Question

(a) Explain how representatives may lead to biases in stock valuation.

(b) Discuss three strategies active managers can use to add value to their portfolios.  

(c) Define bond portfolio indexing strategy and explain its purpose.  

(d) Describe the interest rate anticipation in the active bond portfolio management strategies.

Answer 1

(a) Explain how representatives may lead to biases in stock valuation.

Ans. Common Biases in Investing

Psychologists have identified a number of types of bias that are relevant to investors:

• Representative bias leads to a snap judgment on a question based on its apparent similarity to an earlier matter.
• Cognitive dissonance leads to an avoidance of uncomfortable facts that contradict one's convictions.
• Home country bias and familiarity bias lead to an avoidance of anything outside one's comfort zone.
• Mood bias, optimism (or pessimism) bias, and overconfidence bias all add a note of irrationality and emotion to the decision-making process.
• The endowment effect causes people to over-value the things they own just because they own them.
• Status quo bias is resistance to change.
• Reference point bias and anchoring bias are tendencies to value a thing in comparison to another thing rather than independently.
• The law of small numbers is the reliance on a too-small sample size to make a decision.
• Mental accounting is an irrational attitude towards spending and valuing money.
• The disposition effect is the tendency to sell investments that are doing well and hang onto losers.
• Attachment bias is a blurring of judgment when one's own interests or a related person's interests are involved.
• Changing risk preference is the gambler's disease. A small risk, no matter what the outcome, creates a willingness to take on greater and greater risks.
• Media bias and Internet information bias represent uncritical acceptance of widely-reported opinions and assumptions.

(b) Discuss three strategies active managers can use to add value to their portfolios.

Ans. Sector Rotation: A strategy that a fund manager shifting investment assets from onesector of the economy to another. Sector rotation involves the sale of securities relatedto a particular investment sector and using the funds garnered from that sale topurchase securities in another sector. This strategy is most often used as a method ofdiversifying holdings over a specified holding period.Since not all sectors of the economy perform well at the same time, managers aim togain exposure to multiple sectors through sector rotation. Additionally, a portfoliomanager may attempt to profit through timing a particular economic cycle andengaging a new sector on the rising phase while exiting a sector as it begins to fall.

1. Top down or bottom up approach.
2. Technical strategies: technical analysis of stocks (historical prices).
3. Anomalies and attributes: the idea is to take advantage of some characteristics of companies.

(c) Define bond portfolio indexing strategy and explain its purpose.

Ans. Bond portfolio management strategies can help investors get the most of their portfolio, by actively managing fixed income investments to ensure maximum returns. These strategies include interest rate anticipation, sector rotation and security selection.

Bond portfolio management strategies are based on managing fixed income investments in pursuit of a particular objective – usually maximizing return on investment by minimizing risk and managing interest rates. The management of the portfolio can be done by professional investment managers or by investors themselves.

(d) Describe the interest rate anticipation in the active bond portfolio management strategies.

Here’s a look at the key strategies:

Interest Rate Anticipation

Bond portfolio management strategies that involve forecasting interest rates and altering a bond portfolio to take advantage of those forecasts are called “interest rate anticipation” strategies. Interest rates are the most important factor in the pricing of bonds.

The price of a bond is based on its interest rate, or yield, at any particular time. The most important influence on a bond’s yield is the term structure of interest rates. Generally, the market interest rate for any particular term of bond is represented by the yields on government bonds, as these are viewed as highly liquid and of very low default risk.

Basic interest rate anticipation strategy involves moving between long-term government bonds and very short-term treasury bills, based on a forecast of interest rates over a certain time horizon.

Since long-term bonds change the most in value for a given change in interest rates, a manager would want to hold long-term bonds when rates are falling. This would provide the maximum increase in price for a portfolio. The reverse is true in a rising interest rate environment. Long-term bonds fall the most in price for a given rise in interest rates and a manager would want to hold treasury bills. Treasury bills have a very short duration and do not change very much in value.

Yield curve strategies are more sophisticated interest rate anticipation strategies that take into account the differences in interest rates for different terms of bonds, called the “term structure” of interest rates. A chart of the interest rates for bonds of different terms is called the “yield curve.” A yield curve strategy would position a bond portfolio to profit the most from an expected change in the yield curve, based on an economic or market forecast.

Sector Rotation in Bonds

Bond portfolio management strategies based on sector rotation involve varying the weight of different types of bonds held within a portfolio. An investment manager will form an opinion on the valuation of a specific sector of the bond market, based on fundamental credit factors, technical factors (such as supply and demand), and relative valuations compared to historical norms within that sector. A manager will usually compare her portfolio to the weightings of the benchmark index that she is being compared to on a performance basis.

Security Selection for Bonds

Security selection for bond management involves fundamental and credit analysis and quantitative valuation techniques at the individual security level. Fundamental analysis of a bond considers the nature of the security and the potential cash flows attached to it. Credit analysis evaluates the likelihood that the payments will continue to be made over the bond’s term. Modern quantitative techniques use statistical analysis and advanced mathematical techniques to attach values to the cash flows and assess the probabilities inherent in their nature.