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  • 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 markt 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. enhancd indxing). bul such slyles really are variations of active managementphilosophies. Similar to traditional active managemenr, hybrid-style managers invesr to findundrvalued 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 refend 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 indexd porlfolio is norro 'baf 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 btweenponfolio and index retums similar to the bond index ponfolio managr.

    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, dividnd 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 lss-exciting altmative ofindexing versut the higheFcost but potntially 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/Ocrobr 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 spcific index. The key word here is r.'plr'car?. As discussed in ChapIr 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 dismissd. A passive managereans hisor her fee by constructing a portfolio that closely tracks the prformance of a specified equilyindex (refened to as the ,enchnm* indat) rhar n\eets the client's needs and objctives. 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. Strongvidence 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 outprforms 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 dscription 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 counlris (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. Altxerr

    w?.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 fes, 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 indx are purchased in propoftion to their weights in theindex- This technique helps ensure close tracking, but it may be suboptimal for two rasons.First, the ned to buy many securities will increase transaction costs that will detract from per-formance. Scond, 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 issus. Statisticalrheory teaches us that we don't ned to ask everyone in the Uniled Slales for his or her opinionlo determine who may win an election. Thus. opinion pollsters qury 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 bnchmark 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 scurities areinput to a computer program that determines the composirion of a ponfolio that will minimizelracking enor with

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