1

Outline
 Introduction
 Active management versus passive
management
 When do you sell stock?

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Introduction
 Portfolios need maintenance and
periodic revision:
Because the needs of the beneficiary will
change
Because the relative merits of the portfolio
components will change
To keep the portfolio in accordance with the
investment policy statement and investment
strategy

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Active Management Versus
Passive Management
 Definition
 The manager’s choices
 Costs of revision
 Contributions to the portfolio

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Definition
 An active management policy is one in
which the composition of the portfolio is
dynamic
The portfolio manager periodically changes:
○ The portfolio components or
○ The components’ proportion within the
portfolio
 A passive management strategy is
one in which the portfolio is largely left
alone

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The Manager’s Choices
 Leave the portfolio alone
 Rebalance the portfolio
 Asset allocation and rebalancing within
the aggregate portfolio
 Change the portfolio components
 Indexing

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Leave the Portfolio Alone
 A buy and hold strategy means that the
portfolio manager hangs on to its original
investments

 Academic research shows that portfolio

managers often fail to outperform a simple
buy and hold strategy on a risk-adjusted
basis

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Rebalance the Portfolio
 Rebalancing a portfolio is the process
of periodically adjusting it to maintain the
original conditions

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Rebalancing
Within the Portfolio
 Constant mix strategy
 Constant proportion portfolio insurance
 Relative performance of constant mix
and CPPI strategies

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Constant Mix Strategy
 The constant mix strategy:
Is one to which the manager makes
adjustments to maintain the relative
weighting of the asset classes within the
portfolio as their prices change

Requires the purchase of securities that

have performed poorly and the sale of
securities that have performed the best

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Constant Mix Strategy (cont’d)
Example

A portfolio has a market value of Rs2 million. The

investment policy statement requires a target
asset allocation of 60 percent stock and 30
percent bonds.

The initial portfolio value and the portfolio value

after one quarter are shown on the next slide.

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Constant Mix Strategy (cont’d)
Example (cont’d)

Date Portfolio Value Actual Allocation Stock Bonds

1 Jan Rs2,000,000 60%/40% Rs1,200,0 Rs800,000
00
1 Apr Rs2,500,000 56%/44% Rs1,400,0 Rs1,100,000
What Rs amount of stock should the portfolio
00
manager buy to rebalance this portfolio? What Rs
amount of bonds should he sell?

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Constant Mix Strategy (cont’d)
Example (cont’d)

Solution: a 60%/40% asset allocation for a Rs2.5

million portfolio means the portfolio should
contain Rs1.5 million in stock and Rs1 million in
bonds. Thus, the manager should buy Rs100,000
worth of stock and sell Rs100,000 worth of bonds.

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Constant Proportion
Portfolio Insurance
 A constant proportion portfolio
insurance (CPPI) strategy requires the
manager to invest a percentage of the
portfolio in stocks:

Rs in stocks = Multiplier x (Portfolio value – Floor

value)

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Constant Proportion
Portfolio Insurance (cont’d)
Example

A portfolio has a market value of Rs2 million. The

investment policy statement specifies a floor
value of Rs1.7 million and a multiplier of 2.

What is the Rs amount that should be invested in

stocks according to the CPPI strategy?

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Constant Proportion
Portfolio Insurance (cont’d)
Example (cont’d)

Solution: Rs600,000 should be invested in stock:

Rs in stocks = 2.0 x (Rs2,000,000 –

Rs1,700,000)
= Rs600,000

If the portfolio value is Rs2.2 million one quarter

later, with Rs650,000 in stock, what is the desired
equity position under the CPPI strategy? What is
the ending asset mix after rebalancing?

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Constant Proportion
Portfolio Insurance (cont’d)
Example (cont’d)

Solution: The desired equity position after one

quarter should be:

Rs in stocks = 2.0 x (Rs2,200,000 –

Rs1,700,000)
= Rs1,000,000

The portfolio manager should move Rs350,000

into stock. The resulting asset mix would be:
Rs1,000,000/Rs2,200,000 = 45.5%

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Relative Performance of
Constant Mix and CPPI
 A constant mix strategy sells stock as it
rises

 A CPPI strategy buys stock as it rises

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Relative Performance of
Constant Mix & CPPI (cont’d)
 In a rising market, the CPPI strategy
outperforms constant mix
 In a declining market, the CPPI strategy
outperforms constant mix
 In a flat market, neither strategy has an
obvious advantage
 In a volatile market, the constant mix
strategy outperforms CPPI

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Relative Performance of
Constant Mix & CPPI (cont’d)
 The relative performance of the
strategies depends on the performance
of the market during the evaluation
period
 In the long run, the market will probably
rise, which favors CPPI
 In the short run, the market will be
volatile, which favors constant mix

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Rebalancing Within the
Equity Portfolio
 Constant proportion
 Constant beta
 Change the portfolio components
 Indexing

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Constant Proportion
 A constant proportion strategy within
an equity portfolio requires maintaining
the same percentage investment in each
stock
May be mitigated by avoidance of odd lot
transactions

 Constant proportion rebalancing

requires selling winners and buying
losers

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Constant Proportion (cont’d)
Example

A portfolio of three stocks attempts to invest approximately

one third of funds in each of the stocks. Consider the
following information:

Stock Price Shares Value % of Total Portfolio

FC 22.00 400 8,800 31.15
HG 13.50 700 9,450 33.45
YH 50.00 200 10,000 35.40
Total Rs28,25 100.00
0

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Constant Proportion (cont’d)
Example (cont’d)

After one quarter, the portfolio values are as shown below.

Recommend specific actions to rebalance the portfolio in
order to maintain the constant proportion in each stock.

Stock Price Shares Value % of Total Portfolio

FC 20.00 400 8,000 21.92
HG 15.00 700 10,500 28.77
YH 90.00 200 18,000 49.32
Total Rs36,500 100.00

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Constant Proportion (cont’d)
Example (cont’d)

Solution: The worksheet below shows a possible revision

which requires an additional investment of Rs1,000:

Value Value % of
Stock Price Shares Before Action After Portfolio
FC 20.00 400 8,000 Buy 200 12,000 32.00
HG 15.00 700 10,500 Buy 100 12,000 32.00
YH 90.00 200 18,000 Sell 50 13,500 36.00
Total Rs36,500 Rs37,500 100.00

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Constant Beta Portfolio
 A constant beta portfolio requires
maintaining the same portfolio beta
 To increase or reduce the portfolio beta,
the portfolio manager can:
Reduce or increase the amount of cash in the
portfolio
Purchase stocks with higher or lower betas than
the target figure
Sell high- or low-beta stocks
Buy high- or low-beta stocks

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Change the
Portfolio Components
 Changing the portfolio components is
another portfolio revision alternative
 Events sometimes deviate from what the
manager expects:
The manager might sell an investment
turned sour
The manager might purchase a potentially
undervalued replacement security

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Indexing
 Indexing is a form of portfolio management
that attempts to mirror the performance of
a market index
E.g., the S&P 500 or the DJIA
 Index funds eliminate concerns about
outperforming the market
 The tracking error refers to the extent to
which a portfolio deviates from its intended
behavior

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Costs of Revision
 Introduction
 Trading fees
 Market impact
 Management time
 Tax implications
 Window dressing
 Rising importance of trading fees

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Introduction
 Costs of revising a portfolio can:
Be direct Rs costs
Result from the consumption of
management time
Stem from tax liabilities
Result from unnecessary trading activity

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Trading Fees
 Commissions
 Transfer taxes

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Commissions
 Investors pay commissions both to buy
and to sell shares

 Commissions at a brokerage firm are a

function of:
The Rs value of the trade
The number of shares involved in the trade

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Commissions (cont’d)
 The commission on a trade is split
between the broker and the firm for
which the broker works
Brokers with a high level of production keep
a higher percentage than a new broker

 Some brokers discount their

commissions with their more active
clients

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Commissions (cont’d)
 Discount brokerage firms:
Offer substantially reduce commission rates
Offer few ancillary services, such as market
research

 Retail commissions at a full-service firm

average about 2 percent of the stock
value

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Transfer Taxes
 Transfer taxes are:
Imposed by some states on the transfer of
securities

Usually very modest

Not normally a material consideration in the

portfolio management process

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Market Impact
 The market impact of placing the trade
is the change in market price purely
because of executing the trade

 Market impact is a real cost of trading

 Market impact is especially pronounced

for shares with modest daily trading
volume

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Management Time
 Most portfolio managers handle more
than one account

 Rebalancing several dozen portfolios is

time consuming

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Tax Implications
 Individual investors and corporate
clients must pay taxes on the realized
capital gains associated with the sale of
a security

 Tax implications are usually not a

concern for tax-exempt organizations

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Window Dressing
 Window dressing refers to cosmetic
changes made to a portfolio near the
end of a reporting period

 Portfolio managers may sell losing

stocks at the end of the period to avoid
showing them on their fund balance
sheets

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Rising Importance
of Trading Fees
 Flippancy regarding commission costs is
unethical and sometimes illegal

 Trading fees are receiving increased

attention because of:
Investment banking scandals
Lawsuits regarding churning
Incomplete prospectus information

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Contributions to the
Portfolio
 Periodic additional contributions to the
portfolio from internal or external
sources must be invested
 Dividends:
May be automatically reinvested by the fund
manager’s broker
May have to be invested in a money market
account by the fund manager

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When Do You Sell Stock?
 Introduction
 Rebalancing
 Upgrading
 Sale of stock via stop orders
 Extraordinary events
 Final thoughts

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Introduction
 Knowing when to sell a stock is a very
difficult part of investing

 Behavioral evidence suggests the

typical investor sells winners too soon
and keeps losers too long

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Rebalancing
 Rebalancing can cause the portfolio
manager to sell shares even if they are
not doing poorly

 Profit taking with winners is a logical

consequence of portfolio rebalancing

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Upgrading
 Investors should sell shares when their
investment potential has deteriorated to
the extent that they no longer merit a
place in the portfolio

 It is difficult to take a loss, but it is worse

to let the losses grow

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Sale of Stock Via Stop
Orders
 Definition
 Using stops to minimize losses
 Using stops to protect profits

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Definition
 Stop orders:
Are sell stops

Become a market order to sell a set number

of shares if shares trade at the stop price

Can be used to minimize losses or to protect

a profit

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Using Stops to Minimize Losses
 Stop-loss orders can be used to
minimize losses
E.g., you bought a share for Rs23 and want
to sell it if it falls below Rs18
○ Place a stop-loss order for Rs18

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Using Stops to Protect Profits
 Stop orders can be used to protect
profits
E.g., a stock you bought for Rs33 now
trades for Rs48 and you want to protect the
profits at Rs45
○ If the stock retreats to Rs45, you lock in the
profit if you place a stop order

○ If the stock continues to increase, you can use

a crawling stop to increase the stop price

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Extraordinary Events
 Change in client objectives
 Change in market conditions
 Buy-outs
 Caprice

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Change in Client Objectives
 The client’s investment objectives may
change occasionally:
E.g., a church needs to generate funds for a
renovation and changes the objective for the
endowment fund from growth of income to
income
○ Reduce the equity component of the portfolio

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Change in Market
Conditions
 Many fund managers seek to actively
time the market

 When a portfolio manager’s outlook

becomes bearish, he may reduce his
equity holdings

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Buy-Outs
 A firm may be making a tender offer for
one of the funds holdings
I.e., another firm wants to acquire the fund
holding

 It is generally in the client’s best interest

to sell the stock to the potential acquirer

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Caprice
 Portfolio managers:
Should be careful about making
unnecessary trades
Must pay attention to their experience,
intuition, and professional judgment
 An experienced portfolio manager
worried about a particular holding should
probably make a change

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Final Thoughts
 Hindsight is an inappropriate
perspective for investment decision
making
Everything you do as a portfolio manager
must be logically justifiable at the time you
do it

 Portfolio managers are torn between

minimizing losses and the potential for
price appreciation

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