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					       Portfolio Management
              3-228-07
                Albert Lee Chun

               Equity Portfolio
             Management Strategies

                   Lecture 9
2 Dec 2007                           0
                  Passive Portfolio Management




Albert Lee Chun          Portfolio Management    1
                       Management Fees
 Malkiel (2001) reports that on average that:

    Costs of managing a passive fund oscillate between 10 and 20
     basis points (Vanguard S&P 500: 20 b.p.)

    For active funds the average management fees are 140 b.p.
     (fees for research, analyzing information, transaction costs).

    40 billion dollars are spent each year on management fees.

    Passive strategies have a tend to also minimize taxes (Malkiel
     2001)



Albert Lee Chun           Portfolio Management                        2
                  Managing and Index Portfolio
    Select a benchmark portfolio index to replicate. S&P 500,
     TSX, etc.

    Determine an acceptable tracking error. Which depends on
     the return differential or total return of the replicating
     portfolio minus the return of the benchmark index
                           t  R p ,t  Rb ,t

         where the return of the tracking portfolio is given by
                                          N
                             Rp , t      w R
                                          i 1
                                                 i   i ,t



Albert Lee Chun            Portfolio Management                   3
                  Portfolio Tracking Error
 Return Differential       t  R p ,t  Rb ,t

                                                 T
                                             1
 Average Return Differential        
                                             T
                                                 
                                                 t 1
                                                        t




                                                              
                                                                2
 Variance in Return Differential               1 T
                                       2
                                                  t  
                                              T  1 t 1


 Tracking Error      
                         2




 Annualize Tracking Error  p where P is equal to the number of
                                                    periods in a year.




Albert Lee Chun         Portfolio Management                              4
                  Portfolio Tracking Error



    Objective: Minimize the expected tracking error by
     optimizing over
         1. The number of securities in the portfolio
         2. The securities to include in the portfolio




Albert Lee Chun        Portfolio Management               5
                        Expected Tracking Error

            Expected Tracking
            Error (Percent)
                  4.0

                  3.0

                  2.0

                  1.0


                    500    400    300       200     100     0
                                              Number of Stocks
Albert Lee Chun              Portfolio Management                6
                     Portfolio Indexation
    The number of securities used in the replication determines a
     tradeoff between transaction costs and tracking errors.

    A smaller number of securities will result in lower transaction
     costs but higher tracking errors and visa versa.

    The presence of tracking errors is inevitable.

     1. The replication implies irregular lots.
     2. The composition of securities in the index may change.
     3. The modification of the index: entry and exit of securities,
     merges, defaults, etc.

Albert Lee Chun           Portfolio Management                         7
          Techniques for Replicating an Index




Albert Lee Chun      Portfolio Management       8
                  1. The simplest method
    Purchase all the securities in the index in proportion
     to the weights in the index.
    This helps ensure close tracking

    Advantage: Minimizes the tracking errors
    Disadvantage: High transaction costs and reinvesting
     dividends results in high adjustment fees.




Albert Lee Chun        Portfolio Management                   9
            2. Method of Market Capitalization

    Consider the stocks with the largest market
     capitalization in the index and purchase them in
     proportion to their importance in the index.
    Fewer stocks means lower commissions
    Reinvestment of dividends is less difficult
    Will not track the index as closely, so there will be
     some tracking error.




Albert Lee Chun        Portfolio Management                  10
              3. Method of Stratified Sampling:

    Purchase only the most representative securities in the
     index portfolio.
    Classify the securities in the index into homogeneous
     categories (by industry or activity sector, beta, total
     risk, stock market capitalization, etc....).
    Select from each category, a few titles which best
     represents that group, thus forming a representative
     portfolio for each category.
    The replication portfolio is composed by balancing
     the portfolios for each category according to their
     importance in the index.
Albert Lee Chun        Portfolio Management                    11
                      4. Quadratic Optimization

                                     N     ~ ~ 
             Min Tracking Error     w i ri rm 
                    wi i 1,...,N  i 1        
             such that
              N                    Expected Excess Return
             w
              i 1
                      i   1

                  
                ~ ~  E
              E rp rm
                         N
                               ~  ~   C ( w ,..., w )  R
                          w i ri rm         1       N      0
                          i 1       

                               Transaction costs      Required minimum


Albert Lee Chun                Portfolio Management                  12
                  Quadratic Optimization
    Historical information on price changes and
     correlations between securities are used to determine
     the composition of a portfolio that will minimize
     tracking error with the benchmark
    This relies on historical correlations, which may
     change over time, leading to a failure to track the
     index.




Albert Lee Chun       Portfolio Management                   13
                        Expected Tracking Error

            Expected Tracking
            Error (Percent)
                  4.0

                  3.0

                  2.0

                  1.0


                    500    400    300       200     100     0
                                              Number of Stocks
Albert Lee Chun              Portfolio Management                14
                     Reference Portfolio
    Constructing a Reference Portfolio

     - Value Weighted
     - Price Weighted
     - Equal Weighted

    It may be necessary to rebalance the portfolio when:

     - Mergers and Acquisitions: Companies disappear from the market.
     - Changes to the composition of the index
     - Stock splits and dividend payments
     - New stock issues
     - Stock repurchases

Albert Lee Chun          Portfolio Management                      15
                  Replicating an Index Portfolio
    Small investors often find it more practical and less
     expensive to choose a "pre-made" a fund for
     replicating an index.

     - Mutual Funds

     - Exchange Traded Funds




Albert Lee Chun          Portfolio Management                16
                  Exchange Traded Funds (ETFs)
    Exchange Traded Funds are less expensive than
     mutual funds but more diversified than individual
     stocks. A cross between stocks and mutual funds.
    ETFs seek returns of a broad market index or a sector
     index. They are index-linked rather than actively
     managed.
    ETFs are exchange listed and can be bought and sold
     throughout the trading day: they are "funds that trade
     like stocks."
    Example: SPY, Cubes, Diamonds, Spiders, Webs,
     VIPERS, iShares, Ultra Sectors, etc.

Albert Lee Chun          Portfolio Management                 17
                  Active Portfolio Management




Albert Lee Chun          Portfolio Management   18
                  Active Portfolio Management
    Active Portfolio Management Strategies
    Goal is to earn a portfolio return that exceeds the
     return of a passive benchmark portfolio, net of
     transaction costs, on a risk-adjusted basis.
    Practical difficulties of active manager
       Transactions costs must be offset

       Risk can exceed passive benchmark




Albert Lee Chun          Portfolio Management              19
                  Active Management Strategies
 The chose between using and active or passive portfolio management
     strategy depends on 2 factors:

       1. Belief in the efficiency of the markets. An investor who
       rejects the Efficient Market Hypothesis will tend to adopt an
       active strategy with the goal of obtaining “abnormal” returns:

                           ARit = Rit  E( Rit )
       where,       ARit : is the abnormal return of security i in period t
                    Rit: is the return of security i in period t
                    E(Rit): is the expected return


       2. Degree of risk aversion of the investor.
Albert Lee Chun               Portfolio Management                            20
          Performance of Active Mutual Funds

                  The average fund manager is not able
                        to outperform the index!




Albert Lee Chun           Portfolio Management           21
      Broad Overview of Investment Strategies
    Passive Management Strategies
  1. Efficient Markets Hypothesis
  - Buy and Hold
  - Indexing
  Active Management Strategies
  2. Fundamental Analysis
     “Top Down” (asset class rotation, sector rotation)
    “Bottom Up” (stock undervaluation/overvaluation)
  3. Technical Analysis
     Contrarian (e.g. overreaction)
     Continuation (e.g. price momentum)
  4. Anomalies and Attributes
     Calendar effects (Weekend, January)
     Security Characteristics (P/E,P/B, earnings momentum, firm size)
     Investment Style (value, growth)
Albert Lee Chun             Portfolio Management                        22
          Investment Style and Tracking Error




Albert Lee Chun     Portfolio Management        23
                  Fundamental Strategies
    Top down approach involves analysis of broad
     country and asset class allocations and progresses
     down through sector allocation decisions to the
     bottom level where individual securities are selected.
    Bottom-up approach emphasizes security selection
     without any initial market or sector analysis.




Albert Lee Chun        Portfolio Management                   24
                  Top Down Approach
 Top Down Approach
   - Evaluate and forecast the future economy
   - Chose the proportions to invest in each country or
   economic region.
   - Identify the sectors and industries that would profit
   based on your economic outlook and choose
   proportions to invest in each industy or sector.
   - Choose the best securities in each sector selected.



Albert Lee Chun      Portfolio Management                    25
                  Bottom-Up Approach
      Security selection is places less importance on the
        economic cycle.
      Securities are selected based on well defined
        characteristic of individual stocks such as price-
        dividend ratios, book-to-market ratios, market
        capitalizations, etc.




Albert Lee Chun        Portfolio Management                  26
                  Fundamental Strategies
  Tactical Asset Allocation
  - Asset Class Rotation: Shifts funds between stocks, bonds and
   other securities depending on market forecasts and estimated
   returns.
  Sector, Industry or Style Rotation Strategy
   - Shifts funds between different equity sectors and industries
   (financial stocks, technology stocks, consumer cyclicals,
   durable goods) or among investment styles (e.g., large
   capitalization, small capitalization, value growth)
  Individual Stock Selection
   - Buy low, Sell High



Albert Lee Chun         Portfolio Management                        27
            Sector, Industry and Style Analysis
    How should we choose which sector, industry or style
     to rotate into next?
    Important to look to the underlying nature of the
     economy. Security markets reflect the strength and
     weakness of the economy.
    Most of the variables that determine security market
     value are economic variables: monetary policy,
     interest rates, aggregate output, inflation, etc.
    Macro-analysis links up industry effects to business
     cycles and economic variables.


Albert Lee Chun       Portfolio Management                  28
                  Asset and Sector Performance




Albert Lee Chun          Portfolio Management    29
                  Macro-market Analysis
    A strong relationship exists between the economy and
     the stock market
    Security markets reflect what is expected to go on in
     the economy because the value of an investment is
     determined by
       its expected cash flows
       required rate of return (i.e., the discount rate)




Albert Lee Chun       Portfolio Management                   30
                  Is It A Worm?




Albert Lee Chun   Portfolio Management   31
                  Is It A Wave?




Albert Lee Chun   Portfolio Management   32
                  It’s the Business Cycle!




Albert Lee Chun       Portfolio Management   33
                     Business Cycles
    The aggregate economy expands and contracts in
     discernable periods.
    Economic trends affect industry performance.
    Cyclical or Structural Changes?
       Cyclical changes in the economy arise from the
        ups and downs of the business cycle
       Structure changes occur when the economy
        undergoes a major change in organization or how
        it functions


Albert Lee Chun      Portfolio Management                 34
                     The Stock Market and
                      the Business Cycle

                  How can we predict the next
                       peak or trough?

                                               peak




                         trough


Albert Lee Chun         Portfolio Management          35
                  Business Cycle Indicators

    National Bureau of Economic Research
     (NBER)
    Cyclical indicator categories
       leading indicators

       coincident indicators

       lagging indicators

    Composite series and ratio of series


Albert Lee Chun        Portfolio Management   36
                  Business Cycle Indicators
    Leading indicators – economic series that usually
     reach peaks or troughs before corresponding peaks or
     troughs in aggregate economy activity
    Coincident indicators – economic series that have
     peaks and troughs that roughly coincide with the
     peaks and troughs in the business cycle
    Lagging indicators – economic series that experience
     their peaks and troughs after those of the aggregate
     economy
    Selected series – economic series that do not fall into
     one of the three main groups.

Albert Lee Chun        Portfolio Management                    37
                CONFERENCE BOARD DATA                                             Standar
                                                   Leading Index                      Fac
1.    BCI-01    Average weekly hours, manufacturing                                   .19
2.    BCI-05    Average weekly initial claims for unemployment insurance              .02
3.    BCI-08    Manufacturers' new orders, consumer goods and materials               .05
4.    BCI-32    Vendor performance, slower deliveries diffusion index                 .02
5.    BCI-27    Manufacturers' new orders, non-defense capital goods                  .01
6.    BCI-29    Building permits, new private housing units                           .02
7.    BCI-19    Stock prices, 500 common stocks                                       .03
8.    BCI-106   Money supply, M2                                                      .27
9.    BCI-129   Interest rate spread, 10-year Treasury bonds less federal funds       .33
10.   BCI-83    Index of consumer expectations                                        .01

                                                  Coincident Index
1.    BCI-41    Employees on nonagricultural payrolls                                 .51
2.    BCI-51    Personal income less transfer payments                                .21
3.    BCI-47    Industrial production                                                 .14
4.    BCI-57    Manufacturing and trade sales                                         .11

                                                   Lagging Index
1.    BCI-91    Average duration of unemployment                                      .03
2.    BCI-77    Inventories to sales ratio, manufacturing and trade                   .12
3.    BCI-62    Labor cost per unit of output, manufacturing                          .06
4.    BCI-109   Average prime rate                                                    .26
5.    BCI-101   Commercial and industrial loans                                       .12
6.    BCI-95    Consumer installment credit to personal income ratio                  .19
7.    BCI-120   Consumer price index for services                                     .18




      Albert Lee Chun                    Portfolio Management                        38
                       Other Indicator Sources...
          Indicator                             Released By
          Beige Book                            Federal Reserve Board
          Consumer Confidence Index             Consumer Confidence Board
          Consumer Price Index                  Bureau of Labor and Statistics
          Employee Cost Index                   Bureau of Labor and Statistics
          Employment Situation Report           Bureau of Labor and Statistics
          Gross Domestic Product                Commerce Department
          Housing Starts                        Department of Commerce
                                                Federal Reserve Bank of
          Philadelphia Fed Index
                                                Philadelphia
          Producer Price Index                  Bureau of Labor and Statistics
          Retail Sales Data                     Census Bureau




Albert Lee Chun                    Portfolio Management                          39
         Stock Markets are a Leading Indicator
    Stock prices consistently turn before the economy
     does.
    Stock prices are forward looking.
    Stock prices reflect expectations of earnings,
     dividends, and interest rates
    Stock market reacts to various leading indicator series




Albert Lee Chun        Portfolio Management                    40
                  Forecasting Business Cycles
    The current state of the business cycle has already
     been incorporated into asset prices.
    Investors need to make decisions based on future
     economic conditions.
    To invest properly, it is important to forecast changes
     in economic variables.
    High inflation: high interest rates, bad for stocks in
     general.




Albert Lee Chun         Portfolio Management                   41
                  Sector Rotation Strategy
    Certain industries make attractive investments over
     the course of the business cycle.
    A sector rotation strategy is when one switches from
     one industry group to another over the course of a
     business cycle.




Albert Lee Chun        Portfolio Management                 42
                   The Stock Market and
                    the Business Cycle




                                             peak




      Financial       trough
    Stocks Excel

Albert Lee Chun       Portfolio Management          43
                         Financial Stocks
            Adversely   impacted by interest rates, difficult to
             pass on to their customers.
            Toward the end of a recession, financial stocks
             rise as investors trade securities, businesses
             issue debt and equity, increase in merger
             activity during recovery.
            Expecting increases in loan demand, housing
             construction and companies going public.




Albert Lee Chun           Portfolio Management                      44
                   The Stock Market and
                    the Business Cycle




                     Consumer                peak
                     Durables
                       Excel




      Financial       trough
    Stocks Excel

Albert Lee Chun       Portfolio Management          45
                    Consumer Durables
            Consumer Durables are cars, PCs, Miele
            washing machines, GE refrigerators, John Deer
            lawn machinery, cooking ranges, etc.
            As the economy begins to come out of the
            recession, consumer confidence and income
            increase.




Albert Lee Chun        Portfolio Management                 46
                   The Stock Market and
                    the Business Cycle




                     Consumer                peak
                     Durables
                       Excel



                                        Capital
                      trough          Goods Excel
      Financial
    Stocks Excel

Albert Lee Chun       Portfolio Management          47
                     Capital Goods
    As the economy moves out of recession, businesses
     begin to modernize, renovate and purchase new
     equipment.
    Heavy equipment manufactures, machine tool
     makers, airplane manufacturers become attractive.




Albert Lee Chun      Portfolio Management                48
                   The Stock Market and
                    the Business Cycle
                                               Basic
                                             Industries
                                               Excel



                     Consumer                 peak
                     Durables
                       Excel



                                        Capital
                      trough          Goods Excel
      Financial
    Stocks Excel

Albert Lee Chun       Portfolio Management                49
                      Basic Industries
    End of the business cycle coincides with increases in
     inflation, as demand outstrips supply.
    Inflation doesn’t influence the cost of extracting these
     products, whereas prices increase. Increasing profit
     margins.
    Basic material industries as oil, metal and lumber are
     attractive.




Albert Lee Chun        Portfolio Management                     50
                   The Stock Market and
                    the Business Cycle
                                               Basic
                                             Industries
                                               Excel


                                                           Consumer
                     Consumer                 peak        Staples Excel
                     Durables
                       Excel



                                        Capital
                      trough          Goods Excel
      Financial
    Stocks Excel

Albert Lee Chun       Portfolio Management                                51
                     Consumer Staples
    Consumer staples are food, beverages and
     pharmaceuticals.
    People still need to eat, drink, be merry and get sick.




Albert Lee Chun        Portfolio Management                    52
                   The Stock Market and
                    the Business Cycle
                                               Basic
                                             Industries
                                               Excel


                                                           Consumer
                     Consumer                 peak        Staples Excel
                     Durables
                       Excel



                                        Capital
                      trough          Goods Excel
      Financial
    Stocks Excel

Albert Lee Chun       Portfolio Management                                53
              Central Banks and Interest Rates

    By far the most visible and obvious power of many modern
     central banks is to influence market interest rates.
    When interest rates go down, money supply increases.
     Businesses and consumers have a lower cost of capital and can
     increase spending and capital improvement projects. This
     encourages growth.
    When interest rates go up, the money supply falls and slows
     the economy. Increases in interest rate flight inflation.
    The US central-bank lending rate is known as the Fed funds
     rate.
    Bank of Canada sets a target overnight rate, and a band of plus
     or minus 0.25%.



Albert Lee Chun          Portfolio Management                          54
                   Technical Strategies
     Contrarian investment strategy
 -   Best time to buy a stock is when the majority of other
     investors are selling.
 -   Buy low, sell high. Hope asset prices are mean
     reverting.
 -   Overreaction hypothesis.
     Price momentum strategy
     Earnings momentum strategy



Albert Lee Chun       Portfolio Management                    55
                  Market Overreaction




Albert Lee Chun      Portfolio Management   56
                  Price and Earnings Momentum




Albert Lee Chun          Portfolio Management   57
                  Anomalies and Attributes
    The Weekend Effect
    The January Effect
    Firm Size
    P/E and P/BV ratios




Albert Lee Chun        Portfolio Management   58
                  Large and Small Cap Returns




Albert Lee Chun          Portfolio Management   59
                  Standard Deviation of Returns




Albert Lee Chun          Portfolio Management     60
                  P/E Ratios and Performance




Albert Lee Chun         Portfolio Management   61
                      Value vs. Growth Stocks
    Over time value stocks have offered somewhat higher returns than growth
     stocks.
    However, growth stocks will outperform value stocks from time to time.
    Growth-oriented investor will:
         focus on EPS and its economic determinants
         look for companies expected to have rapid EPS growth
         assumes constant P/E ratio
    Value-oriented investor will:
         focus on the price component
         not care much about current earnings
         Assume that P/E ratio is below its natural level for these stock and that
          the market will soon correct this situation.


Albert Lee Chun                Portfolio Management                                   62
              Value vs. Growth: Mutual Funds




Albert Lee Chun       Portfolio Management     63
                  Value and Growth Stocks




Albert Lee Chun        Portfolio Management   64
                  Russell 100 Performance




Albert Lee Chun       Portfolio Management   65
                  Value vs. Growth




Albert Lee Chun    Portfolio Management   66
                              Style
    Construct a portfolio to capture one or more of the
     characteristics of equity securities
    Small-capitalization stocks, low-P/E stocks, etc…
    Value stocks appear to be underpriced
       price/book or price/earnings

    Growth stocks enjoy above-average earnings per
     share increases




Albert Lee Chun       Portfolio Management                 67
                          Style Grid
    Style grid:
       firm size (large cap, mid cap, small cap)

       Relative value (value, blend, growth)
        characteristics
    Variations in returns among mutual funds are largely
     attributable to differences in styles
    Different styles tend to move at different times in the
     business cycle



Albert Lee Chun        Portfolio Management                    68
                  Style Analysis Grid




Albert Lee Chun     Portfolio Management   69
                  Investment Style




Albert Lee Chun    Portfolio Management   70
                  Optimal Portfolio Selection




Albert Lee Chun         Portfolio Management    71
                                  Next Week
    Optional Readings for this week:
      (Course Reader) Value and Growth Investing: Review and Update (Chan and
     Lakonishok)
      (Course Reader) Hedge Funds: Risk and Return (Maikiel ad Saha)
    For Next Week:
    Rappel des concepts de durée et de convexité
    La durée des taux clés
    Stratégies Barbell et Bullet
    Immunisation de portefeuille
           Review of Duration and Convexity (Rappel des concepts de durée et de convexité)
           Key Rate Duration (La durée des taux clés)
           Barbell and Bullet Strategies (Stratégies Barbell et Bullet)
           Portfolio Immunization (Immunisation de portefeuille)
    (BKMR) chapter 15
    (Course Reader) Fabozzi, Bonds Markets, Analysis and Strategies, 4th edition.,
     p.410-416.
    (Course Reader) Tuckman, Bruce W. Key Rate and Bucket Exposures, Fixed Income
     Securities: Tools for Today's Markets, 2nd edition, New York, J. Wiley, 2002, p. 133-137


Albert Lee Chun                 Portfolio Management                                       72

				
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