

 significant source of wealth today equities constitute differing proportions of average portfolio weights in different countries one characteristic important to investors across markets is ability to be an inflation hedge
 equities have comparatively high historical long-term rates of return
 in study of 17 countries the long term real rates of return to equities exceeded that of bonds in all countries

 passive management
 active management
 semiactive management

 no attempt to reflect investment expectations through changes in security holdings
 indexing
 attempt to match the performance of some benchmark
 in US alone, more than $1 trillion in institutional indexed equities

 principle way historically that investors manage equities
 even with growth of indexing, still accounts for overwhelming majority of equity assets managed
 seek to outperform benchmark

 enhanced indexing or risk-controlled active management
 seek to outperform benchmark but manager worries more about tracking risk than active manager and builds portfolio that will have limited volatility around benchmark’s return

Active Indexing Enhanced
Indexing
0% 1% - 2% 2% + Expected
Active
Return
Tracking
Risk
Information
Ratio
<1%
0
1% - 2%
0.75
4% +
0.50






1971 - Wells Fargo 1 st indexed portfolio
1973 – Wells Fargo has commingled index fund for trust accounts
1976 – Wells Fargo combines funds and uses
S&P 500 as template for combined portfolio
1981 – Wells Fargo has fund to track market outside of S&P 500
1975 – Bogle at Vanguard launches 1 st broadmarket index fund for retail investors

 many studies have found that the average active institutional portfolio fails to beat the relevant comparison index after expenses

 often difference in performance is found to be close to average expense disadvantage of active management compared with the average actively managed fund that has similar objectives, a wellrun indexed fund’s major advantage is expected superior long-term net-of-expenses performance because of relatively low
 portfolio turnover

 management fees high tax efficiency

 indexes are portfolio management benchmarks
 also used
 to measure return of a market or market segment
 as basis for creating an index fund
 to study factors that influence share price movements
 to perform technical analysis
 to calculate a stock’s systematic risk

 characteristics of index
 boundaries of index’s universe
 criteria for inclusion in the index
 how the stocks are weighted
 how returns are calculated


 one of greatest differences among indexes due to how components are weighted

 price-weighted – each stock is weighted according to its absolute share price value-weighted – each stock is weighted according to its market cap

 float-weighted index equal-weighted
– each stock is weighted equally different weighting schemes can lead to different biases


PW biased towards highest price stock
VW biased towards the shares of firms with the largest market caps
(likely large and mostly mature firms and possibly overvalued firms)
 EW biased towards small firms because these indexes have many more small firms than large firms and it must be rebalanced periodically

Stephen Alcorn is a portfolio manager at Amanda Asset Management (AAM). At the end of 2002, a wealthy client engaged Alcorn to manage $10,000,000 for one year in an active focused equity style. the investment management contract specificed a symmetric incentive fee of $10,000 per 100 bps of capital appreciation relative to that of an index of the stocks slected for investment. (Symmetric means that the incentive fee will reduce the investment management fee if benchmark-relative performance is negative.) In an oversight, the contract leaves open the method by which the benchmark index will be calculated. Alcorn invests in shares of Eastman Kodak,
McDonald’s, Intel, Merck, Wal-Mart, and Microsoft achieving a 15.9% price return for the year. The table gives information on the 6 stocks. Using only the information given, address the following:
1.
For each of the 6 shares, explain the price-only return calculation on the following indices for the period 12/31/2002 to 12/31/2003:
1.
2.
3.
PW index
VW index
Float-weighted index
2.
4.
EW index
Recommend the appropriate benchmark index for calculating the performance incentive fee on the account and determine the amount of that fee.

Equity Market Data for the Shares of Six Companies
Kodak
McDonald's
Intel
Merck
Wal-Mart
Microsoft
Total
Share price Share price Price MV Shares MV Shares Free Float
12/31/2002 12/31/2003 Change 12/31/2002 12/31/2003 Factor
35.04
16.08
15.57
53.58
50.51
25.85
24.85
-29.10%
24.09
49.80%
(millions) (millions)
10,056
20,406
7,132
30,570
31.36
101.40% 101,703 204,844
45.1
53.05
27.37
-15.80%
5.00%
5.90%
119,216 100,348
221,992 233,154
277,060 293,352
750,433 869,400
1
1
0.6
1
0.85
1

 investment in an indexed portfolio
 a long position in cash plus a long position in futures contracts on the underlying index
 a long position in cash plus a long position in a swap on the index

 conventional index mutual funds
 exchange-traded funds
 separate accounts or pooled accounts (mostly for institutional investors designed to track a benchmark index)
 indexing can be done by
 full replication
 stratified sampling
 optimization

 equity styles – natural grouping of investment disciplines that has some predictive power in explaining the future dispersion of returns across portfolios

 value – focused on paying a relatively low share price in relation to earnings or assets per share growth – focused on investing in high-earningsgrowth companies
 market-oriented – specified as an intermediate grouping for investment disciplines that cannot be clearly categorized as value or growth

 Value substyles
 low P/E
 contrarian
 high yield
 Growth substyles
 consistent growth
 earnings momentum

 Blend or Core Investor
 market-oriented
 market-oriented with a value (growth) bias
 growth-at-a-reasonable-price
 style rotators

 Socially Responsible Investing
 integrates ethical values and societal concerns with investment decisions
 negative screens
 Long-Short Investing
 value added is alpha
 market neutral strategy
 pairs trade/pairs arbitrage


 price inefficiency on the short side

 many investors look for undervalued stocks but because of the constraints many have on shorting, fewer search for overvalued stocks opportunities to short may arise due to management fraud, windowdressing, or negligence

 sell-side analysts may be reluctant to issue negative opinions on companies’ stocks for reasons other than generic ones such as that a stock has become relatively expensive longshort strategies can make better use of a portfolio manager’s information because both rising and falling stocks offer profit potential
 sell-side analysts issue many more reports with buy recommendations than with sell recommendations rather than simply avoiding a stock with a bad outlook, a long-short manager can short it thereby earning the full performance spread

 enhanced index or risk-controlled active strategies
 basic forms
 derivatives-based strategies
 stock-based strategies