Equity Portfolio Management Strategies

Passive Equity Portfolio Management:

• Holding stocks so the portfolio’s returns will track those of a benchmark index
over time.
• This approach to investing is generally referred to as indexing
• No attempt on the manager’s part to generate alpha
• Indexing is often thought to be a long-term buy-and-hold strategy, occasional
rebalancing of the portfolio is necessary as the composition of the underlying
benchmark changes and cash distributions must be reinvested
Active equity portfolio management:
• An attempt by the manager to outperform an equity benchmark on a risk-
adjusted basis
• There are two main ways to try to add alpha:
• Tactical adjustments (e.g., equity style or sector timing)
• Security selection (i.e., stock-picking) skills
• The goal of active equity management is to earn a return that exceeds the return of a
passive benchmark portfolio, net of transaction costs, on a risk-adjusted basis.
Total Actual Return = [Expected Return] + [“Alpha”]
= [Risk-Free Rate + Risk Premium] + [“Alpha”]
Passive = = [Risk-Free Rate + Risk Premium]
Active = [Risk-Free Rate + Risk Premium] + [“Alpha”]
Passive Management Strategies
1. EFFICIENT MARKETS HYPOTHESIS
Buy and hold
Indexing
Active Management Strategies
2. FUNDAMENTAL ANALYSIS
“Top down” (e.g., asset class rotation, sector rotation)
“Bottom up” (e.g., stock undervaluation/overvaluation)
3. TECHNICAL ANALYSIS
Contrarian (e.g., overreaction)
Continuation (e.g., price momentum)
4. ANOMALIES AND ATTRIBUTES
Security characteristics (e.g., P/E, P/B, earnings momentum, firm size)
Investment style (e.g., value, growth)
Calendar effects (e.g., weekend, January)
Information effects (e.g., neglect)
Three basic techniques for constructing a passive index portfolio:
a. Full replication b. Sampling c. Quadratic optimization
a. Full replication:
• All the securities in the index are purchased in proportion to their weights in
the index.
• This technique helps ensure close tracking, but the need to buy many
securities will increase transaction costs that will detract from performance.
b. Sampling:
A portfolio manager would only need to buy a representative sample of stocks that
comprise the benchmark index. Stocks with larger index weights are purchased
according to their weight in the index; smaller issues are purchased so their
aggregate characteristics (e.g., beta, industry distribution, and dividend yield)
approximate the underlying benchmark.

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Full replication Vs Sampling
Full replication: Virtually no tracking error but positions in say 500 stocks (in S&P 500
index) requires frequent rebalancing
Sampling: Likely increase in tracking error but less expense in forming the managed
portfolio
Being a manager of a passive equity portfolio lies in balancing the costs (larger tracking
error) and the benefits (easier management, lower trading commissions) of using smaller
samples
ACTIVE EQUITY PORTFOLIO MANAGEMENT:
Active equity management based on fundamental analysis can start from either direction,
depending on what the manager thinks is mispriced relative to his or her valuation models.
BASED ON FUNDAMENTAL ANALYSIS : EIC (Top Down) or CIE (Bottom Up)
EIC (Top Down):
• An asset class rotation strategy (tactical asset allocation): to time the equity
market by shifting funds into and out of stocks, bonds, and T-bills depending on broad
market forecasts and estimated risk premiums.
• A sector rotation strategy: Emphasizing or overweighting (relative to the benchmark
portfolio) certain economic sectors or industries in response to the next expected
phase of the business cycle. Second, they can shift
CIE (Bottom Up):
• Identifying the stocks with under valuation/over valuation
BASED ON TECHNICAL ANALYSIS :
1. Loser Stocks: The worst is behind you: The Contrarian Story (based on overreaction
hypothesis)
Premise: It is always darkest before dawn (overreaction hypothesis) and low priced
stocks are cheaper:
Downside: Reaction can be at times justifiable, if the performance is so bad leading
to delisting at times.
Things to consider: If you want to succeed with this strategy, you have to begin with
a long time horizon and a strong stomach for volatility
2. Go with the Flow: Momentum Strategies
Premise: It’s all upside- the momentum story
Downside: There is a point at which price momentum seems to stall and prices
reverse themselves.
Things to consider: Momentum strategy can be adopted, when such momentum is
experienced not only in price but also in volume, after eliminating overpriced stocks.
Sustainability in earnings is also required
BASED ON SECURITY CHARACTERSTICS (e.g., P/E, P/B, earnings momentum,
firm size) AND INVESTMENT STYLE (e.g., value, growth)
1. High Dividend Stocks
Premise: An unbeatable combination of both regular income like bonds and also the
possibility of price appreciation like stocks.
Downside: Dividends are not promised like coupons and high dividend means low
growth
Things to consider: While adopting this strategy, high dividend paying stocks have
to be further screened for sustainability (by looking at dividend payout ratios and free
cash flows to equity) and reasonable earnings growth.
2. Stocks with Low P/E ratios:
Premise: Cheap and safe equity investments, as those stocks trade at low PE ratios
relative to their peer group, they must be underpriced.

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 Downside: A stock may be priced low, as it has no growth and is more risky.
Things to consider: Low PE stocks with reasonable growth and below average risk.
3. Stocks with Low P/BV ratios:
Premise: Such stocks are good bargains as the book value of equity represents a more
reliable measure of what the equity of the firm is worth or that book value is a
measure of liquidation value.
Downside: Book value is an accounting measure mainly influenced by inconsistent
accounting policies. Low P/BV can be due to with high risk, poor growth prospects
and negative or low returns on equity to trade at low price to book ratios.
Things to consider: Low PBV stocks with reasonable growth and below average
risk.
4. Stocks with a steady and stable stream of positive earnings
Premise: Steady earnings are due to diversification into good number of businesses,
risk management products or acquisitions, are considered to be good investments as
they are safe. Downside: However, such firms might already have been priced high.
Stable in earnings is also an indication of low or no growth prospects.
Things to consider: Ensure the firms with stable earnings are in growth phase
5. Blue chip stocks:
Premise: Investment in good companies characterized by financial soundness, good
corporate governance practices and social responsibility provides dual benefits of
higher returns and lower risk.
Downside: The current price of the company may already reflect the quality of the
management and the firm leading to poor returns
Things to consider: It is only when markets underestimate the value of firm quality
that this strategy stands a chance of making excess returns.
6. Growth companies:
Premise: Investment in high growth companies yields huge payoffs.
Downside: Growth can be value destroying than value adding due to low return
projects
Things to consider: PEG being less than one, Beta less one, Debt Equity less than
80%, ROE>Ke
7. Hidden Bargains:
Premise: The strategy of investing in smaller, less followed companies is the strategy
that is most accessible to individual investors.
Downside: Whether these higher returns are just compensation for the higher risk of
these stocks – they are less liquid and information may not be as freely available
Things to consider: Your odds of success improve if you can focus on stocks with
lower transaction costs and more stable earnings that are priced attractively.
8. Get on the Fast Track (The Hare and the Tortoise Revisited):
Premise: Acquisitions help in growing faster
Downside: Serial acquirers generally do not make good investments, they overpay for
target firms, expand into businesses they do not understand and overreact by
borrowing too much to fund their growth.
Things to consider: The largest payoff in acquisitions is to those who hold stock in
target firms at the time the acquisitions are announced. There is a need for screening
the potential target firms much earlier based on certain characteristics like poor
management, low insider ownership and poor returns on projects and for
stockholders.
9. No Money Down, No Risk, Big Profits:
Premise: A Sure Thing: No Risk And Sure Returns

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 Downside: Identification of arbitrage opportunities is difficult, as they disappear in no
time
Things to consider: Continuous tracking and faster execution
10. Core-Satellite approach:
Premise: A combination of passive (core: reducing cost and volatility) and active
(satellite: return maximization) investment. The core-satellite approach provides an
opportunity to access the best of all worlds. Better-than-average performance, limited
volatility and cost control all come together in a flexible package that can be designed
specifically to cater to your needs
Downside: Does not work in case assets are correlated leading to worst of all worlds
rather than best of all
Things to consider: Careful asset allocation duly looking at volatility, expenses,
correlations etc.
BASED ON CALENDER EFFECTS AND INFORMATION EFFECTS:
January Effect: Tendency of stock prices rising in January and falling in December due to
heavy selling in December to avoid taxes by incurring losses and buying in January
Weekend Effect (Monday effect): Stock returns on Monday being more than on Friday due
to the tendency of the firms to release bad news on Friday after the market hours or due to
short selling on Friday
Information Effect: (Neglected firm effect- similar to hidden gems)

Points to note:

Ex: If price of time is 6%, market price of risk is 1.2 and amount of risk in terms of
variance is 100%2, expected return on such a portfolio under CML is
Sol: Rf= 6%
Market price of risk under CML: (Rm-Rf)/σm = 1.2
σp = 10%
As CML = Rf+(Rm-Rf) σm / σp
Expected return on portfolio as per CML = 6+1.2×10 = 18%
Ex: Price of time is 6%, market risk premium as per SML is 7%. If beta of security is 2,
what is the expected return on the stock?
Sol: Price of time + Quantity of risk × Market price of risk
= 6+ 2×7 = 20%

Zero beta portfolio has zero systematic risk.

Arbitrage pricing theory is based on LOOP (Law of One Price). All securities with similar
risk characteristics should trade at the same price: Otherwise, arbitrage takes place due to
disequilibrium in the market, leading to equilibrium. Arbitrage Pricing Theory (APT) is a
Multi factor/index model

Evaluation of Portfolio Performance

Que 1. The following is the information pertaining to the performance of two portfolios
managed by two portfolio managers Jindal and Nazir, along with the benchmark:
Asset Class Benchmark Portfolio Managed by Portfolio Managed by
Nazir Jindal

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 Weight (%) Return (%) Weight (%) Return (%) Weight (%) Return (%)
Stocks 60 18 70 15 40 21
Bonds 25 12 20 9 40 10
Cash and 15 7 10 5 20 6
Equivalents
a. Compute total valued added by portfolio managers, Jindal and Nazir
b. Compute total value added by the selection and allocation abilities of the
portfolio managers
Sol 1:
a. Return generated by Nazir= 15×0.7+ 9 ×0.2 + 5×0.1 = 12.8%
Return from Bench mark portfolio = 18×0.6+12×0.25+7×0.15 = 14.85%
Value added by Nazir = 12.8-14.85 = -2.05%
Return generated by Jindal= 21×0.4+ 10 ×0.4 + 6×0.2 = 13.6%
Value added by Jindal = 13.6-14.85 = -1.25%
b. Allocation Effect:
Manager Deviation in Deviation in Asset-Wise Total Allocation
Allocation Returns (Asset Allocation Effect (%)
(Portfolio Return in the Effect (%) (I×II)
Weight – Bench Benchmark –
mark Weight) Average
Benchmark
Return)
Jindal 0.1 18-14.85 = 3.15 0.315 0.85
-0.05 12-14.85=-2.85 0.1425
-0.05 7-14.85=-7.85 0.3925
Nazir -0.2 18-14.85 = 3.15 -0.63 -1.45
0.15 12-14.85=-2.85 -0.4275
0.05 7-14.85=-7.85 -0.3925

Selection Effect

Manager Actual Weights Deviation in Returns Asset-Wise Total Selection

(Asset return in Selection Effect (%)
managed portfolio – Effect (%)
Asset return in
benchmark portfolio)
Jindal 0.7 15-18 =-3 -2.1 -2.9
0.2 9-12=-3 -0.6
0.1 5-7=-2 -0.2
Nazir 0.4 21=18=3 1.2 0.2
0.4 10-12=-2 -0.8
0.2 6-7=-1 -0.2
Excess returns
Nazir = Allocation effect + Selection effect = 0.85-2.9 = -2.05%
Mr. Nazir exhibited superior asset allocation skills (0.85%) and inferior stock
selections (-2.95%) compared to bench mark. Further, his superior allocation abilities
helped in hiding inferior stock selection skills.
Jindal = Allocation effect + Selection effect = -1.45+0.2 = -1.25%

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 Mr. Jindal performed better than benchmark in selection and worse than benchmark in
allocation.
As a whole, Mr. Nazir underperformed benchmark by 2.05% and Jindal by 1.25%

Que 2. Mr Vardhan, an investor is trying to analyse the performance of four fund managers. You are
an analyst whom he approaches for advice. The relevant data about the funds is given as
under:

Fund Return (%) Unsystematic risk (%)2 Coefficient of correlation

between fund and market returns
SBI Equity Fund 15.05% 18.90% 0.95
HSBC Equity Fund 19.47% 16.20% 0.97
Fidelity Equity Fund 14.80% 14.40% 0.92
Tauras Equity Fund 12.85% 15.30% 0.93
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Market returns and its variance of returns are 19.8% and 361(%) respectively. If Treasury bill
yields 7.5%, determine
a. Sharpe ratio b. Treynor ratio
c. Return from total selectivity, net selectivity and inadequate diversification. Also
comment which of the above fund managers have exhibited superior selection skills.

Sol 2

Fund Return (%) Unsystematic Coefficient of Variance (%)2 S D (%)

Risk (%)2 Determination
SBI Equity 15.05% 18.90% 0.9025 18.9/(1-0.9025) = 13.92
Fund 193.8462
HSBC Equity 19.47% 16.20% 0.9409 6.2/(1- 16.56%
Fund 0.9409)=264.1117
Fidelity 14.80% 14.40% 0.8464 14.4/(1-0.8464) = 9.68%
Equity Fund 93.75
Tauras 12.85% 15.30% 0.8649 15.3/(1-0.8649) = 10.64%
Equity Fund 113.2494

Fund Sharpe Ratio (Ri-Rf)/σi

SBI Equity Fund (15.05-7.5)/13.92 = 0.5424
HSBC Equity Fund (19.47-7.5)/16.56 =0.7228
Fidelity Equity Fund (14.80-7.5)/9.68=0.7541
Tauras Equity Fund (12.85-7.5)/10.64=0.5028

b.

Fund Variance – Unsystematic Risk = Beta = (SR/Mar Var)0.5

Systematic Risk
SBI Equity Fund 174.9462 (174.9462/361)0.5 =0.7
HSBC Equity Fund 257.9117 (257.9117/361)0.5 =0.85
Fidelity Equity Fund 79.35 (79.35/361)0.5 =0.47
Tauras Equity Fund 97.9494 (97.9494/361)0.5 =0.52

Fund Treynor Ratio (Ri-Rf)/σi

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 SBI Equity Fund (15.05-7.5)/0.7 = 10.79
HSBC Equity Fund (19.47-7.5)/0.85 =14.08
Fidelity Equity Fund (14.80-7.5)/0.47=15.53
Tauras Equity Fund (12.85-7.5)/0.52=10.29
c.

Fund Return Rf+Bi(Rm-Rf) Return due to Rf+σi/ σi (Rm-Rf) Return due Return due to
(%) (Return as per total (%) (Return as to net extra
(1) SML) selectivity (%) per CML) selectivity diversifiable
(2) (1-2) =3 (%) risk (%)
4 5=1-4 6= 3-4
SBI Equity 15.05% 7.5+0.7×12.3 -1.06 7.5+13.92/19×12. -1.46 0.40
Fund =16.11 3 = 16.51
HSBC Equity 19.47% 7.5+0.85×12.3 1.51 7.5+16.56/19×12. 1.25 0.26
Fund =17.96 3 = 18.22
Fidelity Equity 14.80% 7.5+0.47×12.3 1.52 7.5+9.68/19×12.3 1.03 0.49
Fund =13.28 = 13.77
Tauras Equity 12.85% 7.5+0.52×12.3 -1.05 7.5+10.64/19×12. -1.54 0.49
Fund =13.90 3 = 14.39
Fund managers of Fidelity equity fund and Tauras equity fund have exhibited superior stock selection
skills followed by the fund managers of SBI equity fund.

Que 3. Consider the following information pertaining to four mutual fund schemes.

Fund Returns Systematic Risk Unsystematic

(%) (%)2 Risk (%)2
Kotak Equity Fund 11 24 14
Invesco Growth Fund 15 8 34
DSP Blackrock 13 15 2
Diversified Fund
Tata Blue Chip Fund 9 11 4
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The return on Nifty is 14% and its variance is 45% . 364 day Treasury bill yield is
6.5%. Rank the above schemes based on Sharpe measure, Treynor measure and
Jensen’s alpha and explain the reasons for conflicts in ranking by the above measures
if any. Also compute information ratio (appraisal ratio).

Sol 3:

Fund Return Systematic Unsystematic Beta= Total Total

s (%) Risk (%)2 Risk (%)2 sqrt( (SR/V Risk Risk
arM)) (Var)%2 (SD)%
Reliance Equity Fund 11 24 14 0.7303 38 6.16
ICICI Growth Fund 15 8 34 0.42164 42 6.48
HDFC Diversified Fund 13 15 2 0.57735 17 4.12
SBI Magnum Blue Chip Fund 9 11 4 0.49441 15 3.87

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Fund
Sharpe Ratio Ran Treynor Ratio Ran Jensen's Alpha
(Ri-Rf)/SD k (Ri-Rf)/β k (Ri- (Rf+β(Ri-Rf)) Rank
Reliance Equity Fund 0.73 3 6.16 3 -0.977 3
ICICI Growth Fund 1.31 2 20.16 1 5.3377 1
HDFC Diversified Fund 1.58 1 11.26 2 2.16987 2
SBI Magnum Blue chip
Fund 0.65 4 5.06 4 -1.208 4

Fund Alpha Unsystemati Information Ratio = Alpha

(%) c Risk (%) / Unsystematic Risk
Reliance Equity Fund 3.74 -0.26
-0.98
ICICI Growth Fund 5.83 0.92
5.34
HDFC Diversified Fund 1.41 1.53
2.17
SBI Magnum Blue chip 2.00 -0.60
Fund -1.21
Note: Information ratio (Appraisal Ratio): Alpha/Residual Risk (Unsystematic Risk)

: or Alpha/Tracking Error

Sharpe measure takes standard deviation as a measure of risk. In case of fully diversified
portfolio, total risk and systematic risk will be equal. In respect of such portfolios there will
be no conflict in the ranking between Sharpe ratio and Treynor ratio. Sharpe measure will be
appropriate for evaluating funds which are not expected to be fully diversified and Treynor
ratio for funds which are supposed to be well-diversified. In case of sector specific funds,
unsystematic risk is expected and hence appropriate to use Sharpe’s ratio. If we compare
growth funds they are highly diversified, hence Treynor ratio is more appropriate. If a fund is
not fully diversified, it will have a higher component of unsystematic risk and hence will rank
lower when Treynor ratio is used. In the given case, conflict of ranking is there with respect
to ICICI Growth Fund and HDFC diversified fund. ICICI Growth Fund is less diversified
than HDFC diversified fund.

Que 4. 182 day T-bill yield is 6%. Return on Sensex is 16% and its standard deviation is
15%. If beta of a mutual fund scheme is 0.8 and its return is 16%. Investor’s target
beta is 0.5. If portfolio’s standard deviation is 14%. Compute the following:
a. Return from manager’s risk
b. Return from investor’s risk
c. Return due to total selectivity
d. Return due to net selectivity
e. Return due to inadequate diversification

Sol 4:
Return from target beta = 6%+0.5(10%) = 11%
Return as per SML = 6%+ 0.8(10%) = 14%

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Return due to manager’s risk = 14%-11% = 3%
Return due to investor’s risk = 11%-6% = 5%
Return due to total selectivity = 16%-14% = 2%
Return due to net selectivity = 16%-[6+(10)×14%/15%] = 0.67%
Return due to inadequate diversification = 2%-0.67% = 1.33%

Que 5: Determine Sortino ratio from the following returns:

Year 2013 2014 2015 2016 2017 2018 2019 2020

Return 14.00% 8.00% -4.00% -6.00% 9.00% 15.00% 9.00% -11.00%

Sol 5:

Sortino Ratio
Squared Negative
Year Return Deviation Deviation
2013 14.0% 9.8%
2014 8.0% 3.8%
2015 -4.0% -8.3% 0.00681
2016 -6.0% -10.3% 0.01051
2017 9.0% 4.8%
2018 15.0% 10.8%
2019 9.0% 4.8%
2020 -11.0% -15.3% 2.3%
Mean Return 4.3% 0.04057
Semi variance 0.0058
Semi
deviation 0.07613
Sortino Ratio 0.55827

Que 6. Compute Tracking Error from the following information:

Period 1 2 3 4 5 6 7 8
Portfolio 2.3% -3.6% 11.2% 1.2% 1.5% 3.2% 8.9% -0.8%
Manager's
Return
Index Returns 2.7% -4.6% 10.1% 2.2% 0.4% 2.8% 8.1% 0.6%

Sol 6:

Perio Portfolio Index

d Manger’s returns Deviatio
returns n    

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  1 2 4=(3)-Average of
3=1-2 Deviation 5=4^2
1 2.30% 2.70% -0.40% -0.60% 0.0000360
2 -3.60% -4.60% 1.00% 0.80% 0.0000640
3 11.20% 10.10
% 1.10% 0.90% 0.0000810
4 1.20% 2.20% -1.00% -1.20% 0.0001440
5 1.50% 0.40% 1.10% 0.90% 0.0000810
6 3.20% 2.80% 0.40% 0.20% 0.0000040
7 8.90% 8.10% 0.80% 0.60% 0.0000360
8 -0.80% 0.60% -1.40% -1.60% 0.0002560
      0.20% Total 0.0007020
        Variance = Total/7 0.0001003
Tracking Error =
        Variance^0.5 1.0%

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