Stock-Trak Report

hassski

ReillyBrown_IAPM_11e_PPT_Ch111331.pptx

Home >Business & Finance homework help >Financial markets homework help >Stock-Trak Report

CHAPTER

Equity Portfolio Management Strategies

11.1 Passive versus Active Management

Equity portfolio management strategies can be placed into either a passive or an active category

One way to distinguish between these strategies is to decompose the total actual return that the portfolio manager attempts to produce:

11-‹#›

11.1 Passive versus Active Management (slide 2 of 3)

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

Exhibit 11.1

11-‹#›

11.1 Passive versus Active Management (slide 3 of 3)

11-‹#›

11.2 An Overview of Passive Equity Portfolio Management 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

11-‹#›

11.2.1 Index Portfolio Construction Techniques

There are three basic techniques for constructing a passive index portfolio:

Full replication

Sampling

Quadratic optimization

11-‹#›

11.2.1 Index Portfolio Construction Techniques (slide 2 of 5)

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

11-‹#›

11.2.1 Index Portfolio Construction Techniques (slide 3 of 5)

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

11-‹#›

11.2.1 Index Portfolio Construction Techniques (slide 4 of 5)

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

11-‹#›

11.2.1 Index Portfolio Construction Techniques (slide 5 of 5)

Completeness funds:

Constructed to complement active portfolios that do not cover the entire market

For example, a large pension fund may allocate some of its holdings to active managers expected to outperform the market

Many times, these active portfolios are overweighted in certain market sectors or stock types

In this case, the pension fund sponsor may want the remaining funds to be invested passively to “fill the holes” left vacant by the active managers

11-‹#›

11.2.2 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

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)

Exhibit 11.2

11-‹#›

11.2.2 Tracking Error and Index Portfolio Construction (slide 2 of 2)

11-‹#›

11.2.3 Methods of Index Portfolio Investing

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

11-‹#›

11.2.3 Methods of Index Portfolio Investing (slide 2 of 4)

Exchange-Traded Funds (ETF)

ETFs 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

Exhibits 11.3, 11.4

11-‹#›

11.2.3 Methods of Index Portfolio Investing (slide 3 of 4)

11-‹#›

11.2.3 Methods of Index Portfolio Investing (slide 4 of 4)

11-‹#›

11.3 An Overview of Active Equity Portfolio Management 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

Exhibits 11.5 and 11.6

11-‹#›

11.3 An Overview of Active Equity Portfolio Management Strategies (slide 2 of 3)

11-‹#›

11.3 An Overview of Active Equity Portfolio Management Strategies (slide 3 of 3)

11-‹#›

11.3.1 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

11-‹#›

11.3.1 Fundamental Strategies (slide 2 of 5)

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

Exhibits 11.7, 11.8

11-‹#›

11.3.1 Fundamental Strategies (slide 3 of 5)

11-‹#›

11.3.1 Fundamental Strategies (slide 4 of 5)

11-‹#›

11.3.1 Fundamental Strategies (slide 5 of 5)

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

11-‹#›

11.3.2 Technical Strategies

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 (returns move back to mean return)

The overreaction hypothesis

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

Exhibits 11.9, 11.10

11-‹#›

11.3.2 Technical Strategies (slide 2 of 3)

11-‹#›

11.3.2 Technical Strategies (slide 3 of 3)

11-‹#›

11.3.3 Factors, Attributes, and Anomalies

Factor-based investment strategy (FF 4/5 factors model)

The manager forms portfolios that emphasize certain characteristics of a collection of securities—such as firm size, relative valuation, low return volatility, momentum, or company quality—that are believed to produce higher risk-adjusted returns than those in a traditional benchmark that is weighted by the market capitalization of the stocks in the index

The risk premia associated with these characteristic-oriented portfolios—or factors, as they are called—allow the investor to earn superior returns with better diversification than holding a traditional passive index fund

Exhibits 11.11, 11.12

11-‹#›

11.3.3 Factors, Attributes, and Anomalies (slide 2 of 5)

11-‹#›

11.3.3 Factors, Attributes, and Anomalies (slide 3 of 5)

11-‹#›

11.3.3 Factors, Attributes, and Anomalies (slide 4 of 5)

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 (small vs. large firms)

P/E and P/BV ratios (value vs. growth firms)

Exhibit 11.13

11-‹#›

11.3.3 Factors, Attributes, and Anomalies (slide 5 of 5)

11-‹#›

11.3.5 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

11-‹#›

11.3.5 Tax Efficiency and Active Equity Management (slide 2 of 3)

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

Where

PTR = pretax return

TAR = tax-adjusted return

See Exhibit 11.14

11-‹#›

11.3.5 Tax Efficiency and Active Equity Management (slide 3 of 3)

11-‹#›

11.3.6 Active Share and Measuring the Level of Active Management

A more direct way to assess how active a manager’s strategy is to look directly at the portfolio’s holdings compared to those in the benchmark

Cremers and Petajisto (2009) have suggested calculating the portfolio’s active share measure as:

Where:

[wp,i, wb,i] represent the investment weight of the ith security in the managed portfolio (p) and benchmark index (b), respectively

11-‹#›

11.3.6 Active Share and Measuring the Level of Active Management (slide 2 of 3)

Active share statistic

The percentage of security holdings in the manager’s portfolio that differ from those in the benchmark index

Exhibit 11.15

11-‹#›

11.3.6 Active Share and Measuring the Level of Active Management (slide 3 of 3)

11-‹#›

11.4 Value versus Growth Investing: A Closer Look

A growth investor focuses on the current and future economic growth “story” of a company, with less regard to share valuation (no attention to P/E)

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

11-‹#›

11.4 Value versus Growth Investing: A Closer Look (slide 2 of 7)

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 (Price vs. EPS)

Not care much about current earnings

Assume the P/E ratio is below its natural level

Exhibits 11.16, 11.17, 11.18, 11.19, 11.20

11-‹#›

11.4 Value versus Growth Investing: A Closer Look (slide 3 of 7)

11-‹#›

11.4 Value versus Growth Investing: A Closer Look (slide 4 of 7)

11-‹#›

11.4 Value versus Growth Investing: A Closer Look (slide 5 of 7)

11-‹#›

11.4 Value versus Growth Investing: A Closer Look (slide 6 of 7)

11-‹#›

11.4 Value versus Growth Investing: A Closer Look (slide 7 of 7)

11-‹#›

11.5 An Overview of Style Analysis

Style analysis:

Attempts to explain the variability in the observed returns to a security portfolio in terms of the movements in the returns to a series of benchmark portfolios capturing the essence of a particular security characteristic

Determines the combination of long positions in a collection of passive indexes that best mimics the past performance of a security portfolio

A simple style grid could be used to classify a manager’s performance along two dimensions: firm size (large cap, mid cap, small cap) and relative value (value, blend, growth) characteristics

11-‹#›

11.5 An Overview of Style Analysis (slide 2 of 5)

Formally, style analysis relies on the constrained least squares procedure, with the returns to the manager’s portfolio as the dependent variable and the returns to the style index portfolios as the independent variables

There are often three constraints employed:

No intercept term is specified

The coefficients must sum to one

All the coefficients must be nonnegative

Exhibits 11.21, 11.22, 11.23

11-‹#›

11.5 An Overview of Style Analysis (slide 3 of 5)

11-‹#›

11.5 An Overview of Style Analysis (slide 4 of 5)

11-‹#›

11.5 An Overview of Style Analysis (slide 5 of 5)

11-‹#›

11.6 Asset Allocation Strategies

An equity portfolio does not stand in isolation; it is part of an investor’s overall investment portfolio

The portfolio manager must consider the appropriate mix of asset categories in the entire portfolio

There are four general strategies for determining the asset mix of a portfolio

11-‹#›

11.6.1 Integrated Asset Allocation

The integrated asset allocation strategy separately examines:

Capital market conditions

Investor’s objectives and constraints

These factors are combined to establish the portfolio asset mix that offers the best opportunity for meeting the investor’s needs

Continuously adjust for both changing market conditions and investor’s objectives

Exhibits 11.24, 11.25

11-‹#›

11.6.1 Integrated Asset Allocation (slide 2 of 3)

11-‹#›

Finding Expected Utility (Benefit/Satisfaction)

Exp. Utility (EU) = Exp Ret (ER) – Risk penalty

Or EU = ER – σ2/RT

σ2 = Risk or volatility; RT=Investor’s risk tolerance

Higher returns make investor happy (higher utility)

Higher risk makes those investors unhappy (low utility) who have low RT as they assign bigger penalty for taking more risk; high RT investors are not unhappy with high risk as they expect high return-high risk relation.

Portfolio with higher EU are better (maybe efficient portfolio).

11-‹#›

11.6.1 Integrated Asset Allocation (slide 3 of 3)

11-‹#›

11.6.2 Strategic Asset Allocation

Strategic asset allocation is used to determine the long-term policy asset weights in a portfolio

Typically, long-term average asset returns, risk, and covariances are used as estimates of future capital market results

Efficient frontiers are generated using this historical information, and the investor decides which asset mix is appropriate for his or her needs during the planning horizon

This results in a constant-mix asset allocation with periodic rebalancing to adjust the portfolio asset weights; no adjustment for changing market conditions and investor’s objectives.

Exhibit 11.26

11-‹#›

11.6.2 Strategic Asset Allocation (slide 2 of 2)

11-‹#›

11.6.3 Tactical Asset Allocation

Frequently adjusts the asset class mix in the portfolio to take advantage of changing market condition; adjust for changing market conditions only; no adjustment for investor’s objectives (assume constant).

Adjustments are driven solely by perceived changes in the relative values of the various asset classes; e.g., increase equity weight when stock market is rising.

Often based on the premise of mean reversion

An inherently contrarian method of investing

11-‹#›

11.6.4 Insured Asset Allocation

Results in frequent adjustments in the portfolio allocation, assuming that expected market returns and risks are constant over time, while the investor’s objectives and constraints change as his or her wealth position changes; adjust asset allocation for changing investor’s objectives only.

Involves only two assets, such as common stocks and T-bills

As stock prices rise, the asset allocation increases the stock component

As stock prices fall, the stock component of the mix falls while the T-bill component increases

11-‹#›