The Top-Down Method
There are two common approaches to constructing an investment portfolio: “top-down” investing and “bottom-up” investing. In the Portfolio Management & Analysis class, we focused on the “top-down” investing approach because we believe it maximizes our goal in scaling portfolio drivers, equity selections, and risk management. We first start with analyzing the board’s economics and political outlook to identify sentiment drivers to forecast which investment categories are most likely to outperform the others. Based on the economic forecast and our risk tolerance, we will decide the allocation on each asset class. We then distinguish the allocation of sub-asset classes based on their issued countries, sector, and market capitalization. For example, investors would likely increase weighting in defensive assets during economic contraction and reduce positions in sectors they believe are likely to underperform. The decided portfolio allocation must be able to explain our investment philosophy and follow the portfolio rules. After the portfolio allocation is determined, we will begin selections on asset classes and individual securities. The portfolio manager is required to actively monitor the market movements and changes in political climates to maximize the risk-adjusted return of the portfolio.
Portfolio Allocation
Return on a completed portfolio is the weighted average return on the risky and risk-free portfolio. Because the allocation between the risk-free and the risky portfolio is investor-specific based on an individual’s risk aversion, we are required to inquire with the investor’s investment goals and anticipation to determine the utility curve on our calculated capital allocation line. The utility score is a certainty equivalent rate of return. Usually, a higher utility score means investors expect a higher return for every unit of increase in risk. A portfolio is desirable only if its certainty equivalent return exceeds that of the risk-free alternative which is to maximize the utility (the satisfaction) of an investor. Therefore, the allocation between the risk-free and the risky portfolio should be the point of tangency between the capital allocation line and the investor’s highest possible utility curve.
Allocation within the Risky Portfolio
Since the risk-free portfolio has a standard deviation of zero, portfolio diversification is mainly focused on the risky portfolio instead of the risk-free portfolio. In general, the greater the risk an investor is willing to take, the higher the potential return is likely to be awarded. Understanding the different types of risks is vitally important to portfolio management. In modern portfolio theory, investment risk is broken down into two types: systematic risk and nonsystematic risk.
The systematic risk is an undiversifiable risk and is associated with the market risk, the interest rate risk, and purchasing power risk. When the overall market declines like the 2020 stock market crash, a handful of portfolios can escape regardless of how diversified the security selection was. Interest rate risk and the inflation rate are the change in fiscal and monetary policies. The fixed income market is more attractive when the interest rate is high and when deflation occurs because of the relatively higher coupon payments.
Portfolio managers usually spend more time analyzing the diversifiable non-systematic risk through portfolio diversification on individual investments. Nonsystematic risk range across the company’s financial default risk, the business operating risk, bond’s call and prepayment risk, investment liquidity risk, the legislative and international political risk. Beta measurement is a good way to understand the degree of nonsystematic risk of individual security. When individual security’s beta against its benchmark is higher than 1, price-performance is more volatile than the benchmark. Conversely, less risk and price volatility are associated with individual security’s beta that is lower than 1. Risk rewards will also be lower.
To some extent, investment is all about managing, swapping, and arbitraging the volatility of individual security prices. If we consider volatility as investment risk, studying and analyzing the correlation between individual security’s variance is the key to creating a desirable risk-adjusted return portfolio. The minimum-variance curve shows the minimal percentage of risk (variance of the portfolio), investors need to take to access the targeted return.
Portfolio Drivers
Even though the past is not an indication of the future, the market is much highly correlated compared to historical performance. The top-down investing strategy first starts with analyzing the microeconomic outlook and portfolio drivers. The Fisher Investment group had a segment the broad portfolio driver into three categories: economic, political, and sentiment.
Economic drivers. What economic forces are likely to drive up which GDP components and how does the change in fiscal and monetary policies will affect the interest rate and money supplies? A successful portfolio manager would have to identify how each economic driver will impact the overall portfolio and each asset class. The fundament outlook of GDP growth is made up of consumer and government spending, business investments, and net exports, and each segment has different impacts on the economy.
Consumption: Since consumer spending makes up the majority of GDP, analyzing the growth drivers of the consumer sentiment index helps us better measure the overall consumer confidence of the current economic condition. Before the global pandemic, the U.S. consumer sentiment index had been maintained above 90 since 2015 and dropped to 71.8 in April last year. Consumers tend to accumulate savings during the time of economic uncertainty, as consumers perceive greater risk. A declining consumption index would negatively affect the consumer cyclical sector like the large company stock price pull-back in restaurants and shopping malls we experienced last year. We can also use U.S. Redbook Index to measure the consumption number by analyzing the same-store sales of large retailers from one year to another. If the retailer were selling more every year, the consumer sentiment and consumer spending have more drivers. Moreover, we can also dig deeper into the comparison of disposable income vs. spending to see how much the consumers have left in their pockets after spending. We want the two numbers to be relatively close because it means consumers feel comfortable about the economy and are willing to spend the exceed income on goods and services.
Business Spending: PMI indexes are the common indicators of business spending. An over 50 index shows businesses are buying more capital to expand themselves. Investors can use the different PMIs to identify macro trends in different industries to their advantage. A growing manufacturing PMI means manufacturers’ new orders have been increased and may raise the price for downstream companies such as retailers and distributors for their increased bargaining power. A higher manufacturing PMI usually benefits the industrial and material sectors. For example, an automobile manufacturer is likely to increase the budget in purchasing raw materials such as steel, plastic, and rubber when the management team expects to receive more new orders in the future months. On the other hand, the CEO Confidence Index is another indicator of further business expending. The nice thing about this index is that we can figure out CEO confidence of further business in each sector and compares the data month by month to find the growth trend. Investors can take advantage of the sectors that CEOs are expected to add more capital.
Government Spending: Spending in federal, defense, and state & local have different drivers to the economy as a whole. The federal budgets allocate to social security, healthcare, education, and public infrastructures are mandatory to some extend which made these investment sectors act more defensive compares to other sectors. Holding a portion of pharmaceutical companies and industrial companies in a portfolio can well diversify some business risks in growth companies. Historically, the change of administration always along with a change in government spending plans. The trillion-dollar infrastructure plan outlined by the Biden administration had been led a wing for growth in the industrial and material sector, and the American family plan was another catalyzer to infrastructure companies who are responsible for school building expansions.
Net Export: The trade balance has always been affected by the change in the currency exchange rate. U.S. imports increased dramatically at the beginning of this year as a result of depreciation in the U.S. dollar. Monitoring monetary policy plans and diplomatic relations are vitally important to predict international trade patterns.
Political Drivers. Every administration change brings a new political climate and industry preference to the economy. The upcoming new tax plan on doubling up capital gain tax rate had imposed a selling pressure on the equity market for asset reclassify purposes. On the state and local level, a state with an increasing tax rate like California also causes a population and business outflow to states with more friendly tax plans such as Arizona and Texas. Political drivers can be country-specific and the changes in legislation and political climates can affect our international equity allocations. Wars and conflicts in emerging counties can negatively affect U.S. businesses who import materials from involved countries but on the other hand increase revenue of the defense companies.
Sentiment Drivers. U.S. wages and salaries growth index are good measurements of consumer sentiments. Higher wages growth with higher labor productivity tends to push up consumption and lead to higher GDP growth. Lower interest rates and a strong stock market always drive up the housing market and tourism market. International market sentiment drivers always relate to change in the U.S currency exchange and demand for portfolio diversification. For the purpose of stretching valuations and approaching euphoria growth, investors are likely to set their sights on the emerging market. Emerging equities that perform less correlate to the U.S. market are attractive to a portfolio that seeks U.S. market risk diversification. The ones that perform highly correlate to the U.S. market and have higher beta than the S&P 500 could sometimes outperform the U.S. equities in a bull market. Dig deeper into the specific business sentiment driver, the disruptive growth in technology development had improved the fundamental of business momentums. The rise of e-commerce, robotic assistance, artificial intelligence, and high-speed internet had added up the variance of demand drivers in B2B and B2C markets.
Benchmarks
Benchmarks are the road maps for structuring a portfolio, managing risk, and more importantly, judging performance. The entire portfolio should be set to track a broad-based index such as S&P 500, MSCI World, or Russell 2000, and the individual sectors or asset classes should be set to track sector-focused indexes. For example, when we are selecting and monitoring international equities, we should compare them to MSCI foreign market index, and the performance of industrial and material companies should be compared with Dow Jones.
Security Selection
We usually run a quantitative screener to begin individual security selections. The criteria we input to the screener to filter out equities have to follow our investment philosophy and specific investment goals. To start, we will first decide the ideal market capsize that matches our investment goal. Equities with medium to small market cap are suitable for growth-seeking investments for the bigger price volatility. P/E ratio is another filter of whether a company is a value play or growth play. Then we can narrow it down to particular investment sectors and countries. After narrowing the prospect list, we will start filling individual equities that are consistent with our portfolio goal and investment philosophy.
The Fisher Investment group recommends a five-step process in analyzing the suitability of individual equities.
1. Understanding business and earnings drivers. Reading a company’s annual report and browsing a company website is a direct and fastest way to learn about the company’s business description, revenue segment, products, and target customers. Sophisticated investors should be able to identify whether the business is placed with catalysts or not due to their sensitiveness of sentiment drivers.
2. Identify strategic attributes. After glancing through the company’s business outlook, a portfolio manager will evaluate the market position of the target company by comparing its competitive and comparative advantage to its peers. Companies with high potential market accessibility usually have a high economic moat on their core technology or service and more. Large market, superior partnerships, ideal economic sensitiveness, strong brand name, high-profit margins, strong corporate governance are all key factors in evaluating strategic attributes.
3. Analyze Fundamental and Stock Price Performance. Companies with strong financials and large catalysts are usually ideal. Therefore, computing the target company’s financial efficient ratios, leverage ratios, profitability ratios are ways to learn about the sustainable development of the target company. We can also learn the correlation between the past stock price performance and the announced business plans to understand the business trend. So, when we are learning business past and future business strategies, we are able to make more correlated predictions on price performance.
4. Identify Risk. Evaluating the target company’s business and financial risk is the key to protecting the portfolio and generating risk-adjusted returns. Like the general equity market, individual companies are also subject to systematic and non-systematic risks. Even though we can’t manage to diversify systematic risks like the currency risk and inflation risk, we can manage our allocations to companies that are highly exposed to systematic risks. Portfolio managers should pay closer attention to nonsystematic risks. Companies that are exposed to supply shortages, weak pipelines, legal issues, bad reputations, and etc. should provide relatively higher reward potential than their peers in order to be considered.
5. Analyze Valuation and Consensus Expectations. The common ways to evaluate a company are either through discounting further cash flow, dividend payment, or comparing multipliers with peer companies to find out the intrinsic value of the target company. There are no strict rules on choosing valuation models, but portfolio managers are expected to use models that are aligned with the company’s business features. For example, we usually use EBITDA multiples instead of revenue multiples to discount future cash flows for manufacturing companies to avoid high inventory depreciation skewing the data. In valuing growth companies, we usually reduce weighing on the discount dividend model and the residual income model in the foot field analysis. The growth companies tend to invest in company capital expenditure with the residual cash instead of paying back shareholders, so the growth of the dividend payment is either very low or they don’t issue dividends at all.
Monitoring
Return Attribution. Tactically, the goal of building and managing a portfolio is to maximize returns and outperform the benchmarks. Portfolio managers usually weigh the portfolio investment sectors differently from the benchmark for the outperforming goal. Building an effective return attribution model helps portfolio managers to break down the excess return over the benchmark by sectors, asset classes, and individual equity selections in order to evaluate the impact of investment decisions. The common return attribution model we use today is the Brinson-Hood-Beebower (BHB) model where it breaks down the excess return to two board decisions: portfolio manager’s decision on individual securities selection that is not the board index and the decision on portfolio allocation that is different from the benchmarks. To build the model, we first calculate portfolio returns and benchmark returns based on each sector’s weighting then multiple the weighting to the returns to see each sector's contributions to the portfolio and the benchmark. Then we compare each contribution to see which sector selections does the excess return attributed to. If our portfolio underperformed the benchmark, running the return attribution model allows us to identify the shortcoming of our allocation in particular selections.
Technical Analysis on Behavior Finance. Other than monitoring return attributions, portfolio managers can also utilize technical analysis to exploit the recurring patterns in equity prices.
Dow Theory: In a bull market, equity prices usually go through the accumulation stage, the big move stage, and the excess stage. In a bear market, equity prices suffer through the distribution phase, public participation phase, and the panic phase. To understand the overall trending pattern of the market, we will look at three different aspects: the primary trend, the secondary trend, and the minor trend. The primary trend measures the long-term movement of the prices lasting from several months to years, the secondary trend deviates the price from the underlying trend lines that are eliminated by correlations, and the minor trend is the daily fluctuation of little importance.
Moving Average: When monitoring the macro change in the equity market, investors also tend to use the 20-week moving average to detect the bull and bear signals. When the market price breakthrough its 20-week moving average and holds for a reasonable period, it is usually a bullish signal. Otherwise, the market or the individual equity will seem bearish.
Sentiment Indicators: Learning the short-term momentum helps portfolio managers to monitor and predict minor trends of price movements. The confidence index is the ratio of the average yield on 10 top-rated corporate bonds divided by the average yield on 10 intermediate-grade corporate bonds. The higher the value, the bullish the sentiment. Another way to look detect short-term momentum is through the put/call ratio. Put options entered way above call options, the market is bearish in the targeted equity.
