Flashcards in Portfolio management Deck (32):
Active management styles
In this section we look at the most common investment management styles and stock selection approaches, including:
top-down bottom-up passive
Some investment managers are also referred to as “large cap” managers or “small cap” managers, indicating that they focus on building funds with shares with large or small market capitalisations. These are not dealt with in this chapter.
Growth and value styles
Investment styles are a common way to distinguish between asset managers. Managers describe themselves as either Growth or Value managers – ie managers who specialise in managing portfolios of growth stocks or value stocks respectively.
Broadly speaking, growth stocks are stocks that are expected to experience rapid growth of earnings, dividends and hence price. In contrast, value stocks are those that appear good value in terms of certain accounting ratios, such as the price earnings ratio or book value per share. In addition, growth stocks tend to be more volatile than value stocks. There are, however, no hard and fast rules as to exactly what constitutes a growth stock or a value stock.
Typically, there are long periods during which growth stocks will out-perform value stocks, and vice versa. Generally speaking, when the market is confident and rising, growth stocks will tend to out-perform and when investors are nervous and the market is falling, investors prefer value stocks. Value stocks are seen to have more asset backing and higher cashflow and therefore will be a safer bet. In the event of unfavourable economic conditions, the theory is that value stocks will at least be worth the accounting value of their assets.
Why might we want to analyse the styles of investment managers?
Benchmark providers have developed growth and value variants of standard indices.
Growth managers and value managers typically aim to actively manage their portfolios. Such indices are therefore used as a benchmark against which to assess the performance of an active growth manager or an active value manager. Equally, these indices could be used as a benchmark for index-tracking purposes.
The most commonly used of these are the MSCI-style indices, which take the universe of a standard index and rank the securities according to price-to-book values. The top half – stocks with low price-to-book values – is associated with the value style and the bottom half – stocks with high price-to-book values – is associated with the growth style.
An alternative approach identifies five growth factors:
An alternative approach identifies five growth factors:
1. sales growth
2. earnings growth
3. forecast earnings growth
4. return on equity
5. earnings revisions
and five value factors:
1. book to price
2. dividend yield
3. earnings yield
4. cashflow yield
5. sales to price
and uses these factors to distinguish between growth and value securities.
Other equity investment management styles
Momentum – 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.
This approach therefore aims to take advantage of momentum effects in investment markets. Investors that used this method during the early years of the late 1990s internet boom would have performed startlingly well!
Contrarian – doing just the opposite to what most other investors are doing in the market in the belief that investors tend to overreact to news.
The rationale for this approach is that whilst over the long term most shares will give an average performance, in the short term markets tend to over-react to good and bad news. So if a share has performed well recently, the chances are increased that it is over-priced and will perform poorly in the coming months. This approach therefore aims to take advantage of excessive volatility in investment markets. Investors that used this approach during the early years of the internet boom would have performed very poorly.
Rotational – 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 (or fortune) in reading the market. In general such investors will wish to be in growth stocks when the market is rising and value stocks when it is falling.
Top-down and bottom-up approaches – considered below. Strictly speaking, these are ways of constructing a portfolio rather than styles employed by individual investment managers.
Equity portfolio management techniquesTop-down
The top-down approach to constructing and managing a portfolio involves a structured decision-making process which starts by considering the asset allocation at the highest level ie between different asset classes. Within each asset class an analysis is then made of how to distribute the available fund between different sectors (eg different industries for equities) and finally the selection of the individual assets to purchase is made.
A top-down investment strategy is therefore based upon deciding what the big picture is likely to be, before looking at the detail. The top-down approach would usually follow the steps set out below.
1. Decide upon the long-term benchmark or strategic allocation of assets between countries and between the main asset categories. This might be determined using asset-liability modelling and the risk budgeting approach described in the next chapter.
2. 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. The tactical decision may be based on fundamental, quantitative and technical analyses. (Quantitative analysis is described later in this chapter and technical analysis in the next chapter. )
3. Given the chosen tactical asset allocation, decide upon the sector split within each asset category, eg whether banks will perform better than food retailers over the relevant time period within the domestic equity sector.
4. Finally, within each sector decide which particular stocks are “best value” (eg whether Bank X will outperform Bank Y within the banking sector). This will depend upon the results of an analysis of each individual company.
The actual buy and sell decisions with regard to individual investments are made on a day-to-day basis by the investment analysts working within each of the bond, equities and derivatives teams.
In contrast, a bottom-up approach seeks to identify the best value individual investments, irrespective of their geographic or sectoral spread.
These are then combined to form the investment portfolio.
Relative merits of the two approaches
The top-down approach lends itself better to controlling the risk of a portfolio by virtue of the fact that a balanced, diversified portfolio is held.
The main risk facing the investor is that of failing to meet its objectives, which in practice will often mean meeting its liabilities as they fall due. Continual reference to the investor’s liabilities as part of a structured investment decision process ensures that the process focuses on the matching requirements of the fund, thereby reducing this risk.
Top-down adherents would also argue that the biggest differences in portfolio performance come from differences in asset allocation rather than in individual stock selection.
This may well depend on the markets considered. For example, currency movements will often be the biggest influence upon the domestic currency returns achieved from overseas investment, with stock selection less important. In contrast, stock selection within unquoted equities may be very important.
\Concentration upon the big picture is a major advantage of the top-down approach, which means that it is most often used in practice. Note that although any specific institution will normally adopt one approach or the other, usually the top-down approach, there may still be scope for fund managers to achieve out-performance through “bottom-up”, or individual stock selection.
Defenders of the bottom-up approach, also known as stock pickers, would argue that starting with allocation between sectors ignores the fact that all investment performance starts with the performance of the individual assets held and that is where the analysis should be concentrated.
In other words, the whole is always simply the sum of the parts. However, the counter- argument is that too much concentration on individual stocks will mean that less time is devoted to analysis of the bigger strategic issues, that will ultimately have a greater impact upon overall investment performance and the satisfactory achievement of investment objectives. For example, it may prove more difficult to attain the appropriate level of diversification via the bottom-up approach.
In practice it is often possible to develop a methodology which combines the two approaches.
For example, prior to each “top-down” meeting, each investment manager might be required to submit “buy” and “sell” recommendations within her own sector. A predominance of well-founded buy recommendations within a particular sector might then indicate that an increased allocation should be given to that sector.
Analyses used to aid stock and sector selection
A number of methods can be used for asset allocation and individual stock selection. These include:
Methods for estimating relative value of sectors and individual shares have been discussed in previous chapters.
This refers to the discussion of fundamental analysis in Chapter 10.
The term quantitative analysis refers to
modern mathematical techniques that can be used to aid stock and sector selection. Essentially these are the asset pricing models described in Chapter 18 of this course, eg CAPM, which can be used to identify mispriced assets and hence trading opportunities.
The use of technical analysis and a particular example of quantitative analysis (multifactor models) are discussed in detail in the next chapter.
A further key decision that must be made by any investor is whether to manage the investment portfolio actively or passively.
Passive equity management
Having identified the strategic asset allocation that best meets the investor’s objectives, a passive approach to investment management involves simply maintaining that asset allocation until there is a change in the required strategy – eg in response to a change in the investor’s objectives. Thus, the investor might determine its long-term strategic asset allocation, reflecting its objectives, liabilities, tax status etc, and then simply maintain that same allocation, without variation, until the next high level review of its investment objectives.
Alternative approaches to passive management
Alternative approaches to passive management include:
index tracking, whereby the investor selects investments to replicate the movements of a chosen index.
tracking competitors, which is sometimes referred to as commercial matching
immunisation, as a method of passively managing a bond fund.
Index tracking is the most important form of passive investment management in practice. The aim of index tracking is to replicate the investment performance of a particular index (or set of indices).
Passive investment managers are, typically, index-trackers. They manage assets without taking active investment decisions. Instead, their objective is to track closely the performance of a specified index. This offers the advantages of lower cost and volatility, but with the loss of upside potential and the implicit restriction to markets and asset classes where a suitable benchmark exists.
The assumption behind the index tracking approach is that markets are relatively efficient and that any out-performance generated by active management does not justify the increased costs. An index-tracking fund therefore attempts to replicate the performance of a market index, either by holding all the shares in the index in the appropriate proportions, by one of a number of sampling techniques, or by synthesizing the index using derivatives.
Why index track?
The mechanics of index tracking
Some investment funds may be sufficiently large to justify holding all of the shares in the index, in proportion to their index weightings – typically their market capitalisations. This strategy is known as full replication of the index. The advantage of this approach is that the investment performance of the tracker fund should very closely mirror or “track” that of the index.
Consequently, the divergence between the performance of the index and that of the tracker fund (tracking error) should be minimised – at least before allowance is made for the tax and expenses that will be incurred by the fund but will not be reflected in the index performance.
normally, active managers are given a maximum tracking error, whereas passive managers are simply judged on how close to zero they can achieve
we give a more formal definition of how tracking error is typically measured in practice in Chapter 21.
Other approaches to index tracking
However, many tracker funds take a different approach. Thus, if the aim is to replicate the returns achieved by say the FTSE 100 index, rather than holding all 100 shares in proportions that correspond exactly to the index weightings, the tracking fund might instead hold:
a representative selection or stratified sample of FTSE 100 shares. In practice, this might involve, say, 30 shares carefully chosen so as to broadly reflect the various characteristics of the shares in the index, eg with regard to factors such as:
– the market weightings in each of the main sectors,
– the sizes of the companies
– their exposures to overseas earnings etc.
This approach is sometimes also referred to as partial replication.
an appropriate combination of cash and derivatives, again to broadly replicate
the performance of the index itself, by the creation of a synthetic fund.
In either case, a multifactor model might be used to help construct a suitable portfolio
so as to replicate as closely as possible the characteristics of the index in question.
Index tracking in practice
Index tracking can be applied in different ways and at different levels – ie at the level of the entire portfolio, within individual asset classes or just within particular sectors within each asset class. It is also possible to adapt different variations upon the general theme of index tracking to different subsets of the entire portfolio.
An investor might actively decide upon the strategic allocation between asset classes and then index track within each asset class.
An alternative approach might be to index track within some classes/sectors and not others. For example, index tracking might be more sensible in particularly:
efficient sectors, such as large blue chip companies, where price anomalies are likely to prove few and far between
inefficient sectors, such as emerging markets, where the potential for underperformance is likely to be greater and/or the level of investment expertise is lower.
A further variant upon the basic theme of index tracking is the core/satellite approach. This involves index tracking a “core” proportion of the portfolio whilst allowing the fund manager(s) to actively manage the remaining “satellite” funds.
There is nothing to prevent a particular investor from using a combination of different approaches for different asset classes, sectors and/or funds.
2.5 Active equity management
Having identified the strategic asset allocation, an active approach involves actively seeking out under-priced or over-priced assets, which can then be traded in an attempt to enhance investment returns via short-term tactical deviations away from the benchmark strategic position.
By seeking out under-priced or over-priced sectors, the investor may be able to make sector selection profits, whilst by identifying individual stocks that are under-priced or over-priced the investor may be able to make stock selection profits. In addition, additional profits (or losses!) may be generated by switching between sectors and/or stocks that appear mispriced relative to each other.
This will not be possible if the investment market in question is efficient. Thus, active investment management is appropriate only if the investor believes that the investment market is in fact inefficient. In contrast, if the market is believed to be efficient, then a passive manager might be employed to track a particular benchmark.
Active investment managers, on the other hand, apply
various types of judgement to the selection of portfolios with the objective of out-performing a benchmark. Active investment managers can be divided into two groups:
1. Multi-asset (balanced) mandates
Such managers manage funds that are invested across a variety of different asset categories such as equities, bonds, property and overseas. The balanced mandate manager will take decisions on the weighting in each asset category and decisions on the type of stocks purchased in each category (value/growth etc). They will try to out-perform managers that operate funds with similar mandates, constraints and tax treatments.
2. Specialist mandates
Here each investment manager specialises in a particular asset category and is employed to manage the funds invested in that asset category only. Each specialist manager will attempt to outperform the relevant benchmark, eg the FTSE 100 index.
This approach might be sensible if pension fund trustees wish to make their own decisions on the amount to be invested in the various asset categories and possibly the type of investment to make in each category. Specialist investment management groups therefore offer a range of specialist funds, for example, specialist “growth-style” equity funds, or specialist UK property funds. Trustees can then invest the pension fund directly in the chosen asset categories via such specialist funds.
Why actively manage?
Active management offers the prospect of large returns (in excess of fees paid) and the limitation of “peer group” risk.
Of course, consistent out-performance is possible only if the investment manager has the skills to exploit any market inefficiencies.
However, successful selection of active investment managers is
hard to achieve and timing the changes to the line-up of active managers is also very difficult.
For example, a good past record of successful out-performance will not guarantee future out-performance. This is because an approach that worked during one period might not prove successful over a different future period, especially given that investment market conditions continually change.
The value, growth, momentum, contrarian and rotational styles described above are all examples of active investment management styles.
“Active over passive” management
An increasingly popular fund management structure is to manage the majority of the fund (the “core” portfolio) on a passive, low-cost basis. Specialist satellite managers are then employed to, hopefully, provide increased performance (in excess of fees paid) in respect of the balance of the fund. This may extend to employing a number of competing managers in respect of the specialist asset classes, if the size of the overall fund warrants this. Increasingly, the satellite managers will include hedge fund and private equity specialists.
the discussion of private equity and hedge funds in Chapter 4 of this course
that the investor might choose to combine the active and passive approaches, managing assets actively within some sectors and passively within others.
Bond portfolio management techniques 3.1 Introduction
One technique for an institutional investor is to identify the bonds that would best match its liabilities and select those which give the best yield. Matching by itself is unlikely, however, to maximise the expected return on the bond portfolio. Consequently, bond portfolio managers will often adopt a more active approach to bond management, occasionally involving a divergence (perhaps only short-term) from the matched position, in order to achieve a higher return. This approach will be based around switching.
Active management of a bond portfolio involves selling one stock and buying another, in the hope of achieving a higher return. Returns can only be enhanced in this way in markets where there is a variety of highly marketable bonds available. The process is known as switching and can be classified in one of two ways. These are known as anomaly switching and policy switching.
Anomaly switching involves moving between stocks with similar volatility, thereby taking advantage of temporary anomalies in price. It is a relatively low risk strategy, but widespread use of computer-based analysis limits opportunities for significant anomalies between similar bonds.
So, this is where an investor spots that similar individual stocks appear to be temporarily cheap or dear. The investor can profit by selling dear stocks and replacing them with cheap stocks. It is a relatively low-risk strategy because the move is from the core portfolio into broadly similar stocks (in terms of coupon and term to maturity, and hence volatility). The chosen stocks will seem relatively more attractive according to one of the analytical criteria discussed below.
The idea is that the anomaly will prove temporary and that the switch can be reversed for a profit, when the situation returns to what is regarded as “normal”. Not surprisingly, increased sophistication of computer-based analysis has greatly reduced opportunities for significant anomalies between similar bonds.
Techniques for identifying anomaly switches
Yield differences and position relative to a yield curve
In considering possible anomaly switches, yield differences are widely used to identify individual bonds which seem cheap or dear in relation to other bonds. However, because high-coupon bonds are likely to have higher gross yields than low coupons, a high gross yield does not in itself indicate that a bond is cheap. The investor must examine whether the yield difference is greater or less than it has been in the past.
The assessment could be carried out against the yield curve or against the most similar term and coupon stocks. Various systems have been set up to compare yields on individual bonds with those on a fitted yield curve and to compare current differences with past averages and with past ranges.
For example, if a bond currently yields 40 basis points more than the yield on the fitted curve at the same maturity, but has recently traded at an average of 50 basis points above the yield curve, it might be considered somewhat expensive, on this measure.
A problem with the evaluation of individual bonds in relation to a fitted yield curve has been the stability of the method used to fit the curve.
In other words, small changes in yields on a few stocks can sometimes cause large changes in the fitted curve. An unstable fitted curve is a poor benchmark to compare individual stocks against.
It is now more usual to review a computer-generated history of yield spreads between actual pairs of bonds.
These can be monitored as well as yield differences. Ideally, a switch under consideration will look attractive, in relation to both yield and price histories. A practical problem in using price ratios is that they do not allow for the fact that the two bonds may have different coupons; they will have different prices but will both be redeemed at 100. So the ratio of the two prices will display a trend. This history of price ratios may be adjusted by this trend to produce what are often known as “stabilised” price ratios.
Some bond analysts have devised price models which try to assess the “correct” price for a stock, given the key variables. A stock’s price is considered anomalous if the actual price differs from the price derived from the model.
You are already familiar with a simple price model that incorporates the term and coupon of a stock:
P = gan| +100vn
This model is too crude for spotting anomalies because we don’t really know what valuation rate of interest to use. The valuation rate should vary between stocks to reflect their differences (eg marketability, coupon, double-dated). More sophisticated price models will therefore try to allow for these further factors.
Rather than compare a bond’s yield with a redemption yield curve it can be compared with one of the alternatives such as a yield surface or par yield curve.
Policy switching is a more risky approach that involves taking a view on future changes in shape or level of the yield curve and moving into bonds with quite different terms to maturity and/or coupon. For example if yields generally were expected to fall, the portfolio might be switched into longer-dated, more volatile stocks.
So, a policy switch is where an investor takes advantage of a movement in the level of the yield curve or a change in the shape of the yield curve. It is a more aggressive approach in which the investor takes a view on future changes in the yield curve. The investor moves into bonds with quite different terms to maturity and/or coupon, and hence volatilities, or even between different types of bond, eg fixed interest to index- linked.
A policy switch offers the prospect of greater profit if expectations are fulfilled, but can be much riskier than an anomaly switch. A less risky form of policy switch might involve a less dramatic move along the yield curve. In making policy switches investors consider the percentage change in value arising from a change in yield, ie the volatility.
Techniques for identifying policy switches
hree techniques that can help when making policy switches:
1. volatility and duration
2. reinvestment rates
3. spot rates and forward rates.
Volatility and duration
Volatility gives a measure of “risk” in terms of price movement for a given change in yield. While this is not an appropriate measure of risk for a fund manager whose investment objectives are determined with reference to long-term liabilities, it is a useful measure, within a bond portfolio, for policy switching.
In practice, the yield curve does not move by a uniform amount over the whole term. We need to consider changes in the shape of the yield curve as well as changes in the level of the yield curve.
Switches based on changes in the level of the yield curve
Calculations of volatility or duration together with forecasts for changes in yield at different points along the yield curve can be used to estimate percentage changes in value and so to determine the area of the market which will give the best returns, if the forecasts prove accurate. This might then lead the fund manager to make a policy switch between bonds of different duration.
For example, following careful research of government spending, inflation forecasts, overseas bond yields and exchange rates, we decide that the yield curve is too high and will shortly fall uniformly (ie once the rest of the market has woken up to the fact that yields are too high).
To profit most from our prediction we should switch from a short-term stock (A) to a longer-term stock (B). Because Stock B is more volatile, its price will rise more when yields fall. Once the yield curve has fallen, we switch back to Stock A.
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An important point here is that we make our move before the rest of the market. If we wait until everyone else thinks the same way as us, then the buying and selling activity will shift the yield curve before we make our switch. We want to be holding Stock B when the yields fall.
On the assumption that our holding of Stock A was part of a matched portfolio, we need to return to Stock A to return to the matched portfolio.
Switches based on pure changes in the shape of the yield curve
It is also possible to profit from changes in the shape of the yield curve regardless of what happens to the average level of the curve.
Suppose that a fund manager is considering a policy switch from Bond A to Bond B because he anticipates a change in the shape of the yield curve. Suppose he is selling $1m nominal of Bond A, he may wish to buy the appropriate amount of Bond B so that his exposure to changes in the level of yields is not altered. If Bond B has a longer term to maturity and/or a lower coupon, it is likely to be more volatile and so the fund manager may wish to buy a smaller amount of nominal, to maintain his original exposure to changes in the level of yields.
Another technique used in connection with policy switches is based on reinvestment rates.
Consider two Bonds A and B, the latter having a longer term to maturity. Knowing their yields to maturity, it is possible to compute a rate at which the proceeds of the first bond would have to be reinvested, up to maturity of the second bond, to match its total return. If this reinvestment rate is particularly high, it may be considered unattainable, leading to the conclusion that Bond B offers better value.
It is useful to select representative bonds at various points along the maturity range and to work out the reinvestment rates between each bond and the next. Examination of the series of reinvestment rates can help to identify areas which seem cheap or dear in relation to neighbouring areas.
Spot rates and forward rates
A similar technique to using reinvestment rates is to derive forward and/or spot rates from the yield curve. This may reveal oddities in the term structure of interest rates which give rise to a policy switch opportunity.
Alternatives to Government bonds
Bond markets have evolved rapidly over the last few years, increasingly the investible universe for investors. In addition to Government bonds the types of bond or bond-like investments include (not exhaustive):
Agency bonds – bonds issued by US government-sponsored agencies.
Investment grade corporate bonds
High yield bonds
Convertible bonds – bonds that may be converted into equity at a later date.
Distressed debt - securities of companies or government entities that are either already in default, under bankruptcy protection, or in distress and heading towards bankruptcy. While is no precise definition, any debt instrument with a yield of 10% over the risk-free rate can be thought of as being distressed
Event-linked bonds – bonds with coupons and redemption payments conditional on the non-occurrence of a defined event, such as an earthquake.
Interest rate and inflation swaps
Credit default swaps – these were discussed in Chapter 3.
Mortgage Backed Securities (MBS)
Asset Backed Securities (ABS) - MBS and ABS were discussed in Chapter 4.
Apart from policy and anomaly switching (see Section 3.4 above), a portfolio manager will use
some or all of the above bond like investments to try and derive additional return from a portfolio relative to a Government bond portfolio.
The additional return or yield premium that a non-government bond offers over a government bond is generally regarded as being made up of two elements:
an additional yield to compensate for the risk that the bond issuer will default (and therefore fail to meet its obligations)
an illiquidity premium to reflect the typically weaker marketability of non-government bonds to Government bonds.
There are some additional structural factors, especially with swaps which are also factored into the price.
Portfolio managers will take a view as to whether the additional yield for default and liquidity are correctly priced into a bond. Portfolio managers will purchase bonds where they believe the yield pick-up is greater than the additional risk of holding the bond.
Yield pick-up refers to the gain in yield when an investor sells one bond and buys another. They will do this if they believe the gain in yield is more than required for the increase in risk.
In recent times bond managers investing in non-government bonds have suffered from poor returns due to the ‘credit crunch’. In particular MBS and ABS were particularly affected, with liquidity ceasing to exist for large periods of time.
The credit crunch
The phrase "credit crunch" was so widely used between 2008 and 2010 that it was added to the Oxford English Dictionary.
The credit crunch was a lending crisis caused when banks became nervous about lending funds to each other because of concerns about the value of collateral used to secure the loans. For example, Northern Rock found itself unable to refinance a significant loan and was forced to approach the Bank of England for a loan facility.
Why did banks become nervous? Over the previous years, easy and cheap credit was readily available. Individual investors borrowed heavily to invest in property. The main problem was in the US. Mortgages were sold to individuals with weak credit ratings – often referred to as sub-prime lending. In the UK self-certified mortgages and high loan-to-value mortgages meant borrowers were often financially overstretched.
Many of these mortgages were repackaged into securitisations. The securitised mortgages were sold on to investment banks who had seen them as a relatively safe way to generate high returns.
Unfortunately borrowers started to default on their loans in large numbers. The value of the securitised investments plummeted resulting in huge losses for banks globally. Many UK banks had exposure to large sums of these “toxic assets” and had write off billions of pounds of assets, requiring bail-outs from the government
Bond portfolios are often held to match specific liabilities. If this is the case various techniques such as immunisation, stochastic asset liability modelling, Value at Risk and multifactor modelling may be used to control the portfolio risk.
As such, these models and techniques are used primarily to develop the benchmark investment strategy. In contrast, switching is based around short-term tactical deviations from the long-term strategy.
Recall that immunisation and stochastic asset liability modelling were discussed in Chapter 17 of this course. Value at Risk and multifactor modelling are considered in detail in the next chapter.