Professional Documents
Culture Documents
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Long Term US Indices
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What about Japan?
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Performance – Absolute and Relative
Measure Absolute Relative (to benchmark)
Return rp ra = rp – r b
Return of the portfolio Also known as active return
(rp) or benchmark rb or outperformance
The higher the better The higher the better
• Definition: Invest in companies with high dividend yield • Cheap stocks may remain
and/or low P/E and/or low P/B ratios; discounted price (buy cheap forever!
Value under-priced stocks and avoid expensive ‘glamour’ stocks) • What catalyst will make the
• Conscious of risk price rise?
• Definition: Invest in companies with high (above-average) • Little attention paid to price
earnings growth • Earnings growth may not
Growth • Growth companies have high P/E and/or high P/B ratios materialize
• Upside potential (expects market to pay a premium in future
for higher growth)
• Definition: Avoids the extremes of either growth of value • May underperform pure growth
investing (sits between value and growth) in sharply rising markets
GARP
• Invests in a catalyst that leads to higher stock prices. • May underperform pure value in
(growth at
reasonable • Smooth historical performance with less extremes sharply declining markets.
price) • Attention to price
• GARP is suitable for riding the business cycle (next slide).
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The Stock Market and the Business Cycle
Natural resources,
energy
Capital good
industries such as
equipment, Pharmaceuticals,
transportation, or peak goods, consumer
construction staples, utilities
Consumer
trough durables,
technology
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Growth and Value Indices
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Other investment style
• Price momentum
– Good or bad recent performance of a particular stock
continues over time (Jegadeesh and Titman)
– Take advantage of upward or downward trends in stock
prices or earnings (see below)
– Momentum signal: past 3-12 months returns
• Earnings momentum
– Firms that exhibit persistent high earnings perform well
– Firms that report unexpectedly high earnings outperform
firms that report unexpectedly low earnings
• Firm size
– Small firms may outperform large size firms
– Liquidity (mostly involving thin trading of small company
stocks) is an important concern.
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Socially Responsible Investing (SRI)
• Integrates ethical or societal concerns with investment
decisions
• Typically uses stock screens
– Negative screens to exclude undesirable characteristics
(such as gambling, tobacco, etc.)
– Positive screens to include desirable characteristics
(such as high labor standards or good corporate
governance)
• Particular screens are employed to reflect client
concerns
• Can introduce unintended consequences, as excluding
polluters (energy and utilities) may introduce a growth
bias.
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Long-Short Investing
• Many portfolios are prohibited from short sales
• Value added by manager is called alpha (excess return)
• If short sales are permitted, manager can effectively contribute
two alphas
– Buying underpriced stocks and selling over-priced stocks
• One of the market neutral strategies designed to deliver returns
that are not impacted by the movements of the broader market
– The short position acts as a hedge against market decline
– Can have twice the negative alpha when stock selections go the
wrong way
– What is important is that the long position outperforms the short
position on a relative basis
• Leverage can magnify alpha but increases risk that short-term
movements force manager to unwind positions.
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How to Estimate the ‘Style’ of a Portfolio?
• A portfolio’s performance can be viewed as a
blend of the performance of its style and of
the stock picks away from its style.
• Example: The Growth Index generates +5%,
the Value Index generates +8% and a manager
generates +7%
– Is the manager a bad value manager, a good
growth manager or something else entirely?
• To answer this question we need to know the
value/growth characteristics of the fund.
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Returns-Based Style Analysis (RBSA)
• Characterizes a portfolio as revealed by its return
• Regresses portfolio return against a set of indices that are:
– Mutually exclusive
– Exhaustive with respect to manager’s universe
– Distinct sources of risk (not highly correlated) – see MPTM,
p.436
• Coefficient values on respective index (for example value
and growth indices – see diagram in an earlier slide) betas
must be non-negative and sum to 1
– The purpose is to examine portfolio’s proportional exposure
to the particular style represented by the index
• Tries to estimate the manager’s characteristics by
comparing her/his returns to the returns of the various
styles.
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Returns Based Style Analysis (RBSA)
• Advantages
– Characterizes entire portfolio of the fund manager
– Facilitates portfolio comparisons
– Aggregates effects of investment process
– Different models usually give similar results and
characterizations
– Clear theoretical basis for portfolio categorization
– Requires minimal information
– Can be executed quickly
– Is cost effective
• Disadvantages
– May not effectively characterize current style
– Mis-specifying indices in model may lead to inaccurate
conclusions
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Holdings-Based Style Analysis (HBSA)
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Holdings Based Style Analysis (HBSA)
• Advantages
– Characterizes each position
– Facilitates direct comparisons of individual positions
– May capture changes in style more quickly than
returns based analysis
• Disadvantages
– Does not reflect the way many managers approach
security selection
– Requires judgment in specifying classification
attributes
– More data intensive than returns-based analysis
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Style Drift in Equity Portfolios
• Style drift is the term used to describe
inconsistency in management style
• Presents an obstacle to investment
planning and risk control
– If a manager is hired to get the value
exposure, you do not want the style to drift
to growth
– Manager may not have as much expertise
in selecting stocks of a different style.
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Active Management Strategies
• Top Down
• Bottom Up
• Quantitative Factor Models
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Top-Down Approach to Security Selection
• Focuses primarily on macroeconomic factors or
investment themes
– What themes are affecting the global economy
– How do these themes affect various sectors and
industries
– Are there any special country or currency
considerations
– Which stocks within the industries or sectors will
most likely benefit
• Examples: expected uplift in industrial production
– Another example: if resource prices are expected to
be positively affected, then buy resource stocks.
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The “Top-Down” Analytical Framework
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The Business Cycle and Industry Sectors
• Economic trends can and do affect industry performance
• Company performance varies within industries
• By identifying and monitoring key assumptions and variables,
we can monitor the economy and gauge the implications of
new information on our economic outlook and industry
analysis
• Cyclical or Structural Changes
– Cyclical changes in the economy arise from the ups and downs
of the business cycle (cyclical indicators in Lecture 3 folder)
– Structure changes occur when the economy undergoes a
major change in organization or how it functions
• Rotation strategy is when one switches from one industry
group to another over the course of a business cycle.
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The Stock Market and the Business Cycle
Natural resources,
energy
Capital good
industries such as
equipment, Pharmaceuticals,
transportation, or peak goods, consumer
construction staples, utilities
Consumer
trough durables,
technology
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Bottom-up Approach to Security Selection
• Focus on company-specific fundamentals or factors
– Focus on company-specific fundamentals such as
revenue, earnings, cash flow or new product
development
– E.g. a value investor might screen stocks based on P/E
or dividend yield
– Have little interest in the state of the economy or other
macro factors but rather try to put together the best
portfolio of stocks based on company-specific
information.
• Invest in companies with good prospects or valuations.
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Example of Bottom Up Security Selection
Find a company with
• Good management
• Good growth prospects
– Few competitors, strong barriers to entry
– Many clients, no substitute products
• Good value
– Low P/B ratio, low P/E ratio
– High Return on Equity
• Etc. (whatever other criteria you decide)
• Invest appropriately to your risk budget (based on
level of risk tolerance).
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Simple Example of Active Equity
Strategy
1. Philosophy: stocks with low p/e ratios reflect
over-pessimism regarding the future
2. Signal creation: calculate p/e using forward
earnings estimates
3. Capture of signal: rank stocks on p/e, buy
lowest 1/3
4. Implementation: rebalance quarterly
5. Feedback: review performance of low p/e
stocks in general, our 1/3 list, then our
portfolio
See SPH-BKM, Chapter 11
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Portfolio Construction
Consider an investor who is measured against the
benchmark, so active risk and active return are their
only considerations:
• If you have no information about a stock, hold it
at benchmark
• For the stocks for which you do have information
(expected returns), weight them so as to overall
maximise your expected return and minimise
your risk (tracking error) within your constraints
(you can use mean variance optimisation (MVO)
or other techniques).
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A Quantitative Four-Factor Model
• Empirical studies using back-tests suggest that some stock
characteristics are a positive signal for future returns:
– Price momentum (price history)
– Value
– Quality
How reliable the earnings are?
– Earnings momentum
Changes in analyst expectations of stock earnings
Rt+1 = α + fbBetat + fssizet + fbmB/Mt + fmmom+ e
• “Stock selection using a multi-factor model – Empirical
evidence from the French stock market”, The European
Journal of Finance 2001.
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A Quantitative Four-Factor Model
(Continued)
Process:
1. Measure each stock in terms of the factors.
2. Combine the measures in some way to get an overall
score for each stock
3. Weight the stocks according to their scores –
overweight the desirable stocks and underweight the
undesirable ones
The above is the basis of the process for many
quantitative equity managers.
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Manager Selection
Equity Manager Questionnaire (MPTM, p.467)
• Creates formal basis for comparing equity
managers by outlining five key areas:
1. Organization, structure and personnel
2. Investment philosophy, policy and process
3. Research capabilities and resources
4. Historical performance/risk factors
5. Fee structure.
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Selecting Equity Managers
• Qualitative factors
– People
– Organizational structure
– Investment philosophy
– Process
– Strength of equity research
• Quantitative factors
– Performance relative to benchmarks and peers
– Measured style orientation and valuation
characteristics of managed portfolios
• Seek consistency between stated and actual
practices.
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Predictive Power of Past Performance
• Must include disclaimer that “past
performance is no guarantee of future
results”
• Studies indicate that few managers
consistently remain in top quartile
• Consistency of performance is important
– same level of performance more highly
valued if it comes from people and
processes with consistent outcomes.
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Optimizing Allocations to a Group
of Managers
• Want to maximize active return for
a given level of active risk
determined by investor’s aversion
to active risk
• Similar to stocks, except you are
picking portfolio managers instead
of stocks.
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Blending Managers: Reward vs. Risk
Blending is the packaging of funds to achieve:
• Enhanced risk/return profile
• Size and style are combined as shown in Tables (slides 4, 5 and 6 in Additional Lecture Notes)
– Small-cap and International are least correlated
– Value, especially smaller cap, dominated recently, turnaround from 2000-end, and longer
term while Growth, Small-cap and International exhibit highest volatility (1998-08)
• Passive equity portfolio management requires benchmarking to a stock market index
– Three methods of stock market index construction (see separate example in Moodle)
1. Price weighted equity indices - weight each stock according to its share price
Examples: Dow Jones Industrial Average (DJIA), Nikkei-Dow Jones Average
2. Value (capitalisation) weighted (also known as market value weighted) equity
Indices: (Market value = value = number of shares outstanding X current market
price) - Examples S&P 500, S&P\ASX 300 (most major indices are value-weighted)
3. Equal weighted equity indices: weights each stock in the index equally – Example:
Value Line Averages in the USA
• Indexation is the process of building a portfolio designed to closely track the index – a passive
portfolio: there are a number of ways of doing this:
– Full Replication
– Stratified Sampling
– Optimisation.
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Conclusions
• Equities typically provide higher portfolio return (and
risk) if they are included in portfolios
• If markets are (very close to) efficient, then indexation
(passive management) makes sense
• There are three main methods for indexation – (i) full
replication, (ii) stratified sampling and (iii) optimisation
• Stocks can be characterised by styles
• Active managers are typically top-down, bottom up or
quant
• Select managers to get desired style exposure and to
maximise information ratio (IR) within your risk
constraints.
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