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Emerging Financial Markets 8: The Top-Down and Bottom-up Approaches

Emerging Financial Markets 8: The Top-Down and Bottom-up Approaches. Prof. J.P. Mei. Active Asset Management in Emerging Markets. The predictability of emerging market returns Market over-reaction or excessive risk premium required by investors

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Emerging Financial Markets 8: The Top-Down and Bottom-up Approaches

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  1. Emerging Financial Markets 8: The Top-Down and Bottom-up Approaches Prof. J.P. Mei

  2. Active Asset Management in Emerging Markets • The predictability of emerging market returns • Market over-reaction or excessive risk premium required by investors • Time-varying expected return and risk require a dynamic asset allocation model • Objective: Outperform the benchmark with careful risk management 2

  3. Sorting by One Variable • PE & DY: The HK experience • The BEHV Paper • Sorting by Different Variables • Form portfolios and track returns out of sample • Quarterly re-balancing • High, Middle, and Low Portfolios and three weighting schemes 3

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  6. The Smith Barney Model:Put It Together • What variables to use? • How do we group them? • What weight do we assign to each group? • What weight do we assign to each variables within each group? • Good modeling is similar to cooking.

  7. The Smith Barney Model (50%, 5%, 20%, 5%, 20%) • Valuation: P/E, P/E(Forecasted), P/B and Earning Yield Gap • Growth: Earnings and GDP Growth for Next Year • Risk: Current account/GDP, Real exchange rate over-valuation, Beta • Interest rate: Real Rate Change • Momentum: Earnings revision and Price Change • Question: How do they translate rankings into weightings?

  8. Strength and Weakness of The Smith Barney Model • Strong marketing appeal: Intuitive and easy to understand. • Flexibility: variables and weights used can be adjusted to changing market conditions. • Timely information: the use of market information • Multi-colinearity: Similar Information • Failure to adjust for political and other risk factors. • Transaction cost could be higher than indexing. 4

  9. A Cautious Note for the Value Approach • P/B does not work in every countries • P/Cash flow does not work everywhere • P/E Trailing & Prospective does not work everywhere • Buy on dip, sell on rally may not work (Thai example) 5

  10. How to Allocate Resources Among Stock Pickers

  11. The Bottom-Up Approach • Company Analysis and Stock Selection • Applying Valuation Models to Emerging Market Stocks (Mariscal & Lee Model) • A link between debt and equity market • A framework to estimate country-risk adjusted PE • Price/Book Value (P/BV) and Price/Cash Flow (P/CF) Ratios • Industry Analysis: High growth potential • Overall portfolio balance 3

  12. The Momentum Trading Strategy (Rowenhorst) • Sort all stocks by lagged returns into decile portfolios • Adjust for beta risk • Country neutral portfolio (sort by return in each country) • Size neutral portfolio (sort by return in each size decile) • Size/country neutral and risk adjustment • The Momentum Strategy (Chan, Hammed, and Tong) -Most profits come from Emerging markets. -Hardly any trading profits after transaction costs. 4

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  14. Size/country-neutral Relative Strength Portfolios

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