1. Version 1.2 Copyright © 2000 by Harcourt, Inc. All rights reserved. Requests for permission to make copies of any part of the work should be mailed to: Permissions Department Harcourt, Inc. 6277 Sea Harbor Drive Orlando, Florida 32887-6777 Lecture Presentation Software to accompany Investment Analysis and Portfolio Management Sixth Edition by Frank K. Reilly & Keith C. Brown Chapter 22

2. Copyright © 2000 by Harcourt, Inc. All rights reserved. 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

3. Copyright © 2000 by Harcourt, Inc. All rights reserved. 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

4. Copyright © 2000 by Harcourt, Inc. All rights reserved. Passive Equity Portfolio Management Techniques Full replication Sampling Quadratic optimization or programming

5. Copyright © 2000 by Harcourt, Inc. All rights reserved. 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

6. Copyright © 2000 by Harcourt, Inc. All rights reserved. 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 Frequently used in conjunction with quadratic optimization (see below)

7. Copyright © 2000 by Harcourt, Inc. All rights reserved. Expected Tracking Error Between the S&P 500 Index and Portfolio Samples of Less Than 500 Stocks Figure 22.1 5004003002001000 2.0 1.0 3.0 4.0 Expected Tracking Error (Percent) Number of Stocks

8. Copyright © 2000 by Harcourt, Inc. All rights reserved. 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 –Variation of Markowitz Portfolio Theory, but … –Rather than maximize E(R) while minimizing , –Maximize  while minimizing 

9. Copyright © 2000 by Harcourt, Inc. All rights reserved. Efficient Frontier for Enhanced/Optimized Index Funds Efficient Frontier pp  Tracking Error (  ) pp 0

10. Copyright © 2000 by Harcourt, Inc. All rights reserved. Quadratic Optimization (or programming techniques) This is the application for which Markowitz optimization is most frequently used in practice Suffers from the same problems as mentioned in Ch. 8 on Markowitz optimization, such as: –Relies on historical correlations, which may change over time, leading to failure to track the index –Also, still need to use some type of factor model to provide structure to the correlations and thereby reduce the number of elements that must be estimated

11. Copyright © 2000 by Harcourt, Inc. All rights reserved. Quadratic Optimization (or programming techniques) Also note, as mentioned before, in this application of Markowitz optimization, we optimize the portfolio with respect to “excess return” (  ) and tracking error (  ), rather than E(R) and . So, in effect, we are assuming the benchmark is efficient, and then optimizing with respect to it. –I.e., in effect, we would be using the benchmark portfolio to define where our efficient frontier is. Thus, if the market is not efficient to begin with (with regard to E(R) and  ), this use of Markowitz optimization will not push the market onto the efficient frontier.

12. Copyright © 2000 by Harcourt, Inc. All rights reserved. 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

13. Copyright © 2000 by Harcourt, Inc. All rights reserved. Other Passive Portfolios Meet unique needs Socially responsible investments Dollar-cost averaging

14. Copyright © 2000 by Harcourt, Inc. All rights reserved. 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

15. Copyright © 2000 by Harcourt, Inc. All rights reserved. Fundamental Strategies Top-down versus bottom-up approaches Asset and sector rotation strategies

16. Copyright © 2000 by Harcourt, Inc. All rights reserved. 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 (sector rotation) or among investment styles (e.g., theme investing) to catch hot concepts before the market does Stockpicking - individual issues

17. Copyright © 2000 by Harcourt, Inc. All rights reserved. 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

18. Copyright © 2000 by Harcourt, Inc. All rights reserved. Technical Strategies Contrarian investment strategy Price momentum strategy Earnings momentum strategy

19. Copyright © 2000 by Harcourt, Inc. All rights reserved. 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

20. Copyright © 2000 by Harcourt, Inc. All rights reserved. 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

21. Copyright © 2000 by Harcourt, Inc. All rights reserved. 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 –note: P/Book is probably a better measure of value than is P/E

22. Copyright © 2000 by Harcourt, Inc. All rights reserved. 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

23. Copyright © 2000 by Harcourt, Inc. All rights reserved. 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

24. Copyright © 2000 by Harcourt, Inc. All rights reserved. Determining Style Style grid: –firm size –value-vs.-growth characteristics Style analysis –constrained least squares

25. Copyright © 2000 by Harcourt, Inc. All rights reserved. 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

26. Copyright © 2000 by Harcourt, Inc. All rights reserved. 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

27. Copyright © 2000 by Harcourt, Inc. All rights reserved. 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

28. Copyright © 2000 by Harcourt, Inc. All rights reserved. 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

29. Copyright © 2000 by Harcourt, Inc. All rights reserved. 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

30. Copyright © 2000 by Harcourt, Inc. All rights reserved. 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

31. Copyright © 2000 by Harcourt, Inc. All rights reserved. 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

32. Copyright © 2000 by Harcourt, Inc. All rights reserved. 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

33. Copyright © 2000 by Harcourt, Inc. All rights reserved. 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

34. Copyright © 2000 by Harcourt, Inc. All rights reserved. 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

35. Copyright © 2000 by Harcourt, Inc. All rights reserved. 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

36. Copyright © 2000 by Harcourt, Inc. All rights reserved. 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

37. Copyright © 2000 by Harcourt, Inc. All rights reserved. End of Chapter 22 –Equity Portfolio Management Strategies

38. Copyright © 2000 by Harcourt, Inc. All rights reserved. Future topics Chapter 27 – Evaluation of Portfolio Performance The Inefficient Stock Market (Haugen) – What Pays Off and Why

39. Copyright © 2000 by Harcourt, Inc. All rights reserved.