Investment Management Level 4 Ed3_Part3.pdf

Passive investing requires a credible and liquid index to track. For examples, the FTSE 100 in the UK, the S&P 500 in the US, and China’s SSE Composite Index, and as well as other global and regional indices (eg, the MSCI World Index). Bond indices include those published by FTSE, Bloomberg, Barclay...

Passive investing requires a credible and liquid index to track. For examples, the FTSE 100 in the UK, the S&P 500 in the US, and China’s SSE Composite Index, and as well as other global and regional indices (eg, the MSCI World Index). Bond indices include those published by FTSE, Bloomberg, Barclays and Markit iBoxx; notably, though, bond indices are harder to replicate compared with equity indices, for two reasons: 1. As time passes, the average maturity of a bond index declines; and replacing any soon-to-be maturing bonds with suitable alternatives, while preserving the duration characteristics of the portfolio, is challenging. 2. The universe of bond issuers is huge. While companies typically issue only one type of equity, they may issue several bonds with different maturities, coupons and possibly structures (eg, callable, puttable) as market conditions vary. For these reasons, duplication of a bond index is often impractical. Therefore, investors usually define suitable benchmarks for their portfolios, and use an existing index or create blends of indices from which they then purchase a subset of the issues available. Notably, indices change their composition over time, eg, firms failing to meet certain thresholds, going out of business, or being acquired by other companies. When new constituents are added to/removed from an index, the passive portfolio holdings need to be accordingly adjusted immediately to reflect the new index composition. There are two main methods in use: physical and synthetic replication. The traditional method used is physical replication and is the approach that has been used by index trackers and the first exchangetraded funds (ETFs). Physical replication can be achieved using either full replication, or optimised sampling. The alternative to physical replication is synthetic replication which involves entering a total return swap with an investment bank, which undertakes to provide the return on the index that is being tracked. The advantages of employing passive strategies are that: • • Statistically, a small percentage of active portfolio managers consistently outperform benchmark equity indices. Once set up, passive portfolios are generally less expensive to run than active portfolios, given a lower ratio of staff to funds managed and lower portfolio turnover. The disadvantages of employing passive strategies, however, include the following: • • • • • Performance is affected by the need to manage cash flows, rebalance the portfolio to replicate changes in index-constituent weightings and adjust the portfolio for index promotions and demotions. Most indices assume that dividends from constituent equities are reinvested on the ex-dividend (xd) date, whereas a passive fund can only invest dividends when received, usually six weeks after the share has been declared xd. Indexed portfolios cannot meet all investor objectives. Indexed portfolios follow the index down in bear markets. Indexed portfolios will replicate any stock, sector or valuation biases of the index. 5 1 Economics Indexation Indexation is a variant of the ‘buy and hold’ strategy that eliminates the diversifiable risk and effectively replicates the performance of a market index, which is known as index matching or indexation. There are several different ways of proceeding with respect to indexation, but the most fundamental one is to decide on the appropriate index for the client, as there are many different market indices available. • • • An investor may want exposure to large-cap UK stocks, in which case the FTSE 100 is the obvious index to select. Alternatively, the investor may be more interested in the large-cap stocks primarily US-based; and for this area, the S&P 500 Index is one of the most appropriate indices. As the name suggests, the UK’s FTSE 100 consists of around 100 large cap stocks whereas its most closely matched US counterpart comprises 500 different companies. The duplication of an index by holding all its constituents is also known as complete indexation. The requirement is to match exactly the underlying components of the relevant index, which can often be complex and expensive. For example, the MSCI ACWI Index contains about 2,900 securities from about 50 developed and emerging market countries. To construct a portfolio of all these securities with the same proportions as the index would involve extremely high commissions and dealing costs. Although the large world indices are relatively stable in terms of their constituents, there is a need from time to time to make changes and modify the components; for example, if a company within the index is taken over by another. Also, the custodians of indices will periodically have to remove some stocks from an index if the market capitalisation falls below a certain threshold level and then they will substitute another company which has grown in stature and market capitalisation to qualify for entry to the index. If a fund manager is replicating such an index, where modifications are being made from time to time, then all the changes and re-balancing will need to be made to the replica and this will involve dealing costs and commissions as well as dealing spreads. The manner of re-balancing is more critical in some indices than others due to the way in which they are weighted (eg, the S&P 500 is market cap-weighted while the Dow Jones Industrial Average (DJIA) is a simple average of the 30 constituent stocks). A bond index fund will be more complex and expensive to replicate. With time the average maturity of a bond index will decline and to replace those bonds which are reaching redemption with suitable alternatives and preserve the duration characteristics of the bond fund is a particularly challenging undertaking. In general terms, duplication or complete indexation is often not practical, therefore, alternative strategies designed to emulate the index’s performance are used. 1.1.2 Passive Bond Strategies Cash Flow Matching – Liability Driven Cash flow matching is a much simpler approach to portfolio management. The approach is simply to purchase bonds whose redemption proceeds will meet a liability of the fund as they fall due. Starting with the final liability, a bond is purchased whose final coupon and redemption proceeds will extinguish the liability. Turning next to the penultimate liability, this may be partly satisfied by the coupon flows arising from bond one, and any remaining liability is matched against the final coupon 6 and redemption value of a second bond. This process is continued for each liability, ensuring that bonds are purchased where the final coupon and redemption values extinguish the net liabilities of the fund as and when they occur. The approach outlined is a simple buy and hold strategy and as such does not require a regular rebalancing. In practice, it is unlikely that bonds exist with precise maturity dates and coupons but, intuitively, it is easier to understand. Immunisation Immunisation is a passive management technique employed by those bond portfolio managers with a known future liability to meet. An immunised bond portfolio is insulated from the effect of future interest rate changes. Immunisation can be performed by using either of two techniques: • • Cash matching involves constructing a bond portfolio, whose coupon and redemption payment cash flows are synchronised to match those of the liabilities to be met. (Note that cash matching, generally for investors who need to fund one lump-sum future liability, differs from cash flow matching, which is intended for investors who need to fund a series of future expenses.) Duration-based immunisation involves constructing a bond portfolio with the same initial value as the present value of the liability it is designed to meet and the same duration as this liability. A portfolio that contains bonds that are closely aligned in this way is known as a bullet portfolio. Alternatively, a barbell strategy can be adopted. If a bullet portfolio holds bonds with durations a close as possible to ten years to match a liability with a ten-year duration, a barbell strategy may be to hold bonds with a duration of 5 and 15 years. Barbell portfolios necessarily require more frequent rebalancing than bullet portfolios. The downside of Passive investing is that it can yield weak returns and reinforce the value of switching to a patient high conviction, active approach. 1.2 Active Investment Management In contrast to passive equity management, active equity management seeks to outperform a predetermined benchmark over a specified time period for an appropriate level of risk. This is based on the belief that investors are emotional and irrational, and regularly display a ‘follow the herd’ mentality such that they buy too high and sell too low. Active investors believe they can profit by identifying stocks trading at prices below their value merits. There are two methods of constructing portfolios using an active management technique: • • Top-down active investment management involves portfolio managers considering the big picture first by assessing the prospects for each of the main asset classes within each of the world’s major investment regions against the backdrop of the world economic, political and social environment. This output then drives the asset allocation decision. A bottom-up approach to active management describes one that focuses solely on the unique attractions of individual stocks. Managers applying the ‘bottom-up’ method of portfolio construction pay no attention to index benchmarks. Bottom-up methods are usually dependent on the style or approach of the individual fund manager or team of managers. In doing so, investors may utilise: 7 1 Economics • • Fundamental analysis measures a company’s intrinsic (or ‘fair market’) value based on economic and financial factors such as revenues, profits, costs and return on equity. If the fair market value is above the price the security is trading at, it is deemed to be undervalued, and vice versa. Technical analysis analyses statistical data (eg, price movements, volumes). Technical analysts believe a security’s past trading activity and price changes are valuable indicators of future price movements. See chapter 6, section 3. Investors may be wholly bottom-up but may also consider top-down factors in choosing securities. For example, the coronavirus pandemic influenced investors’ attitudes towards technology and healthcare stocks. Active investors can employ a variety of investment styles to achieve their aims: Equities Bonds • Growth investing focuses on investing in • Duration switching alters the portfolio companies with above-average. • Value investing seeks established companies • • • • • • 8 that appear to have been ignored in the market and are set for recovery, by looking at their intrinsic value. Blend investing combines growth and value investing, thus offering both styles’ potential benefits and risks. Contrarian investing is similar to value investing, but it takes the view that the market has overreacted to a particular situation, and believes a company offers better prospects in the future as a result. Income investing often focuses on mature, slower-growing companies paying regular dividends. Trend investing seeks to achieve gains through analysing an asset’s price momentum either up or down. Quality investing focuses on creating a portfolio of companies with strong fundamental characteristics (eg, high return on equity, low debt-to-equity, strong free cash flow). Absolute return investing seeks to generate positive returns in all market conditions. • • • • • duration with expected changes in interest rates. For example, an investor expecting a fall in interest rates may increase the duration by replacing low- with high-duration bonds. Riding the yield curve involves buying a long-term bond but selling it before maturity, to profit from a declining yield over the bond’s life. This is a valid strategy when the yield curve is upward sloping. Bond switching (or swapping) exchanges one bond for another. There are two main types: Anomaly switching moves between two bonds similar in all respects apart from their yields and/or prices. This pricing anomaly is exploited by switching from the expensive to the cheap bond. Policy switching switches between two dissimilar bonds, to take advantage of anticipated changes in interest rates, the structure of the yield curve, bond credit ratings, and so on. Intermarket spread switching moves between government and corporate bonds with different terms (eg, coupon rate, maturity date, credit rating) to obtain a more positive yield spread. Economics • • • • 1 The advantages of employing active investment management include that: It can generate greater returns than the market. Investors can tailor an active strategy to meet specific investment goals. They have the flexibility of choice, allowing them to reduce risk. Active investing can offer a challenge, which some investors may enjoy, and allows them to be more involved in managing their money. However, there are drawbacks to active investment management, including: • • • • Better performance is not guaranteed. Investors must be continuously vigilant about the performance of their investments, so active investing can be hard work and time consuming. Fees for professionally managed portfolios tend to be high, which has a compounding effect over time. Some actively managed funds may be ‘closet trackers’. 1.2.1 Active Equity Strategies Growth Investing A growth investing strategy looks for companies with consistent, above-average earnings and revenue growth. As a result, growth investors are willing to pay a premium for a stock now because they believe the company will grow faster in the future. This leaves growth companies with a higher P/E ratio; growth investors are willing to pay a higher price now for long-term future earnings growth. True growth stocks are those that can differentiate their product or service from their industry peers so as to command a competitive advantage. This results in an ability to produce high-quality and aboveaverage earnings growth, as these earnings can be insulated from the business cycle. A growth stock can also be one that has yet to gain market prominence but has the potential to do so. Value Investing The oldest style, based on the premise that deep and rigorous analysis can identify businesses whose value is greater than the price placed on them by the market. By buying and holding such shares often for long periods. A higher return can be achieved than the market average. Managers of equity income or income and growth funds often adopt this style, since out of fashion stocks often have high dividend yields. Income Investing Income investing aims to identify companies that provide a steady stream of income. Income investing may focus on mature companies that have reached a certain size and are no longer able to sustain high levels of growth. Instead of retaining earnings to invest for future growth, mature firms tend to pay out retained earnings as dividends as a way to provide a return to their shareholders. High dividend levels are prominent in certain industries such as utility companies. The driving principle behind this strategy is to identify good companies with sustainable high dividend yields to receive a steady and predictable stream of income over the long term. Because high yields are only worth something if they 9