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Lecture Presentation Software
to accompany
Investment Analysis and
Portfolio Management
Sixth Edition
by
Frank K. Reilly & Keith C. Brown
Chapter 22
Copyright 2000 by Harcourt, Inc. All rights reserved.
Chapter 22 - Equity Portfolio
Management Strategies
Questions to be answered:
What are the two generic equity portfolio
management styles?
What are three techniques for constructing a
passive index portfolio?
How does the goal of a passive equity portfolio
manager differ from the goal of an active
manager?
Copyright 2000 by Harcourt, Inc. All rights reserved.
Chapter 22 - Equity Portfolio
Management Strategies
What are the three themes that active equity
portfolio managers can use?
What stock characteristics differentiate value-
oriented and growth-oriented investment
styles?
What is style analysis and what does it indicate
about a managers investment performance?
What techniques are used by active managers
in an attempt to outperform their benchmark?
Copyright 2000 by Harcourt, Inc. All rights reserved.
Chapter 22 - Equity Portfolio
Management Strategies
What are differences between the integrated,
strategic, tactical, and insured approaches to
asset allocation?
How can futures and options be useful in
managing an equity portfolio?
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Passive versus Active Management
Passive equity portfolio management
Long-term buy-and-hold strategy
Usually track 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
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An Overview of Passive Equity
Portfolio Management Strategies
Replicate the performance of an index
May slightly underperform the target index
due to fees and commissions
Costs of active management (1 to 2 percent)
are hard to overcome in risk-adjusted
performance
Many different market indexes are used for
tracking portfolios
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Passive Equity Portfolio
Management Techniques
Full replication
Sampling
Quadratic optimization or
programming
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Full Replication
All securities in the index are
purchased in proportion to weights in
the index
This helps ensure close tracking
Increases transaction costs, particularly
with dividend reinvestment
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Sampling
Buys a representative sample of stocks in the
benchmark index according to their weights in
the index
Fewer stocks means lower commissions
Reinvestment of dividends is less difficult
Will not track the index as closely, so there will
be some tracking error
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Expected Tracking Error Between the S&P 500 Index
and Portfolio Samples of Less Than 500 Stocks
Figure 22.1
500 400 300 200 100 0
2.0
1.0
3.0
4.0
Expected Tracking
Error (Percent)
Number of Stocks
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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 tracking error with the benchmark
This relies on historical correlations, which
may change over time, leading to failure to
track the index
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Completeness Funds
Passive portfolio customized to
complement active portfolios which do
not cover the entire market
Performance compared to a specialized
benchmark that incorporates the
characteristics of stocks not covered by
the active managers
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Other Passive Portfolios
Meet unique needs
Socially responsible investments
Dollar-cost averaging
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An Overview of Active Equity
Portfolio Management 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
Practical difficulties of active manager
Transactions costs must be offset
Risk can exceed passive benchmark
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Three Strategies
Market timing - shifting funds into and out of
stocks, bonds, and T-bills depending on broad
market forecasts and estimated risk premiums
Shifting funds among different equity sectors and
industries or among investment styles to catch
hot concepts before the market does
Stockpicking - individual issues
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Global Investing
Identify countries with markets undervalued or
overvalued and weight the portfolio accordingly
Manage the global portfolio from an industry
perspective rather than from a country perspective
Focus on global economic trends, industry
competitive forces, and company strengths and
strategies
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Sector Rotation
Position a portfolio to take advantage of the
markets next move
Screening can be based on various stock
characteristics:
Value
Growth
P/E
Capitalization
Sensitivity to economic variables
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Value versus Growth
Growth stocks will outperform value
stocks for a time and then the
opposite occurs
Over time value stocks have offered
somewhat higher returns than
growth stocks
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Value versus Growth
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
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Value versus Growth
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
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Style
Construct a portfolio to capture one or more of
the characteristics of equity securities
Small-capitalization stocks, low-P/E stocks,
etc
Value stocks appear to be underpriced
price/book or price/earnings
Growth stocks enjoy above-average earnings
per share increases
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Does Style Matter?
Choice to align with investment style
communicates information to clients
Determining style is useful in measuring
performance relative to a benchmark
Style identification allows an investor to
diversify by portfolio
Style investing allows control of the total
portfolio to be shared between the investment
managers and a sponsor
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Determining Style
Style grid:
firm size
value-growth characteristics
Style analysis
constrained least squares
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Benchmark Portfolios
Sharpe
T-bills, intermediate-term government bonds,
long-term government bonds, corporate bonds,
mortgage related securities, large-capitalization
value stocks, large-capitalization growth stocks,
medium-capitalization stocks, small-
capitalization stocks, non-U.S. bonds, European
stocks, and Japanese stocks
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Benchmark Portfolios
Sharpe
BARRA
Uses portfolios formed around 13 different
security characteristics, including variability in
markets, past firm success, firm size, trading
activity, growth orientation, earnings-to-price
ratio, book-to-price ratio, earnings variability,
financial leverage, foreign income, labor
intensity, yield, and low capitalization
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Benchmark Portfolios
Sharpe
BARRA
Ibbotson Associates
simplest style model uses portfolios formed
around five different characteristics: cash (T-
bills), large-capitalization growth, small-
capitalization growth, large-capitalization
value, and small-capitalization value
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Timing Between Styles
Variations in returns
among mutual funds are
largely attributable to
differences in styles
Different styles tend to
move at different times
in the business cycle
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Asset Allocation Strategies
Integrated asset allocation
capital market conditions
investors objectives and constraints
Strategic asset allocation
constant-mix
Tactical asset allocation
mean reversion
inherently contrarian
Insured asset allocation
constant proportion
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Asset Allocation Strategies
Selecting an allocation method depends on:
Perceptions of variability in the clients
objectives and constraints
Perceived relationship between the past and
future capital market conditions
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Using Futures and Options in
Equity Portfolio Management
Systematic and unsystematic risk of equity
portfolios can be modified by using futures and
options derivatives
Selling futures on the portfolios underlying
assets reduces the portfolios sensitivity to price
changes of the asset
Options do not have symmetrical impact on
returns
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The Use of Futures in Asset Allocation
Allows changing the portfolio allocation quickly
to adjust to forecasts at lower transaction costs
Futures can maintain an overall balance in a
portfolio
Futures can gain exposure to international
markets
Currency exposure can be managed using
currency futures and options
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The Use of Derivatives in
Equity Portfolios
Futures and options can help control cash inflows
and outflows from the portfolio
Inflows - index contracts allows time to make
investments
Outflow - large planned withdrawal is made by
selling securities, which causes an increase in
cash holdings; futures can counterbalance this
until the withdrawal
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Using Futures in
Passive Equity Portfolio Management
Help manage cash inflows and outflows while
still tracking the target index
Options can be sold to reduce weightings in
sectors or individual stocks during rebalancing
Active Equity Portfolio Management
Modifying systematic risk
Modifying unsystematic risk
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Modifying the Characteristics of
an International Equity Portfolio
Positions in securities and currencies
Futures allow modifying each exposure
separately
Traditional currency rebalancing would require
rebalancing the country allocation
Each security rebalancing would be costly and time
consuming
Currency exposure can be modified without
changing country exposures through currency
contracts
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The Internet
Investments Online
www.russell.com
www.firstquadrant.com
www.wilshire.com
www.mfea.com/planidx.html
www.cboe.com
www.cboe.com/institutional/testimon.htm
www.cboe.com/institutional/portfolio.htm
www.cboe.com/institutional/whitepap.htm
Copyright 2000 by Harcourt, Inc. All rights reserved.
End of Chapter 22
Equity Portfolio Management
Strategies
Copyright 2000 by Harcourt, Inc. All rights reserved.
Future topics
Chapter 23
Forward and Futures Contracts
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