Equity Portfolio Management Strategies

Passive versus Active Management

Total Portfolio Return

=[Expected Return] + [Alpha]
=[Risk-Free Rate + Risk Premium] + [Alpha]

Passive versus Active Management

Passive equity portfolio management

Buy-and-hold
tracking an index
matching market performance
Manager judged - how well they track the target

index

Active equity portfolio management

Outperform a passive BM portfolio on a risk-

adjusted basis ( generating alpha)

( through tactical adjustments or security
selection)

An Overview of Passive Strategies

To replicate the performance of an index

underperform / overperform the target?

Strong rationale for this approach

Costs of active management

Many market indexes are used for tracking portfolios

S&P BSE Sensex, 100, 200, 500
CNX NIFTY Index, 500, Midcap

Index Portfolio Construction

Techniques

Full Replication
Securities in proportion
ensures close tracking
transaction costs (dividend reinvestment).
Ex. HDFC Nifty Index Fund

Index Portfolio Construction

Techniques

Sampling
A representative sample of stocks
Fewer stocks - lower commissions
Dividend Reinvestment less difficult
No close tracking so some tracking error.
Ex. HDFC Nifty Plus

Index Portfolio Construction

Techniques

Quadratic Optimization (or programming

techniques)
Historical information on price changes and

correlations put into a computer program that

determines the portfolio having minimum
tracking error.
Relies on historical correlations, which may

change over time index tracking failure.

Tracking Error and Index Portfolio Construction

Passive manager goal

minimize the portfolios return volatility,
i.e., to minimize tracking error (TE)
Tracking Error Measure
Return differential in time period t

t =Rpt Rbt
where Rpt= return to the managed portfolio in Period t
Rbt= return to the benchmark portfolio in Period t.
TE is measured as of t , normally annualized.
TE = P (P is the number of return periods in a year,

P = 12 for monthly return). where 2=(t mean )2 / (T-1)

where T is the number of return observations

Methods of Index Portfolio

Investing

1.
2.

Two prepackaged passive investment

portfolios are
Index mutual fund
Exchange-traded fund (ETF)

Methods of Index Portfolio Investing

Index Funds
Exact replication in terms of securities &

weights
Low trading and management expense ratios
The advantage - an inexpensive way for

investors to acquire a diversified portfolio

Methods of Index Portfolio Investing

Exchange-Traded Funds (ETF)

ETFs are depository receipts of the securities

that are held in deposit by a financial institution

that issued the certificates
Advantage of ETFs - can be bought &sold.
Backed by a sponsor, smaller fee, continuous
trading when SE is open.
example of ETFs
ICICI Prudential CNX 100 ETF
SENSEX Prudential ICICI Exchange Traded Fund

An Overview of Active Strategies

Goal earn > than a passive BM portfolio,

net of transaction costs, on a risk-adjusted
basis.
Need to select an appropriate benchmark

Practical difficulties of active manager

Offsetting Transactions costs by superior

performance
Higher risk-taking needed to beat the BM ( it
also risk ).

Equity Portfolio Investment Philosophies

and Strategies

Passive Management Strategies

1. Efficient Market Hypothesis
Buy and Hold &
Indexing
Active Management Strategies
2. Fundamental Analysis
Top-Down ( Asset class/sector rotation)
Bottom-Up ( Stock under/over valuation)
3. Technical Analysis
Contrarian (e.g. overreaction)
Continuation (e.g. price momentum)
4. Anomalies & Attributes
Calendar Effects ( weekend, January)
Information effects (e,g., neglect)
Security Characteristics (e.g. P/E, P/BV, Earnings momentum, firm size)
Investment Style (e.g., value, growth)

Fundamental Strategies

Top-Down versus Bottom-Up Approaches

Top-Down
Broad country and asset class allocations
Sector allocation decisions
Individual securities selection

Bottom-Up
Securities selection without any initial market or

sector analysis
Form a portfolio by purchasing equities at a

substantial discount to what his or her valuation

model indicates its worth

Fundamental Strategies

Three Generic Themes

1. Time the equity market by shifting funds into and

out of stocks, bonds, and T-bills (tactical asset

allocation)
2. Shift funds among different equity sectors and

industries or among investment styles.

(sector rotation strategy)
3. Do stock picking and look at individual issues in
an attempt to find undervalued stocks

Fundamental Strategies

The 130/30 Strategy

Long positions up to 130% & short positions up

to 30%
Shorting creates the leverage needed, both

risk and expected returns compared to the

funds BM.
Enable managers to make full use of their

fundamental research to buy the undervalued &

short the overvalued

Technical Strategies

Contrarian Investment Strategy

The belief - best time to buy (sell) a stock is when the majority of

other investors are the most bearish (bullish) about it

The concept of mean reverting.
The overreaction hypothesis - (DeBondt & Thaler). investors
overreact to good/bad news. They contend you could see
subsequent abnormal returns move in the opposite direction. (the
evidence stronger for loser than winners).

Price Momentum Strategy

Focus on the trend of past prices alone and makes purchase and

sale decisions accordingly

Assume that recent trends in past prices will continue.
Chan, Jegadeesh, and Lakonishok (1999) found justification of this
strategy.

Anomalies and Attributes

Earnings Momentum Strategy

Momentum is the difference of actual EPS to the expected EPS
Purchase stocks that have accelerating earnings and sell (or

short sell) stocks with disappointing earnings

Calendar-Related Anomalies
The Weekend Effect (buy Monday sell Friday)
The January Effect ( invest in January)

Firm-Specific Attributes
Firm Size (Small firm produces higher risk adjusted return)
P/E and P/BV ratios (firms with lower P/E & P/BV produce bigger

risk adjusted returns than with firms having higher P/E & P/BV).

Tax Efficiency and Active Equity

Management

Active portfolio managers - need to

consider taxes when selling or holding a
stock whose value has increased
If sold at a profit, for capital gains taxes are paid

and less is left to reinvest.

The reinvestment security needs to have a
superior return to make up for these taxes.
The size of the expected return depends on the
expected holding period & the cost including the
amount of the capital gain tax paid.

Tax Efficiency and Active Equity

Management

Measures of Tax Efficiency

Portfolio Turnover ( indirect measure)
total rupee value of the securities sold divided

by the average rupee value of the assets.

Tax Cost Ratio (%) (direct measure)
The Formula

Tax Cost Ratio = [1 (1 + TAR)/(1 + PTR)] *100

where PTR = pretax return
TAR = tax-adjusted return

Tax Efficiency of Passive & Active

Stock Funds
Active fund high
Exp Ratio &
PTO.
Active fund
outperformed in
1 & 5 year on
pre Tax return
but not so in
ATR for 1 year.

Vanguard
500 Index
Fund

MFS
Research
Fund

Mgmt App

Passive

Active

Exp Ratio

0.18%

1.04%

Port TO

12%

73%

5 Yr Ave.
Pre Tax ret

2.21%

3.56%

Tax Adj ret

1.88%

2.10%

Tax Cost Ra

0.32%

1.41%

1 Yr Ave.
PTR

14.91%

15.46%

Tax Adj ret

14.50%

8.55%

Tax Cost Ra

0.36%

5.98%

Value versus Growth

P/E = Current price per share/EPS

Growth-oriented investor will:

Focus on EPS and its economic determinants
Look for companies expected to have rapid EPS

growth
Assumes constant P/E ratio

Value-oriented investor will:

Focus on the price component
Not care much about current earnings
Assume the P/E ratio is below its natural level

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
Low Price/Book value or Price/Earnings ratios

Growth stocks
High P/E, possibly a price momentum strategy

Does Style Matter?

Choice to align with investment style to

clients.
Helps to measure the performance with
relevant benchmark.
allows an investor to diversify the portfolio.
To see whether the FM drifts from the
mandate.

Asset Allocation Strategies

Integrated asset allocation

Capital market conditions
Investors objectives and constraints

Strategic asset allocation

Constant-mix

Tactical asset allocation

Mean reversion
Inherently contrarian

Insured asset allocation

Constant proportion

Integrated asset allocation

Three step process
1.

2.
3.

Capital market conditions and investorspecific objectives & constraints ( e.g., risk
tolerance, investment horizon, tax status).
Combining the above information, select the
best portfolio.
Compare the actual performance with the
managers original expectations.
Following this comparison make adjustments to the
portfolio by including new information into the
optimization process.

Strategic asset allocation

Is used to determine the LT policy asset

weights in a portfolio by considering the LT
average
asset
returns,
risk,
and
covariances.
Efficient frontiers are generated using the
above mentioned historical information and
the investor decided which asset mix is
appropriate for his/her planning horizon.
This results in a constant-mix asset
allocation with periodic rebalancing.

Tactical asset allocation

Adjust the asset class mix to changing market conditions.

These adjustments are solely by perceived changes in the relative
values of the various asset classes;
The investors risk tolerance & investment constraints are assumed to
be constant over time.
It is based on the premise of mean reversion: a securitys return will
eventually revert to its LT average (mean) value.
This assessment is done on comparative basis. Suppose the normal
stock and bond return is 1.2, reflecting the greater degree of risk in
equity and if the stocks return were suddenly doubled those of bond
returns. It will call for overweighing the bond component in his portfolio.
(say shifting from 60-40 percent initial strategic mix to 50-50 percent
split).
It is inherently contrarian method of investing. The investor adopting
this approach will always be buying the asset class that is currently out
of favour on a relative basis. (Ex. Above example)

Insured asset allocation

Results in continual adjustments in the portfolio allocation,

assuming that the expected market returns and risks are
constant over time, while the investors objectives and
constraints change as his or her wealth position changes.
Ex. Portfolio value leads to wealth, means he can his
exposure to risky assets and vice-versa.
Often IAA involves only common stocks & T Bills.
As stock price , the AA the stock component.
As stock price , the AA the stock component.
This is called as constant proportion strategy. (opposite to
tactical asset allocation).

SAA (constant mix) & IAA

(constant proportion)
Date

Stock

Portfolio
value

Bond

Stock ratio Bond ratio

01-01-15

6000

4000

10000

60

40

31-03-15

6300

4080

10380

60.69

39.31

SAA

6228

4152

10380

60

40

IAA

6300

4080

10380

60.69

39.31

5700

4160

9860

57.81

42.19

SAA

5916

3944

9860

60

40

IAA

5700

4160

9860

57.81

42.19

31-06-15

Asset Allocation Strategies

Selecting an Active Allocation Method

Perceptions of variability in the clients

objectives and constraints

Perceived relationship between the past and
future capital market conditions
The investors needs and capital market
conditions are can be considered constant
and can be considered variable