Chapter 19

EQUITY-PORTFOLIO MANAGEMENT

Chapter 19 Questions
What are the two generic equity-portfolio management styles? What are three techniques for constructing a passive index portfolio? What three generic strategies can active equityportfolio managers use? How does the goal of a passive equity-portfolio manager differ from the goal of an active manager?

Chapter 19 Questions
What investment styles may portfolio managers follow? In what ways can investors use information about a portfolio managers style? What skills should a good value portfolio manager possess? A good growth portfolio manager?

Chapter 19 Questions
How can futures and options be useful in managing an equity portfolio? What strategies can be used to manage a taxable investors portfolio in a tax-efficient way?

Generic Portfolio Management Strategies

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

Passive Equity Portfolio Management Strategies

Attempt to replicate the performance of an index
May slightly underperform the target index due to fees and commissions

Strong rationale for this approach

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

Passive Equity Portfolio Management Strategies

Not a simple process to track a market index closely Three basic techniques:
Full replication Sampling Quadratic optimization or programming

Passive Equity Portfolio Management Strategies

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

Passive Equity Portfolio Management Strategies

Sampling
Buy 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
Tracking error will diminish as the number of stocks grows, but costs will grow (tradeoff)

Passive Equity Portfolio Management Strategies

Quadratic Optimization or Programming
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

Passive Equity Portfolio Management Strategies

Dollar-cost averaging
Purchasing fixed dollar investments per period over time Prevents buying too many shares at high prices and too few shares when prices are low Often part of a passively managed portfolio strategy

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
Need to select an appropriate benchmark

Practical difficulties of active manager

Transactions costs must be offset by superior performance vis--vis the benchmark Higher risk-taking can also increase needed performance to beat the benchmark

Active Equity Portfolio Management Strategies

Global Investing: Different Approaches 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

Active Equity Portfolio Management Strategies

Three Strategies Sector rotation: Shifting funds among different equity sectors and industries Style investing: Focusing on a particular investment style (large cap/small cap; growth/value) Stock picking: Looking at individual issues, attempt to buy low and sell high

Active Equity Portfolio Management Strategies

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

Key is to determine what to rotate into

Active Equity Portfolio Management Strategies

Style Investing
Construct a portfolio to capture one or more of the characteristics of equity securities Small-cap stocks, low-P/E stocks, etc Value stocks (those that appear to be under-priced according to various measures)
Low Price/Book value or Price/Earnings ratios

Growth stocks (above-average earnings per share increases)

High P/E, possibly a price momentum strategy

Active Equity Portfolio Management Strategies

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 fully diversify a portfolio Style investing allows control of the total portfolio to be shared between the investment managers and a sponsor

Active Equity Portfolio Management Strategies

Value versus Growth Growth investing focuses on earnings and changes in company fundamentals Value investing focuses on the pricing of stocks Over time value stocks have offered somewhat higher returns than growth stocks

Active Equity Portfolio Management Strategies

Expectational Analysis and Value/Growth Investing Analysts recommending stocks to a portfolio manager need to identify and monitor key assumptions and variables Value investors focus on one key set of assumptions and variables while growth investors focus on another
Such an analysis can help determine timing strategy for buying/selling

Derivatives in Equity-Portfolio Management

The risk of equity portfolios can be modified by using futures and options derivatives Selling futures reduces the risk of the investors net (portfolio with futures) position to changes in portfolio values
Also offsets positive portfolio value changes

The choice element of options means that they do not have exact offsetting effects
Positive portfolio price effects remain largely intact, but the cost of insuring against negative moves increases by the option premium

Derivatives in Equity-Portfolio Management

Derivatives can be used to offset expected adverse changes in an equity portfolio Any bad portfolio movements are mirrored by gains in derivative investments

Derivatives in Equity-Portfolio Management

The Use of Futures in Asset Allocation Allows changing the portfolio allocation quickly to adjust to forecasts at lower transaction costs than standard trading Futures can help maintain an overall balance (desired asset allocation) in a portfolio Futures can be used to gain exposure to international markets Currency exposure can be managed using currency futures and options

Derivatives in Equity-Portfolio Management

Futures and options can help control cash inflows and outflows from the portfolio Inflows purchase index futures or options when inflows arrive before individual security investments can be made efficiently Outflow sell previously purchased futures contracts rather than individual securities to meet a large expected cash outflow; less disruptive to portfolio management

Derivatives in Equity-Portfolio Management

The S & P 500 Index Futures Contract Purchasers fund a margin account
Initial margin requirements are: $6,000 for speculative buyers and $2,500 for hedging

The value is $250 times the index level When the contract expires, delivery is made in cash, not stocks Margin account is marked to market daily
Maintenance margins $2,500 and $1,500

Derivatives in Equity-Portfolio Management

Determining How Many Contracts to Trade to Hedge a Deposit or Withdrawal In order to appropriate hedge a portfolio deposit or withdrawal, the appropriate number of contracts must be sold
The appropriate number depends on the value of the cash flow, the value of one futures contract, and the portfolio beta (the Index has a beta of 1) Number of Contracts = (Cash Flow/Contract Value) x Portfolio Beta Can also adjust the beta

Derivatives in Equity-Portfolio Management

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

Derivatives in Equity-Portfolio Management

Using Futures in Active Equity Portfolio Management
Modifying systematic risk
Investing in various proportion of the futures index (where beta equals one and the underlying portfolio)

Modifying unsystematic risk

Using options, the portfolio manager can increase exposure to desired industries, sectors, and even individual companies

Derivatives in Equity-Portfolio Management

Modifying the Characteristics of a Global Equity Portfolio International equity positions involve positions in both securities and currencies Futures allow modifying each exposure separately
Can buy or sell currency contracts to change exposures to fluctuating exchange rate to either:
Take advantage of expected future exchange rate changes Hedge currency risks and largely remove this exposure

Taxable Portfolios
Outside of tax-exempt accounts such as IRAs, 401(k)s and 403(b)s, taxes represent a large expense to manage. Some implications of taxes:
Portfolio rebalancing to remain on the efficient frontier triggers capital gains, which may offset the benefit of the optimized rebalancing itself Rebalancing for asset allocation purposes likewise results in tax effects

Taxable Portfolios
Active portfolio managers especially need to consider taxes when deciding whether to sell or hold a stock whose value has increased
If a security is sold at a profit, capital gains are paid and less in left in the portfolio to reinvest A new security (the reinvestment security) needs to have a superior return sufficient to make up for these taxes The size of the expected return depends on the expected holding period and the cost basis (and amount of the capital gain) of the original security

Taxable Portfolios
Tax-Efficient Investing Strategies
Will likely become more important to fund managers, as SEC regulations now require mutual funds to disclose after-tax returns

Possible tax-efficient strategies:

Employ a buy-and-hold strategy since unrealized capital gains are not taxed Loss harvesting, using tax losses to offset capital gains on other investments

Taxable Portfolios
Possible tax-efficient strategies:
Use options to help convert short-term capital gains into a long-term gain (with more favorable tax treatment) Tax-lot accounting for shares, specifying those with the highest cost basis for sale For some investors, simply focus on growth stocks that will provide long-term gains rather than income