Equity PortfolioManagementStrategies
PAssrvE vERsus AcrrvE MANAcEMENT 653
individual companies. Similarly, irrlfel asset allocation is an altempt to limit investrnent lossesby shifting funds between an existing equity ponfolio and a risk-free security depending onchanging mark€t conditions.
Finally. €quity portfolio retum profiles can be modified by the use of futures and options.lt ispossible to lrade futures contracts on major indexes, as well as acquire options on stock markelindexes, on selected industry groups. and on individual stocks. These derivative securities canassist the ponfolio manager in shifting a ponfolio's €xposure to systematic and unsystematic risk.
Equity po(folio nanagement styles fall into either a passiv€ or an active caregory. Unlike theimmunization of bond portfolios, no niddle ground exists between active and passive equitymanagement strategies. Some argue that "hybrid" active/passive equity portfolio managementstyles exist (e.g. enhanc€d ind€xing). bul such slyles really are variations of active managementphilosophies. Similar to traditional active managemenr, hybrid-style managers invesr to findund€rvalued seclors or securities. The following discussion reviews the raditional meaning ofthe terms parrl,? and a.ri? ponfolio management.
Passne equitr porrfolio nduas"nerrisr longlerm buy-and hold strategy. Usually, stocks arepurchased so the po(fol;o\ relums will track those of an index over time. Because ofthe goalof tracking an index. this approach to investing is generally refen€d to as ir../din8. Occasionalrebalancing is needed as dividends must be reinvesled and because stocks merge or drop out ofrhe target index and other stocks are added. Notably, the purpose ofan index€d porlfolio is norro 'b€af lhe target index but to malch ils perfomance. A manager of an equity index portfolioisjudged on how well he or she tracks the target index-that is, minimizes the deviation b€tweenponfolio and index retums similar to the bond index ponfolio manag€r.
Actn'e equi^ portlolio nardS?nenr is an auempt by the nanager to outperfbm, on a risk-adjusted basis, a passive benchmark ponfolio. A benchnark pdnld/io is a passive ponfoliowhose average characteristics (including such factors as beta, divid€nd yield, industry weight-ing, and firm size) match the risk-rerum objeclives ofthe clienr.
When deciding whelher to follow an active or a p.ss;ve strarcgy (or some combination ofthetwo). an investor must assess the tmde off between the low cost but l€ss-exciting alt€mative ofindexing versut the higheFcost but pot€ntially more lucrative ahemative ofactive management.Not surprisingly. Sorensen, Miller. and Samak have noted that the critical faclor in this evaluation is the stockpicking skill of the portfolio manager. Using pension fund performance datafrom the I 985- I 997 period, they showed that the oplimal allocalion 10 indexing declines as man-agerial skill increases. However, they also conclude thai some indexing is appropriate for fundsin most risk objective classes.l
Exhibit 17.I repons the amount of money invesled in the U.S- equity and fixed-income mar-kets using aclive and indexed strategies for two recent yea$. The data are compiled from a suFvey of the srategies employed by more than 2.500 professional money management firms onbehalfofthei clients. Three conclusions are notable. First, active management slralegies domi,nate indexed ponfolios in terms ofthe total amount of money conlrolled by the investment man,agement industry. Second. the indexed sector oflhe induslry is growing quite rapidly, a trend dri-ven in pan by lhe lower management fees ch$ged for passive ponfolios. Third, ahhough the
Eric H. Sorcnsen. Keith L Miller. and Vele Smat. Allo.aring heNan Active a.d Passive Mlnagehent. l.ina,.idlA,z^srr J.,n// 5.1. no..1(S. ember/Ocrob€r 1998): 18 31.
654 CIIAPTER 17 Eoulry PoRrFoLIo MANAGEMENT SrRArEarEs
AC'IIVE AND PASSIVE INVESTMENT IN THE U.S. EQUIfY AND FIXED.INCOME MARKETS
1995(BNoNt
$ 1.945.10275.22
t.67'�1.45
82.?3
t994
s1.338.01135.5.1
r.370.63t2.69
45.4l0 l . l22.1
r53.3
Source: Nelson lNennenl Ma.agenent NeNoa.
arnounl of money managed in active equity and lixed-income surtegies is roughly €omparable.equity indexing is far more popular than fixed-income indexing.
In the following sections, we examine more closely the mechanics of passiv€ and activeequity ponfolio management.
Passive equiry portfolio management attempts to design a po(folio to replicate th€ performanceof a sp€cific index. The key word here is r.'plr'car?. As discussed in ChapI€r 2, lhe ponfolio rnan_ager who eams higher retums by violating the €lienCs policy statement should be firedi a pas-sive manager who isnl really passive should likewise be dismiss€d. A passive managereans hisor her fee by constructing a portfolio that closely tracks the p€rformance of a specified equilyindex (refened to as the ,enchnm* indat) rhar n\eets the client's needs and obj€ctives. If themanager attempts to outperform the index selected, he or she violates the passive pfemise oftheportfolio.
In Chapter 6. we presen@d several reasons for investing in a passive equity ponfolio. Strong€vidence indicates that the stock market is fairly eflicient. For mosl active managers. the cosls ofactively managing a porlfolio (l to 2 percent of the portfolio's assets) are difiicult to overcome.As we saw earlier, the S&P 500 index typically outp€rforms mosl equity mutual funds on anannual basis. Note tha! although the S&P 500 is the most popular index to track. a client canchoose lrcm among aboul J0 d,fferenr rnderes.'
Chapter 5 contained a summary d€scription of nany differenl market indexes. Domestic U-S.equily indexes include the S&P 50O. Industrials. and 100: the Major Market index: the Nasdaqcomposite indexi and the Wilshire 5000. The WaU Strcet Jo rnal publishes the daily values ofindexes for the organized €xchanges. the OTC market, and various industry groups.Indexes exislfor small capitalization stocks (Russell 2000)l for valu€- or growth-orienled stocks (RussellGrowth index and the Russell Value index); and for numerous world regions (such as th€ EAFEindex); as well as for smaller regions. individual countries, and types of counlri€s (emergingmarkets). As passive investing has grown in popularity. money managers have created an indexfund for vinually every broad markel calegory.r
'Tne s@ins populdty of index lnnds n dncussd in JefrEy M. Lldemm, 'The SimFde ro l.der Fu.ds. Altxerrw?.1, I April 196.78 79.rse. ioi exanple, Roben Femholz. Roben Gdt, rnd Joh. Hannon, _Dive6n, weighted Inde\io9. J.lnltl oJ Pon.
lolioManasen?"t21.no.2(Wintr 19981:7+82: and Ajly Khormo, Edwad Nellins.andJefrEr J. Tt\tel Tte Eme.gence ofCountry lndex Fu.ds, JounnloJPorlolioManaqenenr24.no..l(Sunner1998):?88.1
lndex PortfolioConst.uction
Techniques
AN ovERvrEw oF P^ssrvE Eourry PoRrFoLro MANAaEMENT SrRArEarEs 655
The goal ofa passive portfolio is to match the retums to the index as closely as possiblei but,because ofcash inflows and outflows and company mergers and bankruptcies. securities must bebought and sold, which means that lher€ inevilably will be ditrerences between ponfolio andbenchmark retums over time. In addition, even though index funds generally attempt to mini'mize tumover and the resultant transactions fe€s, they necessarily have to do some rebalancing,which means that the long-run retum performan'Je of index funds will lag the benchmark index.Cenainly, subslantial or prolonged deviations of the ponfolio's retums from the index's retumswould b€ a cause for concem.
There ar€ three basic techniques for constructing a passive index ponfolio: full rcplication, sam-pling. and quadratic optimization or programming. The most obvious technique is lull replica-lion, wherein all the securities in the ind€x are purchased in propoftion to their weights in theindex- This technique helps ensure close tracking, but it may be suboptimal for two r€asons.First, the ne€d to buy many securities will increase transaction costs that will detract from per-formance. S€cond, the reinvestment of dividends will also result in high commissions whenmany firms pay small dividends at differenl times in the year.
The second lechnique, sampling addresses the pmblem ofnumerous slock issu€s. Statisticalrheory teaches us that we don't ne€d to ask everyone in the Uniled Slales for his or her opinionlo determine who may win an election. Thus. opinion pollsters qu€ry only a small sample of thepopulation to gauge public sentiment. Sampling techniques also crn be applied ro passive port-folio rnanagement. With sampling, a ponfolio manager would only need to buy a representativesample of slocks that comprise lhe b€nchmark index. Stocks with larger index weights are pur-chased according 10 their weight in th€ indexi smaller issues are purchased so their aggregatecharacteristics (e.9., beta, indusiry dislribution, and dividend yield) approximale the underlyingbenchmark. With fewer stocks to purchase, larger posiiions can be taken in the issues acquired,which should lead to proponionately lower commissions. Funher, the reinleslment ofdividendcash flows will be less problematic because fewer secunties need to be purchased to rebalancethe ponfolio. The disadvaniage of sampling is that ponfolio retums will almost certainly notrack the retums for the benchmark index as closely as with full replication.
Rather than obtaining a sample based on industry or security characteristics. quadratic opti.miralion or programming techniques can b€ used toconstruct a passive portfolio. With qua&aticprogramming, historical information on price changes and comelalions between s€curities areinput to a computer program that determines the composirion of a ponfolio that will minimizelracking enor with the benchmark. A problem with thh techniqu€ is thal il relles on historicalprice changes and correlations, and. if these factors change over rime, the ponfolio may experi'ence very large tracking errors.
Some passive portfolios are not based on a published index. Sometimes customized passiveponfolios, call€d completeness funds, are constructed to complement active ponfolios that donot cover the entire market. For example, a large pension fund may allocate some of its holdingsto active managers expected to outperform lhe market. Many limes, these active ponfolios areoverweighted in cenain market sectors or stock types.In this case, ihe p€nsion fund sponsor maywant the remaining funds to be invested passively to "fill th€ holes left vacant by the activemanagers. The p€rformance of the 'Jompleteness fund will be compared 1o a customized bench-mark that incorporates the characteristics of the stocks not covered by fie active managers.
For example, suppose a pension fund hires three activ€ managers to invest part of the fund\money. One manager emphasiz€s small-capitalization U.S. sto{ks. the second invests only inPacific Rim countri€s. and the third invests in U.S. stocks wiih low P/E ralios. To ensure adequatediversification. the pension fund may want to passively invest the rcmaining ass€rs in a complete'ness fund that will have a customized benchmark that includes large- and mid-capitalization U.S.stocks. U.S. stocks with normal to high P/E ratios. and intemational stocks outside the Pacific Rim.
656 CHAPTER 17 Eeulry PoRrFoLIo MANAaEMENT STRATEGIES
Tracking Erroa andlndex Pordolio
Conslruction
Still other passive ponfolios and benchmarks exist for investors with certain unique needs andpreferences.l Some investors may want their firnds to be invested only in stocks that pay divi-dends or in a company that prrduces a product or service that the inveslor deems socially respon'sible. Benchmarks can b€ produced that reflect these desired attributes, and passive pordolioscan be constructed to track the performance of the customized benchinark over time so investorsspecial needs can be satisfied.5
If the goal of forning a passive portfolio is to replicate the essence of a panicular equity index,the success of constructing such an investnent fund lies not in the absolute retums it Prcducesbur. ratber, in how closely its retums match those of the benchmark (e.g., the Standard & Poor's500 index). That is, the goal of the passive manager sbould be to minimize fte portfolio's r€tumvolatility relative to the b€nchmark. Said differendy, the manager should Fy to minimize tr.ck_ing error.
Tracking error can be defined as the exlent to which retum fluctuations in the managed pon-tolio arc not corrclated with retum fluctuations in the bencbmark. A flexible and straightforwardway of measuring tracking enor can be develop€d as follows. Recalling the notation {iom Chap'ter ?. let
w, = investment weichr of asset t in lhe nam8ed pordolioi, = fttum to rss€t t in p€riod ri' = r€tum to the benchmtrk portfolio iD period ,
With these definitions, we can define the Period t renrm b managed portfolio as
^ . = i n . R . .
N = numbe. oI assets in lhe mmged portrolio
With these definitions, we can then sp€cify the Period t rctum diferential betwee the maFaged ponfolio and the benchmark as
> l 7 l
Nolice that, given the retums to the ly' assets in the managed ponfolio and the b€nchmark, A is afunction of the idvestment w€ights that the manager selects and that not all of the assets in thebenchmark need be included in the managed podolio (i.e.. lt = 0 for some assets).
a, = >,,R" - ^, = n,, - R!
'Recrll onr disession in Chaprd 2 on inv.slos objdtivs ed consEain$: tqo of rhc coNdinls *eE legal dd egu_
latory r.qniEnents dd lnique n@ds od pEieEnces.5Se Shmin Mossavr-Rahndi, Custonized Benchmks in Sfructut€d Msag.heft, Jocml ol Ponfolio MaMq.
nflr 13. no. 4 (suntrr 1988): 65-68i and Chris P. Dialyn$, "Ihe Acdvc D.cisions i. the Stlection of Psiv. M8-
agemnt and Perfmce Bogeys:' iTh. Eon lbook oJ Fir.d lrcon Sc.lttiet 5$ ed , .d FEnk Fatbzi (Chicago. Ill :
Iflio kolessional Publhhing. 1997).
AN OvERvrEw oF PassrvE EQUTTY PoRrFoLlo MANAGEMENT STRATEGIES 657
For a sample of Z retum observations. the vananc€ of A can be calculated as followsl
>17.2S , r - i , :
Finally, the standard deviation of the retum differential is
o^ = JA = periodic tracking error
sa lh^t annualized tracking ?trol (?E) can b€ calculated as
( r - t )
> 175
where P is lhe number of retum periods in a year (e.9., P = 12 for monthly retums, P = 252 fordaily retums).
Suppose an inv€stor has formed a portfolio designed to track a panicular benchmark. Overthe last eight quaners, the reaums to this ponfolio, as well as the index retums and the retum dif-fercnce b€tween the two. werc:
I2
l
5
6'|
I
2.3%-3.6
tt .2t . 21 . 53.28.9
-o.8
2.1%
l0. l2 .2
0.42.48 . 1
0.6
4.4%1.0l � l
_ 1 . 0
t , t0.5
0.8- t .6
The periodic average and standad deviation of therelative to the trenchmark are
manager's rerum differential (i.e., 'delta')
,),
Avense d = I-0.4 + 1.0 +.. . +0.8-t .61+).6 =0.2% f
( { .4 - 0.2) ' + ( l 0 - 0.2): +. . . + (-1.6 - 0.2) ' + (P - t ) = t .o%
Thus, the manager's annualized tsacking error for this two-y€ar Period is 2.0 percenl (= 1.0 per-
cenerally speaking, there is an inverse relationship betwe€n a passiv€ portfolio's trackingerror relative to its index and the time and expense necessary to create and maintain the po{fo-
lio. For example, full replication of the S&P 500 would have virtually no tra€king error butwould necessilale positiods in 500 different stocks and require frequent rebalancing As smallersamples are used to replicate the S&P index's retum performan€e, the expense of forming themanaged portfolio would decline but the potential tracking error is likely to increase Thus, thean of being a manager of a passive equity ponfolio lies in balancing the costs (larger trackingerror) and the benefits (easier management, lower trading commissions) of using smaller sam-ples. Exhibit 17.2 estimates the tracking error that occurs from such sampling.
\
658 CHAPTER 17 Eourry PoRrFoLro MANAGEMENT ST RATEGTES
EXPECIED TMCKINC ERROR BE|WEEN THE S&P 5OO INDEX AND PORTFOLIOSCOMPRISED OF SAMPLES OF FEWER THAN 5OO STOCKS
ll3.0
2.0
4,0
1.0\ l
l
Methods ol lnderPortfolio lnvesting
Although inv€slors can construct their own passive investment portfolios that mimic a panicularequily index, th€re are at l€ast two "pre-packaged" ways ofaccomplishing this goal that are typ-ically more convenient and less expensive for fte small investor These are (l) buying shares in^1 inde! nutual fund ot (2) buying shares in an ercnanqe-traded fund (E'tF).
lndex Funds As we discuss in Chapter 25. mutual funds represent established security pon-folios managed by professional investmenr companies (e.9., Fidelity, Vanguard, Putnan, AIM)in which investors can panicipate. The investmenl company is responsible for deciding how thefund is managed. For an indexed portfolio, the fund manager will typically attempt to replicatethe composition of the panicular index exactly. meaning that he or she will buy the exact secu-rities comprising the index in theirexact weight! and then alter those positions anydme the com'position of the index itself is changed. Since changes to most equity indexes occur infrequendy,index funds tend to generate low rading and managem€nt expense ralios. A prominent exampleof an index tund is Vanguard's 500 Index Fund (VFINX). which is designed to mimic theS&P 500 index. Exhibit 17.3 provides a descnpdve overview of this fund and indicares rhar itshistorical retum performance is vinually indistinguishable from that of rhe benchmark.
The advanlage of index mutual funds is that they provide an inexpensive way for investors toacquire a diversified portfolio that emphasizes the desired market or industry within rhe conl€xlof a rradilional money management product. As with any mutual fund. the disadvantages are ihatinvestors can only liquidate their positions at the end of rhe trading day (i.e., no intra&y lrad-ing). usually cannot short sell. and may have unwanted ta,\ rep€r€ussions if rhe fund has anunforeseen need to sell a ponion of its holdings. thereby realizing capital gains.
Exchange-Traded Funds ETFS arc a more recent developmenr in the world of indexedinveshenl products than index mutual firnds. Essentially, ETFS are depository receipts that giveinvestors a pro mta claim on the capital gains and cash flows of the s€curities that are held ind€posit by the financial institution that issued the certificates. That is, a poffolio ofsecurities isplaced on deposit at a financial institulion or into a unit rus! which then issues a single ryp€ ofcertificate representing ownership of the underlying portfolio. ln that way. ETFS are similar tothe American depository receipts (ADR' described in Chapter 3.
&
t
AN OvERvIEw oF PAssrvE EQUnY PoRrFoLIo MaNAaEMENT STRATEGIES 659
DETAILS OF THE UANGUARD 5OO INDEX TRUST MUTUAL FUND
VANGUASO 'OO INDEI FUND-IW
vangudd500lndexFundisanopen_endfundincorporatedintheUnitedSratesTheFund\objectiveist'matchfteperf;rmance of rh€ Sbndard & poor's 500 Index, which is dominaled by the stocks of lmge U.s. companies. The Fund inves$ all
or subsrantally all of its assets in the slsks that make up the Index-
OB'EC'IVE-INDEX f UI{D-I.ATGE CAP
Bt ooMaElG cLas9ltlcatlol{ DATA CUf, lENT/OPEIAIIOXAT DATA
Style
I) GP NAV $ 105_85t2t3v0t s 86.000.mu3tn6
Equity
Large Cap
U,S.
PERFOTMANCE IANI(ING
1 Y. Pertomanc€ !€. Benchma* Indexes
-203OMAROl31MAY 3IJUL 28SEP 3ONOV 31JANO2 29MAB
RETURN PERCENTIIE
B oF 3/24/02
3) TRA I Month
YTD
2001
CURREN]
a ot 3/2A/O2
3) TRA
4) COMP
9) HRH
3.74.24
.699.64
-t2.02
5 l
50398 l
31
72
E6869 l
86
0
-10
-20
3 MonthYTD
2001200019991998t9971996t995t9941993t992
3.74.88
.69-2.47
9.64
-12.02-9.06
2t.0728.6133.2122.8637.45L l 89.897.45
sPx
3.16- E 4
.27
.87-2.43
9-685Pr
.E99 . 1 0
21.0428.5813.3822.9637.62l. l3
10.061.62
-.01
.02
.u-.03_.18-.04-.04
- . l 3'04.03.03
-. t7_.10- 1 7
- . t l- . t7
5912E4E686849 l
E68792E IE88989
82
24
3 l5039l9E I
342 76892958994863346
O l0O2 Blonbere L.P AU ngh$ Esened. Repnnten wi$ p€mnsion
1
660 CHAPTER 17 Eourry PoRrFoLro MANAaEMENT SrRArEarEs
There are several notabl€ €xampl€ of ETF|, including (l) Standard & Poor's 500 DepositoryReceipts (SPDRS or "spid€r" as they ar€ som€lim€s called). which are bas€d on a basket of alllhe s€curities held in that index; (2) ishries, whi€h re€reate indexed positions in s€veral globaldeveloped and emerging equity markets, including counries such as Australi.t, M€xico,Malaysia, the United Kingdom, France. Germany. Japan, and Chinar and (3) sector ETFS. whichinvest in baskets of slocks from specifiir industry sectors. including consuner services, indus-lrial, technology. financial servic€s. energy, utiliii€s. and cycli€alylransponaiion. Exhibil 17.4showr d€scriptive and retum data for the SPDR Trust cenificales. Notice once again how closelythe retums to these shares track the overall inde^.
A significant advantage of ETFS over index mutual funds is that they can be bought and sold(and shon sold) like common stock through an organized exchange or in an oveFthe-countermarket. Funher, they are backed by a sponsoring organization (e.g.. for SPDRS. the sponsor isPDR Services LLC, a limited liabilily company whose sole member is the American StockExchange where SPDR shares trade) who can alter the composition ofthe underlying portfolioto reflect changes in $e composilion of fte index. Oth€r advanlages relarive (o index fundsinclud€ no payment of a management fee, rhe ability for conlinuous trading while markers areop€n, and the ability to time capital gain tax realizations. ETF disadlanuges include the bro-kerage commission and the inability to r€invest dividends except on a quanerly basis.
tt
i t
c!
I t
The goal of active equity managemenr is to earn a ponfolio retum thar exceeds the retum of apassive benchmark portfolio, net of rransaction cosrs, on a risk-adjusled basis. The job of anaclive equity manager is not eary. If transaction costs and fees total L5 percent of the poftfolio'sassets annually, th€ ponfolio has to eam a return 1.5 percentage points abov€ the passive bench-markjust to keep pace wilh it. Funher. if the manager's strategy involves overweighting spe€ificmarket secbrs in anticipation of price increases. the risk ofthe active portfblio may well exc€edthat of the passive benchmark, so the acrive ponfolio s retum will have to exceed the benchmarkby an even wider margin to compensate for ils higher risk.
Exhibil 17.5 provides a broad overview of the different strltegies that invesrmenl managersmight adopt in forming their portfblios, as w€ll as the investment philosophy' that underlieseach strategy. Notic€, first ofall, thal lhe passiv€ strategies wejust considered are based (al leastimplicitly) on the notion that capital mark€c are el'ficient and so equity portfolios should beinvested to mimic broad indexes and not lrad€d actively. The r€alm ofactive management. how-ever. is one in which managers are effectively beuing" against markets b€ing p€rfeclly efficienl.For convenience. Exhibit 17.5 characrerizes rhes€ bets as falling into lhree general categories:(l) fundamental. (2) technical, and (3) market anomalies and security altribules.
As we saw in Chapler I I, the three-step investment process begins at the lop with an analysis ofbroad country and asset class allocations and progresses down lhrough seclor allocalion deci-sions ro $e bortom level where individual securiles are sele€t€d. The allemarile to rhis "top-
down" approach to investing was ir "bonom-up process thai simply emphasized the seledion ofsecurities withoul any initial market orsector analysis. In similar tashion. acti!e equity manage-m€nt based on fundamental analysis can start from either direction, depending on what exacllythe manager thinks is mispriced relative to his or her valuation models. Generally. actile man-agers use three generic themes in an atlempt to add value to theirponfolios relalive 1o th€ bench-mark. First, they can try to tim€ theequity market by shifring funds inlo and outofstocks, bonds.and T-bills depending on broad markel forecasis and €stimated risk premiums. Second. they canshifi funds among different equity sectors and industries (e.9.. financial slocks, technology
-.1
q
a
I ,
Funda|nentalStrategies
{ r r
AN OvERvIEw oF AcrrvE EQUITY PoRrFoLlo MANAGEMENT ST RATEGTES 661
DEIAILS OF THE SPDR EXCHANAE"TRADED FUND
lPDi lf,usr sEllEsl
SPDRTrustserieslksuesexchange-t.adedfundsca|l€dstandard&P@r'sD€positdyReceiptsor,.SPDRS].TheSPDRTrusthotds all of rhe comon sro.ks of the Sranddd & Pools 5m Composite St@k Price Index and is ittended to provide investment
€sulrs that, before €xpenses, gen€rally cor€spond to the pri@ and yield perfornance of the S&P 500 Index'
OBIEC'IVE-INOEX IUI{D-I.ATGE <AP
BIOOMBEIG CIA'5IFICA'IOII DATA
cumEN DAt
ECuityLarge Cap
Styleu.s.
1 Yr Pe(omance vs, B€nchmark hdexes
Und€rlying Index
l) GP Price52\lk Hi
52\r'k ti
INAV
Sharcs Out (xmo)
Market cap(mil)
l2) sPX
5t229n13128
3nuo2
$ l14.52$132.090 10$ 93.800$114.72$t 15.00 0
250783.0 -10
$28719.67
0
-10
20+03OMAFOI 31MAY 31JUL 28SEP 3ONOV 31JANO2 29MAB
sPDRs@d€signedloPrcvideaseuritywhosemdketvalueaPPrcximatesl/|0thevalueoftheundedyingS&P500Index'
RE URN PERCENTILECURRENT
E or 3/24/023) TRA
4) COMP
9) IiRH
I Month3 MonthYTD
20012000t99919961997r9961995199�41993t992
. 1 5
- .16
.21-.03-.23
.@
. t 4-.61
.65
.
. 1 0
.43-.93
,.6'�7
3.32-l_00
.48'E4
,2.6
9.59
-l l .?59.73
20.19?8.6933.4822.5538.05
.40
sPx
3.76.84.27.47
-2.43
9.6EsPx
-11.89-9. l0
2l .0428.5E33-3822.96
1.3310.061.62
l l68223925l l62
22t 7EO9490879495
30525456l 6
62
54
@ 2m2 [email protected] L.P All tights Es(ed. R.pnnted with pemsson.
A
662 CHAPTER 17 Eeurry PoRrFoLro MANAGEMENT STRATEGTES
EQUITY PORTFOLIO INVESTMENT PHILOSOPHIES AND STRATECIES
Pa$ iv Mana genent St rolegie sl. EFrRr MARTE5 Hvrcfr66
Buy and hold
Atti re M dhd ge hz n I SmteS ie t2. tuNdMrMAr ANA!, s'"Iop down (e,9,. asset class rolation. s(tor rolation)"Boltom ut (e.9.. sl6k undenaluation/ovenaluation)
3. TEcHNrcAr ANArYrs
Contrian (e.g., oveft acdon)
Continuation (e.g.. price momentum)
4. ANoMAls aNo AnRrBur6
Calendd etrects (e.9. weekend, January)
Secunty chdacterisics (e-8., P/E P/& eamings momentDm, nm size)
Invesment style (e.g., value, growth)
I
stocks, consumer cyclicals, durable goods) or amolg investmenl styles (e.9.,large capilalization,small capitalization, value, growth) to catch the next "hot" concept before the r€st of the marketdoes. Third. equity managers can do srockpi€king, looking al individual issues in an anempt tofind undervalued sto€ks-that is, to buy low and s€ll bigh.
An asset class rotation strategy is one $at shifts funds in and out ofthe stock market depend-ing on the manager's percepdon of how the stock ma*et is valued compared to the various alter-native asset classes. Formally. such a strategy is called tactical assel alloculion and will bedescribed in more d€tail later in the chapter. Altematively, a sccl',. rotation slrategy involvesposilioning the ponfolio to tak€ advantag€ of lhe market's nexl move. Oft€n, this means empha-sizing or overweighting (relalive 1o the benchmark portfolio) cenain €conomic sectors or indus-tries in response to th€ nexl expected phase of the business cycle. Exhibit I 7.6 contains sugges-tions on how sector rolalors may position their pofifolios to tale advantage of stock mark€ttrends during the economic cycle,
In geneml, asset and sector rotation straFgies can be extremely profitabl€ bul also very riskyfor a nanager to follow. This is shown in Exhibir l?.7, which lists the annual retums in each ofseveral asset and sector classes from l98l to 2000. Th€ chart documents the tremendous volatil-ity that existed during this period. For instance, bonds. which was the besl-performing asset classin 1990. was th€ next-to-worst class in the following y€ar. Convers€ly, large-cap growth stockswere the single best place to invesl funds for six years (i.e., 1994-1999) but this p€riod wasbracketed by years when this sector performed quite froorly. The message from this display isclear: While there are impressive gains to be made by correctly timing the "hott€st" (or the'toldest") market sectors, a manager must be right substantially more than he or she is wrong.Because this is an extrem€ly difiicult thing to do€onsistently. many investors choose to interprelExhibir I 7.7 as ultimately extolling the viriue of asset and secror class diversificalion.
Finally, a fundamental stock-picker operating on a pure "bottom-up" basis will form a port-folio ofequities that can be purchased at a subslantial discount to what his or her valuation modelindicates they are worth. As we discussed in Chapter 15. these valuation models might be basedon absolute j udgments about the future of the company (i.e., discounted cash flow) or relativ€
\
AN OvERvrEw oF AcrrvE EourrY PoRrFor-ro MANAaE:lrENr SrRArEarEs 663
THE STOCK MARKE| AND THE BUSINESS CVCLE
Technical strategies
Source: Susm E. Kuhn, stcks Ae Srll lou Bes Bnlf For!,4 2l March 1994. l40 O 1994 Tine Inc All Rights
assessmenB ofhow attra€tive the slock is compared with shar€s in otherwise similrr firms ihat
night be acquired (i.e., relative price multiples) ln either case it is usually true that rhe acrive
ma;ager will find siockpicking |o be a more rcliabl€. altbough less prcfitable. wav to add value
to a client than through m.rket timing.
In Chapter 16, we discussed the role that technical analysis plays in the sto{k evrluation process
As we saw, assessing past stock price irends in an effon to surmise what informrtion they imply
about future price movements was one of the primary lools of this analytical approach Active
managers can form equily ponfolios on the basis of past stock price trends by assuming thal one
of tw; ftings will happen: (l) past srock price trends will continue in the same direction or
(2) tbey will reverse themselves.A conrrarian inveshent strategy is based on the beliefthat $e best 1i'ne to buy Gell) a (ock
is when lh€ najority of other inveslors are rhe most bearish (bullish) about it. In this wav' the
conlrarian investor will allempl to always purchase the stock when n is near its lolv€sl price and
sell it (or even shortsellit) when it nears its perk.lmplicit inthis approach is the beliefthat stock
retums arc m"du /e!Pr1ing, indicaring that. over time. stocks will be priced so as to produce
rerums consistenl with th€ir risk'adjusted expected (ie, mean) retums DeBondt and Thaler
demonsrrared fte potential benefits of forming aclive ponfolios based on this notion 6 Specifi-
cally, they showed that invesringo an ore eaction h!-potr?rir could provide consjstently supe-
rior retums. Exhibit 17 8 illustrates a summary of their experiment in which they meirsur€d
retums to a Donfolio of stocks that had had $e worsl market performance over fte prior three
years( i .e. , ' iosers")andaponfol ioofstockswi lhthebesipastperformance(ie" 'winners") I f
investors oueneacted to either bad news or good news about companies as DeBondt and Thal€r
contended, we should see subsequem abnormirl retums move in the opposite direction The
cumulalr\e abnormal rel ms (CAR' shown in rhe di\pldy appear lo suppon lhr' notion'
although the evidence is stonger for losers than for winne|s.
.Wefter F M DeBondr dd Richtrd Thalei D$s de Std* Mdker Oveftacr? ' Jo!'ral d litax.e 40, no l (Jult
1985) :793-805.
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