Portfolio Management: Strategies and Styles

Unit 7: Portfolio Management

• Unit 7 Includes topics on Portfolio Management, Financial Analysis, Mutual Fund Performance and Risk.

Role of the Portfolio Manager

• The role of a portfolio manager attempts to attain the highest return possible while complying with the stated investment objectives and risk constraints.
• A portfolio manager also selects the securities held in a mutual fund.

Investment Styles

• Growth investment style involves looking for securities of companies with above-average growth potential.
• Value investment style involves looking for securities of good-quality under-valued companies
• GARP (Growth at a Reasonable Price) investment style combines the principles of growth and value investing, while avoiding the extremes of either approach.

Investment Management Strategies

• Passive investment management strategy attempts to replicate the performance of a specific market index.
• Active investment management strategy selects securities based on research and analysis aimed to beat the market, the selection is aligned with a mutual fund's investment mandate.

Active Portfolio Management - Top-down Approach

• This investment approach begins with looking at the overall economy and current market trends to determine the industries, markets, and countries that are expected to perform well.
• Portfolio managers look at macroeconomic variables such as the GDP of various countries, interest rates, and employment rates, then consider and select securities of companies within the identified industries.

Active Portfolio Management - Bottom-up Approach

• Portfolio managers using a bottom-up approach focus on individual companies, and are not as interested in the economy and market cycles.
• Portfolio managers using this approach give less consideration to macroeconomic variables, because they believe good companies can succeed even when a given industry is struggling.

Investment Selection Methodology

• Technical analysis involves studying price patterns and trading volumes using charts to help determine the future prices of securities.
• Fundamental analysis focuses on studying the financial conditions of the company, and macroeconomic factors such as the economy, inflation, and interest rates, that may affect the company's earning potential.

Financial Statements

• Balance Sheet provides a picture of a company's past and current financial position by showing the company's assets, liabilities, shareholder equity, and retained income.
• Income Statement shows how much revenue a company earned during a specific period and the expenses incurred to generate the income.
• Cash Flow Statement shows where a company's cash is coming from and how it is being spent; it includes operating activities, investing activities and financing activities.
• Statement of Retained Earnings shows how much of a company's net income is retained for the business after dividends are distributed to shareholders.

Financial Analysis Ratios

• Profitability measures a company's ability to generate profits from its resources.
• Liquidity indicates whether a company has sufficient resources to meet its current financial obligations.
• Debt-Equity, also called the debt-to-assets ratio, measures a company's ability to pay its long-term debt.
• Valuation, also called the price-to-earnings ratio, relates the current share price to the company's earnings per share.

Standard Performance Calculations

• Standard performance data was developed to enable investors to make meaningful comparisons between funds.
• The formula for the annual compounded rate of return includes the assumption that any distributions from the mutual fund are immediately reinvested in the fund.
• Total return = ((redeemable value ÷ initial value)^(1/n) – 1) x 100
• n = the length of the performance measurement period in years, with a minimum value of 1
• Initial value = the beginning NAVPU
• Redeemable value = the end new NAVPU, incorporating all distributions
• Current yield = (seven day return x 365/ 7) x 100
• Effective yield = ((seven day return +1)^(365/7) -1) x 100

Effect of Mutual Fund Distributions on Performance

• Securities held in a mutual fund generate interest, dividend and capital gains income, which is distributed to investors, these distributions affect the fund's NAVPU, and its total return.
• Investors can either reinvest or cash out the income when a mutual fund distributes income.
• Investors receive additional units of the fund if they reinvest.
• The number of units held remains consistent, but the NAVPU is lower if investors choose to cash out the income.

Mutual Fund Risks

• Systemic risk is the risk that a single event can trigger a domino effect that harms other, interconnected financial institutions, and eventually the whole economy.
• Systematic risk, also called market risk, is the risk that affects everyone in the market and cannot be avoided.
• Unsystematic risk is risk specific to a given company or industry, all of which can lead to a decline on a company's security prices.

Measures of Investment Risk

• Standard deviation is a statistical measure indicating how much a mutual fund's performance fluctuates around its average historical return over a period of time, a higher standard deviation indicates a higher risk that the fund may fail to meet its average return.
• Beta is the systematic risk of an investment relative to a benchmark index.
• Duration measures volatility of fixed-income investments; it indicates the number of years it will take for the bondholder to receive the present value of interest and principal payments.

Relationship between Risk and Return

• Investments with higher volatility have the potential for higher returns due to dramatic changes in the price of the investment.
• These investments also have the potential for steeper losses, and issuers provide a risk premium for holding higher risk investments.
• The simplified prospectus and fund facts document identify the types of risk that affect a given mutual fund, and classify the fund's risk level.

Modern Portfolio Theory and the Efficient Frontier

• Modern portfolio theory explains the benefits of taking a portfolio approach rather than focusing on single investments.
• Portfolios on the efficient frontier maximize the return for the amount of risk taken, portfolios below the frontier are considered inefficient, as they do not optimize the risk-return relationship, but incur greater risk for the return level.