Portfolio Analysis PDF - Canadian Securities Institute

SECTION 6 PORTFOLIO ANALYSIS 15 Introduction to the Portfolio Approach 16 The Portfolio Management Process © CANADIAN SECURITIES INSTITUTE  Introduction to...

SECTION 6 PORTFOLIO ANALYSIS 15 Introduction to the Portfolio Approach 16 The Portfolio Management Process © CANADIAN SECURITIES INSTITUTE  Introduction to the Portfolio Approach 15 CHAPTER OVERVIEW In this chapter, we introduce you to the different techniques used to analyze and measure risk and return in a portfolio. You will also learn the formulas used to calculate and interpret expected return and identify strategies for maximizing return while reducing risk. Finally, we will discuss the different management styles used in equity and fixed-income portfolios. LEARNING OBJECTIVES CONTENT AREAS 1 | Calculate rates of return of a single security. Risk and Return 2 | Differentiate among the types and measures of risk, and the role of risk in asset selection. 3 | Calculate and interpret the expected return of Relationship Between Risk and Return a portfolio of securities. in a Portfolio 4 | Summarize the benefits and challenges of combining securities in a portfolio. 5 | Compare and contrast the portfolio The Portfolio Manager Styles management styles of equity and fixed- income managers. © CANADIAN SECURITIES INSTITUTE 15 2 CANADIAN SECURITIES COURSE      VOLUME 2 KEY TERMS Key terms are defined in the Glossary and appear in bold text in the chapter. active investment strategy inflation rate risk alpha interest rate risk beta liquidity risk bottom-up analysis non-systematic risk business risk passive investment strategy buy and hold political risk capital gain rate of return capital loss real rate of return cash flow risk-free rate of return correlation sector rotation default risk specific risk diversification standard deviation ex-ante systematic risk ex-post top-down analysis foreign exchange rate risk volatility holding period return yield indexing © CANADIAN SECURITIES INSTITUTE  CHAPTER 15      INTRODUCTION TO THE PORTFOLIO APPROACH 15 3 INTRODUCTION No perfect security exists that meets all the needs of every investor. If it did exist, there would be no need for investment and portfolio management, and no need to measure the return and risk of investments. In fact, advisors and portfolio managers spend a great deal of time selecting securities, allocating funds among security classes, and managing risks and returns. The portfolio approach to making investment decisions consists of creating a diversified portfolio that allows investors to reduce overall risk without necessarily decreasing the expected return. In taking a portfolio approach to investing, you can theoretically eliminate some types of risks altogether through diversification. Diversification is a strategy that combines a variety of distinct investments in a portfolio with the aim of reducing the investor’s risk of any individual security. Recognizing that there are no perfect securities, investors and advisors use measures and methods to estimate risk and predict return. Based on these results, they construct portfolios designed to fit the particular needs and circumstances of individual investors. Building portfolios that correlate to specific investor needs is key to being successful in the investment industry. Generating the highest returns is not enough; higher returns that require exposure to risky investments may not be appropriate for a particular investor. In this chapter, we integrate information about individual securities, the markets, and the different analysis techniques. We focus on the relationship between risk and return and the various measures used to assess these factors. We also discuss the reasons why an advisor or portfolio manager might choose an active or passive approach to managing an equity or fixed-income portfolio. All this information provides a foundation of knowledge on which to build your skills in using a portfolio approach to investing. RISK AND RETURN 1 | Calculate rates of return of a single security. 2 | Differentiate among the types and measures of risk, and the role of risk in asset selection. Given a choice between two investments with the same amount of risk, a rational investor would always take the security with the higher expected return. Likewise, given two investments with the same expected return, the investor would always choose the security with the lower risk. In reality, the choice is rarely so simple. Risk and return are interrelated in such a way that, to earn higher returns, investors must accept higher risk; and to avoid risk, they must accept lower returns. The choice investors make depends on their risk profile. Some investors will always choose lower-risk securities; others are willing to take on more risk if they believe there is a potential for higher returns. Investors also have different views of what constitutes risk. To some, it means the risk of losing money on an investment. To others, it means the risk of losing purchasing power if the return on the investments does not keep up with inflation. Given that all investors do not have the same risk profile, different securities and different funds were developed to serve various market niches. For example, guaranteed investment certificates (GIC) suit investors seeking safety, fixed-income securities suit those seeking income, and equities suit those seeking growth or capital appreciation. No matter what their risk profile, few people invest all of their funds in a single security. With a portfolio of securities, they are able to diversify their investments and reduce risk to a suitable level. For example, the same portfolio might contain the following investments: Government of Canada bonds, from which the investor expects to earn interest income Common shares, which the investor expects to grow in value while providing dividend payments © CANADIAN SECURITIES INSTITUTE 15 4 CANADIAN SECURITIES COURSE      VOLUME 2 DID YOU KNOW? The return on an investment is rarely guaranteed, which is why it is often called the expected return. Investments are typically purchased in anticipation that they will grow in value; in reality, however, values can also decline. Selling a security for more than its purchase price is called a capital gain, whereas selling a security for less than its purchase price is a capital loss. For an investor, any income derived from an investment, in the form of interest payments or dividend, is called cash flow. Returns on an investment are some combination of cash flows and capital gains or losses. Figure 15.1 shows the formula used to calculate the expected return of a single security. Figure 15.1 | Expected Return of a Single Security Expected Cash Flow + Expected Capital Gain (or - Capital Loss) Expected Return = Beginning Value Where: Expected Cash Flow = Expected dividends, interest, or any other type of income Expected Capital Gain/Loss = Expected Ending Value − Beginning Value Beginning Value = The initial dollar amount invested by the investor Expected Ending Value = The expected dollar amount the investment is sold for RATE OF RETURN Returns from an investment can be stated in absolute dollars; however, absolute numbers obscure the significance of a gain or loss. For example, an investor may state that she earned $100 on a particular investment, but without knowing the amount of the original investment, the number is meaningless. A $100 gain made on an investment of $1,000 is significant, whereas the same gain on an investment of $100,000 might signal a poor investment choice. The more common practice is to express returns as a percentage, called the rate of return or yield. To convert a dollar amount to a percentage, the usual practice is to divide the total dollar returns by the amount invested, as follows: Cash Flow + (Ending Value - Beginning Value) Return % = ´ 100 Beginning Value © CANADIAN SECURITIES INSTITUTE  CHAPTER 15      INTRODUCTION TO THE PORTFOLIO APPROACH 15 5 EXAMPLE Consider the following three scenarios: 1. You purchase a stock for $10 and sell it one year later for $12. The rate of return is 20%, calculated as follows: 0 + (12 - 10) ´ 100 = 20% 10 2. You purchase a stock for $20 and sell it one year later for $22, and during this period you receive $1 in dividends. The rate of return is 15%, calculated as follows: 1 + (22 - 20) ´ 100 = 15% 20 3. You purchase a stock for $10 and receive $2 in dividends, but one year later you sell it for only $9. Your rate of return is 10%, calculated as follows: 2 + (9 - 10) ´ 100 = 10% 10 The examples show that cash flow and capital gains or losses are used in calculating a rate of return. You should also note that all trading periods in the examples are set for one year; hence, the percentage of return is also called the annual rate of return. If the transaction period were longer or shorter than a year, the return would be called the holding period return. The generic formula used to calculate return forms the basis of yield calculations throughout this chapter. DID YOU KNOW? Rates of return can be ex-ante (expected returns) or ex-post (actual historical returns). Investors estimate ex-ante returns to determine where funds should be invested. They calculate ex-post returns to compare actual results against both anticipated results and market benchmarks. Choosing a realistic expected rate of return can be difficult. One common method is to expect the Treasury bill (T-bill) rate plus a certain performance percentage related to the risk assumed in the investment. Thus, corporate bond issues with a higher risk profile are expected to earn a higher rate of return than the more secure Government of Canada bond issues. HISTORICAL RETURNS You can gain important insights into the market and determine appropriate investments and investment strategies by studying historical data. However, past performance is not necessarily indicative of future performance, although historical returns do provide insight into the long-term performance of the market. In other words, we can create an estimate of the future return based on past performance, but we cannot predict it accurately. © CANADIAN SECURITIES INSTITUTE 15 6 CANADIAN SECURITIES COURSE      VOLUME 2 Figure 15.2 illustrates the connected relationship between risk and return. Figure 15.2 | Risk and Return Relationship High Common Shares Expected Return Preferred Shares Debentures Bonds Treasury Bills Low High Risk NOMINAL AND REAL RATES OF RETURN So far, we have looked only at a simple rate of return, otherwise known as the nominal rate of return. For example, if a one-year GIC reports a 6% return, this 6% represents the nominal return on the investment. However, investors are more concerned with the real rate of return, which is the return adjusted for the effects of inflation. The formula used to calculate the real rate of return is as follows: Real Return = Nominal Rate − Annual Inflation Rate EXAMPLE A client earned a 10% nominal return on an investment last year. Over the same period, inflation was measured at 2%. The client therefore earned an approximate real rate of return of 8% on the investment, calculated as follows: 10% − 2% = 8% THE RISK-FREE RATE OF RETURN T-bills often represent the risk-free rate of return, given that there is essentially zero risk associated with this type of investment. The yield paid on a T-bill is roughly determined by estimating the short-term inflation rate and adding a real return. Because T-bills are considered essentially risk-free, other securities must pay at least the T-bill rate plus a risk premium to compensate investors for the added risk. In a statistical sense, risk is defined as the likelihood that the actual return will be different from the expected return. As the uncertainty of the outcome increases, so does the degree of risk. © CANADIAN SECURITIES INSTITUTE  CHAPTER 15      INTRODUCTION TO THE PORTFOLIO APPROACH 15 7 EXAMPLE An investor purchases a $500, 2% GIC and cashes it one year later. He receives exactly $500 plus 2% accrued interest. The same investor purchases $500 worth of common stock at $25 per share in the expectation that the price will rise from $25 per share to $30 in one year. He may receive much more than $30 per share or much less than the original $25 per share. Common stocks are riskier than GICs because the outcomes are much less certain. TYPES OF RISKS Investing in the markets entails the following types of risks, each of which can add to the uncertainty of expected returns for a particular security: Inflation rate risk Inflation rate risk is the risk that inflation will reduce future purchasing power and the real return on investments. Business risk Business risk is the risk that a company’s earnings will be reduced as a result of a labour strike, the introduction of a new product into the market, or the outperformance of a competing firm, among other factors. The uncertainty regarding a company’s future performance is its basic business risk. Political risk Political risk is the risk of unfavourable changes in government policies. For example, the government may decide to raise taxes on foreign direct investment, making it less attractive for foreign investors to invest in the country. Political risk also refers to the general instability associated with investing in a particular country. Investing in a war- torn country, for example, brings additional risk of investment loss. Liquidity risk A liquid asset is one that can be bought or sold at a fair price and converted to cash on short notice. Liquidity risk is the risk that an investor will not be able to buy or sell a security at a fair price quickly enough because buying or selling opportunities are limited. Interest rate risk Interest rate risk is the risk that changing interest rates will adversely affect an investment. For example, investors purchase fixed-income securities expecting to earn a certain return on the investment. However, because of the inverse relationship between interest rates and bond prices, if interest rates rise, the investment will fall in value. Foreign investment risk There are several risks associated with foreign investments. Foreign exchange rate risk is the risk of loss resulting from an unfavourable change in exchange rates. Investors who invest abroad or in businesses that buy and sell products in foreign markets are subject to this risk. Other foreign investment risks include: A dramatic drop off of liquidity for international small-cap issuers Larger bid-ask spreads for small cap international issuers Varying legal rights of shareholders and bond investors Poor shareholder communication in terms of reliability, quality, level of detail, and frequency of reporting © CANADIAN SECURITIES INSTITUTE 15 8 CANADIAN SECURITIES COURSE      VOLUME 2 Default risk When a company issues debt to finance its operations, servicing the debt through interest payments creates a further burden on the company. The more debt the company issues, the greater is the risk that it may have difficulty servicing its debt load through its current operations. Default risk is the risk that such a company will be unable to make timely interest payments or repay the principal amount of a loan when it comes due. SYSTEMATIC AND NON-SYSTEMATIC RISK The risk of a portfolio is determined by the risk of the various securities within it. Certain risks can be reduced by diversifying among a number of securities. However, other risks are always present that cannot be reduced or eliminated through diversification. These risks stem from such things as inflation, the business cycle, and high interest rates. Altogether, this type of risk is called systematic risk, or market risk. Systematic risk is the risk associated with investing in each capital market. When stock market averages fall, most individual stocks in the market also fall. When interest rates rise, nearly all individual bonds and preferred shares fall in value. Systematic risk cannot be diversified away. DID YOU KNOW? The more a portfolio becomes diversified within a certain asset class, the more it ends up mirroring the market for that asset. Non-systematic risk, or specific risk, is the risk that the price of a specific security or a specific group of securities will change in price to a different degree or in a different direction from the market as a whole. For example, the stock of a particular bank may rise in price when the S&P/TSX Composite Index falls, or financial companies as a group may fall more than the S&P/TSX Composite Index. Specific risk can be reduced through diversification. This type of risk theoretically could be eliminated completely by buying a portfolio of shares that consisted of all S&P/TSX Composite Index stocks, by using index funds, or by buying exchange-traded funds based on the S&P/TSX Composite Index. MEASURING RISK Investors may expect a given return on an investment, but the actual results may be higher or lower. To get a better feel for the possible outcomes and their probability of occurrence, several measures of risk have been developed. The two most common of these are standard deviation and beta (also called beta coefficient). Standard deviation is the measure of risk commonly applied to portfolios and to individual securities within that portfolio. The past performance (i.e., the historical returns of securities) is used to determine a range of possible future outcomes. The more volatile the price of a security has been in the past, the larger the range of possible future outcomes. The standard deviation, expressed as a percentage, gives the investor an indication of the risk associated with an individual security or a portfolio. The greater the standard deviation, the greater the risk. When an investor purchases a T-bill, the return is predictable; it cannot change as long as the investor holds the T-bill until maturity. With securities such as equities, the possible outcomes are varied: the price could increase, stay the same, or decrease. The greater the number of possible outcomes, the greater the risk that the outcome will not be favourable. And the greater the distance estimated between the expected return and the possible returns, the greater the standard deviation. Beta is another statistical measure that links the risk of individual securities or a portfolio of securities to the market as a whole. As we saw earlier, the risk that remains after diversifying is market risk. Beta is important because it © CANADIAN SECURITIES INSTITUTE  CHAPTER 15      INTRODUCTION TO THE PORTFOLIO APPROACH 15 9 measures the degree to which individual securities, or a portfolio of securities, tend to move up and down with the market. Once again, the higher the beta, the greater the risk. RELATIONSHIP BETWEEN RISK AND RETURN IN A PORTFOLIO 3 | Calculate and interpret the expected return of a portfolio of securities. 4 | Summarize the benefits and challenges of combining securities in a portfolio. As indicated earlier, few people invest all of their funds in a single security. The focus now shifts to the expected return of a portfolio and the effects of combining securities. CALCULATING THE RATE OF RETURN IN A PORTFOLIO The expected rate of return on a portfolio is calculated using a slightly different method than the one used for the rate of return of a single security. Because the portfolio contains a number of securities, you must first calculate the return generated by each security. The return on the whole portfolio is then calculated as the weighted average return on all the securities held in the portfolio. Figure 15.3 shows the formula for the second calculation. Figure 15.3 | Portfolio Expected Returns Expected Return = R1 (W1 ) + R2 (W2 ) +  + Rn (Wn ) Where: R = The expected return on a particular security W = The proportion (weight or %) of the security held in the portfolio based on the dollar value of the security n = The number of securities in the portfolio EXAMPLE A client invests $100 in two securities: $60 in ABC Co. and $40 in DEF Co. The expected return from ABC Co. is 15%, and the expected return from DEF Co. is 12%. To calculate the expected return of the portfolio, you should look at the rate expected to be generated by each investment proportionally. Because the total amount invested is $100, ABC Co. represents 60% of the portfolio ($60 ÷ $100) and DEF Co. represents 40% ($40 ÷ $100). If ABC Co. earns a return of 15% and DEF Co. earns 12%, the expected return on the portfolio is calculated as follows: Expected Return = (0.15 ´ 0.60) + (0.12 ´ 0.40) = 0.09 + 0.048 = 0.138 = 13.8% MEASURING RISK IN A PORTFOLIO Diversification is an important risk management tool; however, as an advisor, you must guard against too much diversification. When a portfolio contains too many securities, it may be difficult to achieve superior performance. The accounting, research, and valuation functions may also be needlessly complex. Advisors have developed a number of strategies for limiting losses on individual securities or on a portfolio. Most of these strategies involve the use of derivatives. For example, they may use put options on individual equities or on © CANADIAN SECURITIES INSTITUTE 15 10 CANADIAN SECURITIES COURSE      VOLUME 2 investments such as gold, silver, and currencies. Additionally, they can hedge an entire portfolio by using derivatives on stock indexes, bonds, or interest rates. COMBINING SECURITIES IN A PORTFOLIO This section brings together the concepts of diversification, risk and return. Portfolio management stresses the selection of securities for inclusion in the portfolio based on the securities’ contribution to the portfolio as a whole. This approach suggests that some interaction among securities can result in the total portfolio achieving more than the sum of its parts. If investors place all of their savings in a single security, their entire portfolio is at risk. If the investment consists of a single equity security, the investment is subject to business risk and market risk. Alternatively, if all of the investor’s funds are invested in a single debt security, the investment is subject to default risk and interest rate risk. You can eliminate or reduce some of these risks through diversification. However, you must do so carefully, with a good understanding of the methodology for combining securities. A portfolio holding multiple securities whose risk characteristics are very similar is not properly diversified. Furthermore, although total risk does fall significantly when the first few stocks are added, the rate of reduction declines as the number of stocks increases. A point is finally reached where risk can no longer be reduced through diversification. CORRELATION Correlation is the statistical measure of how the returns on two securities move together over time and, therefore, how a change to the value of one security can predict the change in value of another. From a portfolio perspective, we are interested in the way securities relate to each other when they are added to a portfolio, and to how the resulting combination affects the portfolio’s total risk and return. For example, a portfolio consisting only of the stock of several companies in the same industry has a high correlation with the fortunes of that industry. If the stock prices of those companies always move in the same direction and in the same proportion, they would have a perfect positive correlation. Perfect positive correlation is denoted as a correlation of +1. Adding securities with perfect positive correlation to a portfolio does not reduce the overall risk of the portfolio. EXAMPLE Your client has invested 100% of her savings in a gold mining stock. She knows she will make money if the price of gold rises, and if the price declines, she will lose money. To reduce this risk, she wants to diversify into another stock, which happens to be another gold mining company. You explain to your client that her portfolio would not be properly diversified because the value of both securities is tied to the fortunes of gold. If one security declines in value, the other almost certainly will as well. But what if the stock prices of two companies always move in opposite directions and in the same proportion? Such securities have a perfect negative correlation, denoted as −1. When the stock of one company rises as the other falls, the investor holding both stocks can earn a positive return with little risk (other than market risk). EXAMPLE Your client has a portfolio of two securities: an airline company stock and a bus company stock. In good economic times people fly, and in hard times they save money by taking the bus. Therefore, when the economy is strong, the investor’s airline company shares increase in value. When the economy declines, the airline stock declines accordingly, but the loss is offset by an increase in the price of bus company shares. © CANADIAN SECURITIES INSTITUTE  CHAPTER 15      INTRODUCTION TO THE PORTFOLIO APPROACH 15 11 With perfect negative correlation between two assets, there is no variability in the total returns of the assets, and thus no risk for the portfolio. The maximum gain from diversification is therefore achieved when securities held within the portfolio exhibit perfect negative correlation. In reality, however, it is very difficult to find securities with perfect negative correlation. Because the securities in an equity portfolio are always positively correlated to some degree, the portfolio is left with systematic risk, which cannot be eliminated. The impact of systematic risk on return is the main source of uncertainty for an investor with a well-diversified portfolio. Figure 15.4 shows how risk is reduced by adding securities to an equity portfolio. Figure 15.4 | Risk in an Equity Portfolio (Total Risk of the Portfolio) Standard Deviation Systematic Risk 0 1 Number of Securities PORTFOLIO BETA As discussed earlier, the beta relates the volatility of a single equity or equity portfolio to the volatility of the stock market as a whole. Specifically, beta measures that part of the fluctuation in returns driven by changes in the stock market. Volatility in this context is a way of describing the changes in return over a long time frame. The wider the range in market returns, the greater the volatility and the greater the risk. Any equity or equity portfolio that moves up or down to the same degree as the stock market has a beta of 1.0. Any security or portfolio that moves up or down more than the market has a beta greater than 1.0, and a security that moves less than the market has a beta of less than 1.0. EXAMPLE If the S&P/TSX Composite Index rose 10%, an equity fund with a beta of 1.0 would be expected to rise by 10%. If the S&P/TSX Composite Index fell by 5%, the equity fund would be expected to fall by 5%. An equity portfolio with a beta of 1.30, would be expected to rise 13% (calculated as 1.3 × 10%) when the S&P/TSX Composite Index rose 10%. An equity portfolio with a beta of 0.80 would be expected to rise only 8% when the S&P/TSX Composite Index rose 10%. Most portfolio betas indicate a positive correlation between equities and the stock market. © CANADIAN SECURITIES INSTITUTE 15 12 CANADIAN SECURITIES COURSE      VOLUME 2 Industries with volatile earnings (typically cyclical industries) tend to have higher betas than the market, whereas defensive industries tend to have lower betas. This difference implies that, when the market is falling in price, defensive stocks normally fall relatively less and cyclical stocks relatively more. Simplistically, we could say that it is better to have high beta stocks in a rising market and low beta stocks in a falling market. However, this statement is an over-generalization and presumes that history repeats itself. PORTFOLIO ALPHA Equity portfolios often outperform the market and move more than would be expected from their beta. The additional movement is credited to the skill of the advisor or fund manager in picking securities that outperform. This excess return earned on the portfolio is called the alpha. RISK AND RETURN How does the mix of securities in a portfolio affect both the risk and return of the portfolio? Complete the online learning activity to assess your knowledge. THE PORTFOLIO MANAGER STYLES 5 | Compare and contrast the portfolio management styles of equity and fixed-income managers. Portfolio managers, advisors, and investors to some extent, tend to use a combination of two investment strategies: active or passive. ACTIVE INVESTMENT MANAGEMENT The goal of an active investment strategy is to outperform a benchmark portfolio on a risk-adjusted basis. You can judge the success of active strategies by comparing the performance of a portfolio or an asset class within the portfolio to that of an appropriate benchmark or index. EXAMPLE The performance of an equity strategy that focuses on small-capitalization stocks should be gauged against a small-cap equity index. Active equity investment strategies use one of two approaches, bottom-up analysis or top-down analysis, depending on how stocks are selected for purchase or sale. Bottom-up analysis begins with a focus on individual stocks. The portfolio manager looks at the characteristics of various stocks and builds portfolios of the best stocks in terms of forecasted risk-return characteristics. Top-down analysis begins with a study of broad macroeconomic factors before narrowing the analysis to individual stocks. The classic approach is to analyze macroeconomic and capital market factors, and then look at industry-specific factors to evaluate a particular company’s operating environment. Finally, the manager uses company-specific factors to assess the value of the company’s common stock. The two approaches are not mutually exclusive. A compelling recommendation about a particular stock or managed product should always include both external (macroeconomic and industry) and internal factors that are likely to affect the price of the security. © CANADIAN SECURITIES INSTITUTE  CHAPTER 15      INTRODUCTION TO THE PORTFOLIO APPROACH 15 13 PASSIVE MANAGEMENT Managers using a passive investment strategy tend to replicate the performance of a specific market index without trying to beat it. Passive investment strategies also use two approaches: indexing and buy and hold. A buy-and-hold strategy is consistent with the view that securities markets are efficient, meaning that the price of a security at all times reflects all relevant information on expected return and risk. The passive portfolio manager does not believe it is possible to identify stocks as underpriced or overpriced, at least to an extent that would achieve enough extra return to cover the added transactions costs. Indexing involves buying and holding a portfolio of securities that matches the composition of a benchmark index. This method does not require much trading or managerial expertise unless the underlying stocks in the index change. At that point, the manager must trade, to keep the index fund matching the index. EQUITY MANAGER STYLES Equity portfolio managers use one of three approaches to investment management: growth, value, or sector rotation. GROWTH MANAGERS Growth managers focus on current and future earnings of individual companies, specifically earnings per share (EPS). Growth managers look for earnings momentum and will pay more for a company if they feel its growth potential warrants the higher price. Stocks in this type of portfolio usually have a lower dividend yield, or provide no dividend at all, and managers may turn over the securities in the portfolio more often. Growth portfolios have the following risks: If EPS falters, it can cause large percentage price declines. Reported EPS, above or below analysts’ expectations, produces high portfolio volatility. These types of securities are highly vulnerable to market cycles. In terms of valuation ratios, growth portfolios have the following characteristics: High price-to-earnings High price-to-book value High price-to-cash flow Long-term total return is gathered mostly through capital appreciation. Growth managers are usually not concerned with quarterly portfolio fluctuations. Clients must focus on long-term investment horizons and be prepared to tolerate risk in down markets. Growth investing is a matter of expectations. The growth manager’s challenge is to avoid paying too much for over- priced stocks. However, stocks that may seem high today will represent a good investment a year or two from now, if the company continues to grow as expected. This growth style works best in rising markets. Stocks with above-average prices are more vulnerable in bear markets. Growth portfolios are appropriate for investors who are aggressive or who favour momentum investing, and who enjoy making spectacular gains in rising markets. The growth style holds greater potential for capital appreciation because of faster earnings growth. Growth stocks tend to reinvest more of their earnings. However, this style has greater volatility, and hence risk, because more of the total return of the portfolio is derived from capital appreciation than from more stable dividend income. Also, growth stocks may fall more rapidly than other stocks in a declining market. Because portfolio turnover tends to be higher, investors in taxable accounts may be liable for increased amounts of capital gains tax every year. © CANADIAN SECURITIES INSTITUTE 15 14 CANADIAN SECURITIES COURSE      VOLUME 2 VALUE MANAGERS For value investing managers, the focus is on stocks that are perceived to be trading for less than their true or intrinsic value. These managers are bottom-up stock pickers with a research-intensive approach. Security turnover is typically low because these managers usually wait for a stock’s intrinsic value to be realized. By screening stocks for cheap fundamentals, and by investigating a company’s management, products and services, and competitive position, managers can buy discounted stocks that should eventually rise in price. Value managers seek stocks that are overlooked, disliked, or out of favour with individual investors, institutional investors, and equity analysts. However, these reasons also imply that it may take some time for the discounted stock to realize its intrinsic value, if ever. A value portfolio has the following risk characteristics: Lower annualized standard deviation Lower historical beta Stock price is already low and could remain low for a long time In terms of valuation, it has the following characteristics: Low price-to-earnings ratio Low price-to-book value ratio Low price-to-cash flow ratio High dividend yield Over the long term, value investing has produced total returns virtually identical to those of growth investing but with higher current dividend yield and less portfolio volatility. This style tends to perform best in down markets, with some participation in up markets. Because of the lower volatility associated with this style of management, value managers can be used as core managers for clients with low-to-medium tolerance for market risk and long-term investment horizons. This style of investing requires patience as the value of the underpriced bargains are slowly realized by the market. Because turnover in portfolios with a value bias tends to be low, investors incur fewer capital gains. Value investing largely ignores short-term market fluctuations. A value manager’s picks may not be immediately recognized as undervalued by the market. Value investing is more successful in inefficient markets, when stock prices may be out of line with corporate fundamentals. It also tends to work in a stagnant or declining market, when there is greater emphasis on preserving capital or minimizing short- term losses. One drawback to the value style of investing is that, in efficient stock markets, the price of individual securities tends to reflect all that is known about the stocks. An individual stock may therefore be trading at a low price for good reason, which may not show up in its financial statements. Because of the focus on good value, value managers may be drawn to companies that are in need of a turnaround to overcome financial or competitive difficulties. SECTOR ROTATION Sector rotation applies a top-down approach, focusing on analyzing the prospects for the overall economy. Based on that assessment, the managers invest in the industry sectors expected to outperform. These managers typically buy large-cap stocks to maximize their liquidity. They are not as concerned with individual stock characteristics. Their primary focus is to identify the current phase of the economic cycle, the direction the economy is headed in, and the various sectors affected. © CANADIAN SECURITIES INSTITUTE  CHAPTER 15      INTRODUCTION TO THE PORTFOLIO APPROACH 15 15 In other words, managers applying this strategy try to identify emerging trends in the belief that industry selection is more important than stock selection. Risk features include high volatility caused by industry concentration and rotation between industries. The consequences are worse if the manager’s economic scenario is wrong and the favoured industries do not perform as expected. Over short periods, managers and investors who use sector rotation may significantly underperform the market benchmark. The turnover for a portfolio using sector rotation also tends to be high, which pushes up trading costs and the expenses charged to the fund. The higher turnover may create problems for taxable accounts; capital gains tax may be payable because of frequent trades. Also, because this style emphasizes the industry sector, the merits of individual companies get less scrutiny and good individual stocks may be overlooked. The emphasis on large, liquid companies that lead their particular sector also means that the actual stocks picked may not necessarily represent the performance of the entire sector. Stock-specific circumstances may cause an individual holding to behave very differently from its industry peers. Sector rotation is concerned with trying to outperform the market averages such as the S&P/TSX Composite Index. EXAMPLE During the last stages of recession, bank stocks may rally first, to be followed by consumer growth stocks, consumer cyclical stocks, and thereafter those stocks that tend to benefit even later in an economic cycle, such as those for capital goods and commodity-based industries. Theoretically, successful shifts between these groups can produce greater returns than just buying and holding a diversified portfolio of stocks. The most basic industry rotation strategy involves shifting back and forth between cyclical industries and defensive industries. During periods in which stock prices are falling, cyclical stocks tend to fall relatively faster. Defensive stocks, such as banks or utilities, fall at a relatively slower pace, helping the investor to preserve capital. Conversely, during periods of economic expansion, the profit growth of cyclical industries, such as paper and forestry or integrated mines, is more robust; therefore, their stock tends to rise relatively faster. Industry rotation strategies become more complex once additional industry types are considered and variations in economic cycles are taken into account. EXAMPLE Some industry groups are interest rate sensitive. They follow a pattern that conforms almost entirely to the interest rate cycle. However, growth industries may do consistently well in most economic environments because of sustained growth in corporate profits. A minority of industries are counter-cyclical, or they may lag below the market averages. For example, gold stocks are occasionally inversely related to the S&P/TSX Composite Index. Gold stock prices sometimes rise during recessions, while stock market average price levels are falling. Variations in the economic cycle can also have a dramatic bearing on the timing of sector rotation. Generally, two- thirds of an economic recovery is driven by an increase in consumer spending. As a consequence, businesses need to add to plant and capacity, which results in an increased demand for capital goods and provides a boost for the stocks of capital goods makers. © CANADIAN SECURITIES INSTITUTE 15 16 CANADIAN SECURITIES COURSE      VOLUME 2 FIXED-INCOME MANAGER STYLES Fixed-income managers invest in fixed-income products such as bonds, mortgage-backed securities, fixed-income mutual funds, exchange-traded funds, and preferred shares. The managers’ choices may vary depending on the product’s term-to-maturity period or credit quality, or on their expectations regarding interest rates. TERM TO MATURITY Short-term managers hold T-bills and short-term bonds with maturities less than five years. Portfolios holding these products are less volatile when interest rates rise because they have investments maturing that can be reinvested at the higher rates. Medium-term managers focus on terms to maturity that range from five to 10 years. Mortgage funds are a good example. These funds generally invest in high-quality residential mortgages (usually NHA insured) with terms of five years. Long-term managers hold bonds with maturities of greater than 10 years. CREDIT QUALITY The quality of investment-grade bonds ranges from a high Aaa to a low of Baa3 (refer to Moody’s Long-Term Rating Scale in Chapter 6). High-quality issuers are typically federal and provincial governments and some very well- capitalized corporations. Generally, the lower the quality of the bond, the higher the yield it must have. Managers must balance the return potential with the risk of default. Many bond portfolios have predetermined credit quality limits, under which they will not invest. High-yield bonds are non-investment grade products, often called junk bonds. Bonds in this category should have a higher yield, but they face greater credit risk. To mitigate this risk, managers often invest in high-yield bonds that mature in less than three years. Because of the higher credit risk, corporate issues have higher yields than comparable Government of Canada issues. Therefore, by selecting higher-quality corporate issues, a manager can improve a portfolio’s yield without taking on much additional risk. Another factor to consider with corporate issuers is liquidity. Lower-rated bonds have less liquidity than government issues. In a declining market, it may be difficult to find a buyer for this kind of debt. INTEREST RATE ANTICIPATORS Some managers feel they can add value by anticipating the direction of interest rates and structuring their portfolios accordingly. When they anticipate a decrease in the general level of interest rates, they extend the average term on their bond investments. Conversely, when they anticipate an increase in interest rates, they shorten the term. Interest rate anticipation is sometimes also referred to as a form of duration switching. It works best when the yield curve is normal—that is, when there is a wide gap between short-term and long-term rates. If the yield curve is flat, it is not advantageous to extend the term to maturity of the portfolio. DID YOU KNOW? As discussed earlier, duration is an approximate measure of a bond’s price sensitivity to changes in interest rates. Therefore, if you anticipate that interest rates are going to fall, you could sell lower duration bonds and replace them with higher duration bonds. You thus extend the average duration of the portfolio and increase the portfolio’s price sensitivity. As interest rates fall, the increased price sensitivity should lead to greater capital gains. © CANADIAN SECURITIES INSTITUTE  CHAPTER 15      INTRODUCTION TO THE PORTFOLIO APPROACH 15 17 PORTFOLIO MANAGER STYLES Different fund managers will vary in the management styles they employ. It is important to know the style that a manager uses to better understand how the portfolio will behave in different market environments. Complete the online learning activity to assess your knowledge of the different portfolio manager styles. CASE SCENARIO Can you help Sal with his questions about risk? Complete the online learning activity to assess your knowledge. KEY TERMS & DEFINITIONS Can you read some definitions and identify the key terms from this chapter that match? Complete the online learning activity to assess your knowledge. © CANADIAN SECURITIES INSTITUTE 15 18 CANADIAN SECURITIES COURSE      VOLUME 2 SUMMARY In this chapter, we discussed the following key aspects of the portfolio approach to investment: In a portfolio, diversification is a strategy that combines a variety of distinct investments with the aim of reducing the investor’s risk of any individual security. Generally, to achieve higher returns, investors must be willing to accept a higher degree of risk. In statistics, risk is defined as the likelihood that the actual return will be different from the expected return. Systematic risk is non-diversifiable risk; it is always present and affects all assets within a certain class. Non- systematic risk is the risk that the price of a specific security or group of securities will change to a different degree or in a different direction from the market as a whole. Non-systematic risk can be reduced through diversification. Two common measures of risk are standard deviation and beta. Asset allocation involves determining the optimal division of an investor’s portfolio among the different asset classes of cash, fixed income, and equities to maximize portfolio return and reduce overall risk. The return is calculated as the weighted average return on the securities held in the portfolio. Correlation refers to the way securities relate to each other when they are added to a portfolio and how the resulting combination affects the portfolio’s total risk and return. Beta is a measure of a portfolio’s volatility in comparison to that of the market. Higher beta means greater risk. Alpha measures the degree to which an equity portfolio performs better than would be expected from beta. Active managers attempt to outperform the market by actively seeking stocks that will do better than the market. Passive managers tend to replicate the performance of a specific market index without trying to beat it. Fixed-income managers make choices based on term to maturity, credit quality, and their expectations of changes in interest rates. Equity growth managers use the bottom-up style of growth investing by focusing on current and future earnings of individual companies. Equity value managers focus on buying undervalued stock. Equity sector rotators apply a top-down investing approach. They analyze the overall economy and invest in promising industry sectors. REVIEW QUESTIONS Now that you have completed this chapter, you should be ready to answer the Chapter 15 Review Questions. FREQUENTLY ASKED QUESTIONS If you have any questions about this chapter, you may find answers in the online Chapter 15 FAQs. © CANADIAN SECURITIES INSTITUTE