Chapter Twenty-Three
Contemporary Issues in Portfolio Management
KEY POINTS
The book ends with a discussion of several contemporary topics in the portfolio
management business.
Stock lending is an obscure part of the institutional money management business and is
usually associated with short selling. The practice is both lucrative and full of potential
for abuse. Increased regulatory supervision of this activity has already begun.
Long/short portfolios seem to go against market efficiency. Still, many investment
houses actively pursue them. The creation and transfer of stock certificates is
increasingly expensive. There is a trend in the industry eventually to eliminate stock
certificates, maintaining accounts in book entry form only.
Program trading continues to suffer from a bad image, largely due to a public
misperception of what the term means and the effects of the practice.
TEACHING CONSIDERATIONS
This chapter contains material that is likely new to students and may require a bit more
time highlighting the key issues. It may be helpful to spend a little time going through
the short selling process as this process is usually not well understood by students. Also,
some students may mistakenly think that a hedge fund is involved mostly in risk
reduction, while the opposite if often true. Students need to be aware of regulation FD
(Fair Disclosure) and the effect it is having. Finally, students in a portfolio management
class often have an interest in making a career in the investments field of study. It is very
important that they understand the significance of the CFA designation. Spend some
time
As with any discipline, you cannot read a book and know it all. Students should
appreciate the fact that the field of finance is continually evolving as increasingly
sophisticated security analysts and portfolio managers search for ways to earn additional
return and reduce risk.
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ANSWERS TO QUESTIONS
1. We do not expect to find riskless profits in a well-functioning marketplace. Securities
are priced based on their expected returns and their perceived level of risk. Security
valuation is, therefore, based on arbitrage arguments. Investments that dominate
others will be preferred in the marketplace. It is the activities of security analysts and
individual investors who eliminate arbitrage.
2. Increased volatility in the market is generally considered undesirable. A clear cause
and effect would likely lead to calls for regulatory relief from program trading.
Whether this would happen is a matter of conjecture.
3. Portfolio insurance requires alterations to the portfolio based on something that has
already happened rather than on something that is expected to happen.
4. Selling short involves a potentially unlimited loss. Because of this high risk, most
brokerage firms discourage small investors from doing so.
5. Most individual investors are only concerned with the security of their investment, its
potential return and risk, and with their ability to trade out of it at will. Whether stock
is lent is generally unimportant.
6. They have usually not been given permission by the security owner.
7. Facilitating the matching up of those who want to lend stock and those who want to
borrow it.
8. It is essentially “free money.” There is no particular increase in risk, and it generates
a reliable return. Only if one party defaults is there added risk.
9. What is the actual incidence of stock lending? Do some firms do more of this as a
percentage of their assets than others do? What rates of interest are paid, and how
does this vary? What evidence is there that interest is ever credited to a customer
account? What evidence is there that securities held in a cash account are sometimes
lent?
10. Student response.
11. Program trading seeks to eliminate arbitrage opportunities as they develop. Without
arbitrage, program trading would be much less attractive.
12. A derivative asset is one whose value stems largely from the value of another asset.
Calls, puts, and futures contracts are common examples.
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13. Stock loans are marked to market. In the event of default, the lender’s liability is the
extent to which the stock’s value exceeds the value of the collateral.
ANSWERS TO PROBLEMS
1. Student response.
2. a. 1,000 x (1.0) + (10 x 100 x -0.317) = 683 (equivalent to a long position of 683
shares)
b. Sell short 317 shares.
3. Student response.
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