Tutorial 10 Solutions – Portfolio Management – I

[Readings: Ch16 & Ch19]

Q1 [Ch16 – Q1] Why have passive portfolio management strategies increased in use
over time?

Passive portfolio management strategies have grown in popularity because investors are
recognizing that the stock market is fairly efficient and that the costs of an actively
managed portfolio are substantial.

Q2 [Ch16 – Q3] Briefly describe four techniques considered active equity portfolio
management strategies.

There are a number of active management strategies, including market timing, sector
rotation, quantitative screens, and other specific strategies.

To engage in market timing, the manager will carry out analysis and predict which asset
class is forecasted to be the best performing one in the subsequent investment period.
The fund is then shifted towards that asset class.

Following a sector rotation strategy, the manager over-weights certain economic sectors,
industries or other stock attributes in anticipation of an upcoming economic period or
the recognition that the shares are undervalued.

Through the use of computer databases and quantitative screens, portfolio managers are
able to identify groups of stocks based upon a set of characteristics.

Using linear programming techniques, portfolio managers are able to develop portfolios
that maximize objectives while satisfying linear constraints.

Other specific active management techniques can incorporate fundamental analysis,

technical analysis, or the use the anomalies and attributes. For example, based upon the
top-down fundamental approach, Anomalies and attributes can be used as quantitative
screens (e.g., seek small stocks with low P/E ratios) to identify potential portfolio
candidates. Approaches based on past returns namely momentum and contrarian
strategies are also popular among active funds.

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Q3 Describe the three techniques used to construct an indexed portfolio.

Three basic techniques exist for constructing a passive portfolio: (1) full replication of an
index, in which all securities in the index are purchased proportionally to their weight in
the index; (2) sampling, in which a portfolio manager purchases only a sample of the
stocks in the benchmark index; and (3) quadratic optimization or programming
techniques, which utilize computer programs that analyze historical security information
in order to develop a portfolio that minimizes tracking error. These represent tradeoffs
between most accurate tracking of index returns versus cost.

Q4 [Ch16 – Q5] Discuss three strategies active managers can use to add value to
their portfolios.

Managers attempt to add value to portfolio by: (1) timing their investments in the various
markets in light of market forecasts and estimated risk premiums; (2) shifting funds
between various equity sectors, industries, or investment styles in order to catch the next
“hot” concept; and (3) stock selecting mispriced individual issues (buy low, sell high).

Q5 [Ch16 – Q8] There has been a long-standing debate regarding the existence of a
“value-growth” anomaly in financial economic research. Previous studies have
shown that value stocks (i.e., stocks with low price-to-book ratios) have higher
returns than growth stocks (i.e., stocks with high price-to-book ratios) in the
United States and markets around the world, even after adjusting for a market-
wide risk factor. What are some possible explanations for why value stocks might
outperform growth stocks on a risk-adjusted basis? Is this value-growth “anomaly”
consistent with the existence of an efficient stock market?

Value-oriented investors (1) focus on the current price per share, specifically, the price
of the stock is valued as “inexpensive”; (2) not be concerned about current earnings or
the fundamentals that drive earnings growth; and/or (3) implicitly assume that the P/E
ratio is below its natural level and that the (an efficient) market will soon recognize the
low P/E ratio and therefore drive the stock price upward (with little or no change in
earnings).

Growth-oriented investors (1) focus on earnings per share (EPS) and what drives that
value; (2) look for companies that expect to exhibit rapid EPS growth in the future; and/or
(3) implicitly assume that the P/E ratio will remain constant over the near term, that is,
stock price (in an efficient market) will rise as forecasted earnings growth is realized.

Another perspective is that beta is not the only risk factor that is priced by the efficient
market; other risk factors explain the difference in risk-adjusted returns between value
and growth portfolios. Perhaps value stock returns reflect additional bankruptcy risk
that growth stocks do not have.

Some argue that the market may not be 100% efficient; investor behaviors pushes down
the price of stocks that become “value” stocks too far while being too optimistic of future
growth potential in “growth” stocks.

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Q6 [Ch19 – Q2]

After determining the appropriate asset allocation to meet Lucinda Kennedy’s

needs, Richard Bulloch, CFA, invests a portion of Kennedy’s assets in two fixed-
income investment funds:

Trinity Index Fund: A passively managed portfolio of global bonds designed to track
the Barclays Global Aggregate Bond (LGAB) Index using a pure bond indexing
strategy. The management fee is 15 basis points annually.

Montego Global Bond Fund: An actively managed portfolio of global bonds designed
to outperform the LGAB net of fees. The management fee is 50 basis points
annually. Six months after investing in these funds, Kennedy and Bulloch review
the performance data shown in the following exhibit:

Total Returns on Index and Funds

Index or Fund Six-Month Return

LGAB Index 3.21%

Trinity Index Fund* 3.66%

Montego Global Bond Fund* 3.02%

*Net of Fees

Kennedy makes the following statements regarding her fixed-income

investments:

a. “The Trinity Index Fund is being managed well.”

b. “I expected that, as an active manager, Montego would outperform the index;

therefore, the fund should be sold.”

Determine whether you agree or disagree with each of Kennedy’s statements.

Justify your response with one reason for each statement.

a. “The Trinity Fund is being managed well.” Disagree. The fund is not managed
properly because a pure bond indexing strategy should not deviate significantly
from its benchmark.

b. “I expect that, as an active manager, Montego would outperform the index;

therefore, the fund should be sold.” Disagree. Six months is too short a time frame
to evaluate an active bond manager.

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Q7 [Ch19 – Q8] The ability to immunize a bond portfolio is very desirable for bond
portfolio managers in some instances.

a. Discuss the components of interest rate risk. Assuming a change in interest rates
over time, explain the two risks faced by the holder of a bond.

b. Define immunization, and discuss why a bond manager would immunize a

portfolio.

c. Explain why a duration-matching strategy is a superior technique to a maturity-

matching strategy for the minimization of interest rate risk.

d. Explain in specific terms how you would use a zero-coupon bond to immunize a
bond portfolio. Discuss why a zero-coupon bond is an ideal instrument in this
regard.

e. Explain how contingent immunization, another bond portfolio management

technique, differs from classical immunization. Discuss why a bond portfolio
manager would engage in contingent immunization.

(a) Interest rate risk comprises two risks - a price risk and a coupon reinvestment
risk. Price risk represents the chance that interest rates will differ from the rates
the manager expects to prevail between purchase and target date. Such a change
causes the market price for the bond (i.e., the realized price) to differ from the
expected price. Obviously, if interest rates increase, the realized price for the bond
in the secondary market will be below expectations, while if interest rates decline,
the realized price will exceed expectations.

Reinvestment risk arises because interest rates at which coupon payments can be
reinvested are unknown. If interest rates change after the bond is purchased,
coupon payments will be reinvested at rates different than that prevailing at the
time of the purchase. As an example, if interest rates decline, coupon payments
will be reinvested at lower rates than at the time of purchase and their
contribution to the ending wealth position of the investor will be below
expectations. Contrariwise, if interest rates increase there will be a positive impact
as coupon payments will be reinvested at rates above expectations.

(b) A portfolio of investments in bonds is immunized for a holding period if the value of
the portfolio at the end of the holding period, regardless of the course of interest rates
during the holding period, is at least as large as it would have been had the interest rate
function been constant throughout the holding period. Put another way, if the realized
return on an investment in bonds is sure to be at least as large as the computed yield to
the investment horizon, then that investment is immunized. As an example, if an investor
acquired a portfolio bond when prevailing interest rates were 10% and had an
investment horizon of four years, then the investor would expect the value of the portfolio
at the end of four years to be 1.4641 x the beginning value. This particular value is equal
to 10% compounded for four years.

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A bond manager would want to immunize the portfolio in the instance where he/she had
a specified investment horizon and had a definite required or promised yield for the bond
portfolio. In the case where this required or expected yield was below current prevailing
market rates, it would be worthwhile for the bond managers to immunize the portfolio
and therefore “lock in” the prevailing market yield for this period. Put another way, it is
when the bond portfolio manager is willing to engage in non-active bond portfolio
management and accept the current prevailing rate during the investment horizon.

(c) As set forth by a number of authors, the technique used to immunize a portfolio is to
set the duration of the portfolio equal to the investment horizon for the portfolio. It has
been proven that this technique will work because during the life of the portfolio, the two
major interest rate risks (price risk and reinvestment risk) offset each other at this point
in time. The zero coupon bond is an ideal immunization instrument because, by its very
nature, it accomplishes these two purposes when the maturity of the zero coupon bond
equals the investment horizon because the duration of a zero coupon bond is equal to its
maturity period. In contrast, when you match the maturity of the bond to the investment
horizon, you are only taking account of the price risk whereby you will receive the par
value of the bond at the maturity of the bond. The problem is that you are not sure of how
the investment risk will work out. If rates rise, you will receive more in reinvestment than
expected. Alternatively, if rates decline, you will not benefit from the price advantage and,
in fact, will lose in terms of the reinvestment assumptions.

(d) The zero coupon bond is a superior immunization security because it eliminates both
interest rate risks-price and reinvestment.

A zero coupon bond is a perfect immunizer when its duration (or maturity, as they are
the same) is equal to the liability or planning horizon of the portfolio. Given adequate
availability, the portfolio manager would match these elements and no further activity is
necessary to the end of the horizon.

The zero coupon bond is superior to a coupon paying instrument because the lack of cash
flow prior to maturity eliminates any coupon reinvestment and, therefore, the risk of
realized return changes due to uncertainty of these levels. Price risk is also nonexistent
regardless of the timing or nature of yield curve shifts.

(e) The primary difference between contingent and classical immunization is the role of
active management. Classical immunization precisely matches the duration of the
portfolio with the horizon of the particular liability. Management of such a portfolio is
limited to periodic rebalancing necessitated by yield curve shifts, yield changes, and time
effects on duration. Contingent immunization is an active form of management, initially,
and can continue in this mode until the manager’s results are unfavorable to the extent
that a predetermined target return is unlikely to be achieved. At this point, the active
mode is triggered to a classical passive immunization to “lock-in” the minimum desired
return.

Contingent immunization achieves its risk control by establishing two parameters: (1)
The minimum return target for more specifically the difference between the minimum
return target and the immunization return than available in the market, and (2) the

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acceptable range for the terminal horizon date of the program. The chart below illustrates
the potential rewards from contingent immunization based on possible moves in interest
rates. It is interesting to note the similarity of this curve to that of option strategies.

Q8 [Ch19 – P2] Answer the following questions assuming that at the initiation of an
investment account, the market value of your portfolio is $200 million, and you
immunize the portfolio at 12 percent for six years. During the first year, interest
rates are constant at 12 percent.

a. What is the market value of the portfolio at the end of Year 1?

b. Immediately after the end of the year, interest rates decline to 10 percent.
Estimate the new value of the portfolio, assuming you did the required rebalancing
(use only modified duration).

(a) $200 million x (1.06)2 = $224.72 million (assuming semiannual coupon payments
in the bond portfolio).

(b) Since modified duration will equal the remaining horizon (5 years), the change in
bond price must be +10% or (-5)x(-2%). The new value of the portfolio would then be
$247.192 million or $224.72 million x (1.10).

Q9 [Ch19 – P4] Compute the Macaulay duration under the following conditions:

a. A bond with a four-year term to maturity, a 10 percent coupon (annual

payments), and a market yield of 8 percent.

b. A bond with a four-year term to maturity, a 10 percent coupon (annual

payments), and a market yield of 12 percent.

c. Compare your answers to Parts a and b. Assuming it was an immediate shift in

yields, discuss the implications of this for classical immunization.

(a) Computation of Duration (assuming 8% market yield)

(1) (2) (3) (4) (5) (6)

Year Cash Flow PV@8% PVof Flow PV as % of Price (1) x (5)
1 100 .9259 92.59 .0868 .0868
2 100 .8573 85.73 .0804 .1608
3 100 .7938 79.38 .0745 .2234
4 1100 .7350 808.50 .7583 3.0332
1066.24 1.0000 3.5042
Duration = 3.5 years

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(b) Computation of Duration (assuming 12% market yield)

(1) (2) (3) (4) (5) (6)

Year Cash Flow PV@12% PV of Flow PV as % of Price (1) x (5)
1 100 .8929 89.29 .0951 .0951
2 100 .7972 79.72 .0849 .1698
3 100 .7118 71.18 .0758 .2274
4 1100 .6355 699.05 .7442 2.9768
939.24 1.0000 3.4691
Duration = 3.47 years

(c) A portfolio of bonds is immunized from interest rate risk if the duration of the
portfolio is always equal to the desired investment horizon. In this example, although
nothing changes regarding the bond, there is a change in market rates, which causes a
change in duration which would mean that the portfolio is no longer perfectly immunized.