Chapter 15

Revision of the Equity Portfolio

An individual can make a difference; a team can make a miracle

- 1980 U.S. Olympic hockey team

Outline
Introduction
Active

management versus passive management When do you sell stock?

Introduction
Portfolios

need maintenance and periodic

revision:
Because the needs of the beneficiary will change Because the relative merits of the portfolio components will change To keep the portfolio in accordance with the investment policy statement and investment strategy
4

Active Management Versus Passive Management

Definition
The

managers choices Costs of revision Contributions to the portfolio

Definition
An

active management policy is one in which the composition of the portfolio is dynamic
The portfolio manager periodically changes:
The portfolio components or The components proportion within the portfolio

passive management strategy is 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 the aggregate portfolio Change the portfolio components Indexing
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Leave the Portfolio Alone

A

buy and hold strategy means that the portfolio manager hangs on to its original investments research shows that portfolio managers often fail to outperform a simple buy and hold strategy on a risk-adjusted basis
E.g., Barber and Odean show that investors who trade the most have the lowest gross and net returns
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Academic

Rebalance the Portfolio

Rebalancing

a portfolio is the process of periodically adjusting it to maintain the original conditions

Rebalancing Within the Portfolio

Constant

mix strategy Constant proportion portfolio insurance Relative performance of constant mix and CPPI strategies

10

Constant Mix Strategy

The

constant mix strategy:

Is one to which the manager makes adjustments to maintain the relative weighting of the asset classes within the portfolio as their prices change Requires the purchase of securities that have performed 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 percent stock and 30 percent bonds. The initial portfolio value and the portfolio value after one quarter are shown on the next slide.

12

Constant Mix Strategy (contd)

Example (contd)
Date 1 Jan Portfolio Value Actual Allocation $2,000,000 60%/40% Stock Bonds $1,200,000 $800,000

1 Apr

$2,500,000

56%/44%

$1,400,000 $1,100,000

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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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 $1 million 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 Portfolio Insurance

A

constant 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 Portfolio Insurance (contd)

Example
A portfolio has a market value of $2 million. The investment policy statement specifies a floor value of $1.7 million and a multiplier of 2. What is the dollar amount that should be invested in stocks according to the CPPI strategy?

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Constant Proportion Portfolio Insurance (contd)

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 the CPPI strategy? What is the ending asset mix after rebalancing?
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Constant Proportion Portfolio Insurance (contd)

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. The resulting 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 CPPI strategy buys stock as it rises

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Relative Performance of Constant Mix & CPPI (contd)

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 an obvious advantage In a volatile market, the constant mix strategy outperforms CPPI
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Relative Performance of Constant Mix & CPPI (contd)

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 Equity Portfolio

Constant

proportion Constant beta Change the portfolio components Indexing

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Constant Proportion
A

constant proportion strategy within an equity portfolio requires maintaining the same percentage investment in each stock
May be mitigated by avoidance of odd lot transactions

Constant

proportion rebalancing requires selling 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: Stock FC HG YH Total Price 22.00 13.50 50.00 Shares 400 700 200 Value 8,800 9,450 10,000 $28,250 % of Total Portfolio 31.15 33.45 35.40 100.00
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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 constant proportion in each stock. Stock FC Price 20.00 Shares 400 Value 8,000 % of Total Portfolio 21.92

HG
YH Total

15.00
90.00

700
200

10,500
18,000 $36,500

28.77
49.32 100.00
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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: Value Before 8,000 Value After 12,000 % of Portfolio 32.00

Stock FC

Price 20.00

Shares 400

Action Buy 200

HG
YH Total

15.00
90.00

700
200

10,500
18,000 $36,500

Buy 100
Sell 50

12,000
13,500 $37,500

32.00
36.00 100.00
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Constant Beta Portfolio

A

constant beta portfolio requires maintaining the same portfolio beta To increase or reduce the portfolio beta, the portfolio manager can:
Reduce or increase the amount of cash in the portfolio Purchase stocks with higher or lower betas than the target figure Sell high- or low-beta stocks Buy high- or low-beta stocks
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Change the Portfolio Components

Changing

the portfolio components is another portfolio revision alternative Events sometimes deviate from what the manager 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 error refers to the extent to which a portfolio deviates from its intended behavior
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Costs of Revision
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

32

Commissions
Investors

pay commissions both to buy and to sell shares at a brokerage firm are a

Commissions

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 between the broker and the firm for which the broker works
Brokers with a high level of production keep a higher percentage than a new broker

Some

brokers discount their commissions with their more active clients

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Commissions (contd)
Discount

brokerage 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 the portfolio management process

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Market Impact
The

market impact of placing the trade is the change in market price purely because of executing the trade
impact is a real cost of trading

Market

Market

impact is especially pronounced for shares with modest daily trading volume
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Management Time
Most

portfolio managers handle more than one account several dozen portfolios is time

Rebalancing

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
implications are usually not a concern for tax-exempt organizations

Tax

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Window Dressing
Window

dressing refers to cosmetic changes made to a portfolio near the end of a reporting period
managers may sell losing stocks at the end of the period to avoid showing them on their fund balance sheets
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Portfolio

Rising Importance of Trading Fees

Flippancy

regarding commission costs is unethical and sometimes illegal fees are receiving increased attention because of:
Investment banking scandals Lawsuits regarding churning Incomplete prospectus information
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Trading

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 market account by the fund manager
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When Do You Sell Stock?

Introduction
Rebalancing Upgrading Sale

of stock via stop orders Extraordinary events Final thoughts

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Introduction
Knowing

when to sell a stock is a very difficult part of investing evidence suggests the typical investor sells winners too soon and keeps losers too long

Behavioral

44

Rebalancing
Rebalancing

can cause the portfolio manager to sell shares even if they are not doing poorly
taking with winners is a logical consequence of portfolio rebalancing

Profit

45

Upgrading
Investors

should sell shares when their investment potential has deteriorated to the extent that they no longer merit a place in the portfolio
is difficult to take a loss, but it is worse to let the losses grow
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It

Sale of Stock Via Stop Orders

Definition
Using

stops to minimize losses Using stops to protect profits

47

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 a profit
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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

52

Change in Market Conditions

Many

fund managers seek to actively time the market a portfolio managers outlook becomes bearish, he may reduce his equity holdings

When

53

Buy-Outs
A

firm may be making a tender offer for 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 probably make a change
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Final Thoughts
Hindsight

is an inappropriate perspective for investment decision making

Everything you do as a portfolio manager must be logically justifiable at the time you do it

Portfolio

managers are torn between minimizing losses and the potential for price appreciation
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