Chapter 16: Equity Portfolio
Management Strategies
© 2012 Cengage Learning. All Rights Reserved. May not scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Equity Portfolio
Management Strategies
16-2
© 2012 Cengage Learning. All Rights Reserved. May not scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
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 by seeking the
“alpha” value
• See Exhibit 16.1
16-3
© 2012 Cengage Learning. All Rights Reserved. May not scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Exhibit 16.1
•Should High talented managers pursue an active or passive
management strategy?
•Does both active and passive management strategies assume market
efficiency?
16-4
© 2012 Cengage Learning. All Rights Reserved. May not scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
An Overview of Passive Strategies
• Attempt to replicate the performance of an index
that meet the client needs and obj.
– May slightly underperform the target index due to fees
and commissions
– If the manager try to outperform the selected index,
he or she violates the premise of the passive portfolio.
• Strong rationale for this approach
– Strong evidence indicates that the stock market is
fairly efficient
– Costs of actively managing the portfolio (1 to 2
percent) are hard to overcome. It’s hard to overcome
the S&P 500.
16-5
© 2012 Cengage Learning. All Rights Reserved. May not scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
An Overview of Passive Strategies
• Many different market indexes are used for
tracking portfolios
– The daily values of indexes for the organized
exchanges, OTC market, are published.
– S&P 500 Index
– NASDAQ Composite Index
– Russell growth index for growth stocks
• Because of the cash inflows and outflows and
company mergers and bankruptcies, securities must
be bought and sold, which mean that there will be
differences between portfolio and benchmark returns
overtime.
16-6
© 2012 Cengage Learning. All Rights Reserved. May not scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Passive Index Portfolio
Construction Techniques
• Full Replication
– All securities in the index are purchased in proportion
to weights in the index
– This helps ensure close tracking
– Increases transaction costs, because of the need to
buy many securities and because of dividend
reinvestment that result in high commissions, if many
firms pay small dividends at different times in the year.
16-7
© 2012 Cengage Learning. All Rights Reserved. May not scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Passive Index Portfolio
Construction Techniques
• Sampling
– Buys a representative sample of stocks in the
benchmark index
– Stocks with larger index weight are purchased
according to their weights in the index, while small
issues are purchased so their aggregate
characteristic, such as beta and dividends,
approximate the benchmark.
– Fewer stocks means lower commissions
– Reinvestment of dividends is less difficult
– Will not track the index returns as closely, so there
will be some tracking error
16-8
© 2012 Cengage Learning. All Rights Reserved. May not scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Passive Index Portfolio
Construction Techniques
• 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 return
deviation from the benchmark
– This relies on historical stock price changes and
correlations, which may change over time, leading
to failure to track the return of the index
16-9
© 2012 Cengage Learning. All Rights Reserved. May not scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Passive Portfolio Construction
Techniques
• Some passive portfolios are not based on a
published index, such as completeness funds.
• These funds are constructed to complement
active portfolios that don’t cover the entire market.
• The performance of the completeness fund is
compared to a customized benchmark that
incorporates the characteristics of the stocks not
covered by the active managers.
16-10
© 2012 Cengage Learning. All Rights Reserved. May not scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Passive Portfolio Construction
Techniques
• Suppose for example a pension fund hires three
active managers to invest part of the fund’s
money. One manager invest in smallcapitalization Saudi stocks, the second invest in
gulf countries only, and the third invest in Saudi
stocks with low P/E ratio. To ensure
diversification, the fund sponsor invest passively
in the remaining assets to complete the fund. The
completeness fund will have a benchmark that
includes the stocks not covered by the active
managers.
16-11
© 2012 Cengage Learning. All Rights Reserved. May not scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Passive Portfolio Construction
Techniques
• Other passive portfolios and benchmarks exist for
investors with certain unique needs and
preferences. Some investors may want their funds
to be invested only in stocks that pay dividends or
in a company that produces a unique product or
service.
• Benchmarks can be produced to reflect these
desired attributes, and passive portfolios can be
constructed to track the performance of the
customized benchmark over time so investor’s
special needs can be satisfied.
16-12
© 2012 Cengage Learning. All Rights Reserved. May not scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Tracking Error and Index Portfolio
Construction
• The goal of the passive manager should be 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
Δt =Rpt – Rbt
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)
– See Exhibit 16.2
16-13
© 2012 Cengage Learning. All Rights Reserved. May not scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Exhibit 16.2
16-14
© 2012 Cengage Learning. All Rights Reserved. May not scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Methods of Index Portfolio Investing
• Index Funds
– In an indexed portfolio, the fund manager will
typically attempt to replicate the composition of the
particular index exactly
– The fund manager will buy the exact securities
comprising the index in their exact weights
– Change those positions anytime the composition of
the index itself is changed
– Low trading and management expense ratios,
because changes to most equity indexes occur
infrequently.
16-15
© 2012 Cengage Learning. All Rights Reserved. May not scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Methods of Index Portfolio Investing
• The advantage of index mutual funds is that they provide
an inexpensive way for investors to acquire a diversified
portfolio
• The disadvantages are that the investors can only
liquidate their positions at the end of the trading day.
• An example of index funds is the Vanguard's 500 Index
fund (VFINX), which mimic the S&P 500 index.
16-16
© 2012 Cengage Learning. All Rights Reserved. May not scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Methods of Index Portfolio Investing
• Exchange-Traded Funds (ETF)
– ETFs 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
– A portfolio of securities is placed on deposit at a
financial institution or into a unit trust, which issue a
single type of certificate representing ownership of
the underlying portfolio.
– A significant advantage of ETFs over index mutual
funds is that they can be bought and sold (and
short sold) like common stock through an
organized exchange or in an OTC market.
16-17
© 2012 Cengage Learning. All Rights Reserved. May not scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Methods of Index Portfolio Investing
– Other advantages relative to index funds are no
payment of management fees, the ability of continuous
trading while the market is open, and the ability to time
capital gain tax realization.
– The notable example of ETFs
• Standard & Poor’s 500 Depository Receipts (SPDRs),
which are based on a basket of all the securities held in
an index.
• Sector ETFs, which invest in a basket of stocks from
specific industry sectors
16-18
© 2012 Cengage Learning. All Rights Reserved. May not scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
An Overview of Active 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
• See Exhibits 16.5
16-19
© 2012 Cengage Learning. All Rights Reserved. May not scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Exhibit 16.5
16-20
© 2012 Cengage Learning. All Rights Reserved. May not scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
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
 Form a portfolio of equities that can be purchased at
a substantial discount to what his or her valuation
model indicates they are worth to beat the
benchmark
16-21
© 2012 Cengage Learning. All Rights Reserved. May not scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Fundamental Strategies
• Three Generic Themes active managers can
apply to add value to their portfolios relative to
the benchmark
– Time the equity market by shifting funds into and
out of stocks, bonds, and T-bills depending on
broad market forecasts, tactical asset allocation.
– 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
16-22
© 2012 Cengage Learning. All Rights Reserved. May not scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Exhibit 13.3
13-23
© 2012 Cengage Learning. All Rights Reserved. May not scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Fundamental Strategies
– Do stock picking and look at individual issues in an
attempt to find undervalued stocks on a bottom-up
bases. Buy low and sell high. The choice of stocks is
based on absolute judgments about the future of the
company, such as discounted cash flow analysis. Or
based on a comparison with other similar shares.
– Which is more reliable, Timing the equity market or
stock picking?
16-24
© 2012 Cengage Learning. All Rights Reserved. May not scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Technical Strategies
• One of the primary tools of technical analysis
relies on assessing the past stock price trends
in an effort to assume what information they
imply about future price movement
• Contrarian Investment Strategy
– The belief that the best time to buy (sell) a stock is
when the majority of other investors are the most
bearish (bullish) about it
– The contrarian investor purchase the stock when
it’s near its lowest price and sell it when it’s near its
peak
– Such as Mutual fund cash positions
16-25
© 2012 Cengage Learning. All Rights Reserved. May not scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Technical Strategies
Contrarian Investment Strategy (cont.)
– The concept of mean reverting indicates that over time
stocks will be priced to produce returns consistent with
their risk-adjusted returns.
– The overreaction hypothesis indicates that superior
returns can be generated followed by price corrections
(Exhibit 16.9)
16-26
© 2012 Cengage Learning. All Rights Reserved. May not scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Exhibit 16.9
16-27
© 2012 Cengage Learning. All Rights Reserved. May not scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Technical Strategies
• 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
• Breadth of market
– Measures the number of issues increased and the
number of issues declined each day
– The advance–decline index is typically a cumulative
index of net advances or net declines
– See Exhibit 16.10
16-28
© 2012 Cengage Learning. All Rights Reserved. May not scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Exhibit 16.10
15-29
© 2012 Cengage Learning. All Rights Reserved. May not scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Technical Strategies
• Stocks above their 200-day moving average
– The market is considered to be overbought and subject
to a negative correction when more than 80 percent of
the stocks are trading above their 200-day moving
average
16-30
© 2012 Cengage Learning. All Rights Reserved. May not scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Technical Strategies
• Follow the smart money Strategy
- follow the path of sophisticated, and assumed smart,
investors
• The Barron’s Confidence Index
– Measures the yield spread between high-grade bonds
and intermediate grade bonds
– Declining (increasing) yield spreads increase
(decrease) this index, and are a bullish (bearish)
indicator
• T-Bill - Eurodollar yield spread
– Decreases in this spread indicates greater confidence,
and is a bullish indicator
16-31
© 2012 Cengage Learning. All Rights Reserved. May not scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Technical Strategies
• Importance of Volume
– Technicians watch volume changes along with price
movements as an indicator of changes in supply and
demand
– The technician looks for a price increase on heavy
volume relative to the stock’s normal trading volume as
an indication of bullish activity
– Conversely, a price decline with heavy volume is
considered bearish
– Technicians also use a ratio of upside–downside
volume as an indicator of short-term momentum for the
aggregate stock market
16-32
© 2012 Cengage Learning. All Rights Reserved. May not scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Technical Strategies
• Support and Resistance Levels
– A support level is the price range at which the
technician would expect a substantial increase in the
demand for a stock
– A resistance level is the price range at which the
technician would expect an increase in the supply of
stock and a price reversal
– It is also possible to envision a rising trend of support
and resistance levels for a stock
16-33
© 2012 Cengage Learning. All Rights Reserved. May not scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Technical Strategies
• Moving Average Lines
– MA lines are meant to reflect the overall trend for the
price series
– The shorter MA line (the 50-day versus 200-day)
reflecting shorter trends
– If prices reverse and break through the movingaverage line from below accompanied by heavy trading
volume, most technicians would consider this a
positive change; and vice verse
– If the 50-day MA line crosses the 200-day MA line from
below on good volume, this would be a bullish indicator
– See Exhibit 16.11
16-34
© 2012 Cengage Learning. All Rights Reserved. May not scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Technical Strategies
16-35
© 2012 Cengage Learning. All Rights Reserved. May not scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Technical Strategies
• Relative Strength
– Relative Strength (RS) Ratio is defined as the price of
an individual stock or an industry index divided by
some stock market indexes like S&P 500
– Technicians believe that once a trend begins it’ll
continue until some major events causes a change in
direction.
– If this ratio increases over time, it shows that the stock
or industry is outperforming the overall stock market
and technicians would expect this superior
performance to continue (bullish sign).
16-36
© 2012 Cengage Learning. All Rights Reserved. May not scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Anomalies and Attributes
• 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.
The stock price of a firm follows its earnings
• Calendar-Related Anomalies
– The Weekend Effect
– The January Effect
• Firm-Specific Attributes
– Total capitalization of the firm’s outstanding equity(size).
Firms with small caps. Outperform large caps. firms
– P/E and P/BV ratios. Firms with lower ratios produce
bigger risk-adjusted returns (Exhibit 16.12)
16-37
© 2012 Cengage Learning. All Rights Reserved. May not scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Exhibit 16.12
16-38
© 2012 Cengage Learning. All Rights Reserved. May not scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Miscellaneous Issues
• An important issue for active managers is the
selection of the appropriate benchmark.
• One key of success for active managers is to be
consistent with their area of expertise.
• Another key to success is to minimize the trading
activity of the portfolio to reduce the commission.
• Computer-assisted portfolio formation procedures
can be quite useful for active managers.
16-39
© 2012 Cengage Learning. All Rights Reserved. May not scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Tax Efficiency and Active Equity
Management
• Active portfolio managers especially need to
consider taxes when deciding whether to sell or
hold a stock whose value has increased
– If a security is sold at a profit, capital gains are paid
and less is left in the portfolio to reinvest
– A new security (the reinvestment security) needs to
have a superior return sufficient to make up for these
taxes
– The size of the expected return depends on the
expected holding period and the cost basis (and
amount of the capital gain) of the original security
16-40
© 2012 Cengage Learning. All Rights Reserved. May not scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Value versus Growth
• A growth investor focuses on the current and
future economic “story” of a company, with
less regard to share valuation
• A value investor focuses on share price in
anticipation of a market correction and,
possibly, improving company fundamentals.
• Value stocks generally have offered
somewhat higher returns than growth stocks,
but this does not occur with much consistency
from one investment period to another
16-41
© 2012 Cengage Learning. All Rights Reserved. May not scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Value versus Growth styles
• 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
• Which is cheaper value or growth stocks??
16-42
© 2012 Cengage Learning. All Rights Reserved. May not scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Style Analysis
• Construct a portfolio to capture one or more of
the characteristics of equity securities
• Compare the variability of the returns of a
security portfolio to the returns of a series of
benchmark portfolios designed to capture the
essence of a particular security characteristics
• Small-cap stocks, low-P/E stocks, etc…
16-43
© 2012 Cengage Learning. All Rights Reserved. May not scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Style Analysis
• Value stocks (those that appear to be underpriced according to various measures)
– Low Price/Book value or Price/Earnings ratios
• Growth stocks (above-average earnings per share
increases)
– High P/E, possibly a price momentum strategy
• See Exhibit 16.20
16-44
© 2012 Cengage Learning. All Rights Reserved. May not scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Exhibit 16.20
16-45
© 2012 Cengage Learning. All Rights Reserved. May not scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Style Analysis
• The S&P 500 index can be characterized as a
large-cap, blend (between value and growth)
fund. As such, it is not the appropriate
performance benchmark for someone managing a
mid-cap, growth-oriented portfolio.
16-46
© 2012 Cengage Learning. All Rights Reserved. May not scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Does Style Matter?
• Style analysis can determine whether a
manager can maintain a consistent investment
style over time
• Determining style is useful in measuring
performance relative to a benchmark
• Define if the fund has a style drift, and whether
this drift is Intentional or unintentional
• Investors need to be aware of managers
whose their portfolios exhibits unintentional
style drift
16-47
© 2012 Cengage Learning. All Rights Reserved. May not scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Asset Allocation Strategies
• If the portfolio contains different securities, the portfolio
manager should determine the appropriate mix of asset
categories in the entire portfolio
• There are four general strategies that determine the asset
mix of a portfolio.
• Integrated asset allocation: examine separately
– Capital market conditions
– Investor’s objectives and constraints
– The actual returns from the portfolio are then used
along with any changes in investor’s objectives and
constraints and changes in capital market expectations
as inputs to the process of portfolio revision.
16-48
© 2012 Cengage Learning. All Rights Reserved. May not scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Asset Allocation Strategies
• Strategic asset allocation
– Result in a Constant-mix of assets for the long-run
with periodic rebalancing to adjust the portfolio to
the specified asset weights
– Equivalent to the integrated asset allocation
process but without the feedback loop.
• Tactical asset allocation
– Constantly adjusts the asset class mix in the
portfolio to take advantage of changing market
conditions.
– Equivalent to the integrated asset allocation
process but without the feedback loop involving
the investor specific information, because it
assume that it’s constant.
16-49
© 2012 Cengage Learning. All Rights Reserved. May not scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Asset Allocation Strategies
– Mean reversion of security returns to its long-term
average value.
– Inherently contrarian
• Insured asset allocation
– Constantly adjusts the asset class mix in the portfolio
to follow any changes in the investor objectives and
constraints.
– Equivalent to the integrated asset allocation process
but without the feedback loop involving the market
conditions, because it assume that it’s constant.
– For example, an increase in portfolio value increase
the investor's ability to take risk, which can increase
the portion of stocks in the portfolio over T-bills.
16-50
© 2012 Cengage Learning. All Rights Reserved. May not scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
The Internet Investments Online
•
•
•
•
http://www.russell.com
http://www.firstquadrant.com
http://www.panagora.com
http://www.wilshire.com
16-51
© 2012 Cengage Learning. All Rights Reserved. May not scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.