Introduction to Active Portfolio Management

Equity Style Spectrum

Growth

Index GARP

Value

Deep Value

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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
Investment Universe
Focus List Portfolio Construction
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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
Example: McLean Budden Team-based majority voting Approach Fundamental research Active corporate interview program Management process: see handout

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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
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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 > 2.5%, P/B < 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 longterm 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 < 2/3x. Now, 2x is considered low)

New value rules have been proposed by various authors

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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Growth vs Value

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Value vs. Growth

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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: > $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
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 Benchmarks: EAFE (for developed markets), MSCI World (for global markets)
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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 Whether or not to hedge depends on investment horizon, and faith in the PPP

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Impact of Currency

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