Lecture notes, lectures 1-11 PDF

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EXAM NOTES FOR PTM EXAM SEMESTER 1 2013 Topic 1 – introduction of Portfolio Theory Management - Risk averse investors will only assume more risk if they are compensated with greater expected returns - The expected return of a portfolio is the weighted average of the expected returns of individual assets in the portfolio - The variance (standard deviation) of a portfolio is the function of both the variance (standard deviation) of the returns of the individual asset and the covariance (correlation) among the returns of the assets in the portfolio - Thus, for the same level of risk, investors can create portfolios with higher returns by diversifying investments across/within many asset classes. The lower the correlations among the assets, the greater the diversification benefits - Modern portfolio Theory analyses rational portfolio choice based on the efficient use of risk and recognizes the importance of diversification - It sates that h there exists an identifiable set of risk portfolios that dominate all other portfolios in terms of their expected return and risk characteristics from which ration investors will choose their optimal or efficient portfolios - Optimal/efficient refers to a portfolio that gives the highest rate of return for a given level of risk, or lowest level of risk for a given rate of return Key assumptions that underline CAPM i) Investors select securities using Markowitz mean variance framework ii) Markets are frictionless i.e. there are no transaction costs or taxes iii) All investments are infinitely divisible iv) Investors can lend and borrow at the risk free rate - The central notion is that only 2 funds should be held by all investors; the market portfolio which consists if all risky assets in the economy and the riskless asset - In equilibrium, unsystematic risk that can be diversified away is not priced and only systematic risk is relevant to a portfolio‘s return - The line on which all portfolios that contain there funds are plotted is called the capital market line - The market portfolio consists of all risky assets, weighed in terms of their market cap

Market efficiency - An efficient capital market is the one in which security prices adjust to new info rapidly and the current price of a security reflects all currently available in about that security including risk - Market efficiency is based on the assumptions that: i) There is a large no. of traders ii) New info enters the market in a random manner iii) Investors adjust their estimates of security prices rapidly, but not necessarily correctly, to reflect new info received iv) Expected returns include risk in the security price - There are 3 types of efficient market hypothesis: i) Weak form: all info to be derived from past trading data already is reflected in stock prices ii) Semi-strong form: all publicly available info is already reflected iii) Strong form: all info, including insider info is reflected in the prices -

Developed capital markets are highly competitive and lie between weak-form efficiency and strong form efficiency This implies that on average, abnormal returns cannot be generated through technical analysis, but may be yielded via fundamental analysis if investors can forecast earning surprises correctly

Topic 2 – the Overview of the Funds Management Industry -

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Net asset value (NAV) = the no. of shares held by the investor*by the value of each share of the total asset fund Open end funds: stand ready to redeem shares s=for the current value at the request of the investor, this the share price will always be equal to NAV Closed end funds: do not redeem shares for their investors; instead shares are traded like other securities in the secondary markets after insurance and hence may r may not equal the NAV By pooling assets, mutual funds enable small investors to obtain the benefits of large scale investing, including transaction costs, diversification and divisibility, professional management and record keeping and administration On the other hand, fees charged by mutual funds reduce the investor’s rate of return Also, funds may eliminate some of the individuals control over the timing of capital gains realizations

The 5 risk adjusted measurements that are generally used i) Sharpe: the higher the better. It is generally used when the portfolio represents the entire investment fund, or when comparable portfolios have different level of diversification. It measures the excess reruns (over the risk free rate) per unit of total risk = average return on fund – risk free rate/standard deviation of return on fund-risk free risk. So = rfund-rf/sd of rfund ii)

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Treynor: considers excess return over only systematic risk the higher the better. It is generally used when the portfolio represents one sub-portfolio of many where the overall portfolio is well-diversified, or when comparable portfolios have the same level of diversification. It measures the excess returns (over the risk free rate) per unit of systematic risk. This measure relies on the single formulation and is impacted by measurement errors. = rfund-rf/beta of fund Notice how Sharpe and Treynor are different. One says how much excess return do I get per unit of total risk and the other says how much excess rerun do I get per unit of systematic (market) risk

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Jensen’s alpha. Similar to Treynor’s measure, it assumes fully diversified portfolios. This measure provides the absolute abnormal return against a benchmark risk (usually the market portfolio, but can also be an alternate set of benchmark(s)). However, Jensen’s alphas in different risk classes (i.e. different betas) should not be compared with one another. Generally we compute the t-stat f the alpha to determine whether the manager has a true ability to generate abnormal returns. Using a conventional sig. level of 5% in one-tailed test, if t-stat of alpha is greater than 2.0m, the alpha is positive and statistically significant, implying the manager has superior ability. If t-stat of alpha is less that -2.0, the alpha is negative and statistically significant, indicating the manager underperforms the benchmark. If tstat of alpha lies between -2.0 and 2.0, the alpha is statistically insignificant, and can be inferred that the manager has no superior ability. Once again, measurement errors impact this measure = alpha of fund= actual return – expected return i.e. Rfund-E(rfund) Alpha is the abnormal returns which is actual returns-expected returns

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Tracking error: this provides a measure of how the asset/fund differs from the benchmark. It is computed by (i) the sd of the error term in a single factor regression, and (ii) the sd of the diff. between the asset/fund and the benchmark/index. Both computational methods provide differing results, though the former is more accurate while the later is an easy way to compute this measure v) Information ratio: the higher the better. It is generally used when the portfolio represent an active portfolio to be optimally mixed with the passive portfolio. It is calculated by dividing the fund’s alpha with its tracking error - Would info ratio be a good way to compare passive fund managers? No because the passive strategy does not look at errors, therefore we would only look at tracking error to compare passive portfolios i.e. which portfolio has a tighter tracking error -

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To distinguish between passive funds and active funds, we look at the tracking error, Tsquare, Jensen’s alpha, beta ad info ratio For index funds, both info ratio and tracking error are close to 0, Jensen alpha and beta are not stat. different from 0 and 1 respectively, and R-Square is close to 1, indicating well diversification For active funds, info ratio is different from 0, tracking error is large, Jensen alpha and beta are stat different from 0 and 1 respectively, and R-Square is below 1 , implying you are holding unsystematic risk

How are funds created? Closed-ended fund: - Funds don’t produce anything other than alphas. They just take your money and invest in other assets, which are basically liquid assets - To create ac closed ended fund: i) a bunch of people get together ii) they pool their capital i.e. $1b iii) This is then invested into the capital market to achieve higher returns iv) They issue shares, so they have other shareholders (say $1 share issued) v) These shares are valued by: value of the pool at time t/no. of share vi) At time 0 value of shares = $1b/1m vii) We can see that price does not equal value of shares - There are 3 aspects of closed ended funds: i) small caps, ii) topical in nature, iii) retail investors - Small caps are less liquid, less researched - Large fund manager would prefer to hold large caps because they are more liquid, therefore large caps are more researched Open ended funds → mutual funds - The pool is not constant - Starts off like a close ended fund - However starts with units not shares - Units bought on primary fund, i.e. new shares are created and this money is invested in all the asset they have - To redeem your share the fund manager will sell off the assets in proportion to the no. of units you are redeeming - Value of units = value of the poolt/number of unitst - Price of units = value of units 2 Funds Return

A 12%

B 16%

Can we say that fund B has performed better that fund A? No because we have no idea of the risk - There are 2 types of risk 1) beta which measures systematic risk only and 2)sd which measures the variability of returns and measures total risk

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Therefore, do we adjust these returns with total risk or just systematic risk? We use Sharpe ratio = average return on fund – risk free rate/standard deviation of return on fund-risk free risk. So = rfund-rf/sd of rfund

Topic 2 – Investment Policy Statement (IPS) and the Asset Allocation Decision There are 3 steps in the portfolio management process: 1) The planning step: includes objectives and constant determination, IPS creation, strategic asset allocation) 2) The execution step: includes portfolio selection/composition of portfolio and portfolio implementation 3) Feedback step; includes performance evaluation and portfolio monitoring and rebalancing The IPS - An IPS is a written, planning document to govern all investment decision making for the client - Incorporates a client’s return objective and risk tolerance over the client’s relevant time horizon, along with applicable constraints such as liquidity needs, tax considerations, regulatory requirements and unique circumstances - It also covers liability aspects for the advisor - It helps investors understand the risks and costs of investing, sets standards for evaluating portfolio performance, and reduces the possibility of portfolio manager’s inappropriate behavior - Determines the types and relative weights of assets to be included in a portfolio The 2 objectives that must be specified in an IPS Risk objective: - Common measures or risk include variance standard deviation, beta and tracking error - An investors risk tolerance is a function of both willingness and ability to take risk - The investor’s willingness to take risk depends on such factor as age, gender, personality and culture - For the ability to take risk, the higher the level of income and/or wealth, the longer of time horizon, the lower of liquidity needs, generally indicate higher ability to take risk - An investor’s tolerance is determined by the lower level of willingness and ability to take risk Return objective: - This objective must be consistent with the risk objective - The usual measures are total return, nominal returns real returns and pre/post tax returns - The return that the investor says that they want is called stated return desire, which must be evaluated for reasonableness in light of the investors ability to assume risk and capital market expectations

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In contrast, required return is the minimum level of return that investors with requirements must achieve - Return objective needs to meet wealth objectives or liabilities that the portfolio is intended or require to fund, as well as spending needs from capital appreciation and investment income - If assets fund obligations are inflation premium expected rates of inflation must be incorporated in the total return objective Constraints - These place limitations on the ability to make use of particular investments, and hence may lower the returns. Some of them are as follows: Liquidity: - An anticipated or unanticipated need to cash in excess of cash inflows - Can be met by holding cash equivalents or by converting other assets into cash equivalents - An asset’s liquidity refers to the ability to quickly convert the asset into cash at a price close to its fair market value, i.e. the more difficulty to convert an asset to cash, the higher the transaction costs, and the lower the liquidity of the asset - Liquidity risk is the risk of economic loss that is incurred because of the need to s ell relatively less liquid assets to meet liquidity requirements Time Horizon: - This is the time period associated with an investment objective - It may be short-term (=10 years) or a combination of these 2 which is referred to a multi-stage horizon - Time horizon can change the view of risk which is translated in to asset allocation - For instance shorter time horizons indicate lower risk tolerance and hence constrain portfolio choice to be more conservative Tax concerns: - Because after tax returns are what investors should be concerned with, tax concerns play an important role in investment planning - For taxable investors, tax considerations will influence the choice of investments and the timing of sale\ - E.g. it would be beneficial for high-income individuals to invest in municipal bonds since the interest income is tax free, and sophisticated investors often sell securities that are losing money at the end of the tax year and hold on to those that are making money in order to minimise their tax burden

Legal and regulatory factors: - Are external factors imposed by government, regulatory or oversight authorities Unique circumstances: include the following factors i) Personal preference such as avoidance of derivatives that may constrain investment choice\ ii) Time constraints or lack of expertise for managing the portfolio that may require professional management iii) Large investment in the employer’ stock that may require consideration of diversification needs iv) Institutional investors’ needs Life-style funds and life-cycle funds - Mutual funds based on the idea of ‘risk-based investing’, i.e. they change the stock exposure of the fund as a function of investors’ risk tolerance and independent of their investment time horizon - In contrast, life-cycle funds are built on the idea of ‘age-based investing’, or the notion that the stock exposure of the fund decreases as investors approach retirement Mean-variance framework - Suggests all investors, regardless of their age or investment horizon, should hole the same proportion of risky assets, with more or less riskless assets (e.g. cash) depending on the investor’s risk tolerance - This is at odd with the asset allocation approaches used in either life-style or life-cycle funds, where the ratio of bonds to stocks increases as life-style funds become more conservative, and the allocation to equities directly related to investment horizon in lifecycle funds Risk based investing and age based investing - To understand the key ideas of these it is important to realize that long term investors have different views of risk from that of short term investors - For instance, cash which may be riskless for short-term investors is not safe at long horizons due to real interest risk - Additionally, since coupons and principle payments or long-term bonds are usually fixed over their lives, inflation risk makes these bonds risk investments for long-term investors - Another example is that long-term investors view equities as relatively safe assets based on the evidence that stock returns appear to be mean-reverting, i.e. realized stock returns are high at times of low expected future returns

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In this sense, stocks hedge against deterioration in their own expected future return and hence are relatively safer assets for long-term investors

Topic 4 – Equity Portfolio Management Strategies -

the goal of an equity portfolio manager is to outperform a benchmark portfolio on a risk-adjusted basis, where the benchmark portfolio is simply a passive portfolio with average characteristics matched with the risk return objective of the client - three basic strategies used in active equity management are: Fundamental strategies: - involve market timing, asset class and sector rotation (i.e. shift funds between asset classes/sector to take advantage of the appreciation in a specific asset/sector), and stock selection (i.e. identify and buy/sell mispriced stocks) Technical analysis: - works only when the market is in weak form efficiency - it involves inferring future returns based on analysis of historical data - active managers adopt technical strategies based on one of two assumptions i) underreaction hypotheses, that is, pas stock prices will continue in the same direction, an example of this is the price momentum strategy where you long hot stocks and short cold stocks, ii) over-reaction hypothesis where managers believe that the stock returns are mean-reverting. This involves taking a long position on the cold stocks and a short position on the hot stocks which is known as contrarian strategy Market anomalies or security attributes: - strategies are designed to exploit anomalous returns - examples include earnings momentum strategy, small-cap investment and strategies based on calendar or size anomalies -

equity styles are important since they provide investors with the ability in specific exposures and serve as benchmarks to evaluate fund manager’ performance

Types of equity styles Value: - value managers feed pessimistic investor sentiment as buy signal and focus on low absolute or relative PE, PB or PS ratios - thus their portfolios generally have profitability and growth of portfolio below the market averages - value can be further classified as three sub-styles; low PE, contrarian and yield - they are the assets considered mispriced/distressed - active in nature - consider assets are mispriced, therefore cannot follow an index

Growth: - growth managers typically select to invest in high quality firms with above average growth prospects - the sub-styles include consistent growth and earnings momentum - they are assets that have the ability to shoe abnormal growth potential - are active in nature - consider assets are mispriced, therefore cannot follow an index If value and growth investments exist, why can’t I follow them and be considered an active investor? Because if you just invest in assets based on their PE ratios, you are not really identifying a mispriced asset. You have to conduct some sort of research to be an active investor - if the market was efficient there would be no point in investing in value and growth investment - if I have very short time horizons I believe markets are inefficient and vice versa Market-oriented: - market oriented managers do not have a strong or persistent preference to either growth or value - instead, their portfolios have characteristics that are closer to market averages over a business cycle - 4 sub-styles are value bias, growth bias, market-normal and growth at a price Growth and Value - Growth investors are primarily concerned with a company’s earnings - They expect the company will deliver a particular future growth rate in earnings and assume PE ratio will remain constant in the short term - This implies stock price will rise as earnings materialize - The primary risk of growth investors is that future earnings do not always grow as expected and that the PE decreases for some unexpected reason - In contrast, value investors focus on the company’s stock prices and care little abo...