Portfolio Management
3-228-07
Albert Lee Chun
Equity Portfolio
Management Strategies
Lecture 9
2 Dec 2007
0
Passive Portfolio Management
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Management Fees
Malkiel (2001) reports that on average that:

Costs of managing a passive fund oscillate between 10 and 20
basis points (Vanguard S&P 500: 20 b.p.)

For active funds the average management fees are 140 b.p.
(fees for research, analyzing information, transaction costs).

40 billion dollars are spent each year on management fees.

Passive strategies have a tend to also minimize taxes (Malkiel
2001)
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Managing and Index Portfolio

Select a benchmark portfolio index to replicate. S&P 500,
TSX, etc.

Determine an acceptable tracking error. Which depends on
the return differential or total return of the replicating
portfolio minus the return of the benchmark index
t  R p ,t  Rb ,t
where the return of the tracking portfolio is given by
N
Rp , t

w R
i 1
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i
i ,t
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Portfolio Tracking Error
Return Differential
t  R p ,t  Rb ,t
Average Return Differential
Variance in Return Differential
Tracking Error
 

2

1
T
T

t 1
t

1 T

 t  
T  1 t 1

2
    2
Annualize Tracking Error  p where P is equal to the number of

periods in a year.
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Portfolio Tracking Error

Objective: Minimize the expected tracking error by
optimizing over
1. The number of securities in the portfolio
2. The securities to include in the portfolio
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Expected Tracking Error
Expected Tracking
Error (Percent)
4.0
3.0
2.0
1.0
500
400
300
200
100
0
Number of Stocks
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Portfolio Indexation

The number of securities used in the replication determines a
tradeoff between transaction costs and tracking errors.

A smaller number of securities will result in lower transaction
costs but higher tracking errors and visa versa.

The presence of tracking errors is inevitable.
1. The replication implies irregular lots.
2. The composition of securities in the index may change.
3. The modification of the index: entry and exit of securities,
merges, defaults, etc.
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Techniques for Replicating an Index
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1. The simplest method




Purchase all the securities in the index in proportion
to the weights in the index.
This helps ensure close tracking
Advantage: Minimizes the tracking errors
Disadvantage: High transaction costs and reinvesting
dividends results in high adjustment fees.
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2. Method of Market Capitalization




Consider the stocks with the largest market
capitalization in the index and purchase them in
proportion to their importance 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.
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3. Method of Stratified Sampling:




Purchase only the most representative securities in the
index portfolio.
Classify the securities in the index into homogeneous
categories (by industry or activity sector, beta, total
risk, stock market capitalization, etc....).
Select from each category, a few titles which best
represents that group, thus forming a representative
portfolio for each category.
The replication portfolio is composed by balancing
the portfolios for each category according to their
importance in the index.
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4. Quadratic Optimization
 N

~
~
Min Tracking Error     w i ri  rm 
wi i 1,...,N
 i 1

such that
N
w
i 1

i
1
Expected Excess Return

N


~
~
~
~
E rp  rm  E  w i ri  rm   C ( w1 ,..., wN )  R0
 i 1

Transaction costs
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Required minimum
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Quadratic Optimization


Historical information on price changes and
correlations between securities are used to determine
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 a failure to track the
index.
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Expected Tracking Error
Expected Tracking
Error (Percent)
4.0
3.0
2.0
1.0
500
400
300
200
100
0
Number of Stocks
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Reference Portfolio

Constructing a Reference Portfolio
- Value Weighted
- Price Weighted
- Equal Weighted

It may be necessary to rebalance the portfolio when:
- Mergers and Acquisitions: Companies disappear from the market.
- Changes to the composition of the index
- Stock splits and dividend payments
- New stock issues
- Stock repurchases
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Replicating an Index Portfolio

Small investors often find it more practical and less
expensive to choose a "pre-made" a fund for
replicating an index.
- Mutual Funds
- Exchange Traded Funds
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Exchange Traded Funds (ETFs)




Exchange Traded Funds are less expensive than
mutual funds but more diversified than individual
stocks. A cross between stocks and mutual funds.
ETFs seek returns of a broad market index or a sector
index. They are index-linked rather than actively
managed.
ETFs are exchange listed and can be bought and sold
throughout the trading day: they are "funds that trade
like stocks."
Example: SPY, Cubes, Diamonds, Spiders, Webs,
VIPERS, iShares, Ultra Sectors, etc.
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Active Portfolio Management
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Active Portfolio Management



Active 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
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Active Management Strategies
The chose between using and active or passive portfolio management
strategy depends on 2 factors:
1. Belief in the efficiency of the markets. An investor who rejects
the Efficient Market Hypothesis will tend to adopt an active
strategy with the goal of obtaining “abnormal” returns:
ARit = Rit  E( Rit )
where,
ARit : is the abnormal return of security i in period t
Rit: is the return of security i in period t
E(Rit): is the expected return
2. Degree of risk aversion of the investor.
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Performance of Active Mutual Funds
The average fund manager is not able
to outperform the index!
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Broad Overview of Investment Strategies
Passive Management Strategies
1. Efficient Markets Hypothesis
- Buy and Hold
- Indexing
 Active Management Strategies
2. Fundamental Analysis
“Top Down” (asset class rotation, sector rotation)
“Bottom Up” (stock undervaluation/overvaluation)
3. Technical Analysis
Contrarian (e.g. overreaction)
Continuation (e.g. price momentum)
4. Anomalies and Attributes
Calendar effects (Weekend, January)
Security Characteristics (P/E,P/B, earnings momentum, firm size)
Investment Style (value, growth)

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Investment Style and Tracking Error
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Fundamental Strategies


Top down approach involves analysis of broad
country and asset class allocations and progresses
down through sector allocation decisions to the
bottom level where individual securities are selected.
Bottom-up approach emphasizes security selection
without any initial market or sector analysis.
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Top Down Approach
Top Down Approach
- Evaluate and forecast the future economy
- Chose the proportions to invest in each country or
economic region.
- Identify the sectors and industries that would profit
based on your economic outlook and choose
proportions to invest in each industy or sector.
- Choose the best securities in each sector selected.
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Bottom-Up Approach
Security selection is places less importance on the
economic cycle.
Securities are selected based on well defined
characteristic of individual stocks such as pricedividend ratios, book-to-market ratios, market
capitalizations, etc.
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Fundamental Strategies
Tactical Asset Allocation
- Asset Class Rotation: Shifts funds between stocks, bonds and
other securities depending on market forecasts and estimated
returns.
 Sector, Industry or Style Rotation Strategy
- Shifts funds between different equity sectors and industries
(financial stocks, technology stocks, consumer cyclicals,
durable goods) or among investment styles (e.g., large
capitalization, small capitalization, value growth)
 Individual Stock Selection
- Buy low, Sell High

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Sector, Industry and Style Analysis




How should we choose which sector, industry or style
to rotate into next?
Important to look to the underlying nature of the
economy. Security markets reflect the strength and
weakness of the economy.
Most of the variables that determine security market
value are economic variables: monetary policy,
interest rates, aggregate output, inflation, etc.
Macro-analysis links up industry effects to business
cycles and economic variables.
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Asset and Sector Performance
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Macro-market Analysis


A strong relationship exists between the economy and
the stock market
Security markets reflect what is expected to go on in
the economy because the value of an investment is
determined by
 its expected cash flows
 required rate of return (i.e., the discount rate)
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Is It A Worm?
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Is It A Wave?
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It’s the Business Cycle!
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Business Cycles



The aggregate economy expands and contracts in
discernable periods.
Economic trends affect industry performance.
Cyclical or Structural Changes?
 Cyclical changes in the economy arise from the
ups and downs of the business cycle
 Structure changes occur when the economy
undergoes a major change in organization or how
it functions
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The Stock Market and
the Business Cycle
How can we predict the next
peak or trough?
peak
trough
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Business Cycle Indicators



National Bureau of Economic Research
(NBER)
Cyclical indicator categories
 leading indicators
 coincident indicators
 lagging indicators
Composite series and ratio of series
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Business Cycle Indicators




Leading indicators – economic series that usually
reach peaks or troughs before corresponding peaks or
troughs in aggregate economy activity
Coincident indicators – economic series that have
peaks and troughs that roughly coincide with the
peaks and troughs in the business cycle
Lagging indicators – economic series that experience
their peaks and troughs after those of the aggregate
economy
Selected series – economic series that do not fall into
one of the three main groups.
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CONFERENCE BOARD DATA
Leading Index
1.
2.
3.
4.
5.
6.
7.
8.
9.
10.
BCI-01
BCI-05
BCI-08
BCI-32
BCI-27
BCI-29
BCI-19
BCI-106
BCI-129
BCI-83
Average weekly hours, manufacturing
Average weekly initial claims for unemployment insurance
Manufacturers' new orders, consumer goods and materials
Vendor performance, slower deliveries diffusion index
Manufacturers' new orders, non-defense capital goods
Building permits, new private housing units
Stock prices, 500 common stocks
Money supply, M2
Interest rate spread, 10-year Treasury bonds less federal funds
Index of consumer expectations
Standard
Fac
.19
.02
.05
.02
.01
.02
.03
.27
.33
.01
Coincident Index
1.
2.
3.
4.
BCI-41
BCI-51
BCI-47
BCI-57
Employees on nonagricultural payrolls
Personal income less transfer payments
Industrial production
Manufacturing and trade sales
.51
.21
.14
.11
Lagging Index
1.
2.
3.
4.
5.
6.
7.
BCI-91
BCI-77
BCI-62
BCI-109
BCI-101
BCI-95
BCI-120
Average duration of unemployment
Inventories to sales ratio, manufacturing and trade
Labor cost per unit of output, manufacturing
Average prime rate
Commercial and industrial loans
Consumer installment credit to personal income ratio
Consumer price index for services
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.03
.12
.06
.26
.12
.19
.18
38
Other Indicator Sources...
Indicator
Released By
Beige Book
Federal Reserve Board
Consumer Confidence Index
Consumer Confidence Board
Consumer Price Index
Bureau of Labor and Statistics
Employee Cost Index
Bureau of Labor and Statistics
Employment Situation Report
Bureau of Labor and Statistics
Gross Domestic Product
Commerce Department
Housing Starts
Department of Commerce
Philadelphia Fed Index
Federal Reserve Bank of
Philadelphia
Producer Price Index
Bureau of Labor and Statistics
Retail Sales Data
Census Bureau
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Stock Markets are a Leading Indicator

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

Stock prices consistently turn before the economy
does.
Stock prices are forward looking.
Stock prices reflect expectations of earnings,
dividends, and interest rates
Stock market reacts to various leading indicator series
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Forecasting Business Cycles




The current state of the business cycle has already
been incorporated into asset prices.
Investors need to make decisions based on future
economic conditions.
To invest properly, it is important to forecast changes
in economic variables.
High inflation: high interest rates, bad for stocks in
general.
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Sector Rotation Strategy


Certain industries make attractive investments over
the course of the business cycle.
A sector rotation strategy is when one switches from
one industry group to another over the course of a
business cycle.
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The Stock Market and
the Business Cycle
peak
Financial
Stocks Excel
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trough
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Financial Stocks
 Adversely
impacted by interest rates, difficult to
pass on to their customers.
 Toward the end of a recession, financial stocks
rise as investors trade securities, businesses
issue debt and equity, increase in merger
activity during recovery.
 Expecting increases in loan demand, housing
construction and companies going public.
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The Stock Market and
the Business Cycle
Consumer
Durables
Excel
Financial
Stocks Excel
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peak
trough
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Consumer Durables
Consumer Durables are cars, PCs, Miele
washing machines, GE refrigerators, John Deer
lawn machinery, cooking ranges, etc.
 As the economy begins to come out of the
recession, consumer confidence and income
increase.

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The Stock Market and
the Business Cycle
Consumer
Durables
Excel
Financial
Stocks Excel
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trough
peak
Capital
Goods Excel
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Capital Goods


As the economy moves out of recession, businesses
begin to modernize, renovate and purchase new
equipment.
Heavy equipment manufactures, machine tool
makers, airplane manufacturers become attractive.
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The Stock Market and
the Business Cycle
Basic
Industries
Excel
Consumer
Durables
Excel
Financial
Stocks Excel
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trough
peak
Capital
Goods Excel
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Basic Industries



End of the business cycle coincides with increases in
inflation, as demand outstrips supply.
Inflation doesn’t influence the cost of extracting these
products, whereas prices increase. Increasing profit
margins.
Basic material industries as oil, metal and lumber are
attractive.
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The Stock Market and
the Business Cycle
Basic
Industries
Excel
Consumer
Durables
Excel
Financial
Stocks Excel
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trough
peak
Consumer
Staples Excel
Capital
Goods Excel
Portfolio Management
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Consumer Staples


Consumer staples are food, beverages and
pharmaceuticals.
People still need to eat, drink, be merry and get sick.
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The Stock Market and
the Business Cycle
Basic
Industries
Excel
Consumer
Durables
Excel
Financial
Stocks Excel
Albert Lee Chun
trough
peak
Consumer
Staples Excel
Capital
Goods Excel
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Central Banks and Interest Rates

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By far the most visible and obvious power of many modern
central banks is to influence market interest rates.
When interest rates go down, money supply increases.
Businesses and consumers have a lower cost of capital and can
increase spending and capital improvement projects. This
encourages growth.
When interest rates go up, the money supply falls and slows
the economy. Increases in interest rate flight inflation.
The US central-bank lending rate is known as the Fed funds
rate.
Bank of Canada sets a target overnight rate, and a band of plus
or minus 0.25%.
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Technical Strategies

-
-


Contrarian investment strategy
Best time to buy a stock is when the majority of other
investors are selling.
Buy low, sell high. Hope asset prices are mean
reverting.
Overreaction hypothesis.
Price momentum strategy
Earnings momentum strategy
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Market Overreaction
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Price and Earnings Momentum
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Anomalies and Attributes
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The Weekend Effect
The January Effect
Firm Size
P/E and P/BV ratios
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Large and Small Cap Returns
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Standard Deviation of Returns
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P/E Ratios and Performance
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Value vs. Growth Stocks

Over time value stocks have offered somewhat higher returns than growth
stocks.

However, growth stocks will outperform value stocks from time to time.

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 that P/E ratio is below its natural level for these stock and that
the market will soon correct this situation.
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Value vs. Growth: Mutual Funds
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Value and Growth Stocks
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Russell 100 Performance
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Value vs. Growth
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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
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Style Grid



Style grid:
 firm size (large cap, mid cap, small cap)
 Relative value (value, blend, growth)
characteristics
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
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Style Analysis Grid
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Investment Style
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Optimal Portfolio Selection
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Next Week
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
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Optional Readings for this week:
(Course Reader) Value and Growth Investing: Review and Update (Chan and
Lakonishok)
(Course Reader) Hedge Funds: Risk and Return (Maikiel ad Saha)
For Next Week:
Rappel des concepts de durée et de convexité
La durée des taux clés
Stratégies Barbell et Bullet
Immunisation de portefeuille
Review of Duration and Convexity (Rappel des concepts de durée et de convexité)
Key Rate Duration (La durée des taux clés)
Barbell and Bullet Strategies (Stratégies Barbell et Bullet)
Portfolio Immunization (Immunisation de portefeuille)
(BKMR) chapter 15
(Course Reader) Fabozzi, Bonds Markets, Analysis and Strategies, 4th edition.,
p.410-416.
(Course Reader) Tuckman, Bruce W. Key Rate and Bucket Exposures, Fixed Income
Securities: Tools for Today's Markets, 2nd edition, New York, J. Wiley, 2002, p. 133-137
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