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Reference
Reilly, Frank K. and Keith C. Brown, Analysis of Investment and Management Portfolios (9th Edition), Thomson SouthWestern, 2009. Chapter 16
RMIT University
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Reasons for investing in a passive portfolio 1. Capital markets are efficient. Ie: current stock prices, absorb & reflect all market information rather quickly 2. Theres an abundance of good analysis, but few superior ones 3. Minimize the cost of research but not necessarily trading costs 4. Generally lower management fees, cost of operation & have lower overall fees to the investors. Word on equity indices 1. Equity portfolio managers will evaluate their performance against equity benchmark indices. 2. Equity benchmark indices are designed to show how overall stock market or some subsector of the market has performed For eg: STI index measures performance of Spore equities S&P Global 100 index (rating agency) measures the performance of 100 MNCs. Eg: S&P 500 is a stock market index based on the common stock price of 500 Top American companies. 3. There are various ways to construct a index. Price weighted Price of each corporate stock is the only consideration. This every price movement of the stock will have no impact regardless of volume of trade. RMIT University
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Market value approach/mkt capitalization value = P x # of outstanding shares. have a relatively small shift of a large company will have a big impact on index movements. self corrects for stock splits dividends 3. An index is a mathematical end product. We can use mutual funds or index funds to track an index.
RMIT University
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Not a simple process to track a market index closely Three (3) basic techniques for constructing a passive index portfolio:
Full replication Sampling Quadratic optimization or programming
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Drawbacks
Increases transaction costs, particularly with dividend reinvestment
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Sampling
Buy representative sample of stocks in the benchmark index Stocks with larger index weights bought according to their weight in the index Smaller issues bought so that aggregate characteristics approximate the rest of underlying benchmark
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Sampling Contd.
Fewer stocks means proportionally lower commissions Reinvestment of dividends is less difficult Portfolio returns will not track the index as closely, so there will be some tracking error
Tracking error will diminish as the number of stocks grows, but costs will grow (trade-off)
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t = Rpt Rbt
where Rpt= return to the managed portfolio in Period t
Rbt= return to the benchmark portfolio in Period t
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Exhibit 16.2
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Drawback
This relies on historical correlations, which may change over time, leading to failure to track the index
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Quote
index funds are worth considering. They match, mirror or mimic a sharemarket index. With a decade to invest, it makes the most sense as there is plenty of time to ride out the inevitable market corrections and maximise returns. The beauty of indexing is that there is no risk of picking a dud fund manager who may underperform the market and the fees for an index fund are much less than those charged by active managers John Collett in the Age article Build a future fund
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Growth
Growth
CFS, CSAM Relative Value Lazard GARP
Value
Value
Perpetual, MBA
BT, ING
Neutral UBS
Indexed
Vanguard
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ETFs
Watch the following video in class and discuss
http://www.vanguard.com.au/personal_invest ors/etfs/etfs_home.cfm
http://www.nasdaq.com/investing/etfs/
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Fundamental Strategies
Top-Down versus Bottom-Up Approaches
Top-Down
Broad country and asset class allocations Sector allocation decisions
Bottom-Up
Emphasizes the selection of securities without any initial market or sector analysis Form a portfolio of equities that can be purchased at a substantial discount to what his or her valuation model indicates they are worth
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Fundamental Strategies
Three Generic Themes
Time the equity market by shifting funds into and out of stocks, bonds, and T-bills depending on broad market forecasts
Shift funds among different equity sectors and industries (e.g., financial stocks, technology stocks) or among investment styles (e.g., value, growth large capitalization, small capitalization). This is basically the sector rotation strategy Do stock picking and look at individual issues in an attempt to find undervalued stocks
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Fundamental Strategies
The 130/30 Strategy
Long positions up to 130 percent of the portfolios original capital and short positions up to 30 percent The use of the short positions creates the leverage needed, increasing both risk and expected returns compared to the funds benchmark Enable managers to make full use of their fundamental research to buy stocks they identify as undervalued as well as short those that are overvalued
RMIT University
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Technical Strategies
Contrarian Investment Strategy
The belief that the best time to buy (sell) a stock is when the majority of other investors are the most bearish (bullish) about it The concept of mean reverting The overreaction hypothesis (Exhibit 16.9)
Exhibit 16.9
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Calendar-Related Anomalies
The Weekend Effect The January Effect
Firm-Specific Attributes
Firm Size P/E and P/BV ratios (Exhibit 16.12)
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Exhibit 16.12
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Tax Cost Ratio (%) The Formula Tax Cost Ratio = [1 (1 + TAR)/(1 + PTR)] x 100
where PTR = pretax return TAR = tax-adjusted return
Exhibit 16.14
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