5/30/2023

Equity
Portfolio
Management
Strategies
Dr. Mahmoud Otaify
Assistant Professor of Finance

Lecture’s Objectives
Describe how portfolios are constructed to address client investment objectives
and constraints

Describe strategic and tactical asset allocation

Compare passive and active investment management

Describe how active managers attempt to identify and capture market

inefficiencies

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Concepts
• is the process of deciding how to distribute an
Asset allocation investor’s wealth among different countries
and asset classes for investment purposes.

• is composed of securities that have similar

Asset class characteristics, attributes, and risk–return
relationships

Asset (Security) • The process of choosing individual

investments (stocks and bonds)
Selection

ASSET ALLOCATION AND PORTFOLIO

CONSTRUCTION

Developing the investment policy statement (IPS),

Determining The asset allocation of the portfolio

the proportion of the portfolio to
Suitable asset classes
invest in each asset class

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Exercise on the
Lecture
Measuring Risk Tolerance

Asset
Allocation

Strategic Asset Tactical Asset

Allocation Allocation

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Strategic Asset Allocation

Determining
Estimating Risk &
The long- term mix correlation of
return of each
of assets returns between
asset class
the asset classes
If investor sets strategic
assets allocation

fluctuations in asset
class returns

Weights of classes in
portfolio change

Portfolio rebalancing is
needed

investment manager may

an investor has a strategic think the equity market is
asset allocation of 60% overvalued and likely to
equities and 40% bonds produce poor returns in the
short term

If the manager’s expectation

is correct, this 50/50 tactical
The manager will adjust the
allocation will perform better
asset allocation to 50%
in the short term than the
equities and 50% bonds
strategic asset allocation of
60/40

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A short- term adjustment

among asset classes

Tactical
Asset a form of active portfolio
management

Allocation
attempt to add value to a
portfolio by deviating from the
strategic asset allocation

Compare passive and active

Portfolio management?

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PASSIVE AND
ACTIVE
MANAGEMENT

• manage a portfolio
Passive designed to match
managers the performance of a
specified benchmark

• attempt to add value to a

portfolio by selecting
Active investments that are
managers expected, on the basis of
analysis, to outperform a
specified benchmark.

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Passive Buy and Hold

Strategy
Equity Index Investing
Portfolio Strategy
Management
Strategies
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Passive Management

Passive Managers Passive Management Approaches

seek to match the

return and risk of Full
a benchmark Sampling
Replication

attempt to Quadratic
minimize tracking Optimization
error

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1. Full Replication
All the securities in the index are purchased in
Technique
proportion to their weights in the index.
Advantage • This technique helps ensure close tracking
The need to buy many securities will increase
transaction costs that will detract from
performance.
Disadvantages
• The reinvestment of dividends will also result in
high trading expenses when many firms pay
small dividends at different times in the year.

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2. Sampling
• A portfolio manager would only need to buy a representative
Technique
sample of stocks that comprise the benchmark index.

 Addresses the problem of having to buy numerous stock

issues.
 With fewer stocks to purchase, larger positions can be taken
in the issues acquired, which should lead to proportionately
Advantages
lower transaction costs.
• The reinvestment of dividends will be less problematic
because fewer securities need to be purchased to rebalance
the portfolio.

• Portfolio returns will almost certainly not track the returns for
Disadvantage
the benchmark index as closely as with full replication.

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3. Quadratic Optimization (programming))

• Historical information on price changes and

correlations between securities are input to
Technique a computer program that determines the
composition of a portfolio that will minimize
return deviations from the benchmark.

• it relies on historical price changes and

correlations, and if these change over time,
Disadvantage
the portfolio may experience very large
differences from the benchmark.

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Tracking Error and Index Portfolio Construction

Goal of forming a replicate a particular

passive portfolio equity index

Portfolio
Tracking error Index Return
returns

the extent to which return fluctuations in the

managed portfolio are not correlated with return
fluctuations in the benchmark

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Measuring tracking error – Example

Suppose an investor has formed Period Manager Index

a portfolio designed to track a
particular benchmark. Over the 1 2.3% 2.7%
last eight quarters, the returns to 2 -3.6 -4.6
this portfolio, as well as the 3 11.2 10.1
index returns and the return 4 1.2 2.2
difference between the two. 5 1.5 0.4
6 3.2 2.8
Calculate annualized tracking error? 7 8.9 8.1
8 -0.8 0.6

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The periodic average and standard

Measuring tracking error deviation of the manager’s return
differential (i.e., “delta”) relative to the
benchmark are:
Period Manager Index Difference
(∆) 𝐴𝑣𝑒𝑟𝑎𝑔𝑒 ∆
1 2.3% 2.7% -0.4% =
−0.4 + 1 + 1.1 − 1 + 1.1 + 0.4 + 0.8 − 1.4
8
2 -3.6 -4.6 1 = 0.2%
3 11.2 10.1 1.1
4 1.2 2.2 -1 −0.4 − 0.2 + ⋯ + −1.4 − 0.2
𝑆𝐷∆ = = 1%
5 1.5 0.4 1.1 8−1

6 3.2 2.8 0.4

7 8.9 8.1 0.8 Thus, the manager’s annualized tracking error
for this two-year period is 2.0 percent (1𝑥 4)
8 -0.8 0.6 -1.4

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Methods of Index Portfolio Investing – buying

shares in

Index Mutual Fund Exchange-Traded Fund

a portfolio of securities is placed on deposit at a financial
institution or into a unit trust, which then issues a single type of
the fund manager will typically attempt to replicate the certificate representing ownership of the underlying portfolio.
composition of the particular index exactly

they can be bought and sold (and short sold) like common
stock through an organized exchange or in an over-the-counter
market.
smaller management fee

provide an inexpensive way for investors to acquire a

diversified portfolio that emphasizes the desired market or
industry disadvantages include the brokerage commission and the
inability to reinvest dividends, except on a quarterly basis.

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Active Equity Portfolio

Management Strategies
Buy and sell

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Active Management

Active Managers Active Management Approaches

earn a return that exceeds
the return of a passive Technical and
benchmark portfolio, net of Fundamental
transaction costs, on a risk- Behavioural
adjusted basis Analysis
Analysis

try to time a market (buying

when they believe the
Quantitative
market is undervalued and
selling when they believe
Analysis
the market is overvalued)

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Describe how active managers attempt to identify

and capture market inefficiencies?

Fundamental Analysis Technical and Behavioural Quantitative Analysis

Use macroeconomic, industry- specific,
and company- specific factors that make
securities and assets valuable
Identify companies whose better
prospects that current market price
(mispriced stocks)
Analysis
Technical: Use market information,
including price patterns and trading
volumes.
e.g., momentum: rising share continue to
rise
Behavioral: use market sentiment
indicators
e.g., indices of consumer expectations.
Use statistical models to identify shares
that are likely to outperform or
underperform
e.g., identifying stocks with below
market average P/E ratio and above-
average earnings growth

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