Ch 20 - Portfolio Management (1)

Question 1

The most common investment management styles and stock selection approaches are

Answer 1

Growth

Value

Momentum

Contrarian

Rotational

Top-down

Bottom-up

Passive

Active

Question 2

When the market is confident and rising - growth stocks tend to

Answer 2

out-perform

Question 3

When the market is falling - investors prefer

Answer 3

value stocks

Question 4

Growth stocks

Answer 4

Expected to experience rapid growth of earnings, dividends and hence price

Typically have high price-to-book values

Tend to be more volatile than value stocks

Question 5

5 growth factors

Answer 5

Sales growth

Earnings growth

Forecast earnings growth

Return on equity

Earnings revisions

Question 6

Value stocks:

Answer 6

Appear good value in terms of certain accounting ratios, such as P/E ratio or book value per share

Seen to be the safer bet - due to more asset backing and higher cashflow

Question 7

5 value factors

Answer 7

Book to price

Dividend yield

Earnings yield

Cashflow yield

Sales to price

Question 8

Momentum

Answer 8

Purchasing (selling) those stocks which have recently risen (fallen) significantly in price on the belief that they will continue to rise (fall) owing to an upward (downward) shift in their demand curves

Question 9

Contrarian

Answer 9

Doing just the opposite to what most other investors are doing in the market in the belief that investors tend to overreact to news

i.e. Short term markets tend to overreact to news

Aims to take advantage of excessive volatility in investment markets

Question 10

Rotational

Answer 10

Moving between value and growth depending on which style is believed to be attractive at any particular point in time

This approach requires considerable skill in reading the market

Question 11

Top-Down

Answer 11

Involves a structured decision-making process which starts by considering the asset allocation at the highest level (between asset classes).

Within each asset class an analysis is then made of how to distribute the available fund between different sectors

and finally the selection of the individual assets to purchase is made.

Question 12

The top-down approach would usually follows these steps:

Answer 12

Decide upon the long-term benchmark or strategic asset allocation of assets between countries and between the main asset categories

Decide on the short-term tactical split of investments, again between countries and between the main asset categories based on a shorter-term view of global economic and investment issues

Given the chosen tactical asset allocation, decide upon the sector split within each asset category

Finally, within each sector decide which particular stocks are “best value”

Question 13

Types of data that are important to consider for strategic asset allocation

Answer 13

Inflation (short-term and long-term)

Interest rates (same as above)

Economic growth

Currency movements

Equity and bond market yields

Investment objectives, attitude to risk and/or liabilities of the investor

Investment strategies by peer group

Structural shifts within the economy

Question 14

Bottom-Up

Answer 14

Seeks to identify the best value individual investments, irrespective of their geographical or sectoral spread

Question 15

Analyses Used to Aid Stock and Sector Selection:

Answer 15

Fundamental analysis

Quantitative techniques

Technical analysis

Question 16

Relative merits of Top-down approach

Answer 16

More balanced, diversified portfolio

Argued that the biggest difference in portfolio performance come from differences in asset allocation rather than individual stock selection

Concentrates on the bigger picture

Question 17

Relative merits of Bottom-up approach

Answer 17

Argue that the whole is always simply the sum of the parts - thus should concentrate on performance of individual assets

Less diversification

Less time spent on the bigger picture (strategic issues)

Question 18

Approaches to passive management include:

Answer 18

Index tracking

Commercial matching

Immunisation (as a method of passively managing a bond fund)

Question 19

Advantages of index/passive investments:

Answer 19

Lower dealing and research costs

Risk of under-performing the index in question - and indirectly also your competitors - is greatly reduced

Tracking a well-diversified index will ensure that the fund itself is well-diversified

Appropriate if the particular market is believed to be efficient

Question 20

Disadvantages of index/passive investments:

Answer 20

Loss of upside potential

Implicit restriction to markets and asset classes where a suitable benchmark exists

Insufficient regard to the investor’s objectives and hence result in unacceptable levels of actuarial risk

A fully replicating index tracker is forced to buy new constituents of an index at inappropriate times (artificially high price as other index-tracking investors are also trying to buy the new share), and also be a forced seller of shares that drop out of an index

Question 21

The available approaches to index tracking include:

Answer 21

Full replication
Sampling (also called stratified sampling or partial replication)
Synthesizing the index using derivatives

Question 22

Main advantages of sampling and synthetic replication (compared to full replication):

Answer 22

Management costs ought to be lower

Dealing costs are likely to be lower

Question 23

Main disadvantages of sampling and synthetic replication (compared to full replication):

Answer 23

Tracking error is likely to be greater

Research costs of deciding which shares or derivatives to hold may be higher

Question 24

Active investment managers can be divided into two groups:

Answer 24

Multi-asset (balanced) mandates

Specialist mandates

Question 25

Why actively manage? (Advantages)

Answer 25

Offers the prospect of large returns

Limitation of “peer group” risk

Question 26

Disadvantages of active management:

Answer 26

Hard to successfully select active managers (past performance does not indicate future performance)

Timing the changes to the line-up of active managers is also very difficult

COSTS!

Question 27

Anomaly Switching:

Answer 27

Involves moving between bonds with similar volatilities, thereby taking advantage of temporary price anomalies

It is a low-risk strategy

Question 28

Techniques used to identify possible anomalies include:

Answer 28

Yield differences
Price ratios
Yield models
Price models

Question 29

Are low-coupon bonds less or more volatile than high-coupon bonds

Answer 29

more

Question 30

Fixed interest bond volatility

Answer 30

sensitivity of the bond price to a change in its gross redemption yield

Question 31

5 step guide to a anomaly switch (based on yield difference here):

Answer 31

1. Check that the yield is genuinely an anomaly
2. Find the stock in our portfolio that has the closest volatility to the target stock
3. Simultaneously sell (buy)our similar stock and buy (sell) the anomaly stock
4. Wait for the anomaly to disappear (price reverts to normal)
5. Switch back (reasons are):

Avoid a more fragmented portfolio

Fund managers like to “crystallise” their profits

Question 32

Policy Switching:

Answer 32

Involves moving between bonds with different volatilities, to take advantage of predicted changes in the level and/or shape of the yield curve.

This changes the overall characteristics of the portfolio whereas anomaly switching does not

Is a riskier strategy

Question 33

Policy switching may be aided by the analysis of:

Answer 33

Bond volatilities (and duration)
Reinvestment rates
Spot/forward rates

Question 34

Alternatives to Government Bonds

Answer 34

CHICAS DAME - sexier than government bonds and thus managers may use these rather than policy and anomaly switching to try and deliver additional returns

Agency bonds

Investment grade corporate bonds

High yield bonds

Convertible bonds

Distressed debt

Event-linked bonds

Interest rate and inflation swaps

Credit default swaps

Mortgage backed securities

Asset backed securities

Question 35

The additional return (/premium) that a non-government bond offers over a government bond is generally regarded as being made up of two elements:

Answer 35

Credit risk premium

Illiquidity risk premium

Question 36

Where a bond portfolio is used to match specific liabilities, techniques that may be used to control bond portfolio risk include:

Answer 36

Immunisation

Stochastic ALM

VaR calculations

Multifactor modelling