Importance of Equity Managers
Good equity managers have a very clearly defined way of constructing and managing their portfolios.
Sector Rotators “time” the market by assessing economic and financial market trends and selecting stocks in countries, industries and sectors that their analysis demonstrates are attractive markets. Quantitative Managers use computers and mathematical techniques to “screen” stocks according to their preferred parameters. Technical Managers observe the historical patterns of stock price movements and select stocks exclusively on this basis. Meanwhile, Stock Pickers (such as Value Managers, Growth Managers, and Closet Indexers) concentrate almost exclusively on individual “stock selection” using classical financial analysis.
Types of Equity Managers
Sector Rotators
Sector rotators believe in large part that the stock market reflects economic and political trends. They use “macro” or “big picture” analysis to establish an economic and political outlook for the markets. For example, they would focus on financial sector stocks coming out of a recession, hoping that monetary policy loosening and falling inflation would lead to lower interest rates that would in turn benefit financial stocks. Later in the cycle they would focus on cyclical and commodity stocks, expecting that increasing economic activity would lead to higher prices for commodity stocks. They trade actively, moving into “out-of-favour” industries and sectors. They might own all the stocks in an industry, expecting them all to do well with an increase in their commodity price.
Quantitative Managers
Quantitative managers make use of computers and mathematical techniques to sift through financial statistics to select stocks. They observe historical quantitative relationships and incorporate these relationships into “models” which help them choose their stocks. Using a computer program to sift through historical data on companies is called “screening.” A quantitative manager might prepare a program to screen two thousand stocks according to a particular set of characteristics or parameters. For example, she might establish that, historically, stocks with low price-to-earnings ratios and high growth rates of earnings over two years outperformed the market for the next year. This historical observation of performance is called “back testing” of a model. Based on the strength or “robustness” of this relationship, she then would select stocks that currently met these “criteria” or tests.
Technical Managers
Technical managers select stocks according to observed patterns of price behaviour. They believe that price is the only important variable to be analyzed and that the historical price pattern alone predicts the future direction of the stock price. Before computers, these managers plotted graphs of stock prices and analyzed the patterns of these charts according to their established rules. For example, a “head and shoulders” formation indicated that a price had peaked, dropped and then peaked again prior to falling off. This had historically shown that price was peaking and the market or stock would plunge in price or level. Other measures show market breadth, strength, trend and even conviction. Due to their use of charts, these analysts were known as “chartists” in days gone by. Now, computers have increased the ease and power of this form of analysis and management. Most investment dealers employ a technical analyst to provide market and stock commentary for their clients.
Value Managers
Value managers try to find companies trading at less than their “intrinsic value,” the price the underlying company is worth. In other words, they try to buy the stock as cheaply as possible. In doing so, they hope to outperform in the long term, as their undervalued stocks return to higher valuation levels. They also believe that when they make mistakes, they have a more limited downside, since they paid a cheap price for the stock to start with.
Value managers use financial analysis to calculate yardsticks of a stock’s worth. A classic value manager would focus on: a low “P/E ratio” or price-to-earnings ratio (market price divided by earnings) which indicates that the stock is cheaply valued compared to earnings; a low “price-to-book” ratio (market price divided by accounting book value) which indicates that the stock is cheap compared to its historical accounting value; and a high dividend yield (dividend divided by market price) which shows that the stock pays a high cash yield on its price.
Growth Managers
Growth managers invest in stocks from companies with rapidly growing sales and earnings. They believe that the stock prices of these types of companies will increase quickly as well, reflecting their strong growth potential. They do not focus on the valuation of these companies, preferring to examine their industries, management and growth potential. In aggregate, they think that the strong growth of these stocks will outweigh their valuations over a longer period of time. Obviously, growth managers focus on industries with strong growth, such as technology companies.
Closet Indexers
Core managers or “closet indexers” focus on security selection, but try to maintain the same weightings as the index that they are compared to. They use the same valuation techniques as value and growth managers, but they don’t want to make their portfolios appreciably different from either the index or other managers.
There are a couple of reasons for this, the most important of which is relative performance. Relative performance examines how a manager looks in comparison to a particular market index. Managers generally try to beat the index they are being compared to. If the manager’s portfolio is differ considerably when compared to the index, the manager will perform quite differently. If the manager’s performance is good, then there is little problem. When the manager under-performs, the clients are rarely very happy. Therefore, managers try to keep their portfolios similar to the index or to other managers, expecting to be not too different from the expected norms and trends.
The other reason is that clients, sales representatives and consultants want their manager’s performance to be similar to the index or other to managers. Client often don’t want the best performance, but instead look for “conservative” management, meaning performance fairly similar to published performance statistics. Financial sales representatives want their clients to be happy, and explaining wide performance differentials between client performance and published market and performance statistics takes a lot of time. Consultants want the manager’s performance to be similar to the index they are being measured against because they have done “asset planning” studies which are based on the performance of that index.
Frequency of Closet Indexers
This means that there is a large group, perhaps the majority of managers, who try to construct portfolios that will perform similarly to both indexes and other managers. These core or “closet index” managers will pick the best stocks from an industry grouping. For example, if there are twenty-five stocks in an industry group that is 20% of the market index, the manager might select the best four at a 5% weight. Since most stocks in an industry tend to track each other in performance, the manager will have much the same performance in this portion of her portfolio as the index. By implementing this strategy for the significant industry groups in an index, the manager will obtain very similar performance to that of the index. Hopefully, by using financial analysis and valuation techniques to choose the best stocks from the index groups, the manager will outperform the index by a reasonable margin.
