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Introduction to Active Portfolio Management

Introduction to Active Portfolio Management. Equity Style Spectrum. Growth. Index. GARP. Value. Deep Value. Management Styles. Traditionally: Fundamental An investment approach that relies on detailed company specific research to identify buy/sell candidates Quantitative

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Introduction to Active Portfolio Management

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  1. Introduction to ActivePortfolio Management

  2. Equity Style Spectrum Growth Index GARP Value Deep Value

  3. Management Styles Traditionally: • Fundamental • An investment approach that relies on detailed company specific research to identify buy/sell candidates • Quantitative • An investment approach that relies on “models” (involving forecasting financial metrics using mathematical and statistical techniques) to identify buy/sell candidates

  4. Decision Making Process Fundamental vs. Quantitative • Fundamental • Decisions based on human judgment • Applied depth and breath of knowledge to a narrow set of investment opportunities • Company visits may be important in the investment process • Intellectual capital of managers very important • Portfolio results less easily back-tested and replicated • Hard to test the investment strategy because it cannot be quantified

  5. Decision Making Process Discretionary vs Quantitative • Quantitative • Based on objective rules: Relationship between inputs (fundamental or technical/statistical factors) and expected return are formalized in a model • Applied narrow set of information to broad set of investment opportunities • More easily back-tested and replicated (if you know the model) • Intellectual capital of managers less important

  6. Overall Process

  7. Investment Process • Investment universe • Dictated by strategy mandate. Examples: U.S. small cap., global value, international growth • Focus list • Narrow down the universe and perform in-depth research on stocks on the focus list • Portfolio construction • Optimal weight of each stock in the final portfolio, risk management

  8. Discretionary Managers • Team-based majority voting Approach • Fundamental research • Active corporate interview program

  9. Quantitative Managers Example: LSV Asset Management • Use both statistical and fundamental inputs • Management process: see handout

  10. Basic Investment Strategies • Top-down • Bottom-up • Value • Growth • GARP • Market cap • International

  11. Top-down Strategy • Start with forecast of the economy: GDP growth, interest rates, exchange rates, capital flows, employment growth….etc. • Then select industries that will prosper in the forecasted economic environment • Then select companies in the chosen industries, based on financial analysis • Asset allocation funds are examples of top-down strategy • Portfolio weights of two (or more) asset classes vary over time, depending on market conditions

  12. Bottom-up Strategy • Focus on the financial characteristics of individual companies • Start with preliminary screening based on financial analysis, e.g., dividend yield > 2.5%, P/B < 2.5x, consistent sales growth ….etc. • More in-depth company analysis of the stocks left in the universe after screening • Managers with a specific mandate, e.g., value, growth, income…etc. tend to be bottom-up managers

  13. Value Investing • Choosing companies for which analysis reveals unrecognized value • Value stocks tend to have: • High dividend yield • Low P/B, P/E, and P/cash flow • Company experienced profits and stock price decline • Stock underpriced by the market relative to its long-term fundamentals

  14. Value Investing Investment decision Long-term earnings potential? Which? Profits and stock price decline Did investors over-react to short-term negative events?

  15. Value Investing (Cont’d) • Graham and Dodd’s 1934 classic, Security Analysis, published during the Great Depression • Warren Buffet was a student of Ben Graham at Columbia University • But old ratios no longer apply in today’s market (e.g., P/B < 2/3x). Multiples fluctuate (S&P 500’s average is about 2x in 2012) • Value trap: low price stock  value stock • Momentum factor is important here

  16. Value Investing • Discretionary/fundamental • For example, in “The Warren Buffett Way” by Hagstrom (2005): • Business tenets (Is the business idea sound?) • Management tenets (Is management competent?) • Financial tenets (ROE, profit margin, debt … etc.) • Value tenets (PV of cash flow) • Quantitative • LSV (uses both fundamental and statistical inputs)

  17. Growth Investing • Picking companies that are considered to have above average growth prospects • Higher than average valuation (P/B, P/E, P/cash flow) • Pay little or no dividend; excess cash used to finance expansion • Investors expect superior rate of stock price appreciation, rather than dividend yield • Expected to generate above-average sales and earnings growth relative to its industry, or the overall market • Representative sectors: health care and technology

  18. Growth Investing Investment opportunity PM’s view Stock’s Forward Earnings Growth Consensus view Another way of thinking about growth investing

  19. Value vs Growth • Historically, value tends to outperform growth • Positive value premium over the long term

  20. Time-series

  21. Growth vs Value Source: Dimensional Funds

  22. Value vs. Growth

  23. Style Cycles and Geography

  24. TSX Weights by Market Cap • As of September 2012

  25. GARP • Growth at a reasonable price • Looking for growth but also reasonable valuation • Popularized by Peter Lynch of Fidelity’s Magellan Fund (1977-1990) • PEG ratio  1

  26. Blend • Canadian stock market not large enough to have a deep value or uniquely high growth portfolio • Equity funds can be a blended fund (mix of value and growth stocks)

  27. Market Cap • Specialize in a particular size • U.S. dollars (pre-2008 Q4): • Large cap: > $10 billion • Mid cap: $2 - $10 billion • Small cap: $300 million - $2 billion • Micro cap: $50 - $300 million • Nano cap: Under $50 million • Size premium – preference for small-mid cap tilt? If passive, can pick a small-mid cap ETF • If active, may argue that this is the segment of the market where manager can exploit inefficiencies

  28. International • Benchmarks: EAFE (for developed markets), MSCI All Country World (for global markets) • Country selection weakening as a source of alpha and diversification • Economies and stock markets are increasingly globally integrated • New direction: sector selection • Sector calls made independent of geography

  29. Global sector ETFs Examples: 10 Global SectorsiShares S&P Global Materials Sector Index Fund (MXI) iShares S&P Global Consumers Staples Sector Index Fund (KXI) iShares S&P Global Consumer Discretionary Sector Index Fund (RXI) iShares S&P Global Energy Sector Index Fund (IXC) iShares S&P Global Financials Sector Index Fund (IXG) iShares S&P Global Healthcare Sector Index Fund (IXJ) iShares S&P Global Industrials Sector Index Fund (EXI) iShares S&P Global Technology Sector Index Fund (IXN) iShares S&P Global Utilities Sector Index Fund (JXI) iShares S&P Global Telecommunications Sector Index Fund (IXP)

  30. Currency Overlay • Managing currency risk of international portfolio separately. Equity manager’s job not affected • Can be active currency bets, or passive hedge • To hedge or not to hedge

  31. Impact of Currency

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