Equity Portfolio Management Some strategies

Manager’s choices Leave the portfolio alone Rebalancing the portfolio while maintaining asset classes Rebalacing the equity portion of the portfolio

Leave the portfolio alone Buy and hold or naïve strategy Research indicates that high turnover reduces profits significantly. Reduces anxiety associated with portfolio rebalancing

Rebalancing the portfolio Involves periodically adjusting the portfolio to maintain some characteristics Two basic strategies –Constant mix strategy –Constant proportion portfolio insurance (CPPI)

Constant mix strategy Making adjustements to maintain the relative weights of the asset classes as their market values change. Suppose you have a portfolio worth $3 million. 70% is in stocks ($2.1 million) and 30% in bonds ($0.9 million) What happens if the stocks in the portfolio increase in value to $2.48 million and bonds increase in value to 0.92 million?

Now the stocks make up 73% of portfolio while bonds are 28%. Sell $100,000 to stock to get back to 70% and use the proceeds to buy $100,000 worth of bonds. New values: stock = $2.38 million bonds = 1.02 million

CPPI Requires the manager to invest a certain percentage of portfolio in stock according to the following formula $ stocks = multiplier x (portfolio value – floor value) Example: let multiplier be 2.5; portfolio value = $3 million; floor value = $2 million So initial stock allocation will be $2.5 m What happens if stocks go up in value?

Suppose port goes up in value to $3,098,750 – (value of stock = $2,598,750; bonds = 500,000 Using the formula, $2,746,875 should be in stocks so buy $148,125 worth of equity If value of portfolio goes down to $2 million, $ invested in equity is 0 If value of portfolio goes up to $3,333,333, 100% investment in stock. How do we solve for the amount $3,333,333? – S = (S-2 million)(2.5) use this to solve for S.

Comparing the two…. Not possible to definitely say which is better –Rising market: CPPI outperforms constant mix –Declining mkt: CPPI outperforms constant mix –Flat: neither strategy has an obvious advantage –Volatile mkt: CPPI underperforms constant mix

Rebalancing the equity portion Three basic strategies –Constant proportion –Constant beta –Indexing