Download
1 / 137
1.38k likes | 1.59k Vues
Investment Course - 2005. Day One: Global Asset Allocation and Portfolio Formation. Two Important Concepts Involving Expected Investment Returns. 1. Investors perform two functions for capital markets: - Commit Financial Capital - Assume Risk so,
E N D
Investment Course - 2005 Day One: Global Asset Allocation and Portfolio Formation
Two Important Concepts Involving Expected Investment Returns 1. Investors perform two functions for capital markets: - Commit Financial Capital - Assume Risk so, E(R) = (Risk-Free Rate) + (Risk Premium) 2. The expected return (i.e., E(R)) of an investment has a number of alternative names: e.g., discount rate, cost of capital, cost of equity, yield to maturity. It can also be expressed as: k = (Nominal RF) + (Risk Premium) = [(Real RF) + E(Inflation)] + (Risk Premium) where: Risk Premium = f(business risk, liquidity risk, political risk, financial risk)
Historical Real Returns, 1954-2003: The Global Experience Chile: Returns 1/54 – 6/03 Chile*: Returns 1/54 – 12/71; 1/76 – 6/03 Source: Global Financial Data
Performance of U.S.-Oriented Investment Strategies: 1975-2004
Portfolio Management Strategy: Broad View • Passive Management • Attempt to generate “normal” returns over time commensurate with investor risk tolerance • Typically achieved through diversified asset class selection and asset-specific portfolio formation • Active Management • Attempt to generate above-normal returns over time relative to acceptable risk level • Typically achieved either through periodic asset class or security-specific portfolio adjustments
Two Ways to Increase Returns (i.e., “Add Alpha”): • Tactical Allocation Decisions - Global Market Timing - Asset Class Timing - Style/Sector Timing • Security Selection Decisions - Stock or Bond Picking
Allure of Tactical Market Timing • Suppose that on January 1st each year from 1975-2004, you put 100% of your money in what turned out to be the best asset class (stocks, bonds, or cash) at the end of the year. • This is equivalent to owning a perfect lookback option that entitles you to receive the return for the best performing asset class each year. • What difference would that type of tactical portfolio rebalancing make to your investment performance?
The Asset Allocation Decision • A basic decision that every investor must make is how to distribute his or her investable funds amongst the various asset classes available in the marketplace: • Stocks (e.g., Domestic, Global, Large Cap, Small Cap, Value, Growth) • Fixed-Income (e.g., Government, Investment Grade, High Yield) • Cash Equivalents (e.g., T-bills, CDs, Commercial Paper) • Alternative Assets (e.g., Private Equity, Hedge Funds) • Real Estate (e.g., Residential, Commercial) • Collectibles (e.g., Art, Antiques) • The Strategic (or Benchmark) allocation is the proportion of wealth the investor decides to place in each of these asset classes. It is sometimes also referred to as the investor’s long-term normal allocation because it is presumed to be the “baseline” allocation that will remain in place until the investor’s life circumstances change appreciably (e.g., retirement)
The Importance of the Asset Allocation Decision • In an influential article published in Financial Analysts Journal in July/August 1986, Gary Brinson, Randolph Hood, and Gilbert Beebower examined the issue of how important the initial strategic allocation decision was to an investor • They looked at quarterly return data for 91 pension funds over a ten-year period and decomposed the average returns as follows: • Actual Overall Return (IV) • Return due to Strategic Allocation (I) • Return due to Strategic Allocation and Market Timing (II) • Return due to Strategic Allocation and Security Selection (III)
The Importance of the Asset Allocation Decision (cont.) • Graphically: • In terms of return performance, they found that:
The Importance of the Asset Allocation Decision (cont.) • In terms of return variation: • Ibbotson and Kaplan support this conclusion, but argue that the importance of the strategic allocation decision does depend on how you look at return variation (i.e., 40%, 90%, or 100%).
Examples of Strategic Asset Allocations • Public Endowments:
Examples of Strategic Asset Allocations (cont.) • Public Retirement Fund:
Asset Allocation and Building an Investment Portfolio I. Global Market Analysis - Asset Class Allocation - Country Allocation Within Asset Classes II. Industry/Sector Analysis - Sector Analysis Within Asset Classes III. Security Analysis - Security Analysis Within Asset Classes and Sectors
Asset Allocation Strategies • Strategic Asset Allocation: The investor’s “baseline” asset allocation, taking into account his or her return requirements, risk tolerance, and investment constraints. • Tactical Asset Allocation: Adjustments to the investor’s strategic allocation caused by perceived relative mis-valuations amongst the available asset classes. Ordinarily, tactical strategies overweight the undervalued asset class. Also known as market timing strategies. • Insured Asset Allocation: Adjustments to the investor’s strategic allocation caused by perceived changes in the investor’s risk tolerance. Usually, the asset class that experiences the largest relative decline is underweighted. Portfolio insurance is a well-known application of this approach.
Sharpe’s Integrated Asset Allocation Model (cont.) • Notice that the feedback loops after the performance assessment box (M3) make the portfolio management process dynamic in nature. • The strategic asset allocation process can be viewed as going through the model once and then removing boxes (C2) and (I2), thus removing any temporary adjustments to the baseline allocation. • Tactical asset allocation effectively removes box (I2), but allows for allocation adjustments due to perceived changes in capital market conditions (C2). • Insured asset allocation effectively removes box (C2), but allows for allocation adjustments due to perceived changes in investor risk tolerance conditions (I2).
Measuring Gains from Tactical Asset Allocation • Example: Consider the following return and allocation characteristics for a portfolio consisting of stocks and bonds only. StockBond Allocation: Strategic 60% 40% Actual 50 50 Returns: Benchmark 10% 7% Actual 9 8 • The returns to active management (i.e., tactical and security selection) are: Policy Performance: (.6)(.10) + (.4)(.07) = 8.80% Actual Performance: (.5)(.09) + (.5)(.08) = 8.50% Active Return = - 30 bp
Measuring Gains from Tactical Asset Allocation (cont.) Also: (Policy & Timing): (.5)(.10) + (.5)(.07) = 8.50% (Policy & Selection): (.6)(.09) + (.4)(.08) = 8.60% so: Timing Effect: 8.50 – 8.80 = -0.30% Selection Effect: 8.60 – 8.80 = -0.20% Other: 8.50 – 8.60 – 8.50 + 8.80 = +0.20% Total Active = -0.30%
Overview of Equity Style Investing • The top-down approach to portfolio formation involves prudent decision-making at three different levels: • Asset class allocation decisions • Sector allocation decisions within asset classes • Security selection decisions within asset class sectors • The equity style decision (e.g., large cap vs. small cap, value vs. growth) is essentially a sector allocation decision • There is tremendous variation in the returns produced by the myriad style class-specific portfolios, so investors must pay attention to this aspect of the portfolio management process
The investment style of an equity portfolio is typically defined by two dimensions or characteristics: - Market Capitalization (i.e., Shares Outstanding x Price) - Relative Market Valuation (i.e., “Value” versus “Growth”) Defining Equity Investment Style
Equity Style Classification: Specific Terminology • Market Capitalization - Large (> $10 billion) - Mid ($1 - $10 billion) - Small (< $1 billion) • Relative Valuation - Value (Low P/E, Low P/B, High Dividend Yield, Low EPS Growth) - Blend - Growth (High P/E, High P/B, Low Dividend Yield, High EPS Growth)
Equity Style Grid Value Growth Large Small
Style Indexes & Representative Stock Positions: January 2005 Value Growth Large Small
Comparative Classification Ratios: January 2005(Source: Morningstar) Value Growth Large Small
Historical Equity Style Performance: 1991-2004 (Source: Frank Russell)
Relative Return Performance:Value vs. Growth LV Outperforms LG Outperforms
Relative Risk Performance: Value vs. Growth LV Riskier LG Riskier
Relative Return Performance: Large Cap vs. Small Cap LB Outperforms SB Outperforms
Relative Risk Performance:Large Cap vs. Small Cap LB Riskier SB Riskier
Value vs. Growth: Global Evidence (Source: Chan and Lakonishok, Financial Analysts Journal, 2004)
Equity Style Investing: Instruments and Strategies • Passive Style Alternatives - Index Mutual Funds - Exchange-Traded Funds (ETFs) • Active Style Alternatives - Investor Portfolio Formation - Open-Ended Mutual Funds
Methods of Indexed Investing • Open-End Index Mutual Funds: There is a long-standing and active market for mutual funds that hold broad collections of securities that mimic various sectors of the stock market. Examples include the Vanguard 500 Index Fund, which recreates the holdings and weightings of the Standard & Poor’s 500, and the various Fidelity Select Funds, which reproduce the profiles of different industry sectors. • Exchange-Traded Funds (ETF): A more recent development in the world of indexed investment products has been the development of exchange-tradable index funds. Essentially, ETFs are depository receipts that give investors a pro-rata claim on the capital gains and cash flows of the securities held in deposit.
