EQUITYPORTFOLIO MANAGEMENT

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Chapter 17

• EQUITY-PORTFOLIO MANAGEMENT

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Chapter 17 Questions

• What are the two generic equity portfolio
  management styles?
  
• What are three techniques for constructing a
  passive index portfolio?
  
• What three generic strategies can active
  equity-portfolio managers use?
  
• How does the goal of a passive equity-portfolio
  manager differ from the goal of an active manager?

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Chapter 17 Questions

• What investment styles may portfolio managers
  follow?
  
• In what ways can investors use information about
  a portfolio managers style?
  
• What skills should a good value portfolio manager
  possess? A good growth portfolio manager?

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Chapter 17 Questions

• How can futures and options be useful in managing
  an equity portfolio?
  
• What strategies can be used to manage a taxable
  investors portfolio in a tax-efficient way?
  
• What are four asset allocation strategies?

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Generic Portfolio Management Strategies

• Passive equity portfolio management
• Long-term buy-and-hold strategy
• Usually track an index over time
• Designed to match market performance
• Manager is judged on how well they track the
  target index
  
• Active equity portfolio management
• Attempts to outperform a passive benchmark
  portfolio on a risk-adjusted basis

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Passive Equity Portfolio Management Strategies

• Attempt to replicate the performance of an index
• May slightly underperform the target index due to
  fees and commissions
  
• Strong rationale for this approach
• Costs of active management (1 to 2 percent) are
  hard to overcome in risk-adjusted performance
  
• Many different market indexes are used for
  tracking portfolios

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Passive Equity Portfolio Management Strategies

• Not a simple process to track a market index
  closely
  
• Three basic techniques
• Full replication
• Sampling
• Quadratic optimization or programming

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Passive Equity Portfolio Management Strategies

• Full Replication
• All securities in the index are purchased in
  proportion to weights in the index
  
• This helps ensure close tracking
• Increases transaction costs, particularly with
  dividend reinvestment

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Passive Equity Portfolio Management Strategies

• Sampling
• Buys representative sample of stocks in the
  benchmark index according to their weights in the
  index
  
• Fewer stocks means lower commissions
• Reinvestment of dividends is less difficult
• Will not track the index as closely, so there
  will be some tracking error
  
• Tracking error will diminish as the number of
  stocks grows, but costs will grow (tradeoff)

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Passive Equity Portfolio Management Strategies

• Quadratic Optimization
• Historical information on price changes and
  correlations between securities are input into a
  computer program that determines the composition
  of a portfolio that will minimize tracking error
  with the benchmark
• This relies on historical correlations, which may
  change over time, leading to failure to track the
  index

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Passive Equity Portfolio Management Strategies

• Completeness Funds
• Passive portfolio customized to complement active
  portfolios which do not cover the entire market
  
• Performance compared to a specialized benchmark
  that incorporates the characteristics of stocks
  not covered by the active managers

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Passive Equity Portfolio Management Strategies

• Dollar-cost averaging
• Purchasing fixed dollar investments per period
  over time
  
• Prevents buying too many shares at high prices
  and too few shares when prices are low
  
• Often part of a passively managed portfolio
  strategy

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Active Equity Portfolio Management Strategies

• Goal is to earn a portfolio return that exceeds
  the return of a passive benchmark portfolio, net
  of transaction costs, on a risk-adjusted basis
  
• Need to select an appropriate benchmark
• Practical difficulties of active manager
• Transactions costs must be offset by superior
  performance vis-à-vis the benchmark
  
• Higher risk-taking can also increase needed
  performance to beat the benchmark

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Active Equity Portfolio Management Strategies

• Three Strategies
• Market timing - shifting funds into and out of
  stocks, bonds, and T-bills depending on broad
  market forecasts and estimated risk premiums
  
• Shifting funds among different equity sectors and
  industries or among investment styles to catch
  hot concepts before the market does
  
• Stockpicking - individual issues, attempt to buy
  low and sell high

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Active Equity Portfolio Management Strategies

• Global Investing Three Strategies
• Identify countries with markets undervalued or
  overvalued and weight the portfolio accordingly
  
• Manage the global portfolio from an industry
  perspective rather than from a country
  perspective
  
• Focus on global economic trends, industry
  competitive forces, and company strengths and
  strategies

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Active Equity Portfolio Management Strategies

• Sector Rotation
• Position a portfolio to take advantage of the
  markets next move
  
• Screening can be based on various stock
  characteristics
  
• Value
• Growth
• P/E
• Capitalization
• Key is to determine what to rotate into

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Active Equity Portfolio Management Strategies

• Style Investing
• Construct a portfolio to capture one or more of
  the characteristics of equity securities
  
• Small-cap stocks, low-P/E stocks, etc
• Value stocks (those that appear to be
  under-priced according to various measures)
  
• Low Price/Book value or Price/Earnings ratios
• Growth stocks (above-average earnings per share
  increases)
  
• High P/E, possibly a price momentum strategy

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Active Equity Portfolio Management Strategies

• Does Style Matter?
• Choice to align with investment style
  communicates information to clients
  
• Determining style is useful in measuring
  performance relative to a benchmark
  
• Style identification allows an investor to fully
  diversify a portfolio
  
• Style investing allows control of the total
  portfolio to be shared between the investment
  managers and a sponsor

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Active Equity Portfolio Management Strategies

• Value versus Growth
• Growth investing focuses on earnings and changes
  in company fundamentals
  
• Value investing focuses on the pricing of stocks
• Over time value stocks have offered somewhat
  higher returns than growth stocks

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Active Equity Portfolio Management Strategies

• Expectational Analysis and Value/Growth
  Investing
  
• Analysts recommending stocks to a portfolio
  manager need to identify and monitor key
  assumptions and variables
  
• Value investors focus on one key set of
  assumptions and variables while growth investors
  focus on another
  
• Such an analysis can help determine timing
  strategy for buying/selling

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Derivatives in Equity-Portfolio Management

• The risk of equity portfolios can be modified by
  using futures and options derivatives
  
• Selling futures reduces the risk of the
  investors net (portfolio with futures) position
  to changes in portfolio values
  
• Also offsets positive portfolio value changes
• The choice element of options means that they do
  not have exact offsetting effects
  
• Positive portfolio price effects remain largely
  intact, but the cost of insuring against negative
  moves increases by the option premium

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Derivatives in Equity-Portfolio Management

• Derivatives can be used to offset expected
  adverse changes in an equity portfolio
  
• Any bad portfolio movements are mirrored by gains
  in derivative investments

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Derivatives in Equity-Portfolio Management

• The Use of Futures in Asset Allocation
• Allows changing the portfolio allocation quickly
  to adjust to forecasts at lower transaction costs
  than standard trading
  
• Futures can help maintain an overall balance
  (desired asset allocation) in a portfolio
  
• Futures can be used to gain exposure to
  international markets
  
• Currency exposure can be managed using currency
  futures and options

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Derivatives in Equity-Portfolio Management

• Futures and options can help control cash inflows
  and outflows from the portfolio
  
• Inflows purchase index futures or options when
  inflows arrive before individual security
  investments can be made efficiently
  
• Outflow sell previously purchased futures
  contracts rather than individual securities to
  meet a large expected cash outflow less
  disruptive to portfolio management

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Derivatives in Equity-Portfolio Management

• The S P 500 Index Futures Contract
• Purchasers fund a margin account
• Initial margin requirements are 6,000 for
  speculative buyers and 2,500 for hedging
  
• The value is 250 times the index level
• When the contract expires, delivery is made in
  cash, not stocks
  
• Margin account is marked to market daily
• Maintenance margins 2,500 and 1,500

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Derivatives in Equity-Portfolio Management

• Determining How Many Contracts to Trade to Hedge
  a Deposit or Withdrawal
  
• In order to appropriate hedge a portfolio deposit
  or withdrawal, the appropriate number of
  contracts must be sold
  
• The appropriate number depends on the value of
  the cash flow, the value of one futures contract,
  and the portfolio beta (the Index has a beta of
  1)
• Number of Contracts (Cash Flow/Contract Value)
  x Portfolio Beta
  
• Can also adjust the beta

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Derivatives in Equity-Portfolio Management

• Using Futures in Passive Equity Portfolio
  Management
  
• Help manage cash inflows and outflows while still
  tracking the target index
  
• Options can be sold to reduce weightings in
  sectors or individual stocks during rebalancing

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Derivatives in Equity-Portfolio Management

• Using Futures in Active Equity Portfolio
  Management
  
• Modifying systematic risk
• Investing in various proportion of the futures
  index (where beta equals one and the underlying
  portfolio)
  
• Modifying unsystematic risk
• Using options, the portfolio manager can increase
  exposure to desired industries, sectors, and even
  individual companies

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Derivatives in Equity-Portfolio Management

• Modifying the Characteristics of an International
  Equity Portfolio
  
• International equity positions involve positions
  in both securities and currencies
  
• Futures allow modifying each exposure separately
• Can buy or sell currency contracts to change
  exposures to fluctuating exchange rate to
  either
  
• Take advantage of expected future exchange rate
  changes
  
• Hedge currency risks and largely remove this
  exposure

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Taxable Portfolios

• Outside of tax-exempt accounts such as IRAs,
  401(k)s and 403(b)s, taxes represent a large
  expense to manage.
  
• Some implications of taxes
• Portfolio rebalancing to remain on the efficient
  frontier triggers capital gains, which may
  offset the benefit of the optimized rebalancing
  itself
• Rebalancing for asset allocation purposes
  likewise results in tax effects

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Taxable Portfolios

• Active portfolio managers especially need to
  consider taxes when deciding whether to sell or
  hold a stock whose value has increased
  
• If a security is sold at a profit, capital gains
  are paid and less in left in the portfolio to
  reinvest
  
• A new security (the reinvestment security) needs
  to have a superior return sufficient to make up
  for these taxes
  
• The size of the necessary return depends on the
  expected holding period and the cost basis (and
  amount of the capital gain) of the original
  security

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Taxable Portfolios

• Tax-Efficient Investing Strategies
• Will likely become more important to fund
  managers, as SEC regulations now require mutual
  funds to disclose after-tax returns
  
• Possible tax-efficient strategies
• Employ a buy-and-hold strategy since unrealized
  capital gains are not taxed
  
• Loss harvesting, using tax losses to offset
  capital gains on other investments

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Taxable Portfolios

• Possible tax-efficient strategies
• Use options to help convert short-term capital
  gains into a long-term gain (with more favorable
  tax treatment)
  
• Tax-lot accounting for shares, specifying those
  with the highest cost basis for sale
  
• For some investors, simply focus on growth stocks
  that will provide long-term gains rather than
  income from dividends

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Taxable Portfolios

• Diversifying a Concentrated Portfolio
• Context An investor has an undiversified
  portfolio with one or several securities that
  have experienced large price increases
  
• Want to diversify, but the sale of the asset(s)
  will generate large capital gain taxes what
  should be done?

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Taxable Portfolios

• Diversifying a Concentrated Portfolio
• Concentrated Portfolio Strategies
• Borrow and invest the proceeds in a diversified
  portfolio
  
• Instead of diversifying the portfolio, reduce its
  company-specific risk exposure through a collar
  strategy a combination of option purchases
  
• Variable Prepaid Forwards (VPFs), where the
  investor receives proceeds in advance of
  contractual sales of shares in the future
  
• Completion funds, where shares are sold and the
  portfolio is diversified through a completion
  fund
  
• Charitable strategies, contribution and limited
  tax for the charity

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Asset Allocation Strategies

• Many portfolios containing equities also contain
  other asset categories, so the management factors
  are not limited to equities
  
• Four asset allocation strategies
• Integrated asset allocation
• Examine capital market conditions and investor
  objectives and constraints
  
• Determine the allocation that best serves the
  investors needs while incorporating the capital
  market forecast

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Asset Allocation Strategies

• Strategic asset allocation
• Using historical information, generate optimal
  portfolio mixes based on returns, risk, and
  covariances, adjusting periodically to restore
  target allocation
• Tactical asset allocation
• Often a contrarian asset allocation strategy
  dependent on expectations
  
• Insured asset allocation
• Adjust risk exposure for changing portfolio
  values more value means more ability to absorb
  losses

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Asset Allocation Strategies

• Selecting an allocation method depends on
• Perceptions of variability in the clients
  objectives and constraints
  
• Perceived relationship between the past and
  future capital market conditions