Archive for the 'Portfolio Management' Category

Factors Affecting the Business Cycle

The business cycle refers to the swings in gross domestic product from recovery to recession. There are several factors influencing the business cycle.

Consumers tend to be the most important, reflecting 60-70% of GDP in developed countries. Trends in consumer spending can be monitored through retail sales and personal income data.

Business spending on inventories and investment is a smaller but more volatile component of GDP. It can be tracked using surveys such as PMI or ISM.

Monetary policy is used by governments to dampen the overall business cycle. The ability to use monetary policy as a business cycle lever is dampened by inflation, the pace of growth, unemployment levels and capacity utilization.

Posted on 18th February 2009
Under: Economic Analysis, FInancial Planning, Industry Analysis, Investment Returns, Portfolio Management | No Comments »

Inflation’s Effect on Asset Classes

Inflation has different effects on different types of assets. As a result, it is important both to diversify assets in terms of their response to inflation and to form expectations of inflation in order to overweight the assets that will respond best to future conditions.

Cash – inflation causes rising interest rates, and therefore cash tends to earn a higher return when inflation is higher.

Bonds – inflation erodes the fixed payments and terminal values of bonds. Therefore, bonds perform worse when inflation is higher.

Stocks – inflation can increase asset values but erode real cash flows. Rising interest rates can reduce the present value of future cash flows. Stocks tend to do best when inflation is low and predictable, and to fall in either high inflation or deflation.

Real estate – higher cash flows and asset values tend to result in a positive relationship between real estate and inflation.

Posted on 18th January 2009
Under: Asset Allocation, FInancial Planning, Portfolio Management | No Comments »

Business Cycles in the Economy

The typical business cycle can last as long as 10 years or more. It is typically represented by several stages.

In the recovery stage, there is still a large gap between output and capacity. Bond yields are bottoming and stocks often surge. Taking risk (cyclical and risky stocks, high yield bonds) tends to offer above-average rewards.

In the early upswing, the economy experiences robust growth without causing inflation because output is still below capacity. As the capacity utilization improves, so does profitability. Short rates begin to rise, though long-term rates remain stable.

In the later stages of the upswing, the output gap closes and overheating becomes a danger. Inflation can pick up, resulting in rising interest rates and stock market volatility.

In a slowdown, the slowing economy becomes sensitive to potential shocks. Interest rates are peaking, and interest-sensitive stocks tend to perform well.

In a recession, declining GDP leads to falling short-term interest rates and bond yields. The stock market bottoms out and often starts to rise well ahead of the business cycle recovery.

Posted on 18th December 2008
Under: Asset Allocation, Fundamental Analysis, Industry Analysis, Investment Returns, Portfolio Management | No Comments »

Credit Exposures for Derivative Contracts

Derivative agreements are contracts between two parties, under which at least one of the parties faces a financial obligation to the other. Each counterparty to a contract can be subjected to credit risk, or the possibility that the other party fails to meet its obigation.

In a forward contract, commitments are made at the contract outset but settlement is due at expiration. Consider an agreement under which party A agrees to buy the S&P 500 index from party B for 1,500 in one year. If  the S&P 500 is at 1,400, party A owes party B 100, and party B faces potential credit risk (prior to settlement) and actual credit risk (at the time of settlement.) When the S&P 500 is higher than 1,500 it is party A that is subject to credit risk.

Swap contracts are similar to a series of forward contracts, with interim payments occurring along the way. Each payment exposes one party to credit risk. As each payment is made, the total potential credit risk is reduced.

Option contracts have unilateral credit risk – only the seller is obligated to make a payment, so only the buyer is exposed to credit risk once the initial premium has been paid.

Posted on 29th November 2008
Under: Derivatives, Futures, Investing in Commodities, Options, Portfolio Management, Risk Management, Swaps | No Comments »

Risk Factors Related to Investments in Distressed Securities

Market risks related to the economy, interest rates, and the state of the market are relatively unimportant when considering investments in distressed securities. There are, however, several types of risks that particularly apply to investments in distressed securities.

Event risk relates to unexpected company-specific or situation-specific events that affect valuation.

Market liquidity risk arises because distressed securities are less liquid, and demand runs in cycles.

J-factor risk relates to the judge presiding over bankruptcy proceedings. The track record in adjudication and restructuring can play a significant role in both the overall outcome and determining the optimum securities in which to invest.

Posted on 28th November 2008
Under: Active Management, Alternative Assets, Investing in Distressed Securities, Portfolio Management, Risk Management | No Comments »

Strategy and Due Diligence for Private Equity Investments

When considering an investment in private equity, investors need to consider a number of factors.

  • Can a small investor obtain the diversification needed
  • Does the investor have liquidity needs that would prohibit tying up funds for 7-10 years
  • Will the investor be able to fund promised commitments to the private equity fund when called for
  • What mix of sector, stage and geography is required to provide the best diversification

In addition, selecting managers requires special due diligence considerations:

  1. Can the investor and manager evaluate prospects for market success
    • Understanding of the markets, competition and sales prospects
    • Experience and capabilities of management team
    • Management’s commitment – ownership, compensation structure, etc
    • Opinion of customers
    • Identity of current investors – do they have particular expertise that lends confidence to outsiders
  2. Operational review
    • Have experts validated the technology
    • Consideration of employment contracts
    • What intellectual property rights have been established
  3. Financial and legal review
    • Potential dilution of interest
    • Financial statement (or tax returns, or investor-conducted audit)

Posted on 27th November 2008
Under: Active Management, Alternative Assets, Asset Allocation, Investing in Private Equity, Investment Returns, Portfolio Management | No Comments »

Choosing a Fixed Income Manager

When choosing a fixed income manager, some important points to consider include:

  1. Outperformance net of fees is especially difficult for fixed income managers
  2. Style analysis can indicate the ways the portfolio construction differs from that of the benchmark. Is the investor happy with these deviations?
  3. Selection bets can be determined through return decomposition to identify whether the manager is skilled in credit analysis
  4. The investment process should be understood to know the methods used and the drivers of alpha
  5. If multiple managers are used, the alpha generated should not be highly correlated with that of other managers

Posted on 24th November 2008
Under: FInancial Planning, Fixed income investments, Investing in bonds, Portfolio Management | No Comments »

Inventory Cycles in Business

Inventory cycles tend to last two to four years. As business improves, greater confidence in future sales cause management to build inventory in anticipation of those sales. At some point, the sales fall below expectations and the inventories form a glut.

In order to clear inventories, prices are cut and fewer inventories are ordered. Eventually the inventory gets worked down. When sales do finally pick up again, this can sometimes lead to shortages.

Posted on 18th November 2008
Under: Asset Allocation, Industry Analysis, Investment Returns, Portfolio Management | No Comments »

Portfolio Rebalancing Strategies

Buy and Hold

Investors who use a buy and hold strategy set their initial allocation weights and then do nothing. Such allocations are directly related to the market performance of risky assets, and using them implies that risk tolerance is directly related to wealth and market returns.

Consider a 60/40 split between stocks and the risk-free asset. As the stock market rises (falls), stocks represent a larger (smaller) weight in the portfolio and The risk-free asset provides a floor value. Returns are directly related to market performance in a linear relationship.

When markets are trending, buy and hold methods can perform well because the better performing assets get increasingly larger weights and poor-performing assets have less impact.


Constant mix rebalancing is a dynamic process that requires rebalancing to the intial target allocation by trading whenever market conditions alter the ideal balance. The strategy ensures that the portfolio’s risk characteristics remain stable over time, consistent with a risk tolerance that varies proportionately to wealth.

Constant-mix strategies can be characterized as contrarian, as they sell the best-performing assets to buy the worst-performing. However, when markets are mean-reverting this will perform better than a buy and hold strategy. The shape of returns is concave – return increases at a decreasing rate in positive markets and decreases at an increasing rate in negative markets.

Constant Proportion

In a constant proportion strategy, the target allocation is a function of cushion, where cushion is the difference between the portfolio value and the floor value, and the allocation to risky assets is the product of the cushion and the proportion (m).  A buy and hold strategy represents a special case in which m = 1. This strategy is consistent with having no risk tolerance if there is no cushion.

If m > 1, the strategy is known as constant proportion portfolio insurance, or CPPI. CPPI strategies buy more stocks when markets are rising and sell stocks as markets fall. The dynamic allocations also affect the floor value, as changing the weight of the risky asset necessitates an opposite-direction change in the floor value.

In strong bull markets, CPPI performs well by continually allocating more to stocks. In strong bear markets, CPPI avoids large losses by rapidly reducing the allocation to stocks. Such returns can be described as having a convex shape as the return increases at an increasing rate when market returns are positive and decreases at a decreasing weight when market returns are negative.

When markets are characterized by frequent reversals, the constant changes in allocation result in high transaction costs that erode performance.

Posted on 4th November 2008
Under: Active Management, Asset Allocation, FInancial Planning, Investment Returns, Portfolio Management | No Comments »

Portfolio Stress Testing

Portfolio stress testing is a means of identifying unusual circumstances that could lead to larger than expected losses. It frequently takes the form of scenario analysis or a simulation of historical or hypothetical events.

In a scenario analysis, stylized scenarios ranging from modest to extreme outcomes are modeled individually. For example, scenarios could include a 10-basis point interest rate move in either direction, a 100-basis point move in either direction, and a steepening or flattening of the yield curve. By using standard measures such as these, scenario analysis can facilitate risk comparisons across assets. However, it does not account for correlations between risk exposures – for example, the effect of both a 100-basis point move in interest rates and a steepening yield curve would not be known.

Simulation of hypothetical or actual historical events is used to see how the entire portfolio would perform when subjected to a given set of extreme conditions. It is particularly useful when extreme breaks (price gaps) are considered more likely that the model being used assumes.

Posted on 29th October 2008
Under: Governance, Portfolio Management, Risk Management | No Comments »