Lecture Presentation Software

to accompany

Investment Analysis and Portfolio Management

Seventh Edition by

Frank K. Reilly & Keith C. Brown

Chapter 17

Chapter 17 - Equity Portfolio Management Strategies

Questions to be answered: What are the two generic equity portfolio management styles? What are three techniques for constructing a passive index portfolio? How does the goal of a passive equity portfolio manager differ from the goal of an active manager? What is a portfolios tracking error and how is it useful in the construction of a passive equity investment?

Chapter 17 - Equity Portfolio Management Strategies

What is the difference between an index mutual fund and an exchange-traded fund? What are the three themes that active equity portfolio managers can use? What stock characteristics differentiate valueoriented and growth-oriented investment styles? What is style analysis and what does it indicate about a managers investment performance?

Chapter 17 - Equity Portfolio Management Strategies

What techniques are used by active managers in an attempt to outperform their benchmark? What are differences between the integrated, strategic, tactical, and insured approaches to asset allocation? How can futures and options be useful in managing an equity portfolio?

Passive versus Active Management

Passive equity portfolio 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

An Overview of Passive Equity Portfolio Management Strategies

Replicate the performance of an index May slightly underperform the target index due to fees and commissions 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

Index Portfolio Strategy Construction Techniques

Full replication Sampling Quadratic optimization or programming

Full Replication
All securities in the index are purchased in proportion to weights in the index This helps ensure close tracking Increases transaction costs, particularly with dividend reinvestment

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

Expected Tracking Error Between the S&P 500 Index and Portfolio Samples of Less Than 500 Stocks
Expected Tracking Error (Percent) 4.0 3.0 2.0 1.0 500 400 300 200 100 0
Exhibit 17.2

Number of Stocks

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 This relies on historical correlations, which may change over time, leading to failure to track the index

Methods of Index Portfolio Investing

Index Funds
Attempt to replicate a benchmark index

Exchange-Traded Funds
EFTs are 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

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 Practical difficulties of active manager
Transactions costs must be offset Risk can exceed passive benchmark

Fundamental Strategies
Top-down versus bottom-up approaches Asset and sector rotation strategies

Sector Rotation
Position a portfolio to take advantage of the markets next move Screening can be based on various stock characteristics:
Value Growth P/E Capitalization Sensitivity to economic variables

Technical Strategies
Contrarian investment strategy Price momentum strategy Earnings momentum strategy

Value versus Growth

Growth stocks will outperform value stocks for a time and then the opposite occurs Over time value stocks have offered somewhat higher returns than growth stocks

Value versus Growth

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 versus Growth

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
Construct a portfolio to capture one or more of the characteristics of equity securities Small-capitalization stocks, low-P/E stocks, etc Value stocks appear to be underpriced
price/book or price/earnings

Growth stocks enjoy above-average earnings per share increases

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

Determining Style
Style grid:
firm size value-growth characteristics

Style analysis
constrained least squares

Benchmark Portfolios
Sharpe
T-bills, intermediate-term government bonds, long-term government bonds, corporate bonds, mortgage related securities, large-capitalization value stocks, large-capitalization growth stocks, medium-capitalization stocks, smallcapitalization stocks, non-U.S. bonds, European stocks, and Japanese stocks

Benchmark Portfolios
Sharpe BARRA
Uses portfolios formed around 13 different security characteristics, including variability in markets, past firm success, firm size, trading activity, growth orientation, earnings-to-price ratio, book-to-price ratio, earnings variability, financial leverage, foreign income, labor intensity, yield, and low capitalization

Benchmark Portfolios
Sharpe BARRA Ibbotson Associates
simplest style model uses portfolios formed around five different characteristics: cash (Tbills), large-capitalization growth, smallcapitalization growth, large-capitalization value, and small-capitalization value

Timing Between Styles

Variations in returns among mutual funds are largely attributable to differences in styles Different styles tend to move at different times in the business cycle

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

Asset Allocation Strategies

Selecting an allocation method depends on:
Perceptions of variability in the clients objectives and constraints Perceived relationship between the past and future capital market conditions

Using Futures and Options in Equity Portfolio Management

Systematic and unsystematic risk of equity portfolios can be modified by using futures and options derivatives Selling futures on the portfolios underlying assets reduces the portfolios sensitivity to price changes of the asset Options do not have symmetrical impact on returns

The Use of Futures in Asset Allocation

Allows changing the portfolio allocation quickly to adjust to forecasts at lower transaction costs Futures can maintain an overall balance in a portfolio Futures can gain exposure to international markets Currency exposure can be managed using currency futures and options

Using Derivatives in Passive Equity Portfolio Management

Futures and options can help control cash inflows and outflows from the portfolio
Inflows - index contracts allow time to make investments Outflows - large planned withdrawal is made by selling securities, which causes an increase in cash holdings; futures can counterbalance this until the withdrawal

Options can be sold to reduce weightings in sectors or individual stocks during rebalancing

Using Derivatives in Active Equity Portfolio Management

Modifying systematic risk Modifying unsystematic risk

The Internet Investments Online

www.russell.com www.firstquadrant.com www.wilshire.com www.fool.com www.dailystocks.com

End of Chapter 17
Equity Portfolio Management Strategies

Future topics Chapter 18

Bond Fundamentals