The economist's role in the investment process


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The economist's role in the investment process

  1. 1. Asset Management and Private Banking Università Bicocca May 2008
  2. 2. Programs <ul><li>Equity Investment </li></ul>1 <ul><li>Investment Process </li></ul><ul><li>Asset Allocation </li></ul><ul><li>Alternative investment </li></ul><ul><li>Multymanager / open architecture </li></ul><ul><li>Quantitative Techniques and Risk Management </li></ul>
  3. 3. Investment Process / Asset Allocation 2
  4. 4. ORGANISATION Risk Management ASSET ALLOCATION DIVISION MUTUAL FUNDS Forecasting and Strategy Macro Analysis Optimisation Equity Quantitative analysis Bond 4
  5. 5. <ul><li>Step 1: Identify investor’s characteristics and goals </li></ul>5 Investment Process Step 2: Define the approach (benchmark vs total return) Step 4: Portfolio Construction (Optimisation) Step 5: Choose the financial tool for each asset class (open architecture) Step 6: Execute Trades Step 3: Forecast risk and return for each asset class
  6. 6. Step 1: investor’ s characteristics and goals 6 Define: Time Horizon Risk Tolerance Set of asset classes (equity, bond, cash, corporate, high yield, hedge fund, private equity) Approach Responsibility : Private Banker benchmark driven (relative return) risk driven (total return)
  7. 7. <ul><li>Benchmark Driven : investors choose a benchmark according to is risk profile, asset managers takes tactical exposure to maximise expected returns. Esempio: </li></ul><ul><li>Low Risk : 20% Equity 80% Bonds. </li></ul><ul><li>Medium Risk : 40% Equity 60 Bonds </li></ul><ul><li>High Risk : 70% Equity 30% Bonds </li></ul><ul><li>Total Return : flexible approach. Asset managers try to maximise expected return given a certain level of risk (Value at Risk). Esempio : </li></ul><ul><li>Low Risk : VaR 3% </li></ul><ul><li>Medium Risk : VaR 5% </li></ul><ul><li>High Risk : VaR 10% </li></ul>Step 2: Define the approach Responsibility : Private Banker / Asset Manager
  8. 8. Asset Allocation vs benchmark ASSET ALLOCATION OUTPUT Exposure vs benchmark in terms of : <ul><li>Asset Class </li></ul><ul><li>Country </li></ul><ul><li>Currency </li></ul><ul><li>Duration </li></ul>7 GPF Progress 5 anni Benchmark
  9. 9. <ul><li>Relative returns in financial markets are predictable </li></ul>Step 3: forecast risk and return 8 Responsibility : Asset Allocator, Economist, Strategist <ul><li>Economic intuition and qualitative judgment must be supported by empirical evidence (econometric model, quantitative analysis) </li></ul><ul><li>Use investment themes that consistently drive returns across global markets and asset classes (long-term valuation, short-term momentum, fund flows, risk premium, macroeconomic policy) </li></ul>
  10. 10. <ul><li>How do we forecast expected returns? </li></ul>9 Forecasting Theme Rationale Identify a set of factors, which can be grouped into broad investment themes Fund Flows Momentum Risk Premium Valuation Macroeconomic Trade – off growth inflation Distance between price and fundamentals Liquidity goes into some asset classes more than others Rapidly appreciating assets often continue to appreciate Excess Return to invest in the market Step 3: forecast risk and return
  11. 11. Factors Commonly Used in Forecasting Absolute and Relative Market Returns Step 3: forecast risk and return Variable Asset Class Equity Bond Policy Corporate Currency Multiple (PE, PB, PCF) Price Momentum, Earnings Revisions Corporate cash flow (Buy Backs, Issuance) Liquidity (M1, M2, Monetary Policy) Yield Curve Output Gap Inflation Spread over Treasury Balance Sheet Ratio Interest Rate Differential Futures on Interest Rate (Eurodollar, Euribor) 10
  12. 12. <ul><li>Growth </li></ul>Compare your expectations with market expectations Step 3: forecast risk and return 11 Inflation Interest Rate Volatility Sentiment DCF Implied Earnings Growth Break Even Inflation (TIPS, O.A.T) Strip of Futures on Interest Rate (Eurodollar, Euribor) Implied Volatility on Option (VIX) Risk Premium
  13. 13. Step 4: Portfolio Construction (Optimisation) 13 <ul><li>Must have a framework to move from predictability to portfolio construction </li></ul><ul><li>It requires a solid asset allocation tool (Mean Variance, Black-Litterman) and systematic approach to risk management </li></ul><ul><li>Maximise the trade-off between expected gain and volatility or tracking error, given the client’s tolerance for risk (efficient frontier) and historical correlation between asset classes </li></ul>Responsibility: Quantitative Research Team
  14. 14. <ul><li>Portfolio Expected Return = asset class return + alfa generation – costs (management fees and trading costs) </li></ul>Step 5: Investment Tools 14 <ul><li>Identify Optimal trade off between costs and alfa generation </li></ul><ul><li>Investment Tools: Mutual Fund, ETF, Derivatives, Hedge Fund. </li></ul><ul><li>The more efficient a market is, the less worthwile it is to pay costs for alfa generation (Active Funds). </li></ul><ul><li>Concentrate costs where Alfa generation is high . </li></ul>
  15. 15. Step 6: Execute Trade 15 <ul><li>Implement incremental portfolio that reflects current views and alpha strategy </li></ul><ul><li>Careful attention to transaction costs, market liquidity, risk constraints and client guidelines. </li></ul>Responsibility: Fund Manager, Trader
  16. 16. Asset Allocation and Portfolio Construction 13 <ul><li>Portfolio has 3 components: </li></ul><ul><li>Capital Protection </li></ul><ul><li>Currency, Short Term Bonds, Real Yields </li></ul><ul><li>Financials instrumenst: secuirity, ETF </li></ul><ul><li>Core = Market (Beta) Exposure </li></ul><ul><li>Domestic and internationals equities, bonds, corporate, high yields </li></ul><ul><li>Financials instruments: ETF, Passive Funds, Long only </li></ul><ul><li>Satellite = Alfa Exposure </li></ul><ul><li>Extra return vs markets </li></ul><ul><li>Financials instruments: Flexible funds, hedge funds, long – short equities, multimanager, tactical asset allocation </li></ul>
  17. 17. Asset Allocation and Portfolio Construction 13 <ul><li>Strategic asset allocation </li></ul><ul><li>Medium - Long Term wiews </li></ul><ul><li>Change exposure into the Core Component: equity vs Bonds, International equities vs Domestic Equities, Currency exposure </li></ul><ul><li>Change the allocation between Core and Satellite </li></ul><ul><li>Tactical asset allocation </li></ul><ul><li>Short term wiews </li></ul><ul><li>Change exposure into the Satellite Component: Low Risk vs High Risk Funds, short term bets on some markets, etc. </li></ul>Dynamic Optimisation between Core and Satellite
  18. 18. Asset Allocation Total Return 22% 15% 8% International Equity 30% 30% 30% Satellite (alfa) 20% 14% 7% Domestic Equity 2% 2% 2% Medium – long Term Bond (5 – 20) 44% 31% 17% Core (beta) 21% 30% 33% Short terms bonds (1 – 3 ) 5% 9% 20% Euro Currency 26% 39% 53% Capital protection -6.34% -4.03% -0.83% Value at Risk VaR 12 VaR 8 VaR 5
  19. 19. Asset Allocation: Capital Protection 18% 27% 12% <ul><ul><li>LYXOR ETF EUROMTS 1-3Y </li></ul></ul>1% 1% 2% <ul><ul><li>FRTR 4 10/25/09 </li></ul></ul>1% 1% 2% <ul><ul><li>DBR 4 07/04/09 </li></ul></ul>1% 1% 3% <ul><ul><li>BTPS 2 1/2 06/15/08 </li></ul></ul>    14% <ul><ul><li>Euro Bond Short Term 1-3y </li></ul></ul>21% 30% 33% Bond Short Term 1 - 3 1% 2% 4% <ul><ul><li>CCTS 0 03/01/12 </li></ul></ul>1% 2% 4% <ul><ul><li>CCTS 0 06/01/10 </li></ul></ul>2% 3% 7% <ul><ul><li>FRTR 5 1/2 10/25/08 </li></ul></ul>1% 2% 5% <ul><ul><li>ETF Eonia </li></ul></ul>5% 9% 20% Euro Currency 26% 39% 53% Capital Protection -6.34% -4.03% -0.83% Value at Risk VaR 12 VaR 8 VaR 5
  20. 20. Asset Allocation: Market Exposure (Beta) 6% 4% 2% <ul><ul><li>Settoriali EU </li></ul></ul>5% 3% 2% <ul><ul><li>Equity Global EM </li></ul></ul>2% 1% 1% <ul><ul><li>Equity Pacific ex Japan hedged </li></ul></ul>      <ul><ul><li>Equity Pacific ex Japan </li></ul></ul>9% 7% 3% <ul><ul><li>Equity Japan hedged </li></ul></ul>      <ul><ul><li>Equity Japan </li></ul></ul>3% 2% 1% <ul><ul><ul><li>JANUS WORLD US RISK MG CO-A= </li></ul></ul></ul>3% 2% 1% <ul><ul><li>Equity USA hedged </li></ul></ul>      <ul><ul><li>Equity USA </li></ul></ul>9% 7% 4% <ul><ul><li>Equity Europe </li></ul></ul>5% 3% 1% <ul><ul><li>Equity Italy </li></ul></ul>42% 29% 15% Equity       <ul><ul><li>Bond Global High Yield </li></ul></ul>      <ul><ul><li>Bond Global EM </li></ul></ul>      <ul><ul><li>Euro Corporate Bond </li></ul></ul>2% 2% 2% <ul><ul><li>Inflation Linked </li></ul></ul>      <ul><ul><li>Euro Bond Long Term (10 – 30) </li></ul></ul>      <ul><ul><li>Euro Bond Medium Term (5 – 10) </li></ul></ul>      <ul><ul><li>Euro Bond medium Term 3-5y </li></ul></ul>2% 2% 2% Bond 44% 31% 17% Core (beta) -6.34% -4.03% -0.83% Value at Risk VaR 12 VaR 8 VaR 5
  21. 21. Asset Allocation: Satellite (Alfa)       Hedge Fund 2%     <ul><ul><li>MELLON GLOBAL EV CU OPT-A </li></ul></ul>4% 3% 2% <ul><ul><li>FORTIS L FUND-BD CONV WRLD-C </li></ul></ul>2%     <ul><ul><li>AMERICAN EXP WLD-CRY AL+-AE= </li></ul></ul>4% 3% 3% <ul><ul><li>MELLON GLOBAL-EV GL ALPHA-A= </li></ul></ul>4% 4% 2% <ul><ul><li>SCHRODER INT EU ABSOL RT-AAC </li></ul></ul>4% 5% 5% <ul><ul><li>JPM INV-HIGH STAT MAR N-A=-A </li></ul></ul>  2% 2% <ul><ul><li>CAF-DYNARBITRAGE VR 4 EUR-SC </li></ul></ul>  3% 4% <ul><ul><li>ABN AMRO FDS-ABS RET BD =-A </li></ul></ul>    2% <ul><ul><li>FORTIS L FUND-CRED SP EMR-CC </li></ul></ul>20% 20% 20% Basket Flessibili di Terzi 10% 10% 10% System 100 30% 30% 30% Satellite (alfa) -6.34% -4.03% -0.83% Value at Risk VaR 12 VaR 8 VaR 5
  22. 22. Equity Investment <ul><li>Factors driving equity markets returns </li></ul><ul><li>Equity markets performance of the last 3 years. What’ s next? </li></ul><ul><li>Alfa Generation: TOP Down vs Bottom Up Approach </li></ul><ul><li>Quantitative techniques for equity investments </li></ul><ul><li>Fundamental analysis and equity valuation </li></ul>16
  23. 23. <ul><li>Market Return + Currency Return </li></ul>17 Equity Investment Equity Portfolio Expected Return Extra-return vs benchmark BETA + ALFA
  24. 24. <ul><li>Market Return </li></ul>18 Beta: Market Return + Dividend (or Earnings) growth Current Dividend Yield Liquidity + Change in Multiples (PE, PB, etc) Factors changing Multiples Earnings Cycle Sentiment
  25. 25. Valuation Markets look cheap compared to history, fundamentals or other asset class Metrics: Price Momentum Tool : technical analysis Liquidity Liquidity available for financial investments Earnings cycle Dynamic of earnings growth 19 Beta: factors driving market returns Metrics: Economic Growth, inflation, Yield Curve Tool : Macroeconomics analysis Macro Markets with best trade off growth / inflation Metrics: Multiple (PE, PB, DY), Fair Value (DDM, DCF), Relative (B/E Yield) Tool : Fundamental analysis, quantitative metrics Metrics: EPS Growth, margins, sales Tool : Fundamental analysis, quantitative metrics Metrics: Monetary policy, yield curve, M1 / M2, currency reserves, excess liquidity, corporate cash flow. Tool : Research, Balance Sheet Analysis Momentum Markets and currencies have strong recent outperformance
  26. 26. 20 2002 – 2006: what was behind the equity market rally? Liquidity Valuation All the factors were supportive from the equity market perspective Earnings cycle Momentum Global Profits at record level. Restructuring and margins expansions. Best markets not best economy (Europe vs. USA and China) Strong Equity market cheap after 2000 – 2002 collapse on multiples and relative to bonds Central banks loosening monetary policy after market collapse and September 11th. Zero real interest rate, excess global liquidity. Global Growth (3.5% real growth), without inflation (2% CPI Core). Macro Environment
  27. 27. 30 Active aprroach: philosophy and aims Extra-return vs Bcmk 200 / 300 bp per year Disciplined Approach Rule for portfolio construction and rigorous risk management, Absolute (VaR) and Relative to bcmk (RVaR, Tracking Error) Minimising Costs Lower trading costs mean higher portfolio returns Two Phase Defensive Phase (optimisation) Immunisation vs a diversified set of risk factors (market, currency, sector, style, size exposure) Active Phase Bottom up approach. Two Sources of alfa generation: quantitative model and fundamental analysis
  28. 28. Defensive Phase 31 Equity portfolio: alfa generation Evidence shows that performance vs. benchmark is driven more by bets you are not conscious of (factor risk exposure, stock you don’t own) than active bets you are aware of. To maximise expected gains with respect to benchmark and subject to a constraint of tracking error, it is important to isolate sources of alfa generation. Optimisation Process High number of stocks (80% market coverage) Market and currency neutral (beta 1) Sector Neutral Monitoring of Style and Size Bias
  29. 29. <ul><li>Multifactor model, covering over 600 stocks </li></ul><ul><li>Transparency (no black box) </li></ul><ul><li>Testing of different sets of variables (fundamental, technical, valuation) for each sector </li></ul><ul><li>Basket of stocks sector neutral </li></ul><ul><li>Backtest over 12 years </li></ul>Source 2 Source 1 32 Active Phase Two Sources of Alfa Generation Equity portfolio: alfa generation Quantitative Model Fundamental Analysis <ul><li>Analyst / Fund Managers for most sectors </li></ul><ul><li>Proprietary valuation model (DCF + Break up ROE) </li></ul><ul><li>Qualitative study of the company (sector analysis, company visits, management presentations) </li></ul>
  30. 30. 33 Investment Process Three Blocks <ul><li>Portfolio Low Tracking Error </li></ul><ul><li>Quantitative Basket (80 – 100 stocks) </li></ul><ul><li>Fundamental Basket (proprietary valuation model) </li></ul>NO exposure to Market, Currency, Sector, Style Alfa concentrated in Stock Picking Product responsibility = Risk Allocator Quantitative Analysts Fund Managers /Sector Analyst Team
  31. 31. <ul><li>Sectors </li></ul><ul><li>Selected Variables </li></ul><ul><li>Ranking of Stocks in Each Sector </li></ul><ul><li>Sector Construction </li></ul><ul><li>Portfolio Construction </li></ul>Utilities Banks Energy Cash Flow P/E Price to Book STM Dividend Yield EV/EBITDA <ul><li>GDF </li></ul><ul><li>E.On </li></ul><ul><li>Enel </li></ul><ul><li>… </li></ul><ul><li>UBS </li></ul><ul><li>BPM </li></ul><ul><li>Santander </li></ul><ul><li>… </li></ul><ul><li>BP </li></ul><ul><li>ENI </li></ul><ul><li>Repsol </li></ul><ul><li>… </li></ul>GDF, E.On, Enel UBS, BPM, Santander BP, ENI SSM Market 34 Construction of Quantitative Model
  32. 32. REFERENCES <ul><li>Strategic Asset allocation: Portfolio choice for Long Term Investors , Oxford University Press, 2002. </li></ul><ul><li>The Term Structure of the Risk – Return Trade Off . Financial Analysts Journal, January / February 2005 </li></ul><ul><li>Investment Valuation – Damodaran – Wiley Finance - 2004 </li></ul><ul><li>Winning the Loser’s Game – Charles D. Ellis - 2004 </li></ul>