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Finance 450 Active vs. Passive Portfolio Management What is “alpha”? Alpha = the amount by which the market is beaten, after adjusting for risk What is alpha for the market as a whole? Alpha for market as a whole is zero • So, on average, portfolios are ON the SML Provides conceptual value of CAPM • Regardless of whether market is efficient, it is still a zero-sum game Burden of active manager • In order to win (i.e., beat the market), someone else has to lose Key question = what is special about you (and about your knowledge) that will allow you to be the one that wins? Generating alpha Are there ways to consistently generate alpha? See portfolio manager performance example: Portfolio Manager’s Performance: Past Three Years S&P 500 Fund Manager Compound Annual Return -4.98% -22.01% Total Return -14.20% -52.56% Previous Three Years: Portfolio Manager’s Performance: Past Four Years S&P 500 Fund Manager Compound Annual Return 0.50% -14.19% Total Return 2.02% -45.77% Previous Four Years: Portfolio Manager’s Performance: Past Five Years S&P 500 Fund Manager Compound Annual Return 3.17% -0.54% Total Return 16.91% -2.67% Previous Five Years: Portfolio Manager’s Performance: Past Six Years S&P 500 Fund Manager No. of Down Years 2 of 6 4 of 6 Compound Annual Return 3.29% -1.66% Total Return 21.47% -9.58% Previous Six Years: Generating alpha Would you have invested with this manager? Who is this manager with this horrible record? Warren Buffett, of course!!! Portfolio = investment in BerkshireHathaway, over the period of 1970 – 1975 Note: while stock price lagged market substantially, book value per share grew faster than market each year except 1975; this is a metric with which Buffett is more concerned Generating alpha As we have seen previously in discussing the EMH, value stocks tend to outperform growth stocks Concomitantly, Warren Buffett has the best investment record in history, becoming the 2nd richest man in the world in the process However, as we have just now seen, although value wins on average, over the long run, it does not win perfectly consistently! Instead, the markets tend to cycle, with different styles of investment performing well at different times Book to Market as a Predictor of Return: Annualized Rate of Return Value (positive a) tends to outperform Growth (negative a) 25 % 20% 15% 10% Value 5% 0% 1 2 High Book/Market 3 4 5 6 7 8 9 10 Low Book/Market Rolling Annualized Average 5-year Difference Between the Returns to Value and Growth Composites: The Market cycles between Value and Growth, But Value Wins on Average 50% 30% 20% -10% -20% Year 1997 1996 1995 1994 1993 1992 1991 1990 1989 1988 1987 1986 1985 1984 1983 1982 1981 1980 1979 1978 1977 1976 1975 0% 1974 10% 1973 Relative Difference 40% Empirical Regularities: Sources of alpha Three categories that tend to outperform over the long run: • Value stocks vs. Growth stocks • Size: Small caps tend to outperform large caps • Momentum: stocks with momentum (earnings or price) tend to beat stocks without momentum However, the payoffs to all of these tend to cycle! • A typical portfolio manager, being judged on a quarter-byquarter basis, would have been fired long before if he had the same record as Buffett for 1970 – 1975! • (In fact, he fired himself during this period!) None of these beats the market perfectly consistently • A typical portfolio manager would need to try to cycle along with the market, in order to keep from ever lagging too far behind it Empirical Regularities: Sources of alpha Beating the market consistently would require some sort of rotation strategy in order to profit from the type of securities that are performing well in the given type of market But - combination of “fat tails” and “volatility clustering” (discussed previously) can cause problems! • Best performance for a given style is likely to follow closely on the heels of its worst performance, and much of the movement for the style is likely to come in a relatively short burst (thus, if you miss it, it’s gone) • E.g.: 40% of the stock market gains for the entire decade of the 1980’s occurred during a mere 10 trading days ! • So efforts to cycle with the market and keep from falling too far behind it also make it much more difficult to beat the market! Sources of alpha: Advantage of Individual Investors “Individual investors enjoy a key advantage over professionals in one critical respect. You can pick and choose stocks and bide your time unflustered by the fierce and often corrosive quarterly performance sweepstakes, especially in hostile market climates. Value investing … demands sober reflection. Scarce to begin with, sober reflection gets even scarcer as bull markets progress.” • John Neff, “John Neff on investing” Nonetheless, if one wants to try to cycle or rotate with the market and still stay ahead (or at least not get too far behind), • Maturity diversification could be beneficial picking a variety of stocks that are expected to pay off over different time horizons • Two good authors are Peter Lynch and John Neff • William O’Neill could also be useful Passive versus Active Equity Portfolio Management Goal of Active Management • Generate alpha with some consistency • Very difficult to do Goal of Passive Management • Recognizes difficulty of generating alpha • Instead focuses on minimizing “omega” ( = “tracking error”) and trying to match the underlying index Passive versus Active Management Passive equity portfolio management • Designed to match market performance • Usually tracks an index over time • Managers are judged on how well they track the target index • Typically entails a long-term buy-and-hold strategy Active equity portfolio management • Attempts to outperform some passive benchmark portfolio on a risk-adjusted basis Passive Equity Portfolio Management Techniques Full replication Sampling Quadratic optimization or programming Full Replication All securities in the index are purchased in proportion to weights in the index This helps ensure close tracking But, increases transaction costs, particularly with dividend reinvestment Sampling Buys a representative sample of stocks in the benchmark index according to their weights in the index Fewer stocks means lower commissions Reinvestment of dividends is less difficult But, will not track the index as closely, so there will be some tracking error Frequently used in conjunction with quadratic optimization (see below) Expected Tracking Error Between the S&P 500 Index and Portfolio Samples of Less Than 500 Stocks Expected Tracking Error (Percent) Figure 22.1 4.0 3.0 2.0 1.0 500 400 300 200 100 0 Number of Stocks Quadratic Optimization (or programming techniques) Variation of Markowitz portfolio optimization But rather than maximize E(R) while minimizing , Instead maximize a (= expected excess return) while minimizing (= expected tracking error) Efficient Frontier for Enhanced/Optimized Index Funds a Efficient Frontier ap 0 p Tracking Error () An Overview of Active Equity Portfolio Management Strategies Goal is to earn a portfolio return that exceeds the return of a passive benchmark portfolio, net of transaction costs, on a risk-adjusted basis Practical difficulties of active manager • Transactions costs must be offset • Risk can exceed passive benchmark “Tilting” portfolio away from benchmark tends to increase total risk of portfolio compared to total risk of benchmark Technical Strategies Somewhat less commonly used Contrarian investment strategy Price momentum strategy Earnings momentum strategy Fundamental Strategies Much more commonly used Top-down versus bottom-up approaches Asset and sector rotation strategies Selection Process Two general approaches: 1. Top-down, three-step approach – – – Tries to beat the market quarter by quarter Over the short term, performance of a company is dominated by business cycle and performance of industry Similarly, performance of stock price over the short term is dominated by movements in overall market and industry segments Selection Process Two general approaches: 2. Bottom-up, stock valuation, stock picking (stock screening) approach – – – Willing to drift further away from market with hope of greater profits over the long run Over the long run, stock price will be driven by performance of underlying company What Buffett’s approach entails, since he plans to hold stock much longer than length of typical business cycle Top-Down, Three-Step Approach 1. General economic influences • Decide how to allocate investment funds among countries, and within countries to bonds, stocks, and cash • Two components – geographic allocation and asset class allocation 2. Industry influences • Determine which industries will prosper and which industries will suffer on a global basis and within countries • Must understand cyclical vs. structural effects 3. Company analysis • Determine which companies in the selected industries will prosper and which stocks are undervalued Three General Categories of Active Management Strategies Correspond with three stages of top-down approach: • Market timing - shifting funds into and out of stocks, bonds, and T-bills depending on broad market forecasts and estimated risk premiums • Shifting funds among different equity sectors and industries (sector rotation) or among investment styles (e.g., theme investing) to catch hot concepts before the market does • Stockpicking - individual issues Sector Rotation Position a portfolio to take advantage of the market’s next move Screening can be based on various stock characteristics: • • • • • Value Growth P/E Capitalization Sensitivity to economic variables Value versus Growth Growth stocks will outperform value stocks for a time and then the opposite occurs Over time value stocks have offered somewhat higher returns than growth stocks Value versus Growth Growth-oriented investor will: • focus on EPS and its economic determinants • look for companies expected to have rapid EPS growth • assumes constant P/E ratio, • so, as earnings grow, price will grow concomitantly Value versus Growth Value-oriented investor will: • focus on the price component • not care as much about current earnings • assume the P/E ratio is below its natural level • note: P/Book is probably a better measure of value than is P/E Approaches to Valuation of Common Stock How do you determine whether a stock is a good value? Two general approaches have been developed: 1. Discounted cash-flow valuation Present value of some measure of cash flow, such as dividends, operating cash flow, and free cash flow 2. Relative valuation technique Value estimated based on its price relative to significant variables or metrics of value, such as earnings, cash flow, book value, or sales Valuation Approaches and Specific Techniques Approaches to Equity Valuation Discounted Cash Flow Techniques Relative Valuation Techniques • Present Value of Dividends (DDM) • Price/Earnings Ratio (PE) •Present Value of Operating Cash Flow •Price/Cash flow ratio (P/CF) •Present Value of Free Cash Flow •Price/Book Value Ratio (P/BV) •Price/Sales Ratio (P/S) Approaches to the Valuation of Common Stock These two approaches have some factors in common Both are affected by: • Investors’ required rate of return kV How to estimate – CAPM, APT, Haugen’s model? • Estimated growth rate of the variable used gV Will vary depending on stage in industry life cycle Using the Discounted Cash Flow Valuation Approach Requires some measure of cash flow that will be discounted • Dividends Discount at cost of equity • Free cash flow to equity Discount at cost of equity • Operating cash flow Discount at Weighted Average Cost of Capital (WACC) Provides estimate of value for company as a whole (aggregate value of stock plus aggregate value of bonds) Estimated future cash flows are discounted back to the present to provide some measure of the absolute value of the company or its stock With constant expected future growth, form of model is simple, though application can still be problematic Why and When to Use the Relative Valuation Techniques Provides information about how the market is currently valuing stocks – compare stock to: • aggregate market • alternative industries • individual stocks within industries But no guidance as to whether valuations are appropriate – best used when: • have comparable entities • aggregate market is not at a valuation extreme Final Comments on Valuation In the end, as with much in finance, valuation is at least as much of an art as a science Ben Graham’s analogy: you don’t have to know someone’s exact weight to be able to say whether they are “fat” or “skinny” New Enterprise example • Wide range of values from valuation • But even at lowest end, book value still way undervalued Final Comments on Valuation Valuation entails / requires some vision of the future • In a real sense, investing means betting on some vision of the future But, interaction of business cycle effects vs. industry life cycle effects can confound vision of future • Internet stocks = beginning of industry life cycle + upswing in business cycle • New England Wire & Cable = downturn in business cycle + ending of industry life cycle Note – industry life cycle is not always the same thing as the company’s life cycle: • Studebaker example – transitioned from Conestoga wagons (early 1800’s) to farm wagons (later 1800’s) to farm trucks (early 1900’s) to automobiles (through early 1960’s) Final Comments on Valuation New England Wire and Cable example Jorgie’s vision • Problems are temporary, driven by downturn in business cycle • When economy (and gov’t infrastructure spending) turn back up, company will turn around • W&C division is a positive NPV project Larry the Liquidator’s vision • Problems are permanent, caused by obsolescence and foreign competition • Company has moved past the peak of the industry life cycle • W&C division is a negative NPV project