Portfolio Management - Chapter 15

8/3/2019 Portfolio Management - Chapter 15

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Chapter 15

Revision of the Equity Portfolio

Prof. Rushen Chahal 1

Prof. Rushen Chahal


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An individual can make a difference; a team can

make a miracle

- 1980 U.S. Olympic hockey team



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Introduction

Portfolios need maintenance and periodicrevision:

Because the needs of the beneficiary will change

Because the relative merits of the portfoliocomponents will change

To keep the portfolio in accordance with theinvestment policy statement and investment

strategy



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Active Management Versus

Passive Management Definition

The managers choices

Costs of revision Contributions to the portfolio



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Definition

Anactive management policyis one in which

the composition of the portfolio is dynamic

The portfolio man

ager periodically chan

ges:

The portfolio components or

The components proportion within the portfolio

Apassive management strategyis one in

which the portfolio is largely left alone



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The Managers Choices

Leave the portfolio alone

Rebalance the portfolio

Asset allocation and rebalancing within theaggregate portfolio

Change the portfolio components

Indexing



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Leave the Portfolio Alone

Abuyand hold strategymeans 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

E.g.,B

arber an

d Odean

show that in

vestors who trade themost have the lowest gross and net returns



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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 andCPPI strategies



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Constant Mix Strategy

The constant mix strategy:

Is one to which the manager makes adjustmentsto maintain the relative weighting of the asset

classes within the portfolio as their prices change

Requires the purchase of securities that haveperformed poorly and the sale of securities that

have performed the best



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Constant Mix Strategy (contd)

Example

A portfolio has a market value of $2 million. The investment

policy statement requires a target asset allocation of 60 percentstock 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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Example (contd)

What dollar amount of stock should the portfolio manager buy

to rebalance this portfolio? What dollar amount of bonds

should he sell?


Date Portfolio Value Actual Allocation Stock Bonds

1 Jan $2,000,000 60%/40% $1,200,000 $800,000

1 Apr $2,500,000 56%/44% $1,400,000 $1,100,000


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Example (contd)

Solution: a 60%/40% asset allocation for a $2.5 million portfolio

means the portfolio should contain $1.5 million in stock and $1million in bonds. Thus, the manager should buy $100,000

worth of stock and sell $100,000 worth of bonds.



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Constant Proportion

PortfolioI

nsu

ranc

e Aconstant proportion portfolio insurance

(CPPI) strategy requires the manager to invest

a percentage of the portfolio in stocks:

$ in stocks = Multiplier x (Portfolio value Floor value)



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Constant Proportion

PortfolioI

nsu

ranc

e (c

ontd)Example

A portfolio has a market value of $2 million. The investment

policy statement specifies a floor value of $1.7 million and amultiplier of 2.

What is the dollar amount that should be invested in stocks

according to the CPPI strategy?



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Constant Proportion

PortfolioI

nsu

ranc

e (c

ontd)Example (contd)

Solution: $600,000 should be invested in stock:

$ in stocks = 2.0 x ($2,000,000 $1,700,000)

= $600,000

If the portfolio value is $2.2 million one quarter later, with$650,000 in stock, what is the desired equity position under theCPPI strategy? What is the ending asset mix after rebalancing?



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Constant Proportion

PortfolioI

nsu

ranc

e (c

ontd)Example (contd)

Solution: The desired equity position after one quarter should

be:

$ in stocks = 2.0 x ($2,200,000 $1,700,000)

= $1,000,000

The portfolio manager should move $350,000 into stock. Theresulting asset mix would be: $1,000,000/$2,200,000 = 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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Mix & CPPI

(c

ontd) 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 anobvious advantage

In a volatile market, the constant mix strategyoutperforms CPPI



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Mix & CPPI

(c

ontd) 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

Equ

ity Portfolio Constant proportion

Constant beta

Change the portfolio components

Indexing



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Constant Proportion

Aconstant proportion strategywithin an

equity portfolio requires maintaining the same

percentage investment in each stock

May be mitigated by avoidance of odd lot

transactions

Constant proportion rebalancing requiresselling winners and buying losers



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Constant Proportion (contd)

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 33.45YH 50.00 200 10,000 35.40

Total $28,250 100.00


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Example (contd)

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

specific actions to rebalance the portfolio in order to maintain the constantproportion 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 $36,500 100.00


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Example (contd)

Solution: The worksheet below shows a possible revision which requires an

additional investment of $1,000:


Stock Price Shares

Value

Before Action

Value

After

% of

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 $36,500 $37,500 100.00


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Change the

Portfolio Components Changing the portfolio components is another

portfolio revision alternative

Events sometimes deviate from what themanager 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 errorrefers to the extent to which a

portfolio deviates from its intended behavior



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Costs ofRevision

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 dollar 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 dollar value of the trade

The number of shares involved in the trade



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Commissions (contd)

The commission on a trade is split betweenthe broker and the firm for which the brokerworks

Brokers with a high level of production keep ahigher percentage than a new broker

Some brokers discoun

t their commission

s withtheir more active clients



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Commissions (contd)

Discountbrokerage 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 theportfolio management process



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Market Impact

The market impactof placing the trade is thechange in market price purely because ofexecuting the trade

Market impact is a real cost of trading

Market impact is especially pronounced forshares 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

ofTrading Fees Flippancy regarding commission costs is

unethical and sometimes illegal

Trading fees are receiving increased attentionbecause 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

managers broker

May have to be invested in a money marketaccount by the fund manager



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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 aprofit



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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 $23 and want to sell it

if it falls below $18

Place a stop-loss order for $18



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Using Stops to Protect Profits

Stop orders can be used to protect profits

E.g., a stock you bought for $33 now trades for

$48 and you want to protect the profits at $45

If the stock retreats to $45, 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 clients 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 managers outlook becomes

bearish, he may reduce his equity holdings



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Buy-Outs

A firm may be making a tender offerfor one

of the funds holdings

I.e., another firm wants to acquire the fund

holding

It is generally in the clients 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 probablymake a change



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Final Thoughts

Hindsight is an inappropriate perspective forinvestment decision making

Everything you do as a portfolio manager must be

logically justifiable at the time you do it

Portfolio managers are torn betweenminimizing losses and the potential for priceappreciation

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Portfolio Management - Chapter 15

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