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6312 Lecture

This document discusses equity style analysis and active portfolio management. It defines equity style analysis as a system to classify stocks into segments based on distinguishing characteristics like growth versus value and market capitalization. It also discusses Lipper classifications, approaches to analyzing style, and the uses of style analysis in portfolio formation and customizing benchmarks. The document then covers tracking error, its determinants like portfolio composition differences from the benchmark, and how tracking error can be minimized and evaluated in passive and active portfolio management.

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74 views8 pages

6312 Lecture

This document discusses equity style analysis and active portfolio management. It defines equity style analysis as a system to classify stocks into segments based on distinguishing characteristics like growth versus value and market capitalization. It also discusses Lipper classifications, approaches to analyzing style, and the uses of style analysis in portfolio formation and customizing benchmarks. The document then covers tracking error, its determinants like portfolio composition differences from the benchmark, and how tracking error can be minimized and evaluated in passive and active portfolio management.

Uploaded by

api-3699305
Copyright
© Attribution Non-Commercial (BY-NC)
We take content rights seriously. If you suspect this is your content, claim it here.
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Download as PPT, PDF, TXT or read online on Scribd
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Investment Analysis

and
Portfolio Management

Active Portfolio Management


Equity Style analysis
• What is it?
• System of classification by market segments that
have distinguishing characteristics
• Within segment returns are correlated and between
segments returns are uncorrrelated
• Usually along the dimension of growth (focus on
earning growth)/value (focus on price rise) and size
• Growth may be consistent or earnings momentum
and Value may be low P/E, contrarian or yield –
mixture of categories also does exist 2
Continued……..
• A system of style description: Lipper Classification
• Small capitalization: invests in companies with market
capitalization < $ 1 billiion
• Middle capitalization: market capitalization < $ 5 billion
• Growth & Income: combines a growth-of-earnings
orientation and an income requirement for level and/or
dividends
• Growth: companies with long-term earnings expected to
grow significantly faster than stocks in major indices
• Equity income: seeks relatively high current income and
growth of income by investing 60% or more of its portfolio
in equities
• Capital appreciation: aims at maximum capital appreciation,
frequently by means of 100% or more portfolio turnover,
leveraging, purchasing unregistered securities, purchasing
options etc. – may take large cash positions 3
Continued……
• How to classify?
• Based on P/B ratio – problem at the margin and switching
between categories
• Multiple criteria like dividend yield, cash flow yield,
ROE, earning growth forecast etc.
• Scoring system may be used and the universe of stocks
may be sorted based on capitalisation-weighted scores
• A middle category may be isolated to prevent switching
• Does style pay?
• Empirical studies find equity style rotation with perfect
foresight is quite profitable
• Value stocks usually outperform growth – periods of
exception are there
4
Continued…..
• How to analyse style?
• Returns based - excess return regressed on style indices
or asset class returns with intercept suppressed
• Characteristics based – portfolio characteristics in terms
of market cap, PE ratio, PB ratio, ROE etc. are
compared against the characteristics of different style
indices
• Factor based – Factor analysis is used to identify the
factors out of all available fundamental factors that affect
equity returns
• What is the use of style analysis?
• Portfolio formation
• Customizing benchmark
• Determining portfolio or index style
• Style rotation 5
Tracking error
• Uncorrelated fluctuation in returns
• Standard deviation of difference in actual returns
between portfolio and the benchmark
• Usually expressed in annual term
• In passive portfolio management, tracking error
can be minimized by rebalancing the portfolio
more frequently; objective is to balance tracking
error with lower cost of portfolio management
• In active management, tracking error needs to be
compared with alphas earned as the error may be
due to all positive or negative alphas
6
Determinants of Tracking Error –
Vardharaj, Fabozzi & Jones
• Inverse relationship with number of stocks – that
are in the benchmark index – included in portfolio
• Positive relationship with number of stocks – that
are not in the benchmark – included in portfolio
• Increases as the portfolio style or market
capitalization deviates from that of index
• When both style and capitalization deviates from
the index, they seem to have identical impact on
tracking error
• Increases with the deviation in sector weights
from that of the benchmark
7
Determinants continued…..
• Increases with benchmark volatility
• Increases as portfolio beta deviates from 1 either
way
• Decomposition of tracking error helps performance
evaluation
• Sensitivity of Tracking Error – Marginal
contribution to Tracking Error for small change in
portfolio excess weight – positive for overweight
and negative for underweight stocks – help reduce
tracking error
• Reliability of Predicted Tracking Error 8

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