx.) 0 (approx.) < 1 (approx.) < 0.60

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Equity Portfolio Management
Core Satellite Approach
▪ Passive Index Fund as a ‘Core’
▪ Active investments as ‘Satellites’
▪ Low correlations

Benefits
▪ Minimize Volatility, Costs and Tax
▪ Diversification
▪ Risk Control
▪ Opportunities to outperform

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Equity Portfolio Management
Core Satellite Approach

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Source: www.vanguard.com.au
Equity Portfolio Management
Core Satellite Approach

http://www2.goldmansachs.com/gsam/pdfs/USTPD/education/GSAM_I-S_Folder_client.pdf
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Equity Portfolio Management
Active Strategies
Momentum Strategy
▪ Focus on the trend of past prices alone and makes
purchase and sale decisions accordingly
▪ Assume that recent trends in past prices will continue

Contrarian Strategy
▪ The belief that the best time to buy (sell) a stock is when
the majority of other investors are the most bearish
(bullish) about it
▪ The concept of mean reverting
▪ The overreaction hypothesis (Exhibit 16.9)
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Equity Portfolio Management
Active Strategies: Value vs Growth

▪ A growth investor focuses on the current and future

economic “story” of a company, with less regard to share
valuation
▪ A value investor focuses on share price in anticipation of a
market correction and, possibly, improving company
fundamentals.
▪ Value stocks generally have offered somewhat higher
returns than growth stocks, but this does not occur with
much consistency from one investment period to another

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Equity Portfolio Management
Active Strategies: Value vs Growth

▪ Growth-oriented investor will:

✓ Focus on EPS and its economic determinants
✓ Look for companies expected to have rapid EPS growth
✓ Assumes constant P/E ratio
▪ Value-oriented investor will:
✓ Focus on the price component
✓ Not care much about current earnings
✓ Assume the P/E ratio is below its natural level

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Equity Portfolio Management
Active Strategies: Style Analysis

▪ Construct a portfolio to capture one or more of the

characteristics of equity securities
▪ Small-cap stocks, low-P/E stocks, etc.
▪ Value stocks (those that appear to be underpriced
according to various measures)
▪ Low Price/Book value or Price/Earnings ratios
▪ Growth stocks (above-average earnings per share
increases)
▪ High P/E
See Exhibit 16.20
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Equity Portfolio Management
Active Strategies: Value vs Growth

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Equity Portfolio Management

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Bond Portfolio Management
Bond Portfolio Style

▪ The investment style of a bond portfolio can be

summarized by its two most important characteristics:
credit quality and interest rate sensitivity
▪ The average credit quality of the portfolio can be
classified as high, medium, and low grades
▪ The interest rate sensitivity of the bond portfolio can be
separated as short-term, intermediate-term, and long-
term in terms of duration

▪ See Exhibit 19.2

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Bond Portfolio Management

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Bond Portfolio Management
Passive Strategies
Buy and hold
▪ A manager selects a portfolio of bonds based on the
objectives and constraints of the client with the intent of
holding these bonds to maturity
▪ Can by modified by trading into more desirable positions
Indexing
▪ The objective is to construct a portfolio of bonds that will
track the performance of a bond index
▪ Performance analysis involves examining tracking error
for differences between portfolio performance and index
performance

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Bond Management
Active Strategies
Interest-rate anticipation
▪ Risky strategy relying on uncertain forecasts
▪ Ladder strategy staggers maturities [Pic]
▪ Barbell strategy splits funds between short duration and
long duration securities [Pic]
Valuation analysis
▪ The portfolio manager attempts to select bonds based on
their intrinsic value
Credit analysis
▪ Involves detailed analysis of the bond issuer to determine
expected changes in its default risk [Pic]
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Bond Portfolio Management
Active Strategies
Yield spread analysis
▪ Assumes normal relationships exist between the yields
for bonds in alternative sectors
▪ When abnormal relationship occurs, a bond manager
could execute various sector swaps
▪ The spread widens during economic recession
▪ Interest rate volatility also affects the spread
Bond swaps
▪ Involve liquidating a current position and simultaneously
buying a different issue in its place with similar attributes
but having a chance for improved return

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Bond Portfolio Management
Matched Funding Strategies

Dedicated Portfolios
▪ Designing portfolios that will service liabilities
▪ Exact cash match
▪ Conservative strategy, matching portfolio cash flows
to needs for cash
▪ Dedication with reinvestment
▪ Does not require exact cash flow match with liability
stream
▪ Great choices, flexibility can aid in generating higher
returns with lower costs
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Bond Portfolio Management
Immunization Strategies
▪ The process is intended to eliminate interest rate risk that
includes:
▪ Price Risk
▪ Coupon Reinvestment Risk
▪ A portfolio manager (after client consultation) may
decide that the optimal strategy is to immunize the
portfolio from interest rate changes
▪ The immunization techniques attempt to derive a
specified rate of return during a given investment horizon
regardless of what happens to market interest rates

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Bond Portfolio Management
Classical Immunization

▪ Immunize a portfolio from interest rate risk by keeping

the portfolio duration equal to the investment horizon
▪ Duration strategy superior to a strategy based only a
maturity since duration considers both sources of interest
rate risk
▪ An immunized portfolio requires frequent rebalancing
because the modified duration of the portfolio always
should be equal to the remaining time horizon

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Bond Portfolio Management
Immunisation

▪ Duration is also a measure of the 'pivotal time to

maturity' of a bond.

▪ Assuming the yield curve is flat, and allowing a one-off

parallel shift in the yield curve, the value of the bond
measured at the duration time will not vary with the shift
in the yield curve.

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Bond Portfolio Management
Immunisation (Brailsford et al., Ex. 6.10, p.182)
• Consider a 8% 2-year bond with a yield of 6%, face value of
$100,000 and a duration of 1.890 years.

• What is the effect of a change in yield from 6% to 8% on

the value of the bond at the duration date? Using original
yield of 6% p.a.;

Value (Duration=1.890) = 4 000(1.03)1.89-0.5

+ 4 000(1.03)1.89-1.0
+ 4 000(1.03)1.89-1.5
+ 104 000(1.03)1.89-2.0

= $115,983.17
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Bond Portfolio Management
Immunisation (Brailsford et al., Ex. 6.10, p.182)
Example: Now consider the value of the bond at the new
yield of 8% p.a.

Value (Duration=1.890) = 4 000(1.04)1.89-0.5

+ 4 000(1.04)1.89-1.0
+ 4 000(1.04)1.89-1.5
+104 000(1.04)1.89-2.0
= $115,980.15

The change in bond value at the duration date is only $3.02. Note,
this is much smaller than the change in the current value of the
bond, which is $3,717.10.

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 Bond Portfolio Management
Immunisation (Brailsford et al., Ex. 6.10, p.182)

T=0 D = 1.89 Maturity

Increase
in Yield of
6% to 8%
Pt=D
Price decreases
by $3.02
Pt=0

Price decreases
by $3717.10

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Bond Portfolio Management
Horizon Matching

▪ Combination of cash-matching dedication and

immunization
▪ Important decision is the length of the horizon period
▪ With multiple cash needs over specified time periods, can
duration-match for the time periods, while cash-matching
within each time period
▪ See Exhibit 19.18

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Bond Management

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Bond Portfolio Management
Contingent Immunization

▪ Structured active management

▪ Duration of portfolio must be maintained at the horizon
value
▪ Cushion spread is potential return below the current market
return
▪ Safety margin is a portfolio value above the required value
▪ Trigger point refers to the minimum return that will stop
active portfolio management
▪ See Exhibit 19.21
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Bond Management

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