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 Sea Harbor Drive Orlando, Florida Lecture Presentation Software to accompany Investment Analysis and Portfolio Management Sixth Edition by Frank K. Reilly & Keith C. Brown Chapter 22

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

Copyright © 2000 by Harcourt, Inc. All rights reserved. Chapter 22 - Equity Portfolio Management Strategies 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? What techniques are used by active managers in an attempt to outperform their benchmark?

Copyright © 2000 by Harcourt, Inc. All rights reserved. Chapter 22 - Equity Portfolio Management Strategies 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?

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

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

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

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

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

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 Expected Tracking Error (Percent) Number of Stocks

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 This relies on historical correlations, which may change over time, leading to failure to track the index

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

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

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

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 or among investment styles to catch hot concepts before the market does Stockpicking - individual issues

Copyright © 2000 by Harcourt, Inc. All rights reserved. Global Investing 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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Copyright © 2000 by Harcourt, Inc. All rights reserved. The Internet Investments Online

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

Copyright © 2000 by Harcourt, Inc. All rights reserved. Future topics Chapter 23 Forward and Futures Contracts

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