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Style Analysis

Style Analysis. Style analysis (Sharpe, 1988, 1992) Returns based Holdings based Typically provided by financial consultants to their clients, not by the portfolio managers. Returns-Based Style Analysis. A portfolio’s style may be multi-dimensional (e.g., mid-cap, growth)

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Style Analysis

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  1. Style Analysis • Style analysis (Sharpe, 1988, 1992) • Returns based • Holdings based • Typically provided by financial consultants to their clients, not by the portfolio managers

  2. Returns-Based Style Analysis • A portfolio’s style may be multi-dimensional (e.g., mid-cap, growth) • Characterizes the “style” of a portfolio using realized returns (typically monthly) • Regresses portfolio returns against a set of indices that are: • Mutually exclusive • Exhaustive with respect to manager’s investment universe • Distinct sources of risk (i.e., not highly correlated) • Restrict estimated coefficients to sum to 1 (and non-negative if no leverage is allowed)

  3. Regression for U.S. Equity funds • RPt =  + 1Casht + 2Small-cap indext + 3Mid-cap indext + 4Large-cap indext + 5High P/B indext + 6Medium P/B indext + 7Low P/B indext + t • In the regression, restrict  i = 1. In SAS: Proc reg; model y = x1 x2; restrict x1 + x2 = 1; run;

  4. Example: a U.S. Equity fund

  5. Returns-Based Style Analysis • The estimated coefficients (i’s) are called “style weights” • Popular because this type of style analysis is objective, and requires minimal information, and is cost effective • Issues: • May not effectively characterize current style • Misspecifying the X variables in the model may lead to inaccurate conclusions

  6. Holdings-Based Style Analysis • Categorizes individual securities by their characteristics such as: • Valuation • Forecasted growth • Earnings variability • Industry sector weightings • Requires judgment or threshold levels for each classification

  7. Holdings-Based Style Analysis Would you classify this as a value or growth portfolio?

  8. Holdings-Based Style Analysis • Advantages • Characterizes each position • Facilitates comparisons of individual positions • May capture changes in style more quickly than returns based analysis, because it is for a specific point in time • Disadvantages • Requires judgment in making conclusion • More data intensive than returns-based analysis

  9. The Equity Style Box • Popular way of looking at style • Separates universe into nine cells in a matrix according to: • Capitalization (small, mid, large) • Style (value, core/blend, growth) Large Mid Small Example: RBC Canadian Dividend Fund Value Core Growth

  10. More Specific Style Boxes • Example: Morningstar style box for Vanguard’s Mid-Cap Growth Fund • By market value of assets falling into each category as defined by Morningstar • Report as % of total portfolio value Large Mid Small Value Core Growth

  11. Style Drift in Equity Portfolios • Style drift is the term used to describe inconsistency in management style • Presents an obstacle to investment planning and risk control for clients • If hire a manager because want value exposure, do not want style to drift to core or growth • Manager may not have as much expertise in selecting stocks of a different style

  12. Socially Responsible Investing • A non-financial factor/policy • Integrates ethical or societal concerns with investment decisions, reflecting client’s concerns • Can introduce unintended consequences, as excluding polluters (energy and utilities) may introduce a growth bias • Should choose a benchmark that reflects the exclusions

  13. Socially Responsible Investing • Typically uses stock screens • Negative screens to exclude undesirable characteristics (such as gambling, tobacco, etc) • Positive screens to include desirable characteristics (such as high labor standards or good corporate governance)

  14. Example: MFS McLean Budden • The MFS MB Responsible Canadian Equity Core Fund is a screened version of the existing MFS MB Canadian Equity Core Fund. The screens exclude: • Companies that derive more than 10% of their gross annual revenue from the manufacture and sale of tobacco products, alcoholic beverages, armaments, pornography, or from the provision of gaming facilities.  • Companies with significant operations and/or suppliers that do not adhere to local employment standards, and do not address the issue. • Companies whose negative impact on the environment is greater than the average of their peers.

  15. Socially Responsible Investing • Another example • Norwegian Government Pension Fund does not invest in, amongst others: • Walmart (human rights issues) • Boeing, Honeywell International (nuclear weapon-related business) • Freeport McMoRan Cooper and Gold (environmental damages)

  16. Long-Short Investing • Many portfolios are prohibited from short sales • Value added by manager is called alpha • If short sales are permitted, manager can effectively contribute two alphas • One from long portfolio, and one from short portfolio • But can have two negative alpha when stock selections go the wrong way both ways • Hedge funds • 130/30 funds: product with the same transparency as regular pooled funds, and short positions have an upper bound

  17. 130/30 Fees For Canadian institutional clients: • Fees charged by 130/30 funds are typically between 60 and 100 basis points (bps) • For a typical active large-cap U.S. long-only fund, the fee is 50 to 80 bps • Passive U.S. index funds charge 3 bps or so

  18. Price Inefficiency and Short Sales • Short sales may better exploit market inefficiencies because: • Fewer investors search for overvalued stocks due to impediments to short selling • Sell-side equity analysts issue more buy than sell ratings, so there is less information about over-valued stocks • Late 1990s: < 1% of companies rated as “sell” • 2003: ~ 10%

  19. Dissecting Active Return and Risk • Active return = • Consider the following scenario: • An Australian pension fund wants to hire a global equity manager • Decides on the MSCI World ex-Australia Index as the benchmark for performance • Suppose the manager hired is a global value manager • The manager’s “normal” benchmark should be the MSCI World ex-Australia Value Index

  20. Dissecting Active Return and Risk • Suppose in the first year, the returns are: • Manager: 12% • World ex-Australia: 10% • World ex-Australia Value: 15% • Manager beats benchmark by 2%, i.e., active return = 2% • Dissect manager’s active return into true + misfit: • True active return = manager return – manager’s normal benchmark (12% - 15% = -3%) • Misfit active return = manager’s normal benchmark – investor’s benchmark (15% - 10% = 5%) • This decomposition tells the investor that the manager outperformed the World index because value stocks did very well that year

  21. Dissecting Active Return and Risk • Similarly for active risk: dissect into true + misfit • True active risk = standard deviation of true active return • Misfit risk = standard deviation of misfit active return • Normally calculated using monthly returns

  22. Alpha and Beta Separation • Long only active portfolio has exposure to beta (market return) and alpha (manager skill) • Long-short market neutral portfolio designed not to have beta exposure • Can get beta inexpensively from an indexed portfolio and explicitly pay for alpha generated from a long-short portfolio • That is, separating fees for (cheap) beta and (expensive) alpha

  23. Example • A long/short “market neutral” investment strategy: Extract the “alpha” of a manager’s portfolio • To extract alpha, need to get rid of the exposure to the TSX • First, define the following “tracking” portfolio, T:

  24. Example • Long the original portfolio and short the tracking portfolio • End result:

  25. Core-Satellite Portfolios • Overall asset allocation strategy in which there is a passive core (that uses indexed portfolios), and several active “satellite” portfolios • Satellite portfolios are in areas where there are price inefficiencies and/or where managers have specific skills • Division by passive versus active strategies, rather than by traditional asset classes

  26. Selecting Equity Managers • Qualitative factors • People • Organizational structure • Investment philosophy • Process • Strength of equity research • Quantitative factors • Performance relative to benchmarks and peers • Measured style orientation and valuation characteristics of managed portfolios • Seek consistency between stated and actual practices

  27. Predictive Power of Past Performance • Must include disclaimer that “past performance is no guarantee of future results” • Studies indicate that few managers consistently remain in top quartile • Predictability of performance can be more important – clients look for consistent team work and process

  28. Predictive Power of Past Performance Based on a sample of 220 U.S. equity managers (Wood 2006)

  29. Equity Manager Questionnaire • Creates formal basis for comparing equity managers • Five key areas: • Organization, structure and personnel • Investment philosophy, policy and process • Research capabilities and resources • Historical performance/risk factors • Fee structure

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