Investment analysis lies completely within the realm of active management.
Industry observers describe the analysis and decision-making activities invest- ment managers carry out with a mix of somewhat overlapping terms. Research generally refers to the process of gathering data from various sources that can help identify buy or sell opportunities. Analysis refers primarily to processing that data into useful information, although some people use the term broadly to include research. Portfolio management, narrowly defi ned, means making buy and sell decisions based on the results of research and analysis and the current state of the fund’s portfolio of securities (and this is how we use the term in this chapter). However, some people use the term portfolio manage- ment much more broadly, to encompass all the activities that result in port- folio decisions, including research and analysis. All these functions collec- tively comprise the investment advisor’s role.
Different fund managers organize their front offi ce functions differently.
In many fi rms, especially larger ones, the analysts, portfolio managers, and traders are all separate individuals or teams. In some cases, however, portfolio managers prefer to do their own analysis and research. In other cases, particu- larly among fi xed-income funds, portfolio managers may do their own trad- ing. Some of the variation stems simply from personal preference, some from economics (e.g., very small managers can’t afford separate individuals for the functions). We will discuss the functions in this chapter as though they are performed by separate individuals, but in reality, this is not always the case.
Sometimes, one fund has one portfolio manager, as when Peter Lynch was the manager of the Magellan Fund. Many fund companies assign teams of managers to their funds, and some managers and teams handle multiple funds. The fund’s prospectus explains how the fund’s portfolio management responsibilities are assigned. However the responsibility is structured, the portfolio manager exercises the investment advisory function for the fund, deciding what to buy or sell and when to do so. Active portfolio managers make their buy and sell decisions for two reasons:
1. to respond to cash fl ows to or from the fund caused by shareholder pur- chases and redemptions; and
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2. to improve the performance of the fund by taking advantage of opportuni- ties they perceive in the securities markets.
Passive portfolio managers must respond to shareholder cash fl ows, but make no trades in an attempt to improve performance—since they do not believe that identifying market opportunities is possible, their funds tightly conform to the benchmarks. However, they do buy or sell securities to bring the fund back in line when the benchmark itself has changed as, for example, when Laboratory Corporation of America Holdings (ticker symbol LH) was added to the S&P 500 on October 29, 2004, replacing South Trust Corp.
Equity Analysis and Portfolio Management
In actively managed funds, equity analysts attempt to fi nd market opportuni- ties for the portfolio manager. The analysts search for particular stocks or groups of stocks that are either underpriced (buy opportunities) or overpriced (sell opportunities) by the market. Analysts tend to focus on subsets of the overall market, such as companies within certain industrial sectors, and, in some cases, work a specifi c list of candidate stocks. Ultimately, the analysts issue investment recommendations about particular stocks, similar to those that analysts working for brokerage fi rms produce for the fi rms’ clients. They pursue a variety of approaches to making these identifi cations, ranging from the purely qualitative to the purely quantitative.
At the qualitative end of the scale stands the fundamental analyst, who attempts to understand the state of a company so as to make predictions about its future earnings. Fundamental analysts not only study the reports published by and about a company, but also interview its management, and even visit the company to observe operations. They study the industry in which the com- pany operates, reading trade journals and attending conferences. They evalu- ate how well the company stacks up against others in its industry, and try to anticipate how the industry itself is likely to perform. For example, a funda- mental analyst might recommend a particular software company as a potential buy, because research shows that it has good products, sound management, a compelling business plan, and solid fi nancing, and because it is in a segment of the industry that the analyst believes will experience strong growth. (The recommendation is even stronger if the analyst can detect a reason why the market mistakenly undervalues the company.) Fundamental analysts usually specialize in specifi c industries or sectors because of the industry expertise their approach requires. Neuberger Berman, for example, explaining how it selects stocks for its Manhattan Fund, describes its fundamental analysis approach: “. . . . the managers analyze such factors as: fi nancial condition (such
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The Investment Management Front Offi ce 87 as debt-to-equity ratio); market share and comprehensive leadership of the company’s products; earnings growth relative to competitors…”2
Quantitative analysts stand at the opposite end of the spectrum from fun- damental analysts. Technical analysts, sometimes called “chartists,” study pat- terns in prices and volumes within the stock market itself to try to predict how a company’s stock may move in the future (before the widespread use of comput- ers, technical analysts spent much time drawing graphic charts of prices). Other quantitative analysts evaluate stocks using computer models that attempt to predict stock prices, or identify over- or underpriced stocks, by looking for cor- relation between the stock prices and one or more predictor variables (such as economic indicators or the issuer’s fi nancial measures). For example, the pro- spectus for Quant Fund’s Small Cap fund describes its quantitative approach:
A quantitative approach relies on fi nancial models and computer databases to assist in the stock selection process. Proprietary computer models are capable of rapidly ranking a large universe of eligible investments using an array of traditional factors applied in fi nancial analysis, such as cash fl ow, earnings growth, and price to earnings ratios, as well as other non- traditional factors.3
Not surprisingly, many if not most fund groups follow neither purely qualitative nor purely quantitative approaches. Many, for example, use some quantitative techniques to develop a large list of candidate stocks for con- sideration, and then reduce that to a smaller list of stocks to recommend by conducting more qualitative analyses. The advisors for the Goldman Sachs CORE Small Cap Equity Fund do this. To pick stocks, they “use the Goldman Sachs’ proprietary multifactor model, a rigorous computerized rating system, to forecast the returns of securities held in the Fund’s portfolio.” In addi- tion, “the Investment Advisor will monitor, and may occasionally suggest and make changes to, the method by which securities, currencies, or markets are selected for or weighted in a Fund.”4 In other words, once their model sug- gests that a stock might be a good buy, they take a hard look at the company’s fundamentals to see whether they believe it really is.
The portfolio manager uses the analyst’s recommendations as one input in making buy and sell decisions. He or she balances these recommendations against the fund’s cash fl ow needs and current composition of the fund’s port- folio of securities. (Allstate may be a great buy, for example, but the manager might have to forego it if the portfolio is already overweighted with insurance stocks.) Portfolio managers operate under constraints from several sources.
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Regulations. The 1940 Act and subsequent regulations set boundaries on what portfolio managers can do. For example, a registered fund cannotNICSA Book_Ch-5REVsave.indd 87
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own more than fi ve percent of the outstanding stock of a company, no matter how attractive a buy that stock appears to be.
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Prospectus rules. The portfolio manager must abide by the guidelines laid out in the fund’s prospectus. Some prospectuses are very constrain- ing—for example, the Hennessy Balanced Fund follows the “Dogs of the Dow” investment strategy* that requires the fund hold only those ten stocks within the Dow Jones Industrial Index that currently have the high- est dividend yields. Other funds allow the portfolio manager great leeway to pursue performance—for example, the Massachusetts Investor Trust prospectus says the fund holds mostly equities “under normal conditions,”and “generally” invests in large-cap stocks, but makes no guarantees.5 And Legg Mason opened a “go-anywhere” fund in 1999 (Legg Mason Oppor- tunity Trust) that industry observers believed was specifi cally designed to allow a particular high-performing portfolio manager to buy any sort of securities he saw fi t without being accused of “style-drift.”6
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Policies. Different management companies set different levels of con- straints as a matter of policy. In some fund families, the portfolio man- agers can do just about anything they want to do that isn’t forbidden by the regulations or prospectus. At the other end of the scale, some man- agement companies subject their portfolio managers to strict investment policies. Take the General Electric Funds, for example. In 1999, the Wall Street Journal described their “taut guidelines” for stock selection.7 One fund could only buy stocks with a price/earnings to growth ratio of less than one. Another fund had to maintain all its sector weightings within two percentage points of the weightings within the S&P 500. These (and other GE rules) are neither regulatory nor prospectus requirements, but rather prescriptions set by GE Funds’ management.Compliance monitoring, described in the next chapter, concerns itself with ensuring that the manager is following all the relevant rules.
Fixed Income Analysis and Portfolio Management
As the ICI, Morningstar, and Lipper categorization schemes in the last chap- ter illustrate, a fi xed-income fund usually concentrates on a particular sector of the debt securities market. A fi xed-income sector is typically defi ned by type of issuer (e.g., U.S. Treasury, federal agency, corporation, municipality) and the average maturity of the holdings (e.g., short-term, intermediate-term, long-term). Fixed-income funds can be either actively or passively man- aged. Passive fi xed-income funds simply mirror an index that represents their
*Michael B. O’Higgins popularized this “Dogs of the Dow” strategy, which several funds pursue, in his 1990 book Beating the Dow. It advances the notion that the ten highest-yielding stocks in the Dow are depressed in price and will bounce back.
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The Investment Management Front Offi ce 89
The Many Ways to Skin a Cat
Morningstar divides the world of mutual funds into over 60 categories, based on the funds’
investment objectives and approach. Even within a category, however, funds have plenty of room to make investment decisions in their own particular ways. Consider, for example, the funds in Morningstar’s Emerging Markets Stock Funds category. Most if not all of them have precisely the same investment objective in their prospectuses: long-term capital appreciation derived from investing in stocks in emerging-market countries. Most of them defi ne emerging-markets based on the World Bank’s per capita income defi nition or a similar measure. Most of them state that they will hold primarily equity securities spread among several countries, but reserve the right to move to fi xed-income securities when conditions warrant. After that, they start to diverge. Examination of a few prospectuses reveals quite a bit of variation in how exactly they go about pursuing that investment objective.‡
• The Legg Mason Emerging Markets Trust starts with a list of 1,000 potential stocks from which to choose. The investment advisor uses a combination of
“on the ground” fundamental research and quantitative valuation techniques to choose from among the
stocks on the list. In parallel with stock se- lection, management allo- cates the port-folio among countries based on a separate analysis that
“merges quantitative and fundamental approaches.”
• Management of the Dreyfus Premier Emerging Markets Fund searches for value stocks—ones with low price-to-book ratios, price-to-earnings ratios,
or other stated characteristics of undervalued stocks. It employs a bottom-up style,
“emphasizing individual stock selection rather than economic and industry trends...”
• The American Century Emerging Markets Fund follows a growth investment strategy to select stocks. First, the managers use a bottom-up approach, basing their decisions on the “business fundamentals of the individual companies.” In addition, “fund managers also consider the prospects for relative economic growth among countries or regions, economic and political considerations…when making investment decisions.”
• Grantham, Mayo, van Otterloo & Co. even draws the investor a picture of how its managers pick securities for the GMO Emerging Countries Fund, describing each step in the process. They analyze countries, industrial sectors, and companies in parallel, and then bring it all together in a portfolio construction model that incorporates risk considerations.
‡ All the information and quotations are taken from the prospectuses for the funds current in 2004.
Risk
Universe Int'l. Finance Corporation
(IFC) 2000 Companies
Stock Valuation
Country Valuation Sector Valuation
Portfolio
Optimization Benchmark
GMO Evolving Countries Fund
Fund Investment Process
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sector—for example, the Vanguard Short-Term Bond Index Fund seeks to replicate the performance of the Lehman Brothers 1- to 5-Year Government/
Corporate Bond index. Active fi xed-income managers attempt to outperform the market in which they compete by picking bonds and/or sectors that are likely to outperform within the portfolio’s investable universe.
There are three common approaches used by fi xed-income analysts and managers to pursue this goal. They are duration adjustment, relative value analysis, and issue selection. At the heart of all three approaches is an under- standing of the spectrum of U.S. Treasury bond yields that represent the risk- free alternative to all other debt instrument investments. These yields, plotted against time (usually for Treasury securities ranging from three months to 30 years in maturity), combine to form the Treasury yield curve—the basis of the entire U.S. fi xed-income market.
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Duration adjustment. Successful duration adjustment strategy depends on the accurate prediction of the future direction of interest rates. If a man- ager expects the economy’s general level of interest rates—and, therefore, the general level of bond yields—to fall (typically as a result of macroeco- nomic forces such as weak economic growth or a Federal Reserve policy bias toward easier credit conditions), he or she will lengthen the average maturity of bonds held in the portfolio. This also increases the portfolio’s average duration, a proxy, expressed in years, for the average length of time that a bond investment is outstanding (and a measure of the bond’s sensitivity to interest rate changes). Conversely, if the manager expects yields to rise, longer-maturity bonds will be replaced with shorter-matu- rity securities, and the portfolio’s average duration will be shortened.A manager may apply duration adjustments to the entire portfolio, or only within a particular maturity segment (short-, intermediate-, or long-term yields), when yield changes are not expected to occur in parallel fashion along the entire curve. In all cases, however, duration adjustments are made relative to the portfolio’s performance benchmark.
Overall, a portfolio’s duration will be positioned short of, neutral to, or long of the duration of the market index by which its performance is measured. The successful application of interest rate forecasting and duration adjustment is extremely diffi cult but can produce spectacular performance results.
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Relative value analysis. Fixed-income portfolio managers often employ relative value analysis to choose sectors and/or individual securities to hold in a portfolio. Relative value measures the divergence of yield spreads from average historical relationships. For instance, if a port- folio’s investment guidelines permit investing in the U.S. Treasury andNICSA Book_Ch-5REVsave.indd 90
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The Investment Management Front Offi ce 91 corporate bond sectors, a manager will follow the historical relationships of Treasury and corporate bond yields at different maturity points along the yield curve. If the corporate yield spread widens (increases) from its average at, say, the 10-year maturity point, the manager will sell Treasury holdings and buy corporate bonds of similar coupon and maturity. Stated another way, the manager noticing the wider yield spread is also recogniz- ing that corporate bonds have underperformed Treasuries, and are there- fore historically “cheap” to Treasuries. The manager’s reaction will be to sell Treasuries and buy corporates, waiting until the relative yield rela- tionship has returned to its historical average (meaning that corporates by then will have outperformed Treasuries) before reversing the trade. This strategy is also known as “sector rotation.” Active relative value manag- ers employing sector rotation seek to profi t from repeatedly exploiting even tiny aberrations in historical yield relationships.
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Issue selection. A portfolio manager uses issue selection to identify individual bond issues with characteristics (good or bad) that have not been fully refl ected in a bond’s yield (or, in relative value parlance, in the spread between the bond’s yield and the yield of a correspond- ing Treasury security). From an optimistic perspective, these character- istics might include the issuer’s strengthening corporate cash position or undervalued fi xed assets, or a likely upgrade in credit rating as pro- vided by one of the major rating agencies such as Moody’s or Standard& Poor’s.
A debt security’s yield relative to Treasuries is determined in part by its credit risk. The greater the risk of default, the higher the spread a corporate bond’s yield must be versus the alternative risk-free Treasury yield to attract buyers. If a fund buys a bond that subsequently receives a credit upgrade, the fund’s performance benefi ts from the tighter spread of the corporate’s yield to the underlying Treasury; that is, the bond’s price has changed (up or down) relatively better than the Treasury’s price. As an example, Neu- berger Berman describes how its fi xed-income analysts do exactly this.
They “look for securities that appear underpriced compared to securities of similar structure and credit quality, and securities that appear likely to have their credit ratings raised. In choosing lower-rated securities, the managers look for bonds from issuers whose fi nancial health appears comparatively strong but that are smaller or less well known to investors.”8
Prepayment analysis is another component of issue selection. Many debt securities have provisions for being retired before their stated matu- rity dates. Corporate bonds may be structured with call provisions that give the issuer the right, at its discretion, to redeem the issue ahead of
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