Stock-Trak Portfolio Report

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Chapter 16: Equity Portfolio Management Strategies

Passive versus Active Management

• Total Portfolio Return

– The total actual return on any equity portfolio can

be decomposed into:

§ Expected return

§ Alpha

– The Equation

Total Actual Return

=[Expected Return] + [“Alpha”]

=[Risk-Free Rate + Risk Premium]+[“Alpha”]

Passive versus Active Management

• Passive equity portfolio management

– Long-term buy-and-hold strategy

– Usually tracks 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 by seeking the

“alpha” value

• See Exhibit 16.1

Exhibit 16.1

16-4

An Overview of Passive 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

– S&P 500 Index

– NASDAQ Composite Index

Index Portfolio Construction Techniques

• 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

Index Portfolio Construction Techniques

• Sampling

– Buys a 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

Index Portfolio Construction Techniques

• Quadratic Optimization (or programming

techniques)

– 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

Tracking Error and Index Portfolio Construction

• The goal of the passive manager should be to

minimize the portfolio’s return volatility relative

to the index, i.e., to minimize tracking error

• Tracking Error Measure

– Return differential in time period t

Δt =Rpt – Rbt

where Rpt= return to the managed portfolio in Period t Rbt= return to the benchmark portfolio in Period t

– Tracking error is measured as the standard

deviation of Δt , normally annualized (TE)

– See Exhibit 16.2

Exhibit 16.2

16-10

Methods of Index Portfolio Investing

16-11

• Index Funds

– In an indexed portfolio, the fund manager will

typically attempt to replicate the composition of the

particular index exactly

– The fund manager will buy the exact securities

comprising the index in their exact weights

– Change those positions anytime the composition of

the index itself is changed

– Low trading and management expense ratios

– The advantage of index mutual funds is that they

provide an inexpensive way for investors to acquire

a diversified portfolio

Methods of Index Portfolio Investing

16-12

• Exchange-Traded Funds (ETF)

– EFTs are depository receipts that give investors a

pro rata claim on the capital gains and cash flows

of the securities that are held in deposit by a

financial institution that issued the certificates

– A significant advantage of ETFs over index mutual

funds is that they can be bought and sold (and

short sold) like common stock

– The notable example of ETFs

• Standard & Poor’s 500 Depository Receipts (SPDRs)

• iShares

• Sector ETFs

An Overview of Active 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

• See Exhibits 16.5 and 16.6

Exhibit 16.5

16-14

Exhibit 16.6

16-15

16-16

Fundamental Strategies

• Top-Down versus Bottom-Up Approaches

– Top-Down

§ Broad country and asset class allocations

§ Sector allocation decisions

§ Individual securities selection

– Bottom-Up

§ Emphasizes the selection of securities without any initial market or sector analysis

§ Form a portfolio of equities that can be purchased at a substantial discount to what his or her valuation

model indicates they are worth

16-17

Fundamental Strategies

• Three Generic Themes

– Time the equity market by shifting funds into and

out of stocks, bonds, and T-bills depending on

broad market forecasts

– Shift funds among different equity sectors and

industries (e.g., financial stocks, technology stocks)

or among investment styles (e.g., value, growth

large capitalization, small capitalization). This is

basically the sector rotation strategy

– Do stock picking and look at individual issues in an

attempt to find undervalued stocks

16-18

Fundamental Strategies

• The 130/30 Strategy

– Long positions up to 130 percent of the portfolio’s

original capital and short positions up to 30 percent

– The use of the short positions creates the leverage

needed, increasing both risk and expected returns

compared to the fund’s benchmark

– Enable managers to make full use of their

fundamental research to buy stocks they identify as

undervalued as well as short those that are

overvalued

Technical Strategies

16-19

• Contrarian Investment Strategy

– The belief that the best time to buy (sell) a stock is

when the majority of other investors are the most

bearish (bullish) about it

– The concept of mean reverting

– The overreaction hypothesis (Exhibit 16.9)

• Price Momentum Strategy

– Focus on the trend of past prices alone and makes

purchase and sale decisions accordingly

– Assume that recent trends in past prices will

continue

Exhibit 16.9

16-20

Anomalies and Attributes • Earnings Momentum Strategy

– Momentum is measured by the difference of actual EPS to the expected EPS

– Purchases stocks that have accelerating earnings and sells (or short sells) stocks with disappointing earnings

• Calendar-Related Anomalies – The Weekend Effect

– The January Effect

• Firm-Specific Attributes – Firm Size

– P/E and P/BV ratios (Exhibit 16.12)

Exhibit 16.12

16-22

Tax Efficiency and Active Equity Management

• 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 expected return depends on the

expected holding period and the cost basis (and

amount of the capital gain) of the original security

Tax Efficiency and Active Equity Management

• Measures of Tax Efficiency

– Portfolio Turnover

§ Measured as the total dollar value of the securities sold from the portfolio in a year divided by the average dollar

value of the assets

– Tax Cost Ratio (%)

§ The Formula

Tax Cost Ratio = [1 – (1 + TAR)/(1 + PTR)] x 100 where

PTR = pretax return

TAR = tax-adjusted return

§ See Exhibit 16.14

Exhibit 16.14

16-25

Value versus Growth • A growth investor focuses on the current and

future economic “story” of a company, with

less regard to share valuation

• A value investor focuses on share price in

anticipation of a market correction and,

possibly, improving company fundamentals.

• Value stocks generally have offered

somewhat higher returns than growth stocks,

but this does not occur with much consistency

from one investment period to another

Value versus Growth • Growth-oriented investor will:

– Focus on EPS and its economic determinants

– Look for companies expected to have rapid EPS

growth

– Assumes constant P/E ratio

• Value-oriented investor will:

– Focus on the price component

– Not care much about current earnings

– Assume the P/E ratio is below its natural level

Style Analysis • 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

• See Exhibit 16.20

Exhibit 16.20

16-29

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

diversify by portfolio

• Style investing allows control of the total

portfolio to be shared between the investment

managers and a sponsor

• Intentional and unintentional style drift

Asset Allocation Strategies • Integrated asset allocation

– Capital market conditions (C1-C3)

– Investor’s objectives and constraints (IPS or I1-I3)

– Continuous adjustment in asset allocations based on feedback loops from capital markets and IPS (as in Chap 2)

• Strategic asset allocation (long-term asset allocation)

– Constant-mix; no feedback loops from capital markets or investor’s policy statement (IPS)

Asset Allocation Strategies (Cont.)

• Tactical asset allocation (short-term changes in asset mix)

– Mean reversion, inherently contrarian, temp change in capital market conditions (C1-C3)

– Feedback loops from capital markets only; none from IPS

• Insured asset allocation (continual adjustments) – IPS change with age and wealth; no change in capital

market conditions (C1-C3) and no feedbacks from C1-C3; feedbacks only from IPS. Also called Constant Proportion strategy; e.g., change the percentage allocation between stocks & T-bill.

16-32

Asset Allocation Strategies

• Selecting an Active Allocation Method

– Perceptions of variability in the client’s

objectives and constraints

– Perceived relationship between the past and

future capital market conditions

– The investor’s needs and capital market

conditions are can be considered constant and

can be considered variable

The Internet Investments Online

• http://www.russell.com

• http://www.firstquadrant.com

• http://www.panagora.com

• http://www.wilshire.com