portfolio management - chapter 15
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Chapter 15
Revision of the Equity Portfolio
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An individual can make a difference; a team can
make a miracle
- 1980 U.S. Olympic hockey team
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Introduction
Portfolios need maintenance and periodicrevision:
Because the needs of the beneficiary will change
Because the relative merits of the portfoliocomponents will change
To keep the portfolio in accordance with theinvestment policy statement and investment
strategy
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Active Management Versus
Passive Management Definition
The managers choices
Costs of revision Contributions to the portfolio
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Definition
Anactive management policyis one in which
the composition of the portfolio is dynamic
The portfolio man
ager periodically chan
ges:
The portfolio components or
The components proportion within the portfolio
Apassive management strategyis one in
which the portfolio is largely left alone
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The Managers Choices
Leave the portfolio alone
Rebalance the portfolio
Asset allocation and rebalancing within theaggregate portfolio
Change the portfolio components
Indexing
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Leave the Portfolio Alone
Abuyand hold strategymeans that the portfolio
manager hangs on to its original investments
Academic research shows that portfolio managers
often fail to outperform a simple buy and hold
strategy on a risk-adjusted basis
E.g.,B
arber an
d Odean
show that in
vestors who trade themost have the lowest gross and net returns
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Rebalance the Portfolio
Rebalancing a portfolio is the process of
periodically adjusting it to maintain the
original conditions
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Rebalancing
Within the Portfolio Constant mix strategy
Constant proportion portfolio insurance
Relative performance of constant mix andCPPI strategies
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Constant Mix Strategy
The constant mix strategy:
Is one to which the manager makes adjustmentsto maintain the relative weighting of the asset
classes within the portfolio as their prices change
Requires the purchase of securities that haveperformed poorly and the sale of securities that
have performed the best
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Constant Mix Strategy (contd)
Example
A portfolio has a market value of $2 million. The investment
policy statement requires a target asset allocation of 60 percentstock and 30 percent bonds.
The initial portfolio value and the portfolio value after one
quarter are shown on the next slide.
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Constant Mix Strategy (contd)
Example (contd)
What dollar amount of stock should the portfolio manager buy
to rebalance this portfolio? What dollar amount of bonds
should he sell?
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Date Portfolio Value Actual Allocation Stock Bonds
1 Jan $2,000,000 60%/40% $1,200,000 $800,000
1 Apr $2,500,000 56%/44% $1,400,000 $1,100,000
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Constant Mix Strategy (contd)
Example (contd)
Solution: a 60%/40% asset allocation for a $2.5 million portfolio
means the portfolio should contain $1.5 million in stock and $1million in bonds. Thus, the manager should buy $100,000
worth of stock and sell $100,000 worth of bonds.
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Constant Proportion
PortfolioI
nsu
ranc
e Aconstant proportion portfolio insurance
(CPPI) strategy requires the manager to invest
a percentage of the portfolio in stocks:
$ in stocks = Multiplier x (Portfolio value Floor value)
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Constant Proportion
PortfolioI
nsu
ranc
e (c
ontd)Example
A portfolio has a market value of $2 million. The investment
policy statement specifies a floor value of $1.7 million and amultiplier of 2.
What is the dollar amount that should be invested in stocks
according to the CPPI strategy?
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Constant Proportion
PortfolioI
nsu
ranc
e (c
ontd)Example (contd)
Solution: $600,000 should be invested in stock:
$ in stocks = 2.0 x ($2,000,000 $1,700,000)
= $600,000
If the portfolio value is $2.2 million one quarter later, with$650,000 in stock, what is the desired equity position under theCPPI strategy? What is the ending asset mix after rebalancing?
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Constant Proportion
PortfolioI
nsu
ranc
e (c
ontd)Example (contd)
Solution: The desired equity position after one quarter should
be:
$ in stocks = 2.0 x ($2,200,000 $1,700,000)
= $1,000,000
The portfolio manager should move $350,000 into stock. Theresulting asset mix would be: $1,000,000/$2,200,000 = 45.5%
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Relative Performance of Constant
Mix and CPPI
A constant mix strategy sells stock as it rises
A CPPI strategy buys stock as it rises
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Relative Performance of Constant
Mix & CPPI
(c
ontd) In a rising market, the CPPI strategy
outperforms constant mix
In a declining market, the CPPI strategy
outperforms constant mix
In a flat market, neither strategy has anobvious advantage
In a volatile market, the constant mix strategyoutperforms CPPI
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Relative Performance of Constant
Mix & CPPI
(c
ontd) The relative performance of the strategies
depends on the performance of the market
during the evaluation period
In the long run, the market will probably rise,
which favors CPPI
In the short run, the market will be volatile,
which favors constant mix
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Rebalancing Within the
Equ
ity Portfolio Constant proportion
Constant beta
Change the portfolio components
Indexing
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Constant Proportion
Aconstant proportion strategywithin an
equity portfolio requires maintaining the same
percentage investment in each stock
May be mitigated by avoidance of odd lot
transactions
Constant proportion rebalancing requiresselling winners and buying losers
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Constant Proportion (contd)
Example
A portfolio of three stocks attempts to invest approximately one third of
funds in each of the stocks. Consider the following information:
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Stock Price Shares Value % of Total Portfolio
FC 22.00 400 8,800 31.15
HG 13.50 700 9,450 33.45YH 50.00 200 10,000 35.40
Total $28,250 100.00
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Constant Proportion (contd)
Example (contd)
After one quarter, the portfolio values are as shown below. Recommend
specific actions to rebalance the portfolio in order to maintain the constantproportion in each stock.
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Stock Price Shares Value % of Total Portfolio
FC 20.00 400 8,000 21.92
HG 15.00 700 10,500 28.77
YH 90.00 200 18,000 49.32
Total $36,500 100.00
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Constant Proportion (contd)
Example (contd)
Solution: The worksheet below shows a possible revision which requires an
additional investment of $1,000:
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Stock Price Shares
Value
Before Action
Value
After
% of
Portfolio
FC 20.00 400 8,000 Buy 200 12,000 32.00
HG 15.00 700 10,500 Buy 100 12,000 32.00
YH 90.00 200 18,000 Sell 50 13,500 36.00
Total $36,500 $37,500 100.00
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Change the
Portfolio Components Changing the portfolio components is another
portfolio revision alternative
Events sometimes deviate from what themanager expects:
The manager might sell an investment turned sour
The manager might purchase a potentially
undervalued replacement security
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Indexing
Indexing is a form of portfolio management that
attempts to mirror the performance of a market
index
E.g., the S&P 500 or the DJIA
Index funds eliminate concerns about outperforming
the market
The tracking errorrefers to the extent to which a
portfolio deviates from its intended behavior
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Costs ofRevision
Introduction
Trading fees
Market impact
Management time
Tax implications
Window dressing Rising importance of trading fees
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Introduction
Costs of revising a portfolio can:
Be direct dollar costs
Result from the consumption of management
time
Stem from tax liabilities
Result from unnecessary trading activity
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Trading Fees
Commissions
Transfer taxes
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Commissions
Investors pay commissions both to buy and to
sell shares
Commissions at a brokerage firm are a
function of:
The dollar value of the trade
The number of shares involved in the trade
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Commissions (contd)
The commission on a trade is split betweenthe broker and the firm for which the brokerworks
Brokers with a high level of production keep ahigher percentage than a new broker
Some brokers discoun
t their commission
s withtheir more active clients
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Commissions (contd)
Discountbrokerage firms:
Offer substantially reduce commission rates
Offer few ancillary services, such as market
research
Retail commissions at a full-service firm
average about 2 percent of the stock value
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Transfer Taxes
Transfer taxes are:
Imposed by some states on the transfer of
securities
Usually very modest
Not normally a material consideration in theportfolio management process
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Market Impact
The market impactof placing the trade is thechange in market price purely because ofexecuting the trade
Market impact is a real cost of trading
Market impact is especially pronounced forshares with modest daily trading volume
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Management Time
Most portfolio managers handle more than
one account
Rebalancing several dozen portfolios is time
consuming
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Tax Implications
Individual investors and corporate clients must
pay taxes on the realized capital gains
associated with the sale of a security
Tax implications are usually not a concern for
tax-exempt organizations
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Window Dressing
Window dressing refers to cosmetic changes
made to a portfolio near the end of a
reporting period
Portfolio managers may sell losing stocks at
the end of the period to avoid showing them
on their fund balance sheets
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Rising Importance
ofTrading Fees Flippancy regarding commission costs is
unethical and sometimes illegal
Trading fees are receiving increased attentionbecause of:
Investment banking scandals
Lawsuits regarding churning
Incomplete prospectus information
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Contributions to the Portfolio
Periodic additional contributions to the
portfolio from internal or external sources
must be invested
Dividends:
May be automatically reinvested by the fund
managers broker
May have to be invested in a money marketaccount by the fund manager
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Introduction
Knowing when to sell a stock is a very difficult
part of investing
Behavioral evidence suggests the typical
investor sells winners too soon and keeps
losers too long
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Rebalancing
Rebalancing can cause the portfolio manager
to sell shares even if they are not doing poorly
Profit taking with winners is a logical
consequence of portfolio rebalancing
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Upgrading
Investors should sell shares when their
investment potential has deteriorated to the
extent that they no longer merit a place in the
portfolio
It is difficult to take a loss, but it is worse to let
the losses grow
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Sale of Stock Via Stop Orders
Definition
Using stops to minimize losses
Using stops to protect profits
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Definition
Stop orders:
Are sell stops
Become a market order to sell a set number of
shares if shares trade at the stop price
Can be used to minimize losses or to protect aprofit
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Using Stops to Minimize Losses
Stop-loss orders can be used to minimize
losses
E.g., you bought a share for $23 and want to sell it
if it falls below $18
Place a stop-loss order for $18
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Using Stops to Protect Profits
Stop orders can be used to protect profits
E.g., a stock you bought for $33 now trades for
$48 and you want to protect the profits at $45
If the stock retreats to $45, you lock in the profit if you
place a stop order
If the stock continues to increase, you can use a
crawling stop to increase the stop price
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Extraordinary Events
Change in client objectives
Change in market conditions
Buy-outs Caprice
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Change in Client Objectives
The clients investment objectives may change
occasionally:
E.g., a church needs to generate funds for a
renovation and changes the objective for the
endowment fund from growth of income to
income
Reduce the equity component of the portfolio
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Change in Market Conditions
Many fund managers seek to actively time the
market
When a portfolio managers outlook becomes
bearish, he may reduce his equity holdings
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Buy-Outs
A firm may be making a tender offerfor one
of the funds holdings
I.e., another firm wants to acquire the fund
holding
It is generally in the clients best interest to
sell the stock to the potential acquirer
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Caprice
Portfolio managers:
Should be careful about making unnecessary
trades
Must pay attention to their experience, intuition,
and professional judgment
An experienced portfolio manager worried
about a particular holding should probablymake a change
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Final Thoughts
Hindsight is an inappropriate perspective forinvestment decision making
Everything you do as a portfolio manager must be
logically justifiable at the time you do it
Portfolio managers are torn betweenminimizing losses and the potential for priceappreciation
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