INVESTMENT
ANALYSIS AND
PORTFOLIO
MANAGEMENT
JOYCE LEFEVERE
Master Finance and Risk Management
Prof. K. Inghelbrecht
Academic year 2019-2020 - 1st semester
,These notes were taken during the classes of professor K. Inghelbrecht. Due to limited time,
no extra information was added from the book. Also, mistakes concerning typing and
spelling were not yet deleted.
Notes regarding the guest lecture (see 11.) will be changed if the slides will be made
available.
All information was retrieved from:
Inghelbrecht, K. (2019). Investment Analysis and Portfolio Management
Bodie, Kane and Marcus, 2019, Essentials of Investments, 11th Edition, McGraw-Hill
,Table of Contents
INVESTMENT ANALYSIS AND PORTFOLIO MANAGEMENT: INTRODUCTION .............................. 1
1. INTRODUCTION: SOME GENERAL CONCEPTS AND THE INVESTMENT PROCESS ................ 3
Introduction ................................................................................................................................................... 3
Basis concepts: ............................................................................................................................................... 8
1- Return and risk........................................................................................................................................... 8
2- Trade-off between return and risk ............................................................................................................ 9
3- Efficient markets ...................................................................................................................................... 13
4- Pricing of assets ....................................................................................................................................... 14
5- Diversification .......................................................................................................................................... 15
Types of Investments ................................................................................................................................... 16
Investment Process ...................................................................................................................................... 17
Investment Decisions ....................................................................................................................................... 20
Investment Management ................................................................................................................................. 21
Factors Affecting Investment Decisions ........................................................................................................... 23
Players in the Financial Markets ................................................................................................................... 23
Financial intermediaries ................................................................................................................................... 23
Three mayor players in the financial markets: ................................................................................................. 24
Classes of investors (lenders) ........................................................................................................................... 24
Role of Financial Markets ............................................................................................................................. 24
Two types of markets ....................................................................................................................................... 25
Review topic 1 .............................................................................................................................................. 37
2. INVESTING DIRECT AND INDIRECT ...................................................................................... 39
Direct Investing ............................................................................................................................................ 40
Different types of assets (money market, bonds, stocks, derivatives) ............................................................. 40
Stock and bond market indices ........................................................................................................................ 49
Indirect Investing ......................................................................................................................................... 58
Investment Companies ..................................................................................................................................... 59
Open-end Funds (i.e. Mutual Funds) versus Closed-end Funds ....................................................................... 63
Mutual Funds.................................................................................................................................................... 64
Exchange-traded Funds (ETFs) ......................................................................................................................... 77
Review Topic 2 ............................................................................................................................................. 82
J.L. INVESTMENT ANALYSIS AND PORTFOLIO MANAGEMENT | A
,3. RETURN AND RISK, AND PORTFOLIO THEORY .................................................................... 83
Returns ........................................................................................................................................................ 83
Return and risk: overview................................................................................................................................. 83
Return over multiple periods and return/price indices .................................................................................... 86
Summary statistics for returns ......................................................................................................................... 88
Expected Return ........................................................................................................................................... 91
(Expected) Risk ............................................................................................................................................. 95
Return and Risk: overview .............................................................................................................................. 102
Required Rate of Return RR ........................................................................................................................ 103
Nominal versus Real Interest Rates ................................................................................................................ 104
Risk Premiums ................................................................................................................................................ 107
Portfolio Theory ......................................................................................................................................... 112
Risk Premium and Risk aversion ..................................................................................................................... 112
Capital allocation ............................................................................................................................................ 115
Capital Allocation Line .................................................................................................................................... 117
CAL in Practice ................................................................................................................................................ 122
Review Topic 3 ........................................................................................................................................... 133
4. EFFICIENT DIVERSIFICATION ............................................................................................. 135
1- Diversification and portfolio risk ........................................................................................................ 135
Two sources of risk ......................................................................................................................................... 136
Diversification and portfolio risk .................................................................................................................... 137
2- Optimal portfolio with 2 risky assets .................................................................................................. 139
Importance of correlation .............................................................................................................................. 140
Investment Opportunity Set ........................................................................................................................... 144
3- Optimal portfolio with 2 risky assets and risk-free asset..................................................................... 146
Combining Risky Portfolio with Risk-Free Asset ............................................................................................. 146
Optimal Risky Portfolio ................................................................................................................................... 147
Optimal Risky Portfolio with Risk-Free Asset ................................................................................................. 148
Optimal Complete Portfolio ........................................................................................................................... 148
Proportions of Optimal Complete Portfolio ................................................................................................... 150
4- General situation: Diversification with n Risky Assets ........................................................................ 151
Portfolio constructed with 3 stocks ................................................................................................................ 151
Efficient frontier of risky assets ...................................................................................................................... 152
Mean-Variance criterion ................................................................................................................................ 153
Efficient Frontier of risky assets with optimal CAL ......................................................................................... 154
Seperation Property ....................................................................................................................................... 155
Portfolio Construction in Practice ............................................................................................................... 156
Input parameters............................................................................................................................................ 157
J.L. INVESTMENT ANALYSIS AND PORTFOLIO MANAGEMENT | B
,Portfolio Construction with n Risky Assets ................................................................................................. 162
Efficient Frontier with 1000 Risky Assets ....................................................................................................... 162
Empirical Evidence.......................................................................................................................................... 163
Solution: Index Models............................................................................................................................... 164
Single -index Model ........................................................................................................................................ 164
Summary ........................................................................................................................................................ 167
Estimation of Single-Index model ................................................................................................................... 167
Graphical Representation of Single-Index Model ........................................................................................... 168
Single Index Model and Diversification ....................................................................................................... 170
Diversification for n assets ............................................................................................................................. 171
International Diversification ........................................................................................................................... 171
Nonsystematic Risk over the years................................................................................................................. 172
Asset Allocation versus Security Selection .................................................................................................. 173
Asset Allocation .............................................................................................................................................. 173
Some major asset classes ............................................................................................................................... 174
Example: Effficient Frontiers .......................................................................................................................... 175
Some Closing Remarks ............................................................................................................................... 176
5. CAPM AND MULTIFACTOR MODELS ................................................................................. 177
Review topic 4 ............................................................................................................................................ 177
Capital Asset Pricing Model ........................................................................................................................ 178
CAPM: Assumptions: ...................................................................................................................................... 179
CAPM: Implications ........................................................................................................................................ 179
Security Market Line....................................................................................................................................... 185
CAPM and Single-Index Model (SIM).............................................................................................................. 189
CAPM and the Real World .............................................................................................................................. 194
Multifactor Model ...................................................................................................................................... 196
Identifying the Factors.................................................................................................................................... 197
Fama and French 3 Factor Model ................................................................................................................... 198
Using multi-factor models .............................................................................................................................. 200
6. MARKET EFFICIENCY AND BEHAVIORAL FINANCE ............................................................ 203
Market Efficiency ....................................................................................................................................... 203
Active versus passive management................................................................................................................ 203
Why does it matter? ....................................................................................................................................... 205
Why Should Capital Markets Be Efficient? ..................................................................................................... 207
Alternative Efficient Market Hypotheses ....................................................................................................... 208
Implications of Market Efficiency ................................................................................................................... 210
Role of Portfolio Management in Efficient Markets ....................................................................................... 214
Are Markets Efficient? .................................................................................................................................... 217
J.L. INVESTMENT ANALYSIS AND PORTFOLIO MANAGEMENT | C
,Behavioural Finance ................................................................................................................................... 225
7. EQUITY VALUATION........................................................................................................... 227
Expected Return versus Required Return ................................................................................................... 231
Valuation models: Intrinsic Value versus Market Price ............................................................................... 232
Present Value Approach to valuation ............................................................................................................. 232
Intrinsic value or fair price .............................................................................................................................. 234
Dividend Discount Models.......................................................................................................................... 235
Constant Growth DDM ................................................................................................................................... 236
Stock Prices and Investment Opportunities ................................................................................................... 238
Other Discounted Cash Flow Approaches ...................................................................................................... 241
Price-Earnings Ratio ................................................................................................................................... 242
Understanding Price-Earnings Ratio ............................................................................................................... 243
Price/Earnings Ratio and Growth Opportunities ............................................................................................ 244
Price-Earnings Ratios for Different Industries ................................................................................................ 249
P/E Ratios and Stock Risk................................................................................................................................ 249
Pitfalls in P/E Analysis ..................................................................................................................................... 250
Price/Earnings and Expected Returns ............................................................................................................ 252
Other multiples............................................................................................................................................... 253
Which approach is best?............................................................................................................................. 253
Equity Valuation: Input data........................................................................................................................... 254
The Aggregate Stock Market NK ............................................................................................................. 254
Example .......................................................................................................................................................... 255
8. BOND VALUATION AND BOND PORTFOLIO MANAGEMENT ............................................ 257
Review of lectures ...................................................................................................................................... 257
Types of Bonds ........................................................................................................................................... 257
1- Government Bonds ................................................................................................................................ 258
2- Corporate bonds .................................................................................................................................... 259
3- Inflation-Indexed Bonds......................................................................................................................... 260
Bond Pricing ............................................................................................................................................... 261
Example .......................................................................................................................................................... 262
Market Interest Rate r .................................................................................................................................... 262
Inverse Relation between Bond Prices and Yield ........................................................................................... 264
Why do bond prices change? ......................................................................................................................... 264
Default Risk or Credit Risk .............................................................................................................................. 265
Zero-Coupon Bonds ........................................................................................................................................ 267
Bond Yields ................................................................................................................................................ 268
Yield to Maturity............................................................................................................................................. 268
Yield Curve ...................................................................................................................................................... 270
J.L. INVESTMENT ANALYSIS AND PORTFOLIO MANAGEMENT | D
, Theories of the Term Structure ...................................................................................................................... 271
Investing in Bonds: Holding-Period Returns ................................................................................................ 275
Managing Bond Portfolios .......................................................................................................................... 275
Interest Rate Risk and Duration...................................................................................................................... 276
Passive Bond Management (Immunization)................................................................................................... 280
Convexity ........................................................................................................................................................ 284
Active Bond Management .............................................................................................................................. 286
References ................................................................................................................................................. 287
9. (INVESTING USING DERIVATIVES) ..................................................................................... 289
10. PORTFOLIO PERFORMANCE EVALUATION .................................................................... 289
Investment Performance Evaluation .......................................................................................................... 289
Simple Method: Comparison Universe ....................................................................................................... 290
How to account for risk? ............................................................................................................................. 290
Different measures: ................................................................................................................................... 291
Sharpe Ratio ................................................................................................................................................... 291
Treynor Measure ............................................................................................................................................ 292
Jensen’s Alpha ................................................................................................................................................ 294
M2 Measure ................................................................................................................................................... 295
Information Ratio ........................................................................................................................................... 295
Portfolio Construction versus Evaluation .................................................................................................... 296
Which measure is appropriate? .................................................................................................................. 297
Alpha Capture and Transport → NOT NEEDED TO KNOW ........................................................................... 298
Style Analysis → NOT NEEDED TO KNOW ................................................................................................... 298
Performance Attribution: performance evaluation with a Multi-Index model → NOT NEEDED TO KNOW .. 298
Market Timing → NOT NEEDED TO KNOW .................................................................................................. 298
Example → NOT NEEDED TO KNOW .............................................................................................................. 299
References ................................................................................................................................................. 299
11. APPLIED PORTFOLIO MANAGEMENT/GUEST LECTURE: SUSTAINABLE INVESTMENTS301
[slide 3]: 4 big division ................................................................................................................................ 301
1. Intro: Plenty of sustainability challenges ahead.................................................................................. 301
Climate change ............................................................................................................................................... 301
J.L. INVESTMENT ANALYSIS AND PORTFOLIO MANAGEMENT | E
, Environmental pollutions ............................................................................................................................... 301
Labour rights/Product Governance ................................................................................................................ 301
Biodiversity Losses/Ethics............................................................................................................................... 301
Aging population/nutrion ............................................................................................................................... 302
Governance and Data privacy ........................................................................................................................ 302
The inevitable policy responses...................................................................................................................... 302
2. 50 shades of sustainability ................................................................................................................. 302
Return and Impact .......................................................................................................................................... 302
ESG ................................................................................................................................................................. 302
Sustainable Investments: European Definition .............................................................................................. 302
3. …? ...................................................................................................................................................... 303
Market size: a growing trend? ........................................................................................................................ 303
4. Sustainable investments: how we do it in practice? ........................................................................... 303
Sustainable and Responsible investments SRI................................................................................................ 303
J.L. INVESTMENT ANALYSIS AND PORTFOLIO MANAGEMENT | F
,Investment Analysis and Portfolio Management: introduction
Ufora: https://ufora.ugent.be/
Connect: https://connect.mheducation.com/class/k-inghelbrecht-lectures-2019-2020
à gebruiken om te oefenen voor het examen
Exam
- MC questions (20, might also be exercises, scientific calculator)
- Open questions: also related to current events à e.g. impact brexit on the stock market (2
True/false)
- Geen formularium
Assignment (group)
- Data about assets classes à analyze and construct a portfolio
- è optimal combination with the different classes + analyse it
Goals
- Know how to invest directly and indirectly
• Directly: go to stock market yourself, and buy stocks
• Indirectly: buying stocks by pension funds, mutual funds = buying a portfolio à a
company that does the work for you
- Never forget that lunches are (hardly) never free!
• Risk-Return Trade-Off
§ Risk: risk of losing money
§ Return: the gain of the stock
- Understand pricing principles on financial markets
• How can we determine price and (expected) return and risk of a financial asset?
When going to the market, you know the price of the stock on the market. But you don’t
know if that is the correct price à present value models à allows to calculate the fair
value of the stock
Then you can compare it with the actual price on the market
If fair value > price market à better to buy because it is good value.
How get to the fair value of a bond? How integrate it in the strategy?
Return = Rt à if you invest today, you will need information about the return you expect
in the future, so you have to make an expectation about what the return will be at t+1
- Understand how to construct portfolios
• How should we allocate our funds? Diversify!
A portfolio consists of different assets: stocks, government bonds, …
à optimal ways to do it
Optimal = maximize your return & reduce the risk of losing money
à diversification (= spreading assets over different markets) is important
- Be able to evaluate investments (strategies)
• How do we know we did a good investment?
After the investment you need to evaluate if you did a good investment or not!
INVESTMENT ANALYSIS AND PORTFOLIO MANAGEMENT | 1
,PTER 1 UNDERSTANDING INVESTMENTS
Why study investment?
ple 1-1 Most
-
individuals
Consider
Need
themake
sound
investment
amount
framework for
decisions sometime
of retirement
managing
tributing $5,000 annually to a tax sheltered
wealth that can be accumulated by one individual con-
and increasingaccount
wealth if returns are compounded annually.
- Retirement
Over many yearsdecisions: importance
of investing, of differences
the making good decisions
in results that investors realize, owing solely to
the investment returns earned, can be staggering. Note that in the case of a $5,000 annual
Why study investments?
Essential part of a career in the field:
contribution for 40 years, the payoff at a compound earnings rate of 15 percent is almost
- Security analyst and portfolio manager
$9,000,000, whereas at an earnings rate of 10 percent the payoff is $2.21 million, a great
- Stockbrokers and financial advisors/planners
retirement
- Chartered fund but signifi
Financial Analystcantly less than almost $9 million. Similarly, if a 10 percent rate of
• Most individuals
return make
can be obtained investment
instead of a 5 percentdecisions sometime
rate of return, over a period of 40 years the dif-
‣ Compounding
ferencesound
Need approaches a fourfold
= whenframework
you receive multiple.
for
a return, managing Clearly,
you will get ongood
thatand your investment
increasing
initial decisions
wealth
investment, leading to higher
but also on
thereturns canalready
return you makeearnt
a tremendous
earlier difference in the wealth that you can accumulate.
‣ àRetirement
gets stronger the decisions:
longer you investimportance of making good decisions
Final Dollar Wealth if Funds Are
Compounded at
Amount Invested per Year Number of Years 5% 10% 15%
$5000 20 165,330 286,375 512,218
$5000 30 x 3.65 332,194 822,470 2,173,726
$5000 40 603,999 2,212,963 8,895,452
Source: Jones, 2010, Investments: Principles and Concepts, p.6
x 14.73
• Essential part of a career in the field
Building
10% Wealth
10% over Your Lifetime Beyond the retirement issue, the study of invest-
‣ Security analyst and portfolio
ments is more important than evermanager
in the twenty-first Century. After being net sellers of
‣ stocks for manyand
Stockbrokers
100 110
years,
121
individual
financial investors swarmed
advisors/planners r into the financial markets, either by
force (becoming part of a self-directed retirement plan) or by choice (seeking higher returns
‣ Chartered Financial
than those available fromAnalyst
financial institutions). In the late 1990s individuals increased their
+10 +10+1
direct ownership of stocks, reversing the earlier trend. Approximately 51 million households
in the United States (88 million individual investors) own mutual funds. 10
5000 250
Individual investor interest in the stock market is best expressed by the power
à
x20of mutual fundsx20 (20 years)
(explained in Chapter 3), a favorite investment vehicle of small investors.
= 100 000 = 5 000 = 105 000
Mutual funds are now the driving force in the marketplace. With so much individual t inves-
20 40
tor money flowing into mutual funds, and with individual investors owning a large percent-
age of all stocks outstanding, the study of investments is as important as ever, or more so.
In the final analysis, we study investments in the hope of earning better returns
in relation to the risk we assume when we invest. A careful study of investment analysis
and portfolio management principles can provide a sound framework for both managing and
increasing wealth. Furthermore, a sound study of this subject matter will allow you to obtain
maximum value from the many articles on investing that appear daily in newspapers and
magazines, which in turn will increase your chances of reaching your financial goals. Popular
press articles cover many important topics, such as the following examples:
1. Financial assets available to investors
J.L. 2. Whether a mutual fund investor should
INVESTMENT useAND
ANALYSIS a fiPORTFOLIO
nancial advisor
MANAGEMENT | 2
3. Compounding effects and terminal wealth
4. Realized returns vs. expected returns
