In a previous article, we introduced the
CFA Institute Investment Foundation Program (Read
more here). It is a free program
designed for anyone who wants to enter or advance within the investment
management industry, including IT, operations, accounting, administration, and
marketing. Candidates who successfully
pass the online exam earn the CFA Institute Investment Foundations Certificate.
There are total of 20 Chapters in 7
modules, covering all the essential topics in finance, economics, ethics and
regulations. This series of articles
will highlight the core knowledge of each chapter.
Chapter 17 provides an overview of the investment
management. The learning outcome of chapter 17 is as follows:
·
Describe
systematic risk and specific risk;
·
Describe
how diversification affects the risk of a portfolio;
·
Describe
how portfolios are constructed to address client investment objectives and
constraints;
·
Describe
strategic and tactical asset allocation;
·
Compare
passive and active investment management;
·
Explain
factors necessary for successful active management;
·
Describe
how active managers attempt to identify and capture market inefficiencies.
In a previous article, passive and
active management were discussed. Active
investment managers use various methods to try to identify future performance.
Managers using fundamental analysis focus on macroeconomic,
industry-specific, and company-specific factors that make securities and assets
valuable. Other managers use technical and behavioural models to
identify trends and momentum in the market and to predict how trading by other
market participants may change future market prices. Some active managers build
statistical or quantitative models to try to identify shares that are
likely to outperform or underperform. In practice, many managers use a blend of
the techniques discussed in the following sections. Based on their analysis,
active managers purchase assets that are expected to have superior returns and
sell assets that are expected to underperform.
Fundamental Analysis
Active managers often try to identify
and capture market inefficiencies through fundamental analysis. For equity
investors, this process means conducting a thorough analysis of a company’s
business model, its prospects, and its financial situation. This analysis may
involve meeting company management and interviewing them about their strategy
and the prospects of the company.
Typically, an analyst or investment
manager performs some form of fundamental analysis to arrive at an estimated
value for a company’s shares. If the share price is significantly below the
estimated value, the manager will increase the weighting of the shares in the
portfolio or add the shares to the portfolio.
The value of a security can be viewed as
the present value of all the cash flows the security will generate in the
future. Investors can estimate the value
of a stock by discounting all the dividends they expect to receive while they
hold the stock and adding the proceeds from selling the stock. Value that is
estimated this way is called the stock’s fundamental value or intrinsic value.
When analysing equities, they pay close
attention to an issuer’s future prospects for earning money and producing
valuable assets. Among many other issues, they consider the following:
·
Demand
for the company’s products
·
Cost
of producing those products
·
Profit
margins of the company and whether the margins are sustainable
·
Competitiveness
of the company and whether it can remain competitive
·
Quality,
stability, and security of the company’s management, workforce, and physical
and intellectual assets
·
Productivity
of its research and development efforts
·
Amount
of debt the company uses to fund its operations and investments
·
Value
of options to suspend or expand operations or to engage in new initiatives
·
Prospects
for disruptive technological innovations, the imposition or removal of
significant regulatory constraints, and legal or extra-legal expropriations
that may affect the company’s viability
·
Macroeconomic
issues, such as prospects for inflation, national economic growth, and
unemployment
·
Legal
and regulatory environment the company operates within and whether any major
changes are planned
·
Corporate
governance problems that may allow corporate managers to waste or misuse corporate
earnings that otherwise could be distributed to shareholders or be retained to
pay off debt holders
Technical and Behavioural Analysis
Managers using technical analysis study
market information, including price patterns and trading volumes, whereas managers
using behavioural analysis focus on indicators of market sentiment, such as
manufacturers’ new orders or indices of consumer expectations.
Some investment managers use a technical
approach, seeking to assess price and trading volume trends in the stock market
to identify shares that may outperform or underperform. For example, an active
manager who believes in momentum will try to invest in shares that have
recently been rising in the market, which is based on the notion that a rising
share will continue to rise. Other managers might look for signs of imbalance
between the potential buyers and sellers of a share to try to predict which
direction the share is likely to move.
Quantitative Analysis
Some managers build statistical models
to try to identify shares that are likely to outperform. By analysing data,
they identify characteristics that have typically been associated with share
price outperformance. For example, the analysis might suggest that companies
with below-market average valuation levels (for example, the ratio of the share
price to earnings per share, known as P/E) and above-average expected earnings
growth tend to outperform. This insight can then be used to search for shares
that show those characteristics. Managers using this approach are often called
“quants”, because of the quantitative models they use.
As noted earlier, managers may use a
combination of the types of analysis. Also, depending on the asset, asset
class, or market being analysed, the approach(es) used and the precise
variables of interest will differ.
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