|1|1 investments academic year 2004 - 2005 lectures n° 3 & 4 the investment process

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Investments

Academic Year 2004 - 2005

Lectures n° 3 & 4

The Investment Process

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4.1. The investement process

1. Set investment policy2. Perform security analysis3. Construct a portfolio4. Revise the portfolio5. Evaluate the performance of the

portfolio

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1. Set the investment policy

• Investments objectives set in terms of risk/return ratio.

• Depend on :– the return requirement of the investor, – compared with the risk he is willing to assume (risk

tolerance)

• Factors affecting the decision : – utility function (tastes) and risk aversion (wealth, tastes) – investment horizon– liquidity needs– outside environment, etc.

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1. Set the investment policy

• Examples of investment objectives in mutual funds classification :– Maximum capital gain– Growth– Growth and income– Income– Income and security

• Portfolios varying in terms of : asset mix - industry - currency - horizon - active / passive management

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2. Perform security analysis

• Attempts to identify mispriced financial assets:– Buy undervalued securities (expected to rise in price)– Sell overvalued securities (expected to decline in price)

• Two types of security analysis:– Technical analysis = graphical analysis of stock prices, in

order to identify patterns contradicts the weak form of market efficiency

– Fundamental analysis = estimate the intrinsic value of a stock / company based on its expected cash-flows, and compare it with the market price

contradicts the semi-strong form of market efficiency

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2.1. Fundamental Analysis

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• Asset valuation - reminder

Definition : Intrinsic value of a stock = sum of expected future dividends, actualised at a rate k

Several main parameters / uncertainties: Firm parameters :

• Profit of the firm : • Payout ratio : (1-b)

leading to : • Dividend amount : D = . (1-b)• Growth rate of dividend : g, such as : Dt+1 = (1+g) . Dt

k

D

k

D

k

DV

...

)1()1( 221

0

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• DDM Simple Form - reminder

a) We have, if D is constant (Zero-Growth Model)

b) If D is supposed to grow at a constant rate “g” over time, with: Dt+1

= (1+g) . Dt.

The value of the equity of the firm becomes (Constant Growth Model) -

“Gordon - Shapiro” model :

k

D

k

D

k

DV

...

)1()1( 221

0

gk

D

k

gD

k

gD

k

gDV

13

30

2

200

0 ...)1(

)1(

)1(

)1(

)1(

)1(

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• DDM - implications

• The stock price is expected to grow at the same rate (g) as

dividends:• g = growth rate of earnings, but, since dividends are

proportional to earnings (hypothesis of the model)• then g = also the growth rate of dividends

Concept check :

What if dividends are not proportional to earnings?

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• Multiple Growth Model– More complex version of DDM: multistage version for

various values of g over time : Observe current D Estimate growth rate of D : stages 1 Estimate number of stages Estimate growth rate per stage Estimate payout ratio (at different stages) Formula :

• Estimation of g of a limited number of years (N). After a medium-term period (N) : reasonable to estimate g at the same expected growth rate of the economy.

N

NN

kgk

DD

k

D

k

DV

)1(...

)1()1(

1

221

0

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• Valuation Methods

– What if ?

The dividends distributed are very low?The firm is risky?The firm is mature?The firm is at a young development stage?...

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• Should you distribute dividends ?ROE & g

– By the Gordon-Shapiro relation, g and k are key in the determination of intrinsic value :

g : expected growth rate of earnings k : discount rate of earnings

We have : g = (ROE new investment) x (1-payout)

Meaning : Growth of earnings = generation rate of income * retention

ratio

g = ROE * b (1)

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• ROE & g

By (1), we have :

Where : E1 = expected earnings of the firm in the next period

• So : P0/E1 rises when ROE rises

• And : P0/E1 rises for higher levels of b, as long as : ROE > k

So a firm should undertake a new investment only if ROE > k

Meaning : when money is expected to generate higher return if invested within the firm (on new projects) than on the status quo.

)*(

)1()1( 11100 bROEk

bE

gk

bE

gk

DPV

(2)

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• ROE & g

The firm is thus better to rise its retention ratio if its new investment projects yield more than what the firm remunerates its shareholders (k) => endogeneity of b, then ...

By (2), we have :

if stocks trade at intrinsic value

And we have : V < E if ROE < k V > E if ROE > k

bROEk

b

E

P

.

1

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ChemicalsAutoFoodPharmaUS marketunattractive

valuations

0

attractivevaluations

Source : ING Asset Management


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2.2. Security Selection (“Stock Picking”)

• Definition: selecting certain stocks in a portfolio different from the benchmark (the reference index), or to overweight them, in order to outperform the portfolio benchmark.

• Supposes that markets are nearly efficient, i.e., that some securities are mispriced compared to their betas; bringing positive alphas to the portfolio;

• Lead to excessive concentration on certain securities, leading to a firm-specific risk– -> Optimal security selection is a trade-off between

estimated mispricing and the firm-specific risk added to the portfolio (Treynor and Black (1975)).

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2.2. Reminder – CAPM

• Beta measures the extent to which returns of the stock and the market move together. Beta is defined as :

• The risk premium on individual securities is equal to :

• In this simple version of the CAPM, investors are myopic: there is no anticipation of changes in the market conditions.

• Preferences, risk aversion of investors, and security returns are supposed to be stable over time.

M

iiM

MM

MiiM

M

iM

M

Mii

rrCov

22

),(

))(()( fMifi rrErrE

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2.2. Reminder – Single – Index Model

)(2222pmpp e

• First term : systematic risk of the portfolio p.• Second term : can be diversified away (diversifiable risk) :

where is the average of the firm-specific variances.

)(1

)()1

()(2222 e

ne

ne i

ip

)(2

e

Var(R)

E(R)

Systematicrisk

Diversifiable risk)(

1 2e

n

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2.2. Reminder – Market Model

• Hyp: "Return surprises" (Abnormal returns) proportional to the corresponding surprises on the market portfolio. Many applications in event studies.

• where :

• Remark: Over the long term, the beta of a company tends to evolve to 1 over time (no persistence of the systematic risk), due to the size effect and to the life cycle of the firm:

-> Merrill Lynch "adjusted beta" = 2/3 sample beta + 1/3 .1

immiii eRERRER )()(

fmiifi RRERRE )()(

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2.2. Reminder – CAPM testing

Overall methodological difficulty:– Results may also reflect variations of risk premium over

time: movements in returns can be either due to facts linked to the firm individually, or to the market as a whole.

– One can not know whether a change in return ri is due to

the firm's parameters (i), or to the market premium.

– Efficiency tests are joint tests of EMH and risk-adjustment procedures (rise in risk -> rise in risk premium -> rise in returns).

– By :))(()( fMiifi rrErrE

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2.3. Technical Analysis

© 1999 Bloomberg L.P. All rights reserved© 1999 Bloomberg L.P. All rights reserved

• MARKET PSYCHOLOGYMARKET PSYCHOLOGY• PAST-PRESENT-FUTURE PAST-PRESENT-FUTURE • PATTERNS CAN BE SIMILARPATTERNS CAN BE SIMILAR• TRENDSTRENDS• SUPPORT-RESISTANCESUPPORT-RESISTANCE• POINTS&FIGURESPOINTS&FIGURES• MOVING AVERAGESMOVING AVERAGES• MOMENTUMSMOMENTUMS

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3. Construct the portfolio

• Identification of the assets in which to invest– definition of the asset mix : equity - bonds - cash- real

estate…– definition of the asset allocation : % of cash, bonds, equity…

• Decision on three main portfolio dimensions :– diversification :

per country / geographical zone per currency per sector / industry

– timing : when to invest in what : switch between bonds and equity

– selectivity : individually select supposed mispriced securities (“stock picking”)

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3.1. Active Asset Allocation

• Active Portfolio Allocation– Global Asset Allocation : Equity – Bond – Cash

• Active Equity Allocation – Regional Allocation – Sector Allocation– Stock Picking– Market Timing

• Active Bond Allocation– Duration (Volatility)– Yield curve positioning– Corporate<>Government Bonds– Currency Allocation

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Return of different investment alternatives (USA 1926-1997)

– Average Risk Premium Shares : 6,8% Government Bonds : 1,4%

– Average Risk Level Shares : 19,8% Government Bonds : 10,6% Treasury bills : 4,2%

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Return of different investment alternatives (USA 1926-1997)

– E (Nominal return) ? Treasury bills (nom) + Average Risk Premium Shares : 3,8% + 6,8% = 10,6% Gov. Bonds : 3,8% + 1,4% = 5,2%

– E (Real return) ? Treasury bills (real) + Average Risk Premium Shares : 0,6% + 6,8% = 7,4% Gov. Bonds : 0,6% + 1,4% = 2,0%

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-$29,000-$29,000

-$16,000-$16,000

-$4,600-$4,600

$50,200$50,200

$26,400$26,400

$12,200$12,200

-$40

,000

-$40

,000

-$30

,000

-$30

,000

-$20

,000

-$20

,000

-$10

,000

-$10

,000

$0$0

$10,

000

$10,

000

$20,

000

$20,

000

$30,

000

$30,

000

$40,

000

$40,

000

$50,

000

$50,

000

$60,

000

$60,

000

SHARESSHARES

BONDSBONDS

T-BILLST-BILLS

Assuming the past if a good proxy of the future, if you invest 100,000$, you have 95% chances to earn annually between :


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3.1. Active Asset Allocation - Investment Horizon

-10%

-5%

0%

5%

10%

15%

30's 40's 50's 60's 70's 80's 90's

STOCKS BONDS CASH Source : US data, ING group report

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Definition : Shift of funds from one type of investment to another (usually between bonds and stocks) depending on their expected returns over a limited period of time.

Consider two different investment strategies (ex. from Merton): - 52 years investment (1.1.1927 – 31.12.1978) of $ 1,000 in

30-day commercial paper : brings $ 3,600- same investment in the NYSE index: brings $ 67,500

Question : How much would have made an investor that would have correctly anticipated, at the beginning of each month, which type of investment will do better, and completely shifted funds accordingly?

3.1. Active Asset Allocation – Market Timing

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Answer : $ 5,360,000,000.This example shows:

- the considerable of interest compounding, increasing with the investment horizon,

- the difference between the risk-free savings and the stock index : this is explained by the risk born by the investor. The risk relates to the moment of which stock investors will get their return, more than to size of it.

Of course, surperformance limited in practice, due to imperfect anticipations, and to transactions costs.

In practice market timing is the second source of surperformance in active portfolio management, after asset allocation and before security selection.


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MSCI EUROPEMSCI EUROPEAND JPM EUROPE (bonds – straight line)AND JPM EUROPE (bonds – straight line)

6,31%6,31%

-30%-30%

-20%-20%

-10%-10%

0%0%

10%10%

20%20%

30%30%

40%40%

50%50%

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SHARES BESTSHARES BESTIN 58% OF THEIN 58% OF THEOCCURENCESOCCURENCES

BONDS BESTBONDS BESTIN 42% OF THEIN 42% OF THEOCCURENCESOCCURENCES -20%-20%

-15%-15%

-10%-10%

-5%-5%

0%0%

5%5%

10%10%

15%15%

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Monthly relative performances (line = r equity – r bonds)

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3.2. Active Equity Allocation

• Active Portfolio Allocation– Global Asset Allocation : Equity – Bond – Cash

• Active Equity Allocation – Regional Allocation – Sector Allocation– Stock Picking– Market Timing

• Active Bond Allocation– Duration (Volatility)– Yield curve positioning– Corporate<>Government Bonds– Currency Allocation

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3.2. Active Equity Allocation – Regional Allocation

• International portfolio diversification with better risk/return characteristics.

• What it the optimal number of shares in a well-diversified portfolio?

– Depends on the size of the reference market and on the correlation matrix.

– And : Trade-off between diversification and transaction& monitoring costs.

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Exchange rate risk is an important additional source of risk.

• Ex : if the exchange rate $/€ fall of 10% (the euro depreciates), it will harm that much the real return in $ of a portfolio libelled in €.

• Let : E0 = initial exchange rate $/€ (ex. 1$/€)• And : E1 = final exchange rate $/€ (ex. 0.9$/€)

• Then the $ denominated return of the portfolio is :

0

1)(1($)1E

EEurrr f

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• Currency risk hedging in portfolio management?– In equity portfolios (mutual funds): generally not.

Currency risk decision based on fundamental models and market consensus.

Decision on level of risk bearing.

– In bonds portfolios : sometimes. Some banks have only mono-currency bond portfolios.

– Individual portfolios : Hedging possibilities : forward and future markets, and options.

Rare in active management, better then to restrict oneself to one or few currencies, or to dilute in general diversification.

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EUR DKK SEK GBP USD CAD AUD JPY OTHER

BENCHMARK

PORTFOLIO

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3.2. Active Equity Allocation –Regional Allocation

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3.3. Active Equity Allocation – Sector Allocation

• Several classifications can be made for industries: – Cyclical & non-cyclical – Consumer goods & non consumer goods– Defensive – Technology – Growth.

• Each industry is affected by different parameters.

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3.3. Active Equity Allocation–Sector Allocation

• Examples : – Automobile sector (cyclical):

confidence of households (durable good - large impact on budget)

interest rates level (low is good)savings rate (good indicator of durable goods consumption if

declining) inflation rate (bad if high, due to reduced consumption power)public policies (premiums, technical control,..;)

– Food retail (defensive):confidence of households (linked to the level of spending) interest rates level (low is good, for some goods)unemployment rate (modifies the consumption behaviour) inflation rate (bad if high, due to reduced consumption power)

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• Pharmaceuticals (growth) – Regulation (stabilising factor)

– Product development (generics, product life cycle)

– Potential markets (life style of target population)

– Age of the population

• Which diversification is more powerful? Country or Sector ?– Usually, country diversification is larger that sector

diversification (Laurent, 2004).

– However, in some homogenous geographical zones - like the euro zone - sector diversification tends to get larger than countries.

– See illustrations

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Sector diversification : different sectors (Medical & Financial) in the same zone (US)

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Country & Sector diversification : different sectors (Auto & Food) in the different zones (Europe and the US) : maximum effect

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• Diversification is maximum when country and sector diversification are combined;

• Each sector has specific dynamics, according to different economic parameters;

• Fundamental analysis helps identifying the overvalued and undervalued sectors

The portfolio is a combination of diversified assets, with overweigths in undervalued sectors, and underweights in overvalued ones.

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Example : “Middle of the Road” Mutual Fund

14%

16%

4%

11%

39%

9%7%

SHARESSHARES

FIXED INCOMEFIXED INCOME

BBL (L) Invest Utilities (IS)BBL (L) Invest Utilities (IS)BBL (L) Invest Banking & Insurance (IS)BBL (L) Invest Banking & Insurance (IS)BBL (L) Invest Healthcare (G)BBL (L) Invest Healthcare (G)BBL (L) Invest European Telecom (G)BBL (L) Invest European Telecom (G)BBL (L) Invest Nasdaq (G)BBL (L) Invest Nasdaq (G)BBL (L) Invest European Shopping (D)BBL (L) Invest European Shopping (D)BBL (L) Invest Chemicals (C)BBL (L) Invest Chemicals (C)BBL (L) Invest Energy (C)BBL (L) Invest Energy (C)

BBL Renta Fund EuroBBL Renta Fund EuroBBL Renta Fund Belgian Go. EuroBBL Renta Fund Belgian Go. EuroBBL Renta Fund Corporate EuroBBL Renta Fund Corporate EuroBBL Renta Fund GBPBBL Renta Fund GBPBBL Renta Fund Danske KroneBBL Renta Fund Danske KroneBBL Renta Fund DollarBBL Renta Fund DollarBBL Renta Fund AUDBBL Renta Fund AUD

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4. Revise the portfolio

• Or “Portfolio rebalancing” = Repetition/ Update of the three first steps, due to change in : – the investors constraints and objectives– the markets prospects for certain assets or sector – the transaction costs on certain markets– new investment opportunities– tax regulation– or, the passage of time (maturing bonds)

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4. Mixing Active and Passive Strategies

• Active and passive portfolio management can be mixed in one international portfolio.

– Ex : passive strategy on Far East and emerging markets and active strategy on US and European markets.

• In case of external shock, like the 1987 October crash, there is empirical evidence for a world factor, affecting all. But domestic factors dominate in normal conditions.

– Then, as far as portfolio modelling is concerned, the APT (like the multi-factor pricing model that satisfies the no arbitrage condition) seems better designed for use of international context than the CAPM.

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Integrating Active and Passive ManagementJournal of Portfolio Management, Fall 2000, pp 10-19.

How can a fund combine active and passive management to produce superior investment results?

The idea is to reconcile the two schools of active management, stating that (1) active managers should choose and actively manage securities within

each asset class; or on the contrary that (2) managers should passively manage securities within each asset class

and dedicate their time to higher level asset allocation decision.

Split of the allocation decisions between active and passive strategies according to three time horizons:


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Strategic Allocation: the long-term anchor

• The active / passive allocation mix is dependant on the efficiency of each market segment.

• On balance, the allocation should favour passive and index strategies in most efficient segment.

• In less efficient segments, the allocation should incorporate more active strategies.

Strategic asset allocation should be a long term mix that is reviewed and adjusted on the margin perhaps every 3 years.


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Tactical Allocation: the cyclical adjustment - around 3 years

• Active managers have performance cycles. They try to outperform by deviating from their benchmark using several levers : market timing (move to cash), style (growth vs. value stocks), capitalisation (small companies bias), sectors and stock selection.

• By understanding and modelling their performance cycle in function of their levers, active managers should be able to make tactical change in their active / passive allocation mix to increase their overall performance.

• The allocation should favor more active strategies during the parts of the cycle that are constructive for active management levers, and the other way round.


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Dynamic Allocation: opportunistic risk control

• A dynamic asset allocation is a short-term shift around the longer-term anchor.

• Active/Passive dynamic investing is influenced by the risk tolerance of the investor.

• To control risk, active strategies can be transformed into passive strategies at predetermined thresholds.

A transition from active to passive for a particular manager or strategy could happen at most once a year.


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5. Evaluate the Performance

• Four dimensions of performance evaluation : – In absolute terms (returns only):

Arithmetic averages (for expectations) Geometric averages (for past performance)

– Relative to risk: Risk/return ratios : Ex. Sharpe ratio : (rp - rf)/p

– Relative to a benchmark : Comparing with a portfolio of similar investment policy and

risk level (ex. market index) Ex. Information ratio : (rp - rb)/p

– Performance attribution : split performance into active management decisions.

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6. Market Efficiency

• Hypotheses to the Efficient Market Model : 1. All investors have costless access to currently available

information about the future;2. All investors are capable analysts;3. All investors pay close attention to market prices and

adjust their holding appropriately.

• Then :1. The Efficient Market will exist = one in which every

security’s price equals its investment value at all times.2. And : the set of information available will be fully reflected

in market prices.3. And : there is no way to book abnormal profit on such a

market, besides pure luck.

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• Three forms of efficiency: – Weak form : past information incorporated in the prices

– Semi-strong form : past and current public information incorporated in the prices

– Strong form : past and current public and private information incorporated in the prices

• Types of efficiency : – informational (here)

– organisational (effectiveness issue)

– competitive (margins et prices)

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• Consequences of market efficiency in terms of asset management : – Weak form of efficiency : technical analysis does not

lead to abnormal returns

– Semi-strong form of efficiency : fundamental analysis does not lead to abnormal returns

– Strong form of efficiency : insider trading does not lead to abnormal returns

• Overall consequence : active management cannot beat passive management of funds.

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• Concept check :

• What would happen to market efficiency if all investors attempted to follow a passive strategy?

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• Role of active management– Systemic level :

Keep markets efficient

Incorporate new information in prices

Exploit profit opportunities / Eliminate sources of efficiencies

– Microeconomic level : Adapt management to [risk / return] profile of investors

Include tax considerations

Large role of financial advice / financial engineering

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• Consequences on the performance of active portfolio management:– On average, underperformance of the managers

compared to benchmarks

– The surperformances do not always cover the transaction costs (2 x 80bp)

– No surperformance on several successive periods (occasional luck).

|1|1 investments academic year 2004 - 2005 lectures n° 3 & 4 the investment process

Documents

fundamental analysis

expected growth rate

growth rate of earnings

portfolio slide

constant rate g

investment process slide

technical analysis

b growth rate of dividend