Investment Management and Capital Markets

Lecture 8: Portfolio Management

Introduction to Portfolio Management

Investment Strategies
Performance measurement

Institutional Investors

have large holdings in Stocks, Bonds and Real Estate in the UK:

- Pension Funds
- Insurance Companies
- Unit Trusts
- Investment Trusts

Market sizes, Average holding structures

Institutional Investors hold over 60% of UK equities and over 50% of UK Gilts.
(This reverses the trend in the 50s when over 60% of shares were owned by private
investors.)

1995 figures for the average holdings of Insurance and Pension funds is below:

Insurance Pension Fund

Life General

Short term assets 4% 3% 4%

Gilts 16 % 19 % 10 %
Shares 68 % 33 % 72 %
Other assets * 12 % 45 % 14 %

* Land, property

The UK shares market exceeds £ 1 trillion in value and UK government securities

exceed £ 250 billion.

The holdings of Insurance companies and Pension funds each exceed £ 500 bn.

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Investment Objectives and policies

- Pension funds enjoy several tax advantages: exemption from taxes on Income and
Capital Gains and till recently could also claim ACT deductions made by companies
on dividends paid out. They are entrusted by their contributors to meet long term
liabilities. Hence they invest more in longer term assets.

- Insurance companies need to provide for their own variety of liabilities: claims on
shorter term insurance policies and longer term liabilities on assurance policies.
Insurance companies also have less tax advantages. They need to have a higher
degree of liquid assets.

- Investment and Unit trusts have more specific objectives: their objectives are to
meet their investors’ specific expectations on capital appreciation or short term
income expectations. They do not have specific tax exemptions.

Portfolio Management Techniques

The theoretical framework

Every fund has to take into account the risk-return attitudes of its investors.
The appropriate theoretical framework for optimising returns is therefore
Portfolio Theory.

Through application of the diversification principle across a range of assets (Stocks,

Bonds, Cash, Property, International Equities) and the risk-return attitudes of
investors, it can suggest strategies for

Maximising Return: Σ Xi Ri

Minimising Risk: Σ Σ XiXj.σjk = Σ Σ XiXj. ρjk σjσk

Returns are maximised for a given level of risk through selecting a proportion of
different investments which have low correlation of returns with each other.

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Portfolio Management Styles

Investment Styles may be classified as `passive’ or `active.’

Passive strategies: based on belief that markets are efficient and cannot be beaten.

Active strategies: based on belief that markets are inefficient and can be beaten.

Typical passive strategy

- Investing in an index fund, representative of the class of assets

Characteristics of Passive strategies:

- wider diversification and higher market risk

- longer period investment

Consequently, lower turnover, transaction costs and management fees

Typical active strategies

- investing in selective proportions of different assets, based on subjective

analysis and predictions

Characteristics of Active strategies:

- shorter period investment

- poor diversification and greater specific risk

Accompanied by higher turnover, higher transaction costs, higher management fees.

It is estimated that today over 25% of the investment by institutional investors is in

some form of index fund. This supports the growing popularity of the ideas behind
passive management.

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Equity and Bond Fund Investment Styles

Equity Fund Management:

Passive Strategies: Investing along the capital market line, by combining different
proportions of the all share Index and Risk free investment according to risk
preferences.

Active strategies in Equity Investment

Investing in selective equities according to subjective evaluations

- technical analysis: buying stocks which are low priced and selling stocks which are
high priced, using rules to predict returns.

- fundamental analysis: adopting strategies for better performance than those in the
benchmark portfolio, through analysis of all publicly available information, analytical
models, anticipating market movements and moving into stocks of appropriate beta,
analysing sector performance for allocation etc.

Bond Fund Management

Passive Strategies
Investing in a portfolio of bonds of investor desired duration.

Active Strategies: are based on predicting yield curve changes.

Horizon Analysis: tracing yield and time effects on candidate bonds and selecting
those with the highest return according to expectations on the yield curve for a
particular horizon.

Bond Swaps

- Substitution Swaps are based on substituting higher priced bonds (lower ytm) for
lower priced bonds (higher ytm).

- Inter-Market Spread Swaps are based on exchange of bonds from different sectors
of the market on the basis of expectations of narrowing yield spreads.

- Rate Anticipation Swaps are based on switching between long and short tem bonds
depending on which end of the yield curve is expected to change.

Riding the Yield Curve

When the yield curve is upward sloping, and expected to be of the same shape into the
future, bonds with a longer duration give higher returns than those of shorter duration,
and this principle can be used in bond selection.

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Fund Management

Investment Strategies

(a) Equity Funds

Inefficient Market Efficient Market

I
Active Management Passive Management

(a) Technical Invest along the CML

(i) Charting- exploiting historical patterns
(ii) Trading Rules- predicting returns
Momentum/Contrarian
Moving Average
Trading Range Break
Filter

(b) Fundamental
(i) Financial Analysis
(ii) Stock Selection
(iii) Top down / Bottom up
(iv) Market timing
(v) Asset allocation / business cycle effects.
(vi) Probabilistic forecasting.
(vii) Econometric modelling

(b) Bond Funds

Inefficient Market Efficient Market

Strategies based on Predicting Investing in bonds of required
yield changes in the yield curve duration and holding to maturity

Horizon Matching
Bond swaps
(Inter market, rate anticipation, Substitution swaps )
Riding the yield curve

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Asset allocation Issues
(set by investor demand and Fund objectives: capital growth, income, sector, market)

Asset Classes -stocks, bonds, property, cash, foreign assets

Planning Asset Allocation

To maximise returns we need to look at fundamentals of Portfolio theory:

The risk, return, correlation characteristics of different classes of assets.

Strategic Allocation issues relate to the relative proportions of the different assets,
sectors, markets that the fund would like to be invested in the long term taking
into account its objectives and expectations on the risk, return and correlation
characteristics of different asset classes.

Tactical allocation issues relate to managing the relative proportions of the different
asset classes to maximise returns in the short term taking into account market
conditions.

Various asset classes

Cash
In addition to maintaining liquidity requirements funds would like to maintain
some portion of their funds in cash or `near cash.’ This would mean investing in
easily encashable t-bills so that some earnings are generated on such holdings.
This allocation would be the lowest earner but would also represent the lowest risks.

Stocks and Bonds

US studies show that the historical relationship between stocks and bonds
In the period 1926-96 show
- The excess return and risk on stocks has averaged about 9% and 20%….
- The excess return and risk on bonds has averaged about 1% and 9%…
- The correlation between stocks and bonds has averaged about 0.2-0.25….

The historically low correlation between the returns of stocks and bonds points to the
benefits to be achieved through diversification.

Real Estate
Studies have shown that Real Estate offers potential for inclusion within a
Portfolio because of its low correlation with the returns of stocks and bonds.
Studies have shown that returns on Real Estate have a positive correlation with
inflation.

The problems of including Real Estate within a portfolio are –

- illiquidity of investments
- correctly determining market value
- lack of sufficient statistically valid data on risk, return and correlation.

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The problems of liquidity and market value have been overcome in the US through
Investment vehicles known as REITs (Real Estate Investment Trusts), the shares of
which are traded on exchanges. A fund interested in taking on Real Estate exposure
could invest in the shares of REITs which meet its objectives.

Foreign assets
The relatively low correlation between stock and bond markets, raises the issue of
Inclusion of foreign assets within a diversified portfolio, to further increase the
Sharpe Ratio.

Studies of the excess returns (R – LIBOR), and standard deviations

(σ
σ ) of stocks and bonds in the period 1975-1991 from the perspective of a US
investor, investing in selected developed foreign markets Australia, Canada, Japan,
Germany, UK) show:

the excess returns on stocks have been about 5%

the excess return on bonds have been -1 to 2%

correlations between US and foreign stocks have been about 0.5

correlations between US and foreign bonds have been about 0.1-0.2
correlations between US bonds and foreign stocks have been about -0.1 to 0.20
correlations between US bonds and foreign bonds have been about 0.2-0.4

Conclusion

With the above background it is clear that a fund dedicated to investing in various
asset classes can decide on a composition of asset Classes, including cash (t-bills)
suitable to its objectives, and work toward Maximising its Sharpe Ratio.

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