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Session 1

The document discusses the investment process, pooled investment vehicles like mutual funds and ETFs, and the historical performance of stocks, bonds, and other asset classes. It notes that while stocks have dominated over long periods, returns vary in different time periods and markets, and diversification across asset classes is important given uncertainty about future returns. The history of asset returns provides context for understanding concepts like the equity risk premium.

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Harsh Gandhi
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28 views24 pages

Session 1

The document discusses the investment process, pooled investment vehicles like mutual funds and ETFs, and the historical performance of stocks, bonds, and other asset classes. It notes that while stocks have dominated over long periods, returns vary in different time periods and markets, and diversification across asset classes is important given uncertainty about future returns. The history of asset returns provides context for understanding concepts like the equity risk premium.

Uploaded by

Harsh Gandhi
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Today’s Agenda: 14 Sep 2020

• Course Outline

• Group Projects & Evaluation


• Portfolio Management Project
• Equity Research Project
• End Term Exam
• CP

• Resources
• Binder PDFs
• Book PDFs
• Links

• Session 1
• Investment Process
• Pooled investment industry
• History of asset class returns
Investment Analysis &
Portfolio Management
Session 1
Investment Process
Key Stages in Investment Process
I. Planning
– objectives: investment goals expressed in terms of required returns &
risk tolerance
– constraints include liquidity, horizon, regulations, taxes, unique needs
– may be formally stated in a financial plan (retail investors) or an
investment policy statement (institutional investors)

II. Asset allocation


– strategic: target allocation between equity, fixed-income, cash,
alternative assets based on investment policy
– tactical: allocation changes based on capital market expectations.
(Tactical allocation changes imply market timing, i.e., active management)
– allocation weights determined to achieve optimal risk-return trade-off,
while satisfying the constraints
Key Stages in Investment Process
III. Security selection
– selecting securities within each asset class
– may be based on investment analysis (active management) or indexing
(passive management)

IV. Trade execution


– maximising efficiency, minimising costs of trading
– trades may be motivated by new information, rebalancing needs, or cash
flows
Key Stages in Investment Process
V. Portfolio monitoring
– monitoring investor ‘s circumstances, as well as the economic & market
factors
– portfolio will be revised in case of divergence with IPS, changes in
IPS itself, or significant changes in capital market expectations

VI. Performance evaluation


– performance comparison with benchmark or with targeted rate of return
– attribution of performance to strategic asset allocation, market
timing and security selection for feedback
Pooled Investments Industry
• Mutual Funds

• Exchange Traded Funds

• Hedge Funds

• Private Equity Funds

• Separately Managed Accounts, Portfolio Management Services


Pooled Investments : Key benefits
• Expertise to ensure optimal return-risk tradeoff
– earn excess returns through security selection/ market timing
– risk-reduction through diversification

• Cost savings
– economies of scale
– efficient trade execution

• Flexibility to invest small amounts (mutual funds, ETFs)


Mutual Funds
• Investments are pooled & units are held by investors

• Each unit is priced at its Net Asset Value (NAV)


– new units in open-ended funds are created or redeemed at the existing
NAV at the end of the day
– closed-ended funds are traded on exchange like shares

• Main classifications
– by asset allocation into equity MF, debt MF, hybrid MF or money-market
MF and further into sub-segments (ex. small cap, sectoral, etc.)
– by investment management into passive & active and further by
investment style (value, growth, etc.)
– by trading characteristics into open-ended & closed ended
Exchange Traded Funds

Portfolio
ETFs : Key benefits
• Can be continuously traded on exchanges

• Flexibility to grow depending upon demand from investors

• Low costs
– fund managers do not need to hold cash or handle transactions with
small investors directly, unlike open-ended MFs
– usually passively managed
Hedge Funds
• Usually take high risks
– use of leverage, short sales & derivatives
– but seek to eliminate risks not associated with core strategy

• Usually seek to earn absolute returns


- regardless of market conditions

• Not regulated/lightly regulated


– not marketed to retail investors

• Hedge funds charge significant management fees


– fixed fee + % of profits of the funds
Long Term Asset Returns
History of Stock & Bond Returns: Siegel
(1998)
• Jeremy Siegel (1998)
- book: “Stocks for the long run: Definitive guide to financial market returns and
long-term investment strategy”
- returns during 1802-1997 in the US for stocks, bonds, bills, gold & dollar

• Key conclusions
- equities dominated all other assets in the long term, despite adverse periods
(such as stock crash of 1929)
- real returns on stocks remain remarkably stable over long sub-periods,
indicating mean reversion property of stock returns
- bonds & bills also accumulated value but much lower than stocks
- value of gold followed the inflation trend but still eroded in purchasing power
terms
- currency (dollar) lost much of its value in purchasing power terms
History of Stock & Bond Returns: DMS (2002)
• Dimson, Marsh & Staunton (2002)
- book: “Triumph of the Optimists: 101 Years of Global Investment Returns”
- returns during 1900-2000 in 16 developed markets

• Annualised returns on stocks


- real returns were similar across countries (2.5%-7.6%, mean 5.1%)
- nominal returns ranged from 7.6% to 12.5%

• Annualised returns on bonds & bills


- real returns on bonds ranged between -2.2% & 2.8%, and on bills between -4.1%
& 2.8%
- returns and standard deviations on stocks were higher than bonds & bills across
countries (ex. in US, 20.2% on stocks vs 10% on bonds & 4.7% on bills)
- the equity risk premium over bills ranged from 1.8% to 7.1%, mean 5.0%
History of Stock & Bond Returns: Comparison

Source: Dimson, Marsh & Staunton, Triumph of the optimists: 101 years
of global investment returns, 2002
DMS updated: Credit Suisse Yearbook (2019)

• Key findings
– during 2000-2019, stock returns underperformed bond returns (real
returns of 3.1% vs 4.8%) in aggregate for 23 countries

– however, cumulatively (1900-2019), stocks still outperformed bonds & bills


(5.2% vs 2.0% & 0.8%)
Understanding Equity Risk Premium
• What is equity risk premium (ERP)?
− Forward looking estimate of excess returns on equity market
portfolio over the risk-free rate: E(Rm) – Rf
− Expected reward for taking extra risk
Estimation of Equity Market Risk Premium
• Demand-side
– equity risk premium can be estimated based on historical average
difference between returns on stock index and risk-free rate
(government bonds)
– alternatively, as implied by current stock prices & forward earnings
growth forecasts
– alternatively, a country equity risk premium can be added to
estimated equity risk premium for US

• Supply-side
▪ E(rm) = Dividend yield + Earnings growth - ∆Shares + ∆P/E
▪ ERP = E(rm) - Rf
Forecasts based on Relative Market Valuation
• Indicators based on relative market valuation
– ex. index P/E, P/BV ratios – either trailing or forward multiples
– improvements – ex. Shiller’s Cyclically Adjusted Price Earnings ratio (CAPE)
– Shiller’s CAPE = current index value ÷ average of past 10 years’ inflation-
adjusted earnings per share of index stocks
– A high CAPE indicates relatively overvalued market & hence prospects of
lower equity risk premium and vice versa

• Indicators based on relative spread between stock and bond yields


– ex. Fed Model compares earnings yield of stocks with treasury yields
– usually stock yields are lower than bond yields; narrower than usual spread
indicates that stocks have become expensive & vice versa
Debate: Stocks for the Long Run?
▪ A long history of equity risk premium
− However, the magnitude may not remain as high. For ex., equity market return in US
exceeded earnings & dividends growth in the past, which may not be sustainable.
− Significant variation in sub-periods across regions

▪ Some empirical evidence of mean reversion in stock returns in the long run
− Tools like Shiller’s CAPE provide broad predictions of cyclical mean reversion

▪ Equities provide limited hedge against inflation in the longer run, though not
in the short term
− In comparison, returns on fixed income securities are the worst affected by inflation.

▪ Bottomline:
– Case for diversification across asset classes
− Exposure to equity should increase with investor’s risk tolerance & investment horizon

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