T4 Managing an Equity Portfolio

Question 1

You are a portfolio manager with the following portfolio split among equities and fixed interest.
Briefly outline what insider trading is and how insider trading laws might affect:
1. A fund manager making a company visit
2. Management speaking to a fund manager during a company visit

Answer 1

Insider trading refers to transactions based on private information of a listed company that has not been made publicly available and would result in material impact on the market price of the company shares if publicly available. Insider trading is prohibited by Corporations Act.

1. During a company visit, a fund manager can only expect to obtain material information that is already public. If he/she does obtain information that is not already public, it cannot be used.
2. Management must be not give non-public price-sensitive information to a visiting analyst or fund manager during their discussions.

Question 2

Explain the differences between fundamental equity analysis and technical equity analysis.

How does each of these aim to add value?

Answer 2

Fundamental analysis is based on the philosophy that all securities have intrinsic or fair values which are determined by the future cash flows and risk characteristics of the business and that market prices will, in the long run, reflect these intrinsic values. Such an investor then attempts to take advantage of short-term deviations from these intrinsic values (mispricing).
Technical analysis is based on the proposition that information concerning the future movement of stock prices may be obtained by the study of historical stock prices and their patterns. Attempts are made to profit by identifying likely short-term price movements based on these past price patterns.

Question 3

Explain the differences between the following types of equity management:
1. Bottom-up (micro)
2. Top-down/theme-based (macro)
For each of these, indicate if they are fundamental analysis-based or technical analysis-based management styles.

Answer 3

The bottom-up style focuses on individual company research with usually an emphasis on the balance sheet and P/L accounts. Most, if not all, time is spent on modelling of individual companies. Macro-economic factors are considered within the framework of the individual company model.
The top-down style has a sectoral focus, with the aim of identifying broad macro-economic themes and trends. Only within these broad investment themes are stock-specific factors considered.

The two styles are both fundamental in nature and differ only by the degree to which macro and micro data is emphasised in the analysis.

Question 4

Explain the practical problems faced by passive management i.e. tracking some index?

Answer 4

1. Cost issue - very expensive and impractical to replicate the entire index - so, normally you’d cover the larger, more liquid stocks that make up most of the index, and sample the smaller, less liquid ones.
2. Changes in the composition of the relevant index may be hard to tag.

Question 5

What is the usual average ad valorem fee differential (between active and passive FUM)?

Answer 5

0.4% p.a.

Question 6

Which cost items make up the transaction cost incurred by active management?

Answer 6

• brokerage 0.4% (on a round trip basis) plus
• 0.5% (for market impact i.e. impact of trade on mkt price of the shares) of turnover (active manager’s turnover rate is usually 50-80% p.a. vs 8% by a passive manager); plus
• potential CGT on realised capital gains

Question 7

How do you calculate portfolio turnover rate?

Answer 7

Turnover rate = lower of purchases and sales / average asset value

Question 8

Describe the overview of investment styles.

Answer 8

fundamental/qualitative analysis - most commonly used;

technical and quantitative analysis - less prevalent invesment styles.

Question 9

What are the key variables for fundamental analysis (for active management for an equity portfolio)?

Answer 9

Macroeconomic variables - growth, inflation, interest rates

Industry sectors

• govt legislation
• technological innovation and new discoveries
• competitive structure of the industry (porters 5 forces)

Company stock specifics - management, market position, operating leverage, financial leverage, solvency

Question 10

Describe in fundamental analysis how key variables are generally used?

Answer 10

Once you have assessed all relevant fundamental factors during research, you form a view about the long term impact these fundamental factors are estimated to have on the investment in question, then you estimate the expected long term asset Rs based on that long term impact, then you finalise your active management decisions: with that forecasted fundamental value in mind, as an active manager, you may be able to take advantage of short term price fluctuation, especially if the investment’s current mkt price deviates significantly from its long term expected mkt price (overbought or oversold).

Question 11

Forecasting/evaluating earnings is mostly focused on PE. Why might mkt PE differ from PE in theory?

Answer 11

Because in practice, the appropriate PE for any particular company is influenced by further analysis i.e. market average PE (analysing historical PEs with adjustment making the PE data comparable) and stock specific factors (the P and the E, at any time, are subject to interest rates, inflation and economc cycle)

Question 12

What alternative ways are there to forecast valuation of a listed company? (other than PE)

Answer 12

price/book

price/cash flow (quite popular as it focuses on CF avail to coy)

EV/sales

EV/EBIT

Question 13

What is the main criticism against fundamental analysis?

Answer 13

The info gathered for the analysis is always lagging reality, hence provides little present/forecast guide to underlying changes within an industry/sector/company.

Question 14

Name the 5 active fundamental management investment styles.

Answer 14

growth, value, GARP, quality, contrarian

Question 15

What is growth investing? What is value investing? What is GARP investing?

Answer 15

Value stocks present an opportunity to buy shares below their actual value, and growth stocks exhibit above-average revenue and earnings growth potential. Growth and value most common styles (and the 2 tend to have negative correlation)

GARP stands for “growth at a reasonable price” and is really a combination of value and growth investing. GARP investors are looking for a stock that is trading for slightly less than its estimated value that also has earnings growth potential.

Question 16

What does growth investing focus on?

Answer 16

Focus is on future earnings, forecast EPS, forecast sales growth, sustainable growth, PE growth, positive earnings surprise /momentum, very good price growth e.g. US IT stocks, US and European healthcare stocks

You’d typically find growth stocks in sectors that are heavy on R&D spending and innovation

Question 17

What is quality investing?

Answer 17

Quality investing is an investment strategy based on a set of clearly defined fundamental criteria that seeks to identify companies with outstanding quality characteristics. There has not been an absolute definition of quality yet, but it is usually linked to some measure of profitability e.g. ratio of gross profit to assets, ratio of equity income to book value, ROE)

Question 18

Describe briefly Piotroski’s F-score.

Answer 18

It emerged as a multi-factor definition of quality in the context of quality investing. It uses 9 measures for identifying quality company characteristics. Each measure captures a different aspect of the company’s health hence assesses equity quality. Score range for each measure = 0-9, higher the better.

The measures assess profitability, accrual measure, capital structure, liquidity. Research on quality investing is ongoing and the optimal mix of quality factors for portfolio construction is yet to be determined.

Question 19

What is contrarian investing? What are the main features of it?

Answer 19

• exploit behavioural biases (e.g. herding of crowds, anchoring on the past) do the opposite of what the majority do ‘bet against popular trends’
• tend to appear wrong for a long time (as mkt may take many years before it corrects its view to agree with the contrarian’s )
• typically buy early, sometimes years ahead of the price recovery
• challenge is that the manager must maintain his conviction for many years, often turns out to be incorrect and have to then be cut throat in conceding one’s incorrect and selling losers

Question 20

What is theme-based (thematic/top-down) investing? Is it often employed in growth investing or value investing?

Answer 20

Theme-based/top-down investing is identifying macroeconomic factors/trends with a sectoral focus in an attempt to estimate trends/themes. Company specific factors are only assessed within a theme-based model. It is more commonly used in growth investing, as opposed to value-investing whereby it is more common to use bottom-up fundamental analysis to estimate company value relative to its current market price.

In practice, bottom-up stock picking is far more common than top-down/theme-based stock picking.

Question 21

What is technical analysis? What are the issues faced if relying solely or predominantly on the technical analysis based approach?

Answer 21

It is the study of historical price/vol relationships/trends/patterns to unearth clue to future price momentum.

Premises inconsistent with weak form of EMH (market reflects current publicly avail info and has no relationship with past performances.). The Purists would say: all there is to know is in the charts! Markets follow readable paths. Financial statements and management forecasts are worthless baggage. Technical analysis more approapriate for futures mkt rather than physcial shares mkt due to the rapidity of tading and absence of minute by mintue change of the fundametal factors (which influence commodities, share indices, bonds, forex)

The main issue faced by the technical analysis-based approach is:

wholesale/institutional fund managers are rated on not just their performance, their methodology, sources of information and how they make their decisions are all assessed. They also have to explain to their clients articulating sources of their inv strategy decisions in terms of some fundamental factors like the macroeconomic variables (interest rates, inflation, exchange rates), corporate earnings, preferred industry sectors etc.

Question 22

Why do managers bother using technical analysis at all?

Answer 22

• Cross-reference check - against fundamental analysis already done.
• Relative performance - charts can be used to gauge relative performance (sectors, markets, stocks)
• Signal changes in direction - discover longstanding trends and spot the broken points of trends which may signify exhaustion/start of a recovery; help mgrs decide entry/exit points e.g. help them gauge if there is more selling pressure before investing in haste; help momentum-based investors as earnings trends tend to persis for the short run (3-6 months or possibly more in some cases)

Question 23

What is quantitative as an investment style?

Answer 23

a stock picking process using a 4-factor criteria {value, growth, momentum, quality}, with each factor having its won set of quantitative metrics.

Main criticism is that quant models are not informed by detailed forecasts re: company, industry, economy; relies on statistically measuring past time-series and assuming these continue into the future. Note that Quantitative investing is also inconsistent with the weak form of EMH as it digs into historical data.

Question 24

What is factor investing? Name MSCI’s 6 equity risk premia factors.

Answer 24

It is one type of quantitative investing as it targets quantifiable firm characteristics / factors that explain differences in stock returns and is based on observable data. Factor investing is an alternative to passive and active investing.

MSCI’s 6 equity risk premia factors: value, low size (small companies), low volatility, high div yld, quality and momentum. MSCI’s 6 factor model attempts to build a truly diversified portfolio with the understanding of which factors drive long term equity returns. One can use the MSCI factor indices passively for factor allcation - a good way to prevent manager style drift.

Question 25

What are the main benefits of using the MSCI factor indices?

Answer 25

It allows manager to passively follow the indices to undertake factor allocation.

It prevents manager style drift.

It enables investors to invest via factor allocation based on their preferences for performance and risk, beliefs on individual factors and investment constraints.

Question 26

Describe 2 common option strategies used by a portfolio manager?

Answer 26

1. Option writing to hedge position = covered call (already own same volum of shares which you sell a call option for )
2. Typical strategy when uncertain and nervous about which way the market moves: sell shares, buy calls, balance of the funds in money market.