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Chapter 17

EQUITY-PORTFOLIO MANAGEMENT

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?


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


How can futures and options be useful in managing an equity portfolio?

What strategies can be used to manage a taxable investor’s portfolio in a tax-efficient way?

What are four asset allocation strategies?

Generic Portfolio Management StrategiesPassive 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

Passive Equity Portfolio Management StrategiesAttempt 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

Passive Equity Portfolio Management StrategiesNot a simple process to track a market index closely

Three basic techniques:Full replicationSamplingQuadratic optimization or programming

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


SamplingBuys representative sample of stocks in the benchmark index according to their weights in the indexFewer stocks means lower commissionsReinvestment of dividends is less difficultWill 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)


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


Completeness Funds

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

Passive Equity Portfolio Management Strategies Dollar-cost averagingPurchasing fixed dollar investments per

period over timePrevents buying too many shares at high

prices and too few shares when prices are low

Often part of a passively managed portfolio strategy

Active Equity Portfolio Management StrategiesGoal 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

Active Equity Portfolio Management Strategies

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


Global Investing: Three StrategiesIdentify countries with markets undervalued or overvalued and weight the portfolio accordinglyManage the global portfolio from an industry perspective rather than from a country perspectiveFocus on global economic trends, industry competitive forces, and company strengths and strategies


Sector RotationPosition a portfolio to take advantage of the market’s next moveScreening can be based on various stock characteristics: Value Growth P/E Capitalization

Key is to determine what to “rotate into”


Style InvestingConstruct a portfolio to capture one or more of the characteristics of equity securitiesSmall-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


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


Value versus GrowthGrowth investing focuses on earnings and changes in company fundamentalsValue investing focuses on the pricing of stocksOver time value stocks have offered somewhat higher returns than growth stocks


Expectational Analysis and Value/Growth InvestingAnalysts 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

Derivatives in Equity-Portfolio Management

The risk of equity portfolios can be modified by using futures and options derivativesSelling futures reduces the risk of the investor’s 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


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


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


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


The S & P 500 Index Futures ContractPurchasers 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 levelWhen the contract expires, delivery is made in cash, not stocksMargin account is marked to market daily Maintenance margins $2,500 and $1,500


Determining How Many Contracts to Trade to Hedge a Deposit or WithdrawalIn 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


Using Futures in Passive Equity Portfolio ManagementHelp manage cash inflows and outflows

while still tracking the target indexOptions can be sold to reduce weightings

in sectors or individual stocks during rebalancing


Using Futures in Active Equity Portfolio ManagementModifying systematic risk

Investing in various proportion of the futures index (where beta equals one and the underlying portfolio)

Modifying unsystematic riskUsing options, the portfolio manager can

increase exposure to desired industries, sectors, and even individual companies


Modifying the Characteristics of an International Equity PortfolioInternational equity positions involve positions in both securities and currenciesFutures 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

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

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

Taxable Portfolios

Tax-Efficient Investing StrategiesWill 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 taxedLoss harvesting, using tax losses to offset

capital gains on other investments

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

Taxable Portfolios

Diversifying a Concentrated PortfolioContext: 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?

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

Asset Allocation Strategies

Many portfolios containing equities also contain other asset categories, so the management factors are not limited to equitiesFour asset allocation strategies:Integrated asset allocation

Examine capital market conditions and investor objectives and constraintsDetermine the allocation that best serves the investor’s needs while incorporating the capital market forecast


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


Selecting an allocation method depends on: Perceptions of variability in the client’s

objectives and constraints Perceived relationship between the past

and future capital market conditions

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Documents

passive index portfolio

passive benchmark portfolio

portfolio managers style

taxable investors portfolio

good growth portfolio

good value portfolio

generic strategies

benchmark index