Value
These funds invest in securities perceived to be selling at deep discounts to their intrinsic or potential worth. Such securities may be out of favor or not actively followed by analysts. Long-term holding, patience, and strong dis- cipline are often required until the ultimate desired value is achieved.
Growth Fund
Typically a growth fund is a euphemism for a fund that is likely to take on greater risks (relative to, say, an income fund) so as to try to grow the cap- ital base. In all likelihood, a growth fund strategy is not to stay strictly indexed, unless of course there is a meaningful growth-type index available (as perhaps a Nasdaq-type index might be, though even here a concern might be raised about more Internet-related components of this index as repre- senting a disproportionate exposure to one particular sector). Generally speaking, equities, which demonstrate beta values greater than one, are likely to be strong growth fund candidates.
Capital Preservation Fund
Perhaps at the opposite end of the continuum from a growth-oriented fund would be a capital preservation fund. As the name clearly suggests, the idea with a capital preservation fund is more to maintain capital than to expose it, and typically with securities that tend not to exhibit much volatility. While it is certainly possible to find some equities within a capital preservation fund, they would likely exhibit betas of less than one. More typical com- ponents of a capital preservation fund would consist of relatively strong (highly rated) bonds.
TABLE 4.4 Fund Management Themes Used with Product Types
Fund Theme Bonds Equities Currencies
Indexing √ √
Total return √ √
Growth √
Balanced √ √
Value √
Income √
Tax-free √
Yield enhancement √
Capital preservation √
International √ √ √
Overlay √
Relative return √ √
Absolute return √
Bull and/or bear √
Long and short √
Balanced Fund
A balanced fund usually is expected to represent a blend of equity and bond holdings. The idea is that by diversifying within one fund—such as taking a more aggressive/growth-oriented position in equities and a more conserv- ative/preservation stance with bonds—this mix could result in an optimal best-of-both-worlds strategy for a given investor. Indeed, one school of thought holds that there is a “life cycle” blend of equities and bonds that is dynamic in nature. The general idea is that in the early stages of one’s life, it is quite acceptable to be predisposed to equities rather than bonds; this would be a time in life when risk taking is more appropriate. In the middle stages of life, a shift to more of an equal holding of equities and bonds is more in keeping with hitting stride with income earnings as well as the need to ensure adequate resources for the coverage of present and future liabili- ties (as with a home mortgage and/or college educations). And then in the later stages of life, the notion is that the right strategy is more of a bias to bonds and capital preservation, if only so that the capital base that was once exposed (and properly so) is now more protected.
Income Fund
Income funds are closely linked to capital preservation funds in that both strive to limit capital exposure to an acceptable minimum. Income funds tend to prefer securities with higher coupons and dividends than capital preser- vation funds; in short, securities that generate as many “income”-like cash flows as possible. Again, equities probably would be limited to shares exhibiting a beta of less than one. Some utilities readily come to mind.
Although higher coupons are paid only when greater credit risk is taken on, there are some rather aged (though still available) bonds with “large”
coupons relative to their present credit risk profile. For example, a long-dated security may have been brought to market a while ago when prevailing yields were much higher and/or when the issuer’s credit rating was worse than what it has evolved to become. Another possibility for income-oriented funds is to bias bond holding toward securities, which may embody more complex structures, as with callables. However, here as well capital preservation pre- cautions must be maintained.
Tax-Free Funds
As discussed in some detail in Chapter 3, there can be entire segments within certain markets where designated securities are afforded some type of tax protection. If due only to the fact that these securities already enjoy a par- ticular tax advantage, they are not typically sought after as higher-yielding
securities. Tax-free yields tend to be lower relative to like-rated securities that are not tax-advantaged because of the tax-free advantage. While it should be expected that investors who might not be motivated by a tax-free oppor- tunity might favor tax-free securities for a particular strategy (as when a total return-oriented portfolio manager believes that he may have spotted a mis- priced relationship between taxables and nontaxables and wishes to capture it), tax-free securities are most likely to be found in “pure” tax-free funds and less likely to be found anywhere else.
Asset-Liability Management
Just as tax-free investment management can be thought of as a type of “tai- lored” management style (in this case tailored to tax-oriented strategies), asset-liability portfolio management might best be thought of as a “tailored”
management style. Simply put, for an entity with fairly well-defined future liabilities (as with pensions or life insurance policies), it is highly desirable to put into place a matching (or nearly matching) series of asset streams to pair off against the anticipated liabilities. Perhaps not surprisingly, bonds are often a favored asset to use with asset-liability management owing to the fact that they have fairly well-defined characteristics when it comes to cash flow generation. Knowing when coupons and/or principal payments are likely to be made and in what amount can be tremendously helpful when trying to ensure that promises for timely payments on pension or life insur- ance policies are kept.
Insurance companies use actuarial tables and the like for the sole pur- pose of optimally deriving and applying any relevant statistical insights to better structure and manage life insurance–related commitments.
Yield Enhancement
Closely related to asset-liability management is the portfolio management approach of yield enhancement. In fact, it might be most helpful to describe yield enhancement as not so much a distinct investment style vis-à-vis asset- liability management, but rather as a management orientation as practiced by banks. A bank’s “liabilities” can be thought of as its outstanding debt in the form of certificates of deposit or the bonds it has issued into the mar- ketplace and so on. Just as a corporation must successfully pair off its pen- sion liabilities with a predictable asset stream(a series of cash flows that generate payments of specific times into the future) and a life insurance com- pany must successfully pair off its insurance liabilities with a reliable asset stream, so must a bank be able to generate a pool of bankable assets (so to speak). In the old-fashioned world of banking the idea was to be profitable
simply by extending loans (the asset stream) that paid cash flows (coupons and principal) at rates in excess of wherever banks had to pay (the liability stream) to attract money (via certificates of deposit and the like) to be in a position to extend loans in the first place. In the world of more modern-day finance, a bank’s assets might very well include some loans but increasingly also might include investments in market securities such as bonds and equi- ties. Indeed, just as restrictions and guidelines typically exist for types of investments that an insurance company might engage in (as presented in Chapter 5), so too do such guidelines and restrictions exist for banks (also as presented in Chapter 5). These types of restrictions and guidelines exist on a global basis.
The reason why the term “yield enhancement” might be applied to banks in particular relates back to the notion of trying to assemble a collection of assets with an overall yield in excess of the yield that must be paid out on the bank’s liabilities. There is typically a maturity element to a bank’s asset and liability streams, and while it may be relatively straightforward to lock in a long-term loan or purchase a long-dated bond (both being assets), it may prove somewhat difficult to pair those off with a multiyear CD certificate of deposit or comparable product. This paradigm of a bank’s generally running long-dated asset streams against short-dated liabilities gave rise to the notion of “gap management,” or managing the differences between a bank’s asset and liability streams. A number of consulting and software responses exist to assist banks with gap-management and other needs.
Value Investing
Value investing is often described as a process of separating “solid” com- panies from more speculative ones. A solid company might be defined in any number of ways, though criteria might include a long track record of steady earnings, an absence of large fluctuations in equity price, and/or perceptions of strong and experienced leadership at the helm. Value-oriented funds may not turn in the same kind of performance as more opportunistic portfolios when the market is soaring, though they would be expected to do better than opportunistic portfolios when markets are steady to weaker.
International Fund
An international fund is simply one that makes a deliberate effort to invest in securities denominated in currencies other than the home market currency.
Thus, an international fund based in the United States might include secu- rities denominated in yen, euros, Australian dollars, and so forth.
Overlay Fund
Many portfolio managers regard the currency decision as being separate and distinct from the decision-making process of picking individual equities or bonds. The rationale is that there are very different drivers behind curren- cies, bonds, and equities and that they are best treated in isolation or quasi- isolation. The notion that there are different drivers with currencies is perhaps reasonable, if only to the extent that they do exhibit very different risk/return profiles relative to equities and bonds. Yet as discussed in Chapter 2 under interest rate parity, there are meaningful links between key interest rate differentials and currency movements. Some portfolio managers make the strategic decision to concentrate exclusively on managing bonds or man- aging equities; they outsource the job of managing currencies or delegate it to someone who is more expert in that arena.
There are generally three types of currency management approaches:
quantitative, fundamental, and blend. The quantitative approach involves a strict adhesion to mathematical models that attempt to signal appropri- ate times to buy or sell particular currencies. A fundamental approach claims to actively consider factors such as the state of a particular economy or capital flows or market sentiment. Note, however, that currency port- folio managers are not slaves to whatever the models might be saying; the models are intended to complement personal judgments, not override them.
And finally, there are currency specialists who purport to use a particular mix of the two approaches.
This is not the place to decide if one approach is better than any other.
The debate should be an internal one to the fund concerned, and directed to which particular approach would be most consistent with the investment philosophy of the portfolios—at least until it can be proven that one style alone is always and everywhere superior to all others.
Table 4.4 summarizes the fund types according to product profile. It is intended to be more conceptual than a carved-in-stone description of the way that investment funds use various financial products.
A Last Word
Historically investors have described themselves as being equity investors, bond investors, currency investors, or whatever. While these labels do have some value in describing the type of investing investors do, their prominence may give way to other more meaningful types of classifications. That is, per- haps instead of describing their investing profile by financial products, investors may describe their investing profile in terms of creditconsidera- tions. At one time in the not too distant past, the distinction between these two phenomena was not that great. For the United States and much of
Western Europe, for example, highly rated government debt dominated the bond landscape in these respective markets (if not globally), and equities commonly were seen as being the higher-risk investment. Today, however, there are many flavors of bond products, and investors are increasingly pushed to define exactly what criteria they will use to distinguish between a bond or an equity. Is the line in the sand whether or not the security car- ries voting rights? Is it a matter of where the security sits in the capital struc- ture of the company balance sheet? Is it a consideration of how the security’s risk/return profile compares to other product types?
In a world where bonds of certain governments actually go into default7 and where some “equities” exhibit less price volatility and greater returns relative to same-issuer fixed income products, a more meaningful set of labels may be of help to distinguish one investment philosophy from another. For example, instead of investors describing themselves as oriented to a partic- ular product profile (equities, bonds, currencies, etc.) they would describe themselves as oriented to a particular market risk profile (high, medium, low, or any other classifications of relevance). In turn, the market risk profile approach would encompass risks of product, cash flow, and credit.
Why would investors be interested in such a different way of looking at the marketplace? If investors focus on ultimately arriving at their destina- tion and are indifferent to how they get there, then they will find great value in a market risk orientation to investing. If the “destination” is high capital exposure/shoot-for-the-stars, then a variety of investment products could fill the needs, products that cut across traditional lines separating bonds from equities (and other conventional product categories).
Issuers and investors, as well as regulators and rating agencies, will increasingly ask these questions and creative responses will need to be pro- vided. For example, one approach might be construct and maintain a com- parative total return table that would provide total return and risk profiles as sliced by credit risk as opposed to product labels. How do total returns of junior subordinated debt issued by a double-A-rated company stack up against the senior debt of a triple-B-rated company, for example, and how do these compare with a preferred stock? Much exciting work lies ahead.
CHAPTER SUMMARY
This chapter showed how combining various legs of the product and cash flow triangles can facilitate an understanding of how various strategies can
7Ecuador’s Brady bonds, which were backed by U.S. Treasuries, nonetheless went into default in 1999.
be developed and how products can be created. How credit can be a key factor within the product creation process was considered. There are hun- dreds upon thousands of actual and potential products and strategies in the global markets at any given time. The purpose here is simply to provide a few examples of how that creative process might be organized in a straight- forward and meaningful fashion. Finally, the chapter presented an overview of relative versus absolute return objectives and discussed a few portfolio types that might be found under the heading of relative (capital preserva- tion) or absolute (long/short).
APPENDIX
Relative Return Investing Strategies
Many portfolio managers have their performance evaluated against a bench- mark or index. The goal with such an exercise is generally either to match the portfolio’s performance with the benchmark’s or to beat the benchmark.
Either objective is wrought with unique challenges. Indeed, it is the rare and quite the exceptional fund manager who can successfully outperform the market year in and year out and in a variety of market environments. For such investors who have identified a systemized way of investing, their suc- cess can be reflected in their fund’salpha.
In the finance industry the term “alpha” denotes returns generated in excess of a market index. For example, if the S&P 500 returns 10 percent and a stock portfolio returns 11.2 percent, then 120 basis points of alpha can be said to have been generated. Since alpha is typically used as a refer- ence to excess returns, investors tend not to refer to negative alpha. In short, either alpha has been generated or it has not. Recognizing that returns and especially excess returns typically are generated in tandem with at least some measure of risk, the financial industry uses the term “sigma” to denote vari- ability of returns or the notion that returns can be negative, just as they can be positive. It is certainly possible for a return to be negative yet also be a contributor to positive alpha. For example, if the return of the S&P 500 is 8 percent while the return of the stock portfolio is –7.5 percent then it can be said that 50 bps of alpha has been generated.
The notions of risk and reward, or sigma and alpha, are seen as insep- arable and of great relevance when evaluating market opportunities. At many firms these functions are called trading and risk management respectively, and each area has detailed roles and responsibilities. For example, the trad- ing function may be responsible for achieving the best possible execution of trades in the marketplace, while the risk management function may be responsible for overseeing the overall profile of a portfolio. Arguably, the more successful firms are those that have found ways to marry these two key areas in such a way that they are seen as complementary and reinforc- ing rather than competing and at odds.
This appendix highlights some strategies that can be used to eke out a few extra basis points of return for a benchmarked portfolio. Broadly speaking, such strategies may be categorized as:
䡲 Stepping outside of benchmark definitions 䡲 Leveraging a portfolio
䡲 Capitalizing on changes within a benchmark’s parameters
For the equity markets, benchmarks are fairly well known. For exam- ple, the Dow Jones Industrial Average (DJIA or Dow) is perhaps one of the best-known stock indexes in the world. Other indexes would include the Financial Times Stock Exchange Index (or FTSE, sometimes pronounced foot-see) in the United Kingdom and the Nikkei in Japan. Other indexes in the United States would include the Nasdaq, the Wilshire, and the Standard
& Poor’s (S&P) 100 or 500.
In the United States, where there is a choice of indexes, the index a port- folio manager uses is likely driven by the objectives of the particular port- folio being managed. If the portfolio is designed to outperform the broader market, then the Dow might be the best choice. And if smaller capitalized stocks are the niche (the so-called small caps), then perhaps the Nasdaq would be better. And if it is a specialized portfolio, such as one investing in utilities, then the Dow Jones Utility index might be the ticket.
Indexes are composed of a select number of stocks, a fact that can be a challenge to portfolio managers. For example, the Dow is composed of just 30 stocks. Considering that thousands of stocks trade on the New York Stock Exchange, an equity portfolio manager may not want to invest solely in the 30 stocks of the Dow. Yet if it is the portfolio manager’s job to match the per- formance of the Dow, what could be easier than simply owning the 30 stocks in the index? Remember that there are transaction costs associated with the purchase and sale of any stocks. Just to keep up with the performance of the Dowafter costsrequires an outperformance of the Dow before costs. How might this outperformance be achieved? There are four basic ways.
1. Portfolio managers might own each of the 30 stocks in the Dow, but with weightings that differ from the Dow’s. That is, they might hold more of those issues that they expect to do especially well (better than the index) while holding less of those issues that they expect may do less well (worse than the index).
2. Portfolio managers might choose to hold only a sample (perhaps none) of the stocks in the index, believing that better returns are to be found in other well-capitalized securities and/or in less-capitalized securities.
Portfolio managers might make use of statistical tools (correlation coef- ficients) when building these types of portfolios.
3. Portfolio managers may decide to venture out beyond the world of equi- ties exclusively and invest in asset types like fixed income instruments, precious metals, or others. Clearly, as a portfolio increasingly deviates from the makeup of the index, the portfolio may underperform the index,