BFE 420 Portfolio Engineering Lecture 7

Ms P. Mawire

Harare Institute of Technology

pmawire@hit.ac.zw

March 19, 2019

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Overview

1 Equity portfolio management Strategies

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WAKE UP

Johnny’s mother had three children.The first child

is named April. The second child was named May
. What was the third child’s name?

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Active strategies

The goal of active equity management is to earn a portfolio return

that exceeds the return of a passive benchmark portfolio, net of
transaction costs, on a risk-adjusted basis.
If transaction costs and fees total 1.5 percent of the portfolio’s assets
annually, the portfolio has to earn a return 1.5 percentage points
above the passive benchmark just to keep pace with it.
Further, if the manager’s strategy involves overweighting specific
market sectors in anticipation of price increases, the risk of the active
portfolio may well exceed that of the passive benchmark, so the active
portfolio’s return will have to exceed the benchmark by an even wider
margin to compensate for its higher risk.
Managers are effectively “betting” against markets being perfectly
efficient.

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Active Return

Active return is the portfolio’s return in excess of the return on the

portfolio’s benchmark.

Tracking risk, the annualized standard deviation of active returns,

measures active risk (risk relative to the portfolio’s benchmark).6

The information ratio equals a portfolio’s mean active return divided

by tracking risk and represents the efficiency with which a portfolio’s
tracking risk delivers active return.

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Three general bets categories

fundamental
technical
market anomalies and security attributes

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Fundamental analysis
The purpose of fundamental analysis is to predict stock price
developments for making investment decisions.
At the company level, fundamental analysis may involve examination
of financial data, of management, business concept and competition.
At the industry level, there could be an analysis of demand and supply
of the products in that specific industry. With regards to the national
economy, fundamental analysis might focus on economic data for
evaluating that economy. To estimate the evolution of stock prices,
fundamental analysis combines the analysis of the economy, industry,
and the company to determine the intrinsic value of the share.
If the intrinsic value is not equal to the current market price, it is
assumed that the shares are either overvalued or undervalued. The
general idea of fundamental analysis is to identify undervalued
companies by analyzing the intrinsic value based on the financial
statements of the company. These financial statements are used to
calculate a number of financial indicators to reach some conclusions
about the company’s liquidity, leverage, profitability, etc.
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Bottom-Up Approach to Fundamental Analysis

With the bottom-up approach, investors focus directly on a

company’s basics, or
fundamentals.

Analysis of such information as the company’s products, its

competitive
position, and its financial status leads to an estimate of the
company’s earnings potential
and, ultimately, its value in the, market.

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Top-down Approach to Fundamental Analysis

Investors begin with the economy and the overall market(interest

rates and inflation).

The next consider future industry prospects or sectors of the economy

that are likely to do particularly well or poorly.

Finally after macro factors and overall economy individual companies

are analyzed

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Three fundamental analysis themes

Time the equity market

Shift funds among different equity sectors and industries

Do stock picking and look at individual issues in an attempt to find

undervalued stocks

Managers attempt to add value to their portfolio by timing their

investments in the various markets in light of market forecasts and
estimated risk premiums

Also try to shift funds between various equity sectors, industries, or

investment styles in order to catch the next ”hot” concept

Stock picking of individual issues (buy low, sell high).

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Technical analysis Strategies

Technical analysis strategies are used to forecast future price moves

by analyzing past and current market action.
Unlike fundamental analysts – who evaluate a security’s intrinsic value
– technical analysts use price charts and various analytical tools –
including technical indicators and chart patterns – to evaluate a
security’s strength or weakness and predict future price changes.
Technical analysts are concerned with the trends implied by past
data, charts and indicators, and they often make a lot of money
trading companies they know almost nothing about.
Contrarian Investment Strategy-An investment strategy that is
characterized by purchasing and selling in contrast to the prevailing
sentiment of the time.
Price momentum strategy-Focus on the trend of past prices alone and
makes purchase and sale decisions accordingly.Assume that recent
trends in past prices will continue.
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Contrarian Investment Strategy

A contrarian believes that certain crowd behavior among investors can

lead to exploitable mispricings in securities markets.

Widespread pessimism about a stock can drive a price so low that it

overstates the company’s risks, and understates its prospects for
returning to profitability.

Identifying and purchasing such distressed stocks, and selling them

after the company recovers, can lead to above-average gains.

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Contrarian Investment Strategy

The belief that the best time to buy (sell) a stock is when the
majority of other investors are the most bearish (bullish) about it.

The concept of mean reverting- stocks that have performed poorly in

the past will perform better in the future and stocks that have
performed well in the past will not perform as well.

The overreaction hypothesis-crowd overreacts to both good news and

bad news(buying panic, selling panic) that unjustifiably drives up the
company’s stock price

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Contrarian Investment Strategy vs. Momentum strategy

Momentum strategy believes that stocks which have performed good

will be doing so also in the future, so it buys stocks with good
historical performance and sells stocks which have done worse.

Contrarian strategy believes that stocks whose historical performance

is bad are going to do better in the future and historical winner stocks
are going to come down, so it suggests buying losers and selling
winners based on historical data.

The ideas underlying contrarian strategies are ultimately formalized by

the concepts of co-integration and error correction. When applied to
price, processes error correction represents changes in returns when
prices diverge from some common trend.

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Earnings Momentum Strategy

Momentum is measured by the difference of actual EPS to the

expected EPS

Purchases stocks that have accelerating earnings and sells (or short
sells) stocks with disappointing earnings.

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Common Normalies

January effect –The stocks which had underperformed in the year’s

fourth quarter tend to outperform in the markets in January.

Weekend effect

Low book value – the stocks which are below average or have price to
book ratios also outperform the market.

Neglected stocks –it is complementary to a small firm anomaly.

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Semi active strategies /enhanced index or risk-controlled
active strategies)
These are designed for investors who want to outperform their
benchmark while carefully managing their portfolio’s risk exposures.

An enhanced index portfolio is designed to perform better than its

benchmark index without incurring much additional risk.

The portfolio manager creates such a portfolio by making use of his

investment insights while neutralizing the portfolio’s risk
characteristics inconsistent with those insights.

Although tracking risk (also called active risk) will increase, the
enhanced indexer believes that the incremental returns more than
compensate for the small increase in risk.

Such a portfolio is expected to perform better than the benchmark on

a risk-adjusted basis.
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 The End

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