Lecture Presentation Software to accompany

Investment Analysis and Portfolio Management

Seventh Editionby

Frank K. Reilly & Keith C. Brown

Chapter 17

Chapter 17 - 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?• What is a portfolio’s tracking error and how is it

useful in the construction of a passive equity investment?

Chapter 17 - Equity Portfolio Management Strategies

• What is the difference between an index mutual fund and an exchange-traded fund?

• 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 manager’s investment performance?

Chapter 17 - Equity Portfolio Management Strategies

• What techniques are used by active managers in an attempt to outperform their benchmark?

• 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?

Passive versus Active Management• Passive equity portfolio management

– Long-term buy-and-hold strategy– Usually tracks 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

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

Index Portfolio Strategy Construction Techniques

• Full replication

• Sampling

• Quadratic optimization or programming

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

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

Expected Tracking Error Between the S&P 500 Index and Portfolio Samples of Less Than 500 Stocks

Exhibit 17.2

500 400 300 200 100 0

2.0

1.0

3.0

4.0

Expected Tracking Error (Percent)

Number of Stocks

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

Methods of Index Portfolio Investing

• Index Funds– Attempt to replicate a benchmark index

• Exchange-Traded Funds– EFTs are depository receipts that give investors

a pro rata claim on the capital gains and cash flows of the securities that are held in deposit by a financial institution that issued the certificates

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

Fundamental Strategies

• Top-down versus bottom-up approaches• Asset and sector rotation strategies

Sector Rotation• Position a portfolio to take advantage of the market’s

next move• Screening can be based on various stock

characteristics:– Value– Growth– P/E– Capitalization– Sensitivity to economic variables

Technical Strategies

• Contrarian investment strategy• Price momentum strategy• Earnings momentum strategy

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

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

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

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

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

Determining Style

• Style grid: – firm size– value-growth characteristics

• Style analysis– constrained least squares

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

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

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

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

Asset Allocation Strategies• Integrated asset allocation

– capital market conditions– investor’s objectives and constraints

• Strategic asset allocation– constant-mix

• Tactical asset allocation– mean reversion– inherently contrarian

• Insured asset allocation– constant proportion

Asset Allocation Strategies

• Selecting an allocation method depends on: – Perceptions of variability in the client’s

objectives and constraints – Perceived relationship between the past and

future capital market conditions

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 portfolio’s underlying assets reduces the portfolio’s sensitivity to price changes of the asset

• Options do not have symmetrical impact on returns

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

Using Derivatives in Passive Equity Portfolio Management

• Futures and options can help control cash inflows and outflows from the portfolio– Inflows - index contracts allow time to make

investments– Outflows - large planned withdrawal is made by selling

securities, which causes an increase in cash holdings; futures can counterbalance this until the withdrawal

• Options can be sold to reduce weightings in sectors or individual stocks during rebalancing

Using Derivatives in Active Equity Portfolio Management

• Modifying systematic risk• Modifying unsystematic risk

The InternetInvestments Online

www.russell.comwww.firstquadrant.comwww.wilshire.comwww.fool.comwww.dailystocks.com

End of Chapter 17–Equity Portfolio Management Strategies

Future topicsChapter 18

• Bond Fundamentals