Learning Outcomes

BFC5935 Portfolio Management  Managed Fund Industry & Managed Fund Products

and Theory Equity Portfolio Management Strategies

 Passive Strategies
 Active Strategies
Lecture 9 – Portfolio Management I
Bond Portfolio Management Strategies
 Passive Strategies
 Active Strategies
 Matching Strategies
Lecturer: Dr. Manapon Limkriangkrai, CFA

Managed Fund Products 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
3 Source: https://russellinvestments.com/us/solutions/financial-professionals/lifepoints 4

Equity Portfolio Management Portfolio Management

Passive Strategies
Equal Weighting
 diversification
 equal investment
Minimum Variance
Passive equity portfolio management  least variance
 Long-term buy-and-hold strategy Minimum risk given expected return
 Usually tracks an index over time  lies on the mean-variance efficient set
Active equity portfolio management Index Tracking
 Attempts to outperform a passive benchmark portfolio  match the expected return and risk characteristics
on a risk-adjusted basis by seeking the “alpha” value

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

Passive Strategies Passive Strategies: Index Funds

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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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)

Portfolio Management Equity Portfolio Management

Passive Strategies Active Strategies: Fundamental Strategies
Index Funds
 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 Equity Portfolio Management
Active Strategies: Fundamental Strategies Management Approaches

The 130/30 Strategy Passive Semi-Active Active

 Long positions up to 130 percent of the portfolio’s
original capital and short positions up to 30 percent Low Exp. Return/Active Return High
 The use of the short positions creates the leverage
Low Risk/Active Risk High
needed, increasing both risk and expected returns
compared to the fund’s benchmark Information Ratio
 Enable managers to make full use of their fundamental
(approx.) 0 (approx.) < 1 (approx.) < 0.60
research to buy stocks they identify as undervalued as
well as short those that are overvalued

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Equity Portfolio Management Equity Portfolio Management

Core Satellite Approach 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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Source: www.vanguard.com.au

Equity Portfolio Management Equity Portfolio Management

Core Satellite Approach 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)
http://www2.goldmansachs.com/gsam/pdfs/USTPD/education/GSAM_I-S_Folder_client.pdf
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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: 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
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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: Value vs Growth
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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 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 Bond Portfolio Management

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

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

 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
 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 Bond Portfolio Management

Immunisation (Brailsford et al., Ex. 6.10, p.182) Immunisation (Brailsford et al., Ex. 6.10, p.182)
• Consider a 8% 2-year bond with a yield of 6%, face value of Example: Now consider the value of the bond at the new
$100,000 and a duration of 1.890 years. yield of 8% p.a.

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

• What is the effect of a change in yield from 6% to 8% on
+ 4 000(1.04)1.89-1.0
the value of the bond at the duration date? Using original
+ 4 000(1.04)1.89-1.5
yield of 6% p.a.;
+104 000(1.04)1.89-2.0
= $115,980.15
Value (Duration=1.890) = 4 000(1.03)1.89-0.5
+ 4 000(1.03)1.89-1.0 The change in bond value at the duration date is only $3.02. Note,
+ 4 000(1.03)1.89-1.5 this is much smaller than the change in the current value of the
+ 104 000(1.03)1.89-2.0 bond, which is $3,717.10.
= $115,983.17
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Bond Portfolio Management Bond Portfolio Management

Immunisation (Brailsford et al., Ex. 6.10, p.182)
Horizon Matching

T=0 D = 1.89 Maturity

Increase  Combination of cash-matching dedication and
in Yield of
6% to 8% immunization
Pt=D
 Important decision is the length of the horizon period
Price decreases
by $3.02  With multiple cash needs over specified time periods, can
Pt=0
duration-match for the time periods, while cash-matching
Price decreases within each time period
by $3717.10
 See Exhibit 19.18

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Bond Management 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 Copyright statement for items

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