Equity 
Portfolio Management
4 Equity Portfolio Management
The Roles of Equities in a Portfolio
• Equities represent a sizable portion of the global
investment universe and thus often represent a
primary component of investors’ portfolios.
• Rationales for investing in equities include potential
participation in the growth and earnings prospects of
an economy’s corporate sector as well as an
ownership interest in a range of business entities by
size, economic activity, and geographical scope.
Publicly traded equities are generally more liquid
than other asset classes and thus may enable investors
to more easily monitor price trends and purchase or
sell securities with low transaction costs.
• The Roles of Equities in a Portfolio
• Equity Investment Universe
• Passive Equity Portfolio Management Strategies
• Active Equity Portfolio Management Strategies
• Investment Styles
• Asset Allocation Strategies
The Roles of Equities in a Portfolio
• Equities provide several roles in (or benefits
to) an overall portfolio, such as capital
appreciation, dividend income,
diversification with other asset classes, and a
potential hedge against inflation.
• In addition to these benefits, client investment
considerations play an important role for
portfolio managers when deciding to include
equities in portfolios
 Capital Appreciation Dividend income

Long-term returns on equities, driven predominantly by capital appreciation, Dividends have comprised a significant component of long-term
have historically been among the highest among major asset classes. total returns for equity investors

Diversification Hedge Against Inflation
• One characteristic important to investors
across markets is ability to be an inflation
hedge
– equities have comparatively high historical long-
term rates of return
– in study of 17 countries the long term real rates of
return to equities exceeded that of bonds in all
countries
• Client consideration for equities in a portfolio

It is important to note that correlations are not constant over time

Equity Investment Universe

• Segmentation by size and style

Equity Investment Universe Equity Investment Universe
• Segmentation by geography • Segmentation by economic activities
Equity Investment Universe
• Segmentation by economic activities
Cost in an Equity Portfolio
• Management fees – a percentage of the funds
under management at regular intervals
– For actively managed portfolios, management fees
include direct costs for research, and the direct
costs for portfolio management
– For passively managed portfolios, management
fees are typically low
Income in an Equity Portfolio
• Dividend Income
• Securities Lending Income
Cost in an Equity Portfolio
• Performance fees:
– Generally associated with hedge funds and
long/short equity portfolios
– A high water mark is the highest value, net of fees,
that the fund has reached
• Administration fees
• Marketing and distribution costs
• Trading costs
 Active vs. Passive Management
• Passive Investment 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
• Semiactive Management
– enhanced indexing or risk-controlled active management
– seek to outperform benchmark but manager worries more about
tracking risk than active manager and builds portfolio that will have
limited volatility around benchmark’s return

Indexing, Enhanced Indexing, and 
Active vs. Passive Management Active Approaches: A Comparison
Indexing Enhanced Active
Indexing
Expected 0% 1% - 2% 2% +
Active
Return
Tracking <1% 1% - 2% 4% +
Risk
Information 0 0.75 0.50
Ratio
 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%) are hard to
overcome in risk-adjusted performance
• Many different market indexes are used for tracking
portfolios
Equity Indices
• Indexes are portfolio management benchmarks
• also used
– to measure return of a market or market segment
– as basis for creating an index fund
– to study factors that influence share price movements
– to perform technical analysis
– to calculate a stock’s systematic risk
Indexing
• Many studies have found that the average active
institutional portfolio fails to beat the relevant
comparison index after expenses
– often difference in performance is found to be close to
average expense disadvantage of active management
– compared with the average actively managed fund that
has similar objectives, a well-run indexed fund’s major
advantage is expected superior long-term net-of-
expenses performance because of relatively low
• portfolio turnover
• management fees
• high tax efficiency
Methods of Index Portfolio Investing
• Pooled investment: open-end mutual funds,
index funds and exchange-traded funds (ETFs)
• Derivatives-based approaches
• Separately managed equity index-based
portfolios
Methods of Index Portfolio Investing 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
– Advantage: provide an inexpensive way for investors to
acquire a diversified portfolio

Methods of Index Portfolio Investing Methods of Index Portfolio Investing

• ETFs
– 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
– 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)
– Regional or country ETFs
– Sector ETFs
 Index Portfolio Construction  Index Portfolio Construction 
Techniques Techniques
• Not a simple process to track a market index • Full Replication
closely – All securities in the index are purchased in
• Three basic techniques: proportion to weights in the index
– Full replication – This helps ensure close tracking
– Sampling – Increases transaction costs, particularly with
– Quadratic optimization or programming dividend reinvestment

Index Portfolio Construction  Index Portfolio Construction 
Techniques Techniques
• Full Replication
• 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
– Relies on historical correlations, which may
change over time, leading to failure to track the
index
Tracking Error and Index Portfolio Construction
Tracking Error Management
• 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)
Tracking Error and Index Portfolio Construction
Investment Style Tracking Error Range
Passive Less than 1.0% (0.5% or lower is
normal)
Structured Between 1% and 3%
Active Over 3% (5% to 15% is normal)
Source: Andrew Alford, Robert Jones, Kurt Winkelmann, 2003, A
Spectrum Approach to Active Risk Budgeting, Journal of Portfolio
Management 30, no. 1, pp 49 ‐ 63
 Rebalancing an Equity Portfolio

• Why?
– to manage tracking error (if indexing or not)
– to maintain a desired set of weights or risk level
– client needs change
– Market risk level changes
– bankruptcies, mergers, IPOs
• Why not?
– it’s costly!
Based on the levels of tracking error and excess return figures
provided in the exhibit, explain whether the funds are likely
replicating or sampling?

Rebalancing: Example 1 Rebalancing: Example 1
Jan. 1 Price Number $ Value % of Beta June 1 Price per Number $ Value % of Beta
per of Shares Total Share of Shares Total
Value
Share Value
down X 16 167 $2672 0.256 1.3
X 20 167 $3340 0.333 1.2
20%
Y 15 222 $3330 0.333 1.6
up Y 20 222 $4440 0.425 1.7
Z 35 95 $3325 0.333 0.8 33%
Total $9995 1.20 unch. 35 95 $3325 0.319 0.8
Z
Total 10445 1.31
 Rebalancing: Example 1 Rebalancing: Example 1
June 1 Price per Number $ Value % of Beta
• Portfolio is no longer equally weighted Rebal- Share of Shares Total
anced Value
• To rebalance:
X 16 167 $3488 0.334 1.3
– Sell Y, buy X and Z
Y 20 222 $3480 0.334 1.7
– Positions must be reset to $10445/3 = $3482 35 95 $3465 0.332 0.8
Z
– Sell 4440 - 3482 = $958 of Y (48 shares) 10433 1.27
Total
– Buy 3482 - 2672 = $810 of X (51 shares)
– Buy 3482 - 3325 = $157 of Z (4 shares)

Rebalancing: Example 1 Rebalancing: Example 2

• LT effects of this strategy? • Reestablishing a beta of 1.2:

– No unique solution for more than 2 securities
• Alternatives? – Need to sell high  stocks and buy low  stocks
– For example, sell Y, buy Z, hold X constant
• Example 2: Rebalancing to reestablish a – p = (.256)(1.3)+(WY)(1.7)+(1-.256-WY)(.8)
specific level of systematic risk (Target Beta = – Find Y such that p = 1.2
1.2) • WY = .302 => WZ = 1-.256-.302 = .442
• $3488 in X, $3151 in Y, $4611 in Z
 Active Equity Portfolio  Active Equity Portfolio Management 
Management Strategies 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

Approach to Active Management Approach to Active Management

• With regard to how these investment ideas are implemented—
for example, how securities are selected—active strategies can
be divided into two broad categories: fundamental and
quantitative.
• Fundamental approaches are based on research into
companies, sectors, or markets and involve the application of
analyst discretion and judgment.
• Quantitative approaches are based on quantitative models of
security returns that are applied systematically with limited
involvement of human judgment or discretion.
• The labels fundamental and quantitative in this context are an
imperfect shorthand that should not be misunderstood. The
contrast with quantitative approaches does not mean that
fundamental approaches do not use quantitative tools.
Fundamental approaches often make use of valuation models
(such as the free cash flow model), quantitative screening
tools, and statistical techniques (e.g., regression analysis).
Furthermore, quantitative approaches often make use of
variables that relate to company fundamentals. Some
investment disciplines may be viewed as hybrids in that they
combine elements of both fundamental and quantitative
disciplines.
Approach to Active Management
Types of Active Investment Strategies:
Bottom up vs. Top down  Bottom‐up strategies
• Both fundamental and quantitative managers can be
further categorized as either bottom-up or top-down
strategies.
• Bottom-up strategies use information about individual
companies such as profitability or price momentum to
build portfolios by selecting the best individual
investments.
• Top-down strategies use information about variables
that affect many companies such as the macroeconomic
environment and government policies to build
portfolios by selecting the best markets or sectors.
• Managers can use a blend of bottom-up and top-down
approaches.
Types of Active Investment Strategies:
• Quantitative bottom-up managers look for quantifiable
relationships between company-level information (e.g.,
P/E ratio) and expected return that will persist into the
future.
• Fundamental bottom-up managers incorporate both
quantifiable and qualitative characteristics of individual
companies into their analysis:
– business model and branding,
– competitive advantage, and
– quality of company management and corporate
governance).
• Types of bottom-up strategies include both value-based
and growth-based approaches
 Types of Active Investment Strategies:
Bottom‐up strategies
• Value-based approaches attempt to identify securities that
are trading below their estimated intrinsic value.
• Sub-styles of value investing include the following:
– Relative value: Comparing price multiples such as P/E and
P/B to peers. An undervalued company has an inexplicably low
multiple relative to the industry average.
– Contrarian investing: Purchasing or selling securities against
prevailing market sentiment. For instance, buying the securities
of depressed cyclical stocks with low or negative earnings.
– High-quality value: Equal emphasis is placed on both intrinsic
value and evidence of financial strength, high quality
management, and demonstrated profitability (the “Warren
Buffet” approach).
Types of Active Investment Strategies:
Bottom‐up strategies
• Income investing: Focus is on high dividend yields and
positive dividend growth rates.
• Deep-value investing: Focus is on extremely low
valuations relative to assets (e.g., low P/B), often due to
financial distress.
• Restructuring and distressed debt investing: Investing
prior to or during an expected bankruptcy filing. The goal is
to release value through restructuring the distressed
company or through the company having sufficient assets in
liquidation to generate appropriate returns.
• Special situations: Identifies mispricings due to corporate
events such as divestures, spin-offs, or mergers

Types of Active Investment Strategies: Types of Active Investment Strategies:
Bottom‐up strategies Bottom‐up strategies
• Growth-based approaches attempt to identify companies
with revenues, earnings, or cash flows that are expected to
grow faster than their industry or the overall market.
• Analysts will be less concerned about high valuation
multiples and more concerned about the source and
persistence of the growth rates of the company.
• Focus could be on:
– Consistent long-term growth.
– Shorter-term earnings momentum.
– GARP (growth at a reasonable price); looking for growth at a
reasonable valuation. Often this strategy will use the P/E-to-
growth (PEG) ratio, which is calculated as the stock’s P/E ratio
divided by expected earnings growth in percentage terms.
 Types of Active Investment Strategies:
Top‐Down Strategies
• Both fundamental and quantitative managers could use
a top-down approach focusing on the overall
macroeconomic environment and broad market
variables rather than information relating to individual
investments.
The Stock Market and the Business Cycle
Types of Active Investment Strategies:
Top‐Down Strategies
• Top-down managers typically use broad market ETFs and derivatives to
overweight the best markets and underweight the least attractive markets
according to the following dimensions:
– Country and Geographic Allocation to Equities
– Sector and Industry Rotation
– Volatility: Volatility trading can be conducted through VIX futures,
variance swaps, or option volatility strategies such as straddles.
– Thematic investment strategies: Focus on opportunities presented by new
technologies, changes in regulations, and economic cycles. Themes could
be long term and structural such as the shift to cloud computing,
blockchain technology, or clean energy. Themes might also be shorter term
in nature such as the impact on the value of a currency of a major political
vote.
Types of Active Investment Strategies:
Factor Based Strategies
Types of Active Investment Strategies: Types of Active Investment Strategies:
Factor Based Strategies Activist Strategies
• Activist investors specialize in taking stakes in listed companies and
advocating changes for the purpose of producing a gain on the
investment. The investor may wish to obtain representation on the
company’s board of directors or use other measures in an effort to initiate
strategic, operational, or financial structure changes. In some cases,
activist investors may support activities such as asset sales, cost-cutting
measures, changes to management, changes to the capital structure,
dividend increases, or share buybacks. Activists—including hedge funds,
public pension funds, private investors, and others—vary greatly in their
approaches, expertise, and investment horizons. They may also seek
different outcomes. What they have in common is that they advocate for
change in their target companies.

Types of Active Investment Strategies: Creating a Fundamental Active 
Activist Strategies Investment Strategies
Creating a Quantitative Active  Quantitative Investment 
Investment Strategies Management
• The quantitative active investment strategy has • How do we forecast performance ?
a well-defined process: – Screening (Fundamental or Technical factors)
– 1. Define the market opportunity. – Rank based on some set of factors that correlates
– 2. Acquire and process data. with future performance (such as regression
– 3. Back-test the strategy. analysis)
– 4. Evaluate the strategy. • How do we improve forecasting model?
– 5. Construct the portfolio. – Add more data (more observations)
– Uncover new causal relationships (variables)

Quantitative Investment 
QIM
Management
• Regardless of forecast, there are three basic results 2. Profitable QIM techniques won’t be
common to QIM: commercialized
Starting with a multifactor model:
– 1. Information comes from unexpected events • Ri = b1F1 + b2F2 + . . . + bkFk + ei
• events with low probability have high info content!
• It isn’t easy to get information from these residuals:
– 1. patterns are complex
– 2. quality of data is limited
– 3. outliers may draw undue attention (although irrelevant)
– 4. human judgement is superior
– 5. analysis must be flexible (more data, constraints)
– 6. danger of data mining
– 7. even if significant, outliers are too few in number!
 EQUITY INVESTMENT STYLE 
QIM
CLASSIFICATION
3. Non-linear models are important • An investment style classification process is designed
to split a stock universe into subgroups of stocks that
represent the styles (i.e., size, value, etc.). These
• Neural Networks
groups should contain stocks that have a high
• Genetic Algorithms correlation with each other (because they are part of
• Fuzzy Logic the same style), but correlation between groups
• Non-Linear Dynamics should be lower indicating that styles are distinct
• Classification Trees (Recursive Partitioning) sources of risk and return. This process is useful for
classifying the style of a portfolio and benchmarking
managers

Investment Styles Investment Styles
• Value Versus Growth
• Value Versus Growth
– Value investor focuses on share price in anticipation
– A growth investor focuses on the current and of a market correction and improving company
future economic “story” of a company, with less fundamentals
regard to share valuation
– Value stocks generally have offered somewhat higher
– Focus on EPS and its economic determinants returns than growth stocks, but this does not occur
– Look for companies expected to have rapid EPS with much consistency from one investment period to
growth another
– Focus on the price component
– Not care much about current earnings
– Assume the P/E ratio is below its natural level
 Style Analysis 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

Does Style Matter? 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
Does Style Matter?