BrillyBrown CH 11 2019

CHAPTER 11
Equity
Portfolio
Management
Strategies
©2019 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or
posted to a publicly accessible website, in whole or in part. 8-1
11.1 Passive versus Active Management
• Equity portfolio management strategies can be

either a passive or an active category
• Distinguish between these two by decomposing
the total actual return attempts to produce:
• Passive equity portfolio management

• Long-term buy-and-hold strategy
• Usually tracks an index
• 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 “alpha”
• Exhibit 11.1
(slide 3 of 3)
11.2 An Overview of Passive Equity
Portfolio Management Strategies
• Attempt to replicate the performance of an index
• May slightly underperform the target index due to fees
and commissions – Forming Index is Cost Free
• Strong rationale for this approach
• Costs of active management (1 to 2 percent) are hard
to overcome in risk-adjusted performance
• Many different market indexes are used for tracking
portfolios
https://www.investopedia.com/terms/i/indexfund.asp
• S&P 500 Index
• NASDAQ Composite Index
Fidelity Index Funds
• https://fundresearch.fidelity.com/fund-scre
ener/results/table/overview/averageAnnual
ReturnsYear3/desc/1?fidelityFundOnly=F&
indexFundOnly=Index&order=fidelityFund
Only,indexFundOnly
11.2.1 Index Portfolio Construction
Techniques
• There are three basic techniques for

constructing a passive index portfolio:
• Full replication
• Sampling
• Quadratic optimization – See Weekly file
Techniques
• Full replication
• All securities in the index are purchased in
proportion to weights in the index
• Ensures close tracking
• Increases transaction costs, particularly with
dividend reinvestment
Techniques
• Sampling
• Buy 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
Techniques
• Quadratic optimization (or programming

techniques)
• Historical information on price changes and
correlations between securities to determine
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 – See Weekly File
11.2.2 Tracking Error and Index Portfolio
Construction
• The goal of the passive manager - 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
N
Δ t  wi Rit  Rbt  R pt  Rbt
i 1
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)
TE    P
• Exhibit 11.2
11.2.2 Tracking Error and Index Portfolio
Construction
11.2.3 Methods of Index Portfolio Investing
• Index Funds
• The fund manager attempts to replicate the
composition of the particular index
• Buying the exact securities comprising the index in
their exact weights – student funds start here
• Must change those positions anytime the composition
of the index itself is changed – which cost $
• Low trading and management expense ratios
• They provide an inexpensive way for investors to
acquire a diversified portfolio
• Exchange-Traded Funds (ETF)

• ETFs give investors a pro rata claim on the capital
gains and cash flows of the securities that are held in
deposit by the issuing financial institution
• Advantages of ETFs over index mutual funds:
• Time gain for tax purposes
• Can be margined, sold short or might have options
• Immediacy of the trade
• The notable example of ETFs
• Standard & Poor’s 500 Depository Receipts (SPDRs)
• iShares
• Sector ETFs
• Exhibits 11.3, 11.4
11.3 An Overview of Active Equity Portfolio
Management 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
• Exhibits 11.5 and 11.6
Jack Bogle Vanguard Funds
• https://www.cnbc.com/2019/01/16/in-his-la
st-major-interview-jack-bogle-gave-a-warni
ng-about-this-bull-market.html
11.3.1 Fundamental Strategies
• Top-Down versus Bottom-Up Approaches

• Top-Down
• Broad country and asset class allocations
• Sector allocation decisions
• Individual securities selection
• Bottom-Up
• Emphasizes the selection of securities without any
initial market or sector analysis – Peter Lynch
• Form a portfolio of equities that can be purchased
at a substantial discount to what the valuation
model indicates they are worth
• Three generic themes

• Time the equity market by shifting funds into and out
of stocks, bonds, and T-bills depending on broad
market forecasts
• Shift funds among different equity sectors and
industries (e.g., financial stocks, technology stocks) or
among investment styles (e.g., value, growth large
capitalization, small capitalization). This is basically
the sector rotation strategy
• Do stock picking and look at individual issues in an
attempt to find undervalued stocks
• Exhibits 11.7, 11.8
• The 130/30 Strategy

• Long positions up to 130 percent of the portfolio’s
original capital and short positions up to 30 percent
• The use of the short positions creates the leverage
needed, increasing both risk and expected returns
compared to the fund’s benchmark
• Enable managers to make full use of their
fundamental research to buy stocks they identify as
undervalued as well as short those that are
overvalued
11.3.2 Technical Strategies
• Contrarian Investment Strategy

• Best time to buy (sell) a stock is when the majority of
other investors are the most bearish (bullish) about it
• Reversion to the mean
• The overreaction hypothesis
• 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
• Exhibits 11.9, 11.10
11.3.2 Technical Strategies
Research on Momentum
• https://www.anderson.ucla.edu/faculty-and
-research/anderson-review/momentum
11.3.3 Factors, Attributes, and Anomalies
11.3.3 Factors, Attributes, and Anomalies
• Earnings Momentum Strategy

• Momentum is measured by the difference of actual EPS to the
expected EPS
• Purchases stocks that have accelerating earnings and sells (or
short sells) stocks with disappointing earnings
• Calendar-Related Anomalies
• The Weekend Effect
• The January Effect
• Firm-Specific Attributes
• Firm Size
• P/E and P/BV ratios
• Exhibit 11.13
11.3.5 Tax Efficiency and Active Equity
Management
• Measures of Tax Efficiency

• Portfolio Turnover
• Measured as the total dollar value of the securities
sold from the portfolio in a year divided by the
average dollar value of the assets
Tax Cost Ratio  1    1  TAR   1  PTR     100
Where
PTR = pretax return
TAR = tax-adjusted return
• See Exhibit 11.14

11.3.5 Tax Efficiency and Active Equity
Management
11.5 An Overview of Style Analysis
• Style analysis:
• Attempts to explain the variability in the observed returns
to a security portfolio in terms of the movements in the
returns to a series of benchmark portfolios capturing the
essence of a particular security characteristic
• A simple style grid could be used to classify a
manager’s performance along two dimensions: firm
size (large cap, mid cap, small cap) and relative
value (value, blend, growth) characteristics
• Think Morningstar X-ray – worth up to 5 extra points
if good complete discussion

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BrillyBrown CH 11 2019

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CHAPTER 11

• Equity portfolio management strategies can be

• Passive equity portfolio management

• There are three basic techniques for

• Quadratic optimization (or programming

• Exchange-Traded Funds (ETF)

• Top-Down versus Bottom-Up Approaches

• Three generic themes

• The 130/30 Strategy

• Contrarian Investment Strategy

• Earnings Momentum Strategy

• Measures of Tax Efficiency

• See Exhibit 11.14

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