Please enable JavaScript.
Coggle requires JavaScript to display documents.
Chapter 15 Introduction to the portfolio approach - Coggle Diagram
Chapter 15 Introduction to the portfolio approach
Risk and return
Selling a security for more than its purchase price is called capital gain, whereas selling a security for less than its purchase price is a capital loss.
Expected return= expected cash flow + expected capital gain (or - capital loss) / beginning value
Rate of return
Return%= Cash flow+ (Ending value - beginning value) / beginning value * 100
“all trading periods in the examples are set for one year; hence, the percentage of return is also called the
annual rate of return
”
“If the transaction period were longer or shorter than a year, the return would be called the
holding period return
”
“Rates of return can be
ex-ante
(expected returns)
or
ex-post
(actual historical returns)
. Investors estimate ex-ante returns to determine where funds should be invested. They calculate ex-post returns to compare actual results against both anticipated results and market benchmarks.”
“One common method is to expect the Treasury bill (T-bill) rate plus a certain performance percentage related to the risk assumed in the investment.”
“corporate bond issues with a higher risk profile are expected to earn a higher rate of return than the more secure Government of Canada bond issues”
Historical returns
“create an estimate of the future return based on past performance, but we cannot predict it accurately. For this reason, investors use diversification to reduce risk”
Nominal and real rates of return
“Real Return = Nominal Rate – Annual Inflation Rate”
The risk-free rate of return
“T-bills often represent the risk-free rate of return”
“other securities must pay at least the T-bill rate plus a risk premium to compensate investors for the added risk.”
Types of risks
Inflation rate risk
Business risk
“a company’s earnings will be reduced as a result of a labour strike, the introduction of a new product into the market, or the outperformance of a competing firm, among other factors. ”
.
Political risk
“the risk of unfavourable changes in government policies. ”
Liquidity risk
“an investor will not be able to buy or sell a security at a fair price quickly enough because buying or selling opportunities are limited.”
Interest rate risk
“changing interest rates will adversely affect an investment.”
Foreign investment risk
“the risk of loss resulting from an unfavourable change in exchange rates.”
Other foreign investment risks
“A dramatic drop off of liquidity for international small-cap issuers
• Larger bid-ask spreads for small cap international issuers
• Varying legal rights of shareholders and bond investors
• Poor shareholder communication in terms of reliability, quality, level of detail, and frequency of reporting”
Default risk
“the risk that such a company will be unable to make timely interest payments or repay the principal amount of a loan when it comes due.”
Systematic and non-systematic risk
systematic risk
“risks are always present that cannot be reduced or eliminated through diversification. These risks stem from such things as
inflation, the business cycle, and high interest rates
. Altogether, this type of risk is called systematic risk, or market risk.”
“Systematic risk is the risk associated with investing in each capital market.”
non-systematic risk (specific risk)
“the risk that the price of a specific security or a specific group of securities will change in price to a different degree or in a different direction from the market as a whole.”
“Specific risk can be reduced through diversification. ”
Measuring tisk
Standard deviation
commonly applied to portfolios and to individual securities within that portfolio
“The past performance (i.e., the historical returns of securities) is used to determine a range of possible future outcomes.”
A statistical measure of risk, expressed as a percentage; the higher the measure for an investment, the greater the volatility of returns and therefore the greater the risk.
Beta (beta coefficient)
“a statistical measure that links the risk of individual securities or a portfolio of securities to the market as a whole. ”
“Beta is important because it measures the degree to which individual securities, or a portfolio of securities, tend to move up and down with the market. Once again, the higher the beta, the greater the risk.”
Relationship between risk and return in a portfolio
Calculating the rate of return in a portfolio
Expected return = R1 (W1) + R2(W2)..... Rn(Wn)
Measuring risk in a portfolio
“a portfolio manager, you must guard against too much diversification.”
“The accounting, research, and valuation functions may also be needlessly complex.”
“Most of these strategies involve the use of derivatives.”
“they may use put options on individual equities or on investments such as gold, silver, and currencies. Additionally, they can hedge an entire portfolio by using derivatives on stock indexes, bonds, or interest rates.”
Combining securities in a portfolio
correlation
“Correlation is the statistical measure of how the returns on two securities move together over time and, therefore, how a change to the value of one security can predict the change in value of another.”
“how the resulting combination affects the portfolio’s total risk and return”
e.g. positive correlation, not reduce the overall risk of the portfolio ; negative correlation , can earn a positive return with little risk (other than market risk)
portfolio beta
“ the beta relates the volatility of a single equity or equity portfolio to the volatility of the stock market as a whole.”
“Any equity or equity portfolio that moves up or down to the same degree as the stock market has a beta of 1.0”
move up.down more than the market : beta greater than 1.0;
move up & down less than the market : beta less than 1.0
“Most portfolio betas indicate a positive correlation between equities and the stock market.”
“Industries with volatile earnings (typically cyclical industries) tend to have higher betas than the market, whereas defensive industries tend to have lower betas. ”
portfolio alpha
“Equity portfolios often outperform the market and move more than would be expected from their beta. ”
“This excess return earned on the portfolio is called the
alpha
”
The portfolio manager styles
Active investment management
“The goal of an active investment strategy is to outperform a benchmark portfolio on a risk-adjusted basis. ”
“The performance of an equity strategy that focuses on small-capitalization stocks should be gauged against a small-cap equity index.”
2 approaches
bottom-up analysis
“Bottom-up analysis begins with a focus on individual stocks. The portfolio manager looks at the characteristics of various stocks and builds portfolios of the best stocks in terms of forecasted risk-return characteristics.”
top-down analysis
“Top-down analysis begins with a study of broad macroeconomic factors before narrowing the analysis to individual stocks. ”
“The two approaches are not mutually exclusive. A compelling recommendation about a particular stock or managed product should always include both external (macroeconomic and industry) and internal factors that are likely to affect the price of the security.”
Passive management
“Managers using a passive investment strategy tend to replicate the performance of a specific market index without trying to beat it. ”
2 approaches
indexing
• Indexing involves buying and holding a portfolio of securities that matches the composition of a benchmark index. ”
“This method does not require much trading or managerial expertise unless the underlying stocks in the index change. At that point, the manager must trade, to keep the index fund matching the index.”
buy and hold
“A buy-and-hold strategy is consistent with the view that securities markets are efficient, meaning that the price of a security at all times reflects all relevant information on expected return and risk”
Equity management styles
growth managers
“Growth managers focus on current and future earnings of individual companies, specifically earnings per share (EPS). ”
“Growth managers look for earnings momentum and
will pay more for a company if they feel its growth potential warrants the higher price
.”
“Stocks in this type of portfolio usually have a lower dividend yield, or provide no dividend at all, and managers may turn over the securities in the portfolio more often.”
risks
“If EPS falters, it can cause large percentage price declines.
• Reported EPS, above or below analysts’ expectations, produces high portfolio volatility.
• These types of securities are highly vulnerable to market cycles.”
characteristics
High price-to - earnings
High price - to - book value
High price-to- cash flow
lower dividend yield
“Growth portfolios are appropriate for investors who are aggressive or who favour momentum investing, and who enjoy making spectacular gains in rising markets ”
this growth style works best in rising markets
“this style has greater volatility, and hence risk, because more of the total return of the portfolio is derived from capital appreciation than from more stable dividend income. Also, growth stocks may fall more rapidly than other stocks in a declining market”
value managers
“the focus is on stocks that are perceived to be trading for less than their true or intrinsic value.”
“these managers are
bottom-up stock
pickers with a research-intensive approach. Security turnover is typically low because these managers usually wait for a stock’s intrinsic value to be realized”
“managers can
buy discounted stocks
that should eventually rise in price. Value managers
seek stocks that are overlooked, disliked, or out of favour
with individual investors, institutional investors, and equity analysts.”
risk characteristics
“Lower annualized standard deviation
• Lower historical beta
• Stock price is already low and could remain low for a long time”
valuation characteristics
“Low price-to-earnings ratio
• Low price-to-book value ratio
• Low price-to-cash flow ratio
• High dividend yield”
“Because of the lower volatility associated with this style of management, value managers can be used as core managers for
clients with low-to-medium tolerance
for market risk and
long-term investment horizons”
“his style tends to perform best in down markets, with some participation in up markets.”
more successful in inefficient, stagnant and declining markets
, when there is a greater emphasis on preserving capital or minimizing short-term losses
drawback
in efficient market, the price of individual securities tends to reflect all that is known about the stocks, therefore, a stock may be trading at a low price for a good reason, may not show up in its financial statements
value managers may be drawn to companies that are in need of a turn-around to overcome financial or competitive difficulties
Sector rotation
“Sector rotation applies
a top-down approach
, focusing on analyzing the prospects for the overall economy. ”
managers invest in the industry sectors expected to outperform; buy large-cap stocks to maximize their liquidity
“Their
primary focus
is to identify the current phase of the economic cycle, the direction the economy is headed in, and the various sectors affected.”
Risk
“high volatility caused by industry concentration and rotation between industries”
“consequences are worse if the manager’s economic scenario is wrong and the favoured industries do not perform as expected.”
“Over short periods, managers and investors who use sector rotation may significantly underperform the market“
The higher turnover may create problems for taxable accounts; capital gains tax may be payable because of frequent trades. ”
“Sector rotation is concerned with trying to outperform the market averages such as the S&P/TSX Composite Index.”
“industry rotation strategies become more complex once additional industry types are considered and variations in economic cycles are taken into account”
The most basic industry rotation strategy involves shifting back and forth between cyclical and defensive shares. During periods when stock prices are falling, companies that belong to cyclical industries tend to fall relatively faster than those companies that belong to defensive industries. Conversely, during periods when stock prices are rising, companies that belong to cyclical industries tend to rise relatively faster than those companies that belong to defensive industries.
Fixed-income manager styles
“Fixed-income managers invest in fixed-income products such as bonds, mortgage-backed securities, fixed-income mutual funds, exchange-traded funds, and preferred shares”
Term to maturity
short term managers: less than 5 years; less volatile because they are maturing that can be reinvested at higher rate
Medium-term manager: 5 to 10 years; e.g. mortgage funds are a good example; invest in high-quality residential mortgages (usually NHA insured) with a terms of 5 years
Long-term managers: greater than 10 years
Credit quality
“The quality of investment-grade bonds ranges from
a high Aaa to a low of Baa3
”
“High-quality issuers are typically federal and provincial governments and some very well-capitalized corporations.”
“Managers must balance the return potential with the risk of default. Many bond portfolios have predetermined credit quality limits, under which they will not invest.”
“High-yield bonds are non-investment grade products, often called
junk bonds
.”
strategy: invest in high-yield bonds that mature in less than 3 years
“Another factor to consider with corporate issuers is liquidity.”
“ by selecting higher-quality corporate issues, a manager can improve a portfolio’s yield without taking on much additional risk.”
Interest rate anticipators
“anticipate a decrease in the general level of interest rates, they extend the average term on their bond investments. Conversely, when they
anticipate an increase in interest rates, they shorten the term (because the bond price is going down, investors who buy long-term bonds but then attempt to sell them before maturity) short-term bonds' risk is not significant
”
“Interest rate anticipation is sometimes also referred to as a form of duration switching”
it works best when the yield curve is normal (a wide gap between short-term and long-term rates)
“If the yield curve is flat, it is not advantageous to extend the term to maturity of the portfolio.”
“duration is an approximate measure of a bond’s price sensitivity to changes in interest rates. Therefore, if you anticipate that
interest rates are going to fall, you could sell lower duration bonds and replace them with higher duration bonds
. You thus extend the average duration of the portfolio and
increase the portfolio’s price sensitivity.
As interest rates fall, the increased price sensitivity should lead to greater capital gains.”