Today’s Agenda: 14 Sep 2020

• Course Outline

• Group Projects & Evaluation

• Portfolio Management Project
• Equity Research Project
• End Term Exam
• CP

• Resources
• Binder PDFs
• Book PDFs
• Links

• Session 1
• Investment Process
• Pooled investment industry
• History of asset class returns
Investment Analysis &
Portfolio Management
Session 1
Investment Process
 Key Stages in Investment Process
I. Planning
– objectives: investment goals expressed in terms of required returns &
risk tolerance
– constraints include liquidity, horizon, regulations, taxes, unique needs
– may be formally stated in a financial plan (retail investors) or an
investment policy statement (institutional investors)

II. Asset allocation

– strategic: target allocation between equity, fixed-income, cash,
alternative assets based on investment policy
– tactical: allocation changes based on capital market expectations.
(Tactical allocation changes imply market timing, i.e., active management)
– allocation weights determined to achieve optimal risk-return trade-off,
while satisfying the constraints
Key Stages in Investment Process
III. Security selection
– selecting securities within each asset class
– may be based on investment analysis (active management) or indexing
(passive management)

IV. Trade execution

– maximising efficiency, minimising costs of trading
– trades may be motivated by new information, rebalancing needs, or cash
flows
Key Stages in Investment Process
V. Portfolio monitoring
– monitoring investor ‘s circumstances, as well as the economic & market
factors
– portfolio will be revised in case of divergence with IPS, changes in
IPS itself, or significant changes in capital market expectations

VI. Performance evaluation

– performance comparison with benchmark or with targeted rate of return
– attribution of performance to strategic asset allocation, market
timing and security selection for feedback
Pooled Investments Industry
• Mutual Funds

• Exchange Traded Funds

• Hedge Funds

• Private Equity Funds

• Separately Managed Accounts, Portfolio Management Services

Pooled Investments : Key benefits
• Expertise to ensure optimal return-risk tradeoff
– earn excess returns through security selection/ market timing
– risk-reduction through diversification

• Cost savings
– economies of scale
– efficient trade execution

• Flexibility to invest small amounts (mutual funds, ETFs)

 Mutual Funds
• Investments are pooled & units are held by investors

• Each unit is priced at its Net Asset Value (NAV)

– new units in open-ended funds are created or redeemed at the existing
NAV at the end of the day
– closed-ended funds are traded on exchange like shares

• Main classifications
– by asset allocation into equity MF, debt MF, hybrid MF or money-market
MF and further into sub-segments (ex. small cap, sectoral, etc.)
– by investment management into passive & active and further by
investment style (value, growth, etc.)
– by trading characteristics into open-ended & closed ended
Exchange Traded Funds

Portfolio
ETFs : Key benefits
• Can be continuously traded on exchanges

• Flexibility to grow depending upon demand from investors

• Low costs
– fund managers do not need to hold cash or handle transactions with
small investors directly, unlike open-ended MFs
– usually passively managed
Hedge Funds
• Usually take high risks
– use of leverage, short sales & derivatives
– but seek to eliminate risks not associated with core strategy

• Usually seek to earn absolute returns

- regardless of market conditions

• Not regulated/lightly regulated

– not marketed to retail investors

• Hedge funds charge significant management fees

– fixed fee + % of profits of the funds
Long Term Asset Returns
History of Stock & Bond Returns: Siegel
(1998)
• Jeremy Siegel (1998)
- book: “Stocks for the long run: Definitive guide to financial market returns and
long-term investment strategy”
- returns during 1802-1997 in the US for stocks, bonds, bills, gold & dollar

• Key conclusions
- equities dominated all other assets in the long term, despite adverse periods
(such as stock crash of 1929)
- real returns on stocks remain remarkably stable over long sub-periods,
indicating mean reversion property of stock returns
- bonds & bills also accumulated value but much lower than stocks
- value of gold followed the inflation trend but still eroded in purchasing power
terms
- currency (dollar) lost much of its value in purchasing power terms
History of Stock & Bond Returns: DMS (2002)
• Dimson, Marsh & Staunton (2002)
- book: “Triumph of the Optimists: 101 Years of Global Investment Returns”
- returns during 1900-2000 in 16 developed markets

• Annualised returns on stocks

- real returns were similar across countries (2.5%-7.6%, mean 5.1%)
- nominal returns ranged from 7.6% to 12.5%

• Annualised returns on bonds & bills

- real returns on bonds ranged between -2.2% & 2.8%, and on bills between -4.1%
& 2.8%
- returns and standard deviations on stocks were higher than bonds & bills across
countries (ex. in US, 20.2% on stocks vs 10% on bonds & 4.7% on bills)
- the equity risk premium over bills ranged from 1.8% to 7.1%, mean 5.0%
History of Stock & Bond Returns: Comparison

Source: Dimson, Marsh & Staunton, Triumph of the optimists: 101 years
of global investment returns, 2002
DMS updated: Credit Suisse Yearbook (2019)

• Key findings
– during 2000-2019, stock returns underperformed bond returns (real
returns of 3.1% vs 4.8%) in aggregate for 23 countries

– however, cumulatively (1900-2019), stocks still outperformed bonds & bills

(5.2% vs 2.0% & 0.8%)
Understanding Equity Risk Premium
• What is equity risk premium (ERP)?
− Forward looking estimate of excess returns on equity market
portfolio over the risk-free rate: E(Rm) – Rf
− Expected reward for taking extra risk
Estimation of Equity Market Risk Premium
• Demand-side
– equity risk premium can be estimated based on historical average
difference between returns on stock index and risk-free rate
(government bonds)
– alternatively, as implied by current stock prices & forward earnings
growth forecasts
– alternatively, a country equity risk premium can be added to
estimated equity risk premium for US

• Supply-side
▪ E(rm) = Dividend yield + Earnings growth - ∆Shares + ∆P/E
▪ ERP = E(rm) - Rf
Forecasts based on Relative Market Valuation
• Indicators based on relative market valuation
– ex. index P/E, P/BV ratios – either trailing or forward multiples
– improvements – ex. Shiller’s Cyclically Adjusted Price Earnings ratio (CAPE)
– Shiller’s CAPE = current index value ÷ average of past 10 years’ inflation-
adjusted earnings per share of index stocks
– A high CAPE indicates relatively overvalued market & hence prospects of
lower equity risk premium and vice versa

• Indicators based on relative spread between stock and bond yields

– ex. Fed Model compares earnings yield of stocks with treasury yields
– usually stock yields are lower than bond yields; narrower than usual spread
indicates that stocks have become expensive & vice versa
 Debate: Stocks for the Long Run?
▪ A long history of equity risk premium
− However, the magnitude may not remain as high. For ex., equity market return in US
exceeded earnings & dividends growth in the past, which may not be sustainable.
− Significant variation in sub-periods across regions

▪ Some empirical evidence of mean reversion in stock returns in the long run
− Tools like Shiller’s CAPE provide broad predictions of cyclical mean reversion

▪ Equities provide limited hedge against inflation in the longer run, though not
in the short term
− In comparison, returns on fixed income securities are the worst affected by inflation.

▪ Bottomline:
– Case for diversification across asset classes
− Exposure to equity should increase with investor’s risk tolerance & investment horizon