Portfolio management Flashcards
Active management styles
In this section we look at the most common investment management styles and stock selection approaches, including:
growth
value
momentum
contrarian
rotational
top-down bottom-up passive
active
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?
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benchmark providers
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
Top-down approach 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.
Bottom-up approach
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:
fundamental analysis
quantitative techniques
technical analysis.
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
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
Full replication
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.
Note that:
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.
Recall:
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
Matching
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.
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
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.
