Introduction to Active Portfolio Management

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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

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Decision Making Process Fundamental vs.
Quantitative

• Fundamental
• Decisions based on human judgement
• 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

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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

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Overall Process
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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

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Discretionary Managers

• Team-based majority voting Approach
• Fundamental research
• Active corporate interview program

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Quantitative Managers

• Example LSV Asset Management
• Use both statistical and fundamental inputs
• Management process see handout

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Basic Investment Strategies

• Top-down
• Bottom-up
• Value
• Growth
• GARP
• Market cap
• International

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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

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Bottom-up Strategy

• Focus on the financial characteristics of
  individual companies
• Start with preliminary screening based on
  financial analysis, e.g., dividend yield gt 2.5,
  P/B lt 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, incomeetc. tend to be bottom-up managers

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Value Investing

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

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

• Graham and Dodds 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 todays market
  (e.g., P/B lt 2/3x). Multiples fluctuate (SP
  500s average is about 2x in 2012)
• Value trap low price stock ? value stock
• Momentum factor is important here

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Value Investing

• Discretionary/fundamental
• For example, in The Warren Buffett Way by
  Hagstrom (2005)
• Business tenets
• Management tenets
• Financial tenets (ROE, profit margin, debt
  etc.)
• Value tenets (PV of cash flow)
• Quantitative
• LSV (uses both fundamental and statistical inputs)

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Growth Investing

• Picking companies that are considered to have
  above average growth prospects
• Higher than average valuation (P/B, P/E, P/cash
  flow)
• Stock expected to generate above-average sales
  and earnings growth relative to its industry, or
  the overall market
• Growth stocks usually pay little or no dividend,
  excess cash used to finance expansion
• Investors expect superior rate of stock price
  appreciation, rather than dividend yield

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Value vs Growth

• Historically, value tends to outperform growth
• Positive value premium over the long term

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Time-series
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Growth vs Value
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Value vs. Growth
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Style Cycles and Geography
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GARP

• Growth at a reasonable price
• Looking for growth but also reasonable valuation
• Popularized by Peter Lynch of Fidelitys Magellan
  Fund (1977-1990)
• PEG ratio ? 1

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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)

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Market Cap

• Specialize in a particular size
• U.S. dollars (pre-2008 Q4)
• Large cap gt 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

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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

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Global sector ETFs
Examples 10 Global SectorsiShares SP Global
Materials Sector Index Fund (MXI) iShares SP
Global Consumers Staples Sector Index Fund (KXI)
iShares SP Global Consumer Discretionary Sector
Index Fund (RXI) iShares SP Global Energy
Sector Index Fund (IXC) iShares SP Global
Financials Sector Index Fund (IXG) iShares SP
Global Healthcare Sector Index Fund (IXJ)
iShares SP Global Industrials Sector Index Fund
(EXI) iShares SP Global Technology Sector Index
Fund (IXN) iShares SP Global Utilities Sector
Index Fund (JXI) iShares SP Global
Telecommunications Sector Index Fund (IXP)
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Currency Overlay

• Managing currency risk of international portfolio
  separately. Equity managers job not affected
• Can be active currency bets, or passive hedge
• To hedge or not to hedge

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Impact of Currency