Chapter 25
Contemporary Issues in Portfolio
Management
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Life is my college; may I graduate well and earn
some honors.
- Louisa May Alcott
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Outline
Introduction
 Tactical asset allocation
 Stock lending
 Program trading
 Role of derivative assets
 The chartered financial analyst program
 Regulation Fair Disclosure
 Security analyst independence

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Introduction
 Some
emerging areas are controversial:
• Tactical asset allocation contradicts the EMH
• Stock lending and program trading have image
problems
• Derivatives are not permitted in some portfolios
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Tactical Asset Allocation
 What
is tactical asset allocation?
 How TAA can benefit a portfolio
 Designing a TAA program
 Caveats regarding TAA performance
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What Is
Tactical Asset Allocation?
 Definition
 Intuitive
versus quantitative techniques
 Overview of the technique
 Policy decisions
 Strategy
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Definition
 Tactical
asset allocation (TAA) managers:
• Seek to improve the performance of their funds
• By shifting the relative proportion of their
investments into and out of asset classes
• As the relative prospects of those asset classes
change
 For
example, shift to stocks if stocks are
expected to outperform bonds
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Definition (cont’d)
 TAA attempts
to take advantage of shortterm deviations from long-term trends
 The
most difficult part of TAA is asset class
appraisal
• The process of determining the relative merits
of the various asset classes given current
economic conditions
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Intuitive Versus
Quantitative Techniques
 In
the intuitive approach, decisions are
based on personal opinion and gut feeling
• Suffers from hindsight bias
– Portfolio managers remember the times they were
correct
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Intuitive Versus Quantitative
Techniques (cont’d)
 In
the quantitative approach, managers use
an analytical assessment and a system for
implementing precise portfolio changes
• E.g., use the gap between the S&P 500 dividend
yield and the average yield on AAA corporate
bonds
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Overview of the Technique
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Policy Decisions
 Policy
decisions involve:
• Deciding to use a TAA program in the first
place
• Establishing the extent to which the program
will be employed
• Determining the number of asset classes to
employ
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Strategy
 There
are three alternative strategic
functions:
• Static strategy maintains a static portfolio mix
• Reactive strategy involves decisions based on
events that have already occurred
• Anticipatory strategy involves shifting funds
before the markets move
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How TAA Can
Benefit A Portfolio
 The
goal of an anticipatory strategy is to
outperform the portfolio without TAA
• The potential gains to a clairvoyant manager
from TAA are enormous (see next slide)
 The
portfolio manager must assess return
within a risk/return framework
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How TAA Can
Benefit A Portfolio (cont’d)
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Designing A TAA Program
 Before
implementing a TAA program, a
fund manager must establish:
• The normal mix
– The benchmark proportion each asset class
constitutes in the portfolio
• The mix (exposure) range
– Specifies how much the current mix can deviate
from the normal mix
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Designing A
TAA Program (cont’d)
 Before
implementing a TAA program, a
fund manager must establish (cont’d):
• The swing component
– The percentage of the total portfolio whose
composition by asset class may change
– The key element of TAA is properly investing the
swing component
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Caveats Regarding
TAA Performance
 Efficient
market implications
 Impact of transaction costs
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Efficient Market Implications
 TAA program
implicitly assume it is
possible to outperform a buy-and-hold
strategy by shifting asset classes
• Inconsistent with the efficient market
hypothesis
 Some
fund managers have good records
with TAA programs
• Might be skill or luck
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Impact of Transaction Costs
 The
portfolio incurs trading fees each time a
trade occurs
 If
the marginal gains from TAA switching
do not exceed transaction costs, the program
is not effective
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Stock Lending
 Definition
 Mechanics
of a short sale
 How a stock lending transaction works
 Stock lending’s lucrative nature
 Regulatory concerns
 Long/short portfolios
 Certificateless trading
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Definition
 Stock
lending:
• Is the practice by which one institution loans
stock to another institution
• Is often used to support short-selling by
customers of the second institution
• Can earn substantial income with very little risk
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Definition (cont’d)
 Stock
lending is similar to a repurchase
agreement:
• The institution wanting to borrow stock
– Puts up collateral (about 102 percent of the
securities lent)
– Agrees to return the securities at a later date
• The lender can earn interest on the cash
collateral
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Mechanics of A Short Sale
 A short
sale:
• Involves borrowing securities from someone
• Selling the securities to another market
participant
• Eventually purchasing shares from another
market participant and
• Returning the substitute shares to the original
lender
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Mechanics of
A Short Sale (cont’d)
 A short
sale is normally motivated by a
bearish sentiment
 The actual lender in a short sale is normally
an unknowing participant
• A hypothecation agreement gives the broker
the right to lend shares to someone else
– The investor can still trade the shares and continues
to earn dividends
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Mechanics of
A Short Sale (cont’d)
 The
short seller:
• Has an obligation to return what was borrowed
at some point in the future
• Must pay dividends to the lender
• Eventually covers short by repurchasing shares
to replace the shares borrowed earlier
– If the purchase price is below the selling price, the
short seller makes a profit
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How A Stock Lending
Transaction Works
 If
the customer wants to short sell:
• The brokerage firm first checks if other
customers have the stock in a margin account
• The brokerage firm may use a stock loan finder
to locate another firm with the needed shares
• The first firm deposits collateral with the
second firm (T-bills or cash)
– Part of the interest is used to pay a finder’s fee to the
stock loan finder
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Stock Lending’s
Lucrative Nature
 Advantages
of stock lending
 Disadvantages of stock lending
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Advantages of Stock Lending
 Stock
lending is very lucrative
• In 1999, the total income to stock lenders
approached $1 billion
 Stock
lending is popular when markets see
increased merger and acquisition activity:
• Merger arbitrage involves buying shares of
likely takeover candidates and short selling
shares of the anticipated acquirer
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Advantages of
Stock Lending (cont’d)
 Stock
lending can be used by brokerage
firms to finance the margin purchases of
their customers
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Disadvantages of
Stock Lending
 A customer
potentially gives up the right to
vote:
• The short seller is essentially a negative owner
 Some
risk is associated with the possibility
that the stock borrower might not return the
securities
• Stock loans are “marked to market”
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Regulatory Concerns

Stock lending does technically not fall under SEC
jurisdiction
• Does not involve the purchase or sale of securities

A possible area of abuse lies in the lending of
shares in cash accounts
• Cash account holders do not sign hypothecation
agreements
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Long/Short Portfolios
 Short
selling is an element of a hedging
strategy called building a long/short
portfolio:
• Combines elements of speculation, fundamental
stock analysis, and hedging to reduce risk
– Sells overvalued shares and buys undervalued
shares
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Certificateless Trading

The difference in settlement procedures across
countries can cause significant problems
• E.g., U.S. settlement takes 3 business days versus 6
weeks in France

Computer automation makes it possible to process
some types of transactions almost immediately
• E.g., newly issued U.S. government bonds are
registered in book entry form only
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Program Trading
 Program
trading:
• Is not easy to define
• Can be used to mean any computer-aided
buying or selling activity in the stock market
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Program Trading (cont’d)
 The
Wall Street Journal defines program
trading as the simultaneous purchase or sale
of at least 15 different securities with a total
value of $1 million or more
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Program Trading (cont’d)
 Stoll
and Whaley elements of program
trading:
• Portfolio trading
• Computerized trading
• Computer decision making
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Program Trading (cont’d)
 Program
trading is also the generic term
used to describe any strategy that
instantaneously recommends buy or sell
order because of apparent arbitrage
• E.g., buy futures and sell stock if the basis is
theoretically too small
• E.g., buy stock and sell futures if the basis is
theoretically too wide
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Program Trading (cont’d)
 Program
traders fall into one of two groups:
• Institutions that buy stock index futures and Tbills to create the equivalent of an index
portfolio
• Institutions that combine a well-diversified
stock portfolio with short position in stock
index futures to create synthetic T-bills
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Program Trading (cont’d)
 Program
trading has a bad name as it may
increase security price volatility
 Many
professional traders and investment
managers believe that program trading
benefits the public
• Helps reduce commission costs
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Role of Derivative Assets
 Process
of education
 Getting board approval
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Process of Education
 People
think derivatives are speculative
 Various exchanges offer seminars on ways
in which derivative assets can be used in
conservative portfolios
• E.g., risk management conferences by CBOE,
CBOT, CME, LIFFE
• Derivative asset education is designed to give
people more choices
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Getting Board Approval
 Once
the portfolio manager is convinced of
futures and/or options, he must convince:
• Boards of trustees
• Supervisors or
• Fund beneficiaries
 The
manager should be able to explain the
merits of derivatives using everyday
language
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The Chartered
Financial Analyst Program
 History
 The
CFA program exams
 CFA program themes
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History
 The
CFA program began in 1959 when the
Institute of Chartered Financial Analysts
(ICFA) was formed
– Promotes investment education and ethical behavior
– Awarded the first charter in 1963
 The
Financial Analysts Federation (FAF)
merged with the ICFA in 1990 to form the
Association for Investment Management
and Research (AIMR)
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The CFA Program Exams
 To
earn the CFA designation, candidates
must pass three separate exams taken at
least a year apart
• Each CFA exam is given only once per year
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The CFA
Program Exams (cont’d)
 Level
I is multiple choice:
• Covers basic tools and inputs to the investment
valuation process
 Level
II is essay, valuation, analysis, and
problem sets
• Emphasizes security valuation and specialized
topics
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The CFA
Program Exams (cont’d)
 Level
III is essay, valuation, analysis, and
problem sets
• Covers portfolio management
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CFA Program Enrollment
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CFA Program Themes
 Competence
 Presentation
standards
 Fiduciary duties
 Ethics
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Competence
 People
who complete the CFA program are
technically very competent and are likely to
keep their noses clean during their
professional careers
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Presentation Standards
 CFA candidates
learn state-of-the-art
standards and may prepare their own reports
in accordance with AIMR requirements
 From
a fiduciary perspective, compliance
with AIMR requirements is on its way to
being mandatory
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Fiduciary Duties
 Fiduciary
duties require conduct that:
• Is in the individual client’s best interest
• Is fair to the collective group of all clients
 Research
reports are an important part of
fiduciary dutues
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Ethics
 The
coverage of ethics in the CFA program
is very useful:
• For example:
– Analysts must distinguish between fact and opinion
– Research reports should be objective, unbiased, and
have a reasonable basis
– Bigger clients should not be given preferential
treatment
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Regulation Fair Disclosure
 Introduction
 The
SEC position
 The industry position
 AIMR response
 The future of the regulation
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Introduction
 Regulation
FD was approved by the SEC in
August 2000
 The key provision:
• Prevents companies from giving material
information to security analysts, mutual funds,
or institutional investors
• Unless the company simultaneously issues the
same information to the general public
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The SEC Position
 The
purpose of Regulation FD is:
• To increase the quantity and quality of available
information to investors
• To eliminate what some perceive as an unfair
advantage enjoyed by Wall Street’s big guns
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The Industry Position
 Evidence
indicates that less information is
available to the public:
• Companies are reluctant to answer questions
not publicly answered before
• Companies have begun to provide less
information between quarterly reports
• Quarterly conference calls between firms and
the brokerage industry have become scripted
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AIMR Response
 AIMR
study when Regulation FD was first
announced:
• “To avoid any possible SEC enforcement
actions, corporations will reduce their
communications to ‘sound bites’ and
‘boilerplate’ disclosures”
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AIMR Response
 AIMR
study one year later:
• “While the overall goal of providing small
investors and investment professionals with the
same information is being achieved, it has been
at the cost of less information in terms of
quantity and quality”
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The Future of the Regulation
 SEC
Commissioner Laura Unger’s
recommendations regarding Regulation FD:
• The SEC should provide more guidance on
materiality
• The SEC should make it easier for issuers to
use technology to comply with Regulation FD
• The SEC should analyze what issuers are
saying post-FD
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Security Analyst Independence
 Introduction
 Analyst
ratings
 Bullish ratings as the ship sinks
 Separation of research and investment
banking
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Introduction
 Some
aspects of the security analyst
business have long needed improvement
 The
Enron collapse brought the issue of
security analyst independence in the
spotlight
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Analyst Ratings
 A high
proportion of analyst stock ratings
are positive
• Firms have little incentive to begin coverage of
a firm that is unlikely to be an attractive
investment
– “Buy” recommendations bring in more business
than “sell” recommendations
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Analyst Ratings (cont’d)
 Efforts
are beginning to standardize
language used in assigning ratings
• E.g., “accumulate” and “market perform”
ratings
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Analyst Ratings (cont’d)
 NASD
proposals in early 2002 require
analysts to:
• Better explain their rating system
• Disclose banking relationship with companies
they cover
• Not earn a bonus from attracting underwriting
business from the firms they cover
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Bullish Ratings as
the Ship Sinks
 Sudden
adverse news that hits a company is
difference from a gradual accumulation of
negative events coupled with an analyst’s
hope that things will improve
• E.g., dot.coms in 1999 and 2000
– Some analysts maintained “buy” recommendations
four days before the firm went into bankruptcy
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Separation of Research
and Investment Banking
 The
opinion of a security analyst should not
be biased by activities elsewhere in the firm
 The
Security Industries Association list of
best practices states:
• “Research should not report to investment
banking; it should also not report to any other
business unit in a way that compromises its
integrity”
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