EQUITY RESEARCH AND PORTFOLIO MANAGEMENT By P K AGARWAL IIFT, NEW DELHI 1
MARKOWITZ APPROACH Requires huge number of estimates to fill the covariance matrix (N(N+3))/2 Eg: For a 2 security case: Require returns of both securities = 2 Require risks of both securities = 2 Covariance = 1 Total = 5 inputs 2
SINGLE INDEX MODEL Reduces the number of inputs for diversification Easier for security analysts to specialize 3
SINGLE INDEX MODEL 4
SINGLE INDEX MODEL 5
SINGLE-INDEX MODEL INPUT LIST Risk premium on the S&P 500 portfolio Estimate of the SD of the S&P 500 portfolio n sets of estimates of Beta coefficient Stock residual variances Alpha values 6
SINGLE INDEX MODEL 7
OPTIMAL RISKY PORTFOLIO OF THE SINGLE-INDEX MODEL 8
ARBITRAGE PRICING THEORY Arbitrage pricing theory (APT) is a general theory of asset pricing that holds that the expected return of a financial asset can be modeled as a linear function of various macroeconomic factors or theoretical market indices, where sensitivity to changes in each factor is represented by a factor-specific beta coefficient. 9
APT.. The model-derived rate of return will then be used to price the asset correctly - the asset price should equal the expected end of period price discounted at the rate implied by the model. If the price diverges, arbitrage should bring it back into line. 10
APT.. The arbitrage pricing theory (APT) describes the price where a mispriced asset is expected to be It is often viewed as an alternative to the capital asset pricing model (CAPM), since the APT has more flexible assumption requirements. 11
APT.. Whereas the CAPM formula requires the market's expected return, APT uses the risky asset's expected return and the risk premium of a number of macroeconomic factors. By going short an over priced security, while concurrently going long on the portfolio, the arbitrageur is in a position to make a theoretically risk-free profit. 12
MULTI FACTOR MODEL A financial model that employs multiple factors in its computations to explain market phenomena and/or equilibrium asset prices. The multi-factor model can be used to explain either an individual security or a portfolio of securities. It will do this by comparing two or more factors to analyze relationships between variables and the security s resulting performance. 13
MULTI FACTOR MODEL Factors are compared using the following formula: Ri = ai + βi(m) Rm + βi(1)f1 + βi(2)f2 + +βi(n)fn + ei Where: Ri is the returns of security i Rm is the market return F(1,2,3 N) is each of the factors used β is the beta with respect to each factor including the market (m), e is the error term, a is the intercept 14
MULTI Multi-factor models are used to construct portfolios with certain characteristics, such as risk, or to track indexes. When constructing a multi-factor model, it is difficult to decide how many and which factors to include One example, the Fama and French model, has three factors: size of firms, book-to-market values and excess return on the market 15
MULTI Multi-factor models can be divided into three categories: macroeconomic, fundamental and statistical models. Macroeconomic models compare a security s return to such factors as GDP, inflation and interest. Fundamental models analyze the relationship between a security's return and its underlying financials. Statistical models are used to compare the returns of different securities based on the statistical performance of each security in and of itself. 16
FAMA & FRENCH 3 FACTOR MODEL Fama and French attempted to better measure market returns and, through research, found that value stocks outperform growth stocks; similarly, small cap stocks tend to outperform large cap stocks. As an evaluation tool, the performance of portfolios with a large number of small cap or value stocks would be lower than the CAPM result, as the three factor model adjusts downward for small cap and value outperformance. 17
FAMA Is outperformance tendency due to market efficiency or market inefficiency. On the efficiency side the outperformance is generally explained by the excess risk that value and small cap stocks face as a result of their higher cost of capital and higher business risk. On the inefficiency side, outperformance is explained by market players mispricing the value of these companies, which provides the excess return in the long run as the value adjusts 18
PORTFOLIO MANAGEMENT STRATEGIES 19
PASSIVE STRATEGY A strategy that involves minimal expectational input, and instead relies on diversification to match the performance of some market index. A passive strategy assumes that the marketplace will reflect all available information in the price paid for securities, and therefore, does not attempt to find mispriced securities. 20
PASSIVE STRATEGY By tracking an index, an investment portfolio typically gets good diversification, low turnover (good for keeping down internal transaction costs), and extremely low management fees. With low management fees, an investor in such a fund would have higher returns than a similar fund with similar investments but higher management fees and/or turnover/transaction costs 21
RATIONALE OF PASSIVE STRATEGY In the long term, the average investor will have an average before-costs performance equal to the market average. Therefore the average investor will benefit more from reducing investment costs than from trying to beat the average. The efficient-market hypothesis postulates that equilibrium market prices fully reflect all available information, or to the extent there is some information not reflected, there is nothing that can be done to exploit that fact. 22
RATIONALE.. The principal agent problem: an investor (the principal) who allocates money to a portfolio manager (the agent) must properly give incentives to the manager to run the portfolio in accordance with the investor's risk/return appetite, and must monitor the manager's performance. 23
PASSIVE STRATEGY The capital asset pricing model (CAPM) and related portfolio separation theorems, which imply that, in equilibrium, all investors will hold a mixture of the market portfolio and a riskless asset. That is, under suitable conditions, a fund indexed to "the market" is the only fund investors need 24
PASSIVE STRATEGY Some active managers may beat the index in particular years, or even consistently over a series of years. Nevertheless the retail investor still has the problem of discerning how much of the outperformance was due to skill rather than luck, and which managers will do well in the future 25
ACTIVE MANAGEMENT STRATEGY Active investing refers to a portfolio management strategy where the manager makes specific investments with the goal of outperforming an investment benchmark index. Active management is the opposite of passive management, because in passive management the manager does not seek to outperform the benchmark index. 26
ACTIVE.. Ideally, the active manager exploits market inefficiencies by purchasing securities (stocks etc.) that are undervalued or by short selling securities that are overvalued. active management may also serve to create less volatility (or risk) than the benchmark index. The reduction of risk may be instead of, or in addition to, the goal of creating an investment return greater than the benchmark. 27
ACTIVE.. Active portfolio managers may use a variety of factors and strategies to construct their portfolio(s) quantitative measures such as price/earnings ratio P/E ratios and PEG ratios sector investments that attempt to anticipate long-term macroeconomic trends (such as a focus on energy or housing stocks) 28
ACTIVE.. purchasing stocks of companies that are temporarily out-of-favor or selling at a discount to their intrinsic value. Some actively managed funds also pursue strategies such as merger arbitrage, short positions, option writing, and asset allocation. 29
WHY ACTIVE MANAGEMENT The primary attraction of active management is that it allows selection of a variety of investments instead of investing in the market as a whole They may be skeptical of the efficient-market hypothesis, or believe that some market segments are less efficient in creating profits than others. 30
WHY.. They may want to manage volatility by investing in less-risky, high-quality companies rather than in the market as a whole, even at the cost of slightly lower returns. Conversely, some investors may want to take on additional risk in exchange for the opportunity of obtaining higher-than-market returns. 31
WHY.. Investments that are not highly correlated to the market are useful as a portfolio diversifier and may reduce overall portfolio volatility. 32
DISADVANTAGES The most obvious disadvantage of active management is that the fund manager may make bad investment choices or follow a high risk approach in managing the portfolio The fees associated with active management are also higher than those associated with passive management 33
DISADVANTAGES Active fund management strategies that involve frequent trading generate higher transaction costs which diminish the fund's return. Short-term capital gains resulting from frequent trades often have an unfavorable income tax impact 34
DISADVANTAGES When the asset base of an actively-managed fund becomes too large, it begins to take on index-like characteristics because it must invest in an increasingly diverse set of investments instead of those limited to the fund manager's best ideas 35