1. EQUITY-PORTFOLIO MANAGEMENT
Chapter 17
EQUITY-PORTFOLIO MANAGEMENT

2. Chapter 17 Questions
What are the two generic equity portfolio management styles?
What are three techniques for constructing a passive index portfolio?
What three generic strategies can active equity-portfolio managers use?
How does the goal of a passive equity-portfolio manager differ from the goal of an active manager?

3. Chapter 17 Questions
What investment styles may portfolio managers follow?
In what ways can investors use information about a portfolio manager’s style?
What skills should a good value portfolio manager possess? A good growth portfolio manager?

4. Chapter 17 Questions
How can futures and options be useful in managing an equity portfolio?
What strategies can be used to manage a taxable investor’s portfolio in a tax-efficient way?
What are four asset allocation strategies?

5. Generic Portfolio Management Strategies
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

6. Passive Equity Portfolio Management Strategies
Attempt to replicate the performance of an index
May slightly underperform the target index due to fees and commissions
Strong rationale for this approach
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

7. Passive Equity Portfolio Management Strategies
Not a simple process to track a market index closely
Three basic techniques:
Full replication
Sampling
Quadratic optimization or programming

8. Passive Equity Portfolio Management Strategies
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

9. Passive Equity Portfolio Management Strategies
Sampling
Buys 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”
Tracking error will diminish as the number of stocks grows, but costs will grow (tradeoff)

10. Expected Tracking Error Between the S&P 500 Index and Portfolio Samples of Less Than 500 Stocks
Expected Tracking Error (Percent)
Exhibit 17.2
4.0
3.0
2.0
1.0
500
400
300
200
100
Number of Stocks

11. Passive Equity Portfolio Management Strategies
Quadratic Optimization
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

12. Passive Equity Portfolio Management Strategies
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. Passive Equity Portfolio Management Strategies
Dollar-cost averaging
Purchasing fixed dollar investments per period over time
Prevents buying too many shares at high prices and too few shares when prices are low
Often part of a passively managed portfolio strategy

14. 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
Need to select an appropriate benchmark
Practical difficulties of active manager
Transactions costs must be offset by superior performance vis-à-vis the benchmark
Higher risk-taking can also increase needed performance to beat the benchmark

15. Active Equity Portfolio Management Strategies
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, attempt to buy low and sell high

16. Active Equity Portfolio Management Strategies
Global Investing: Three Strategies
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

17. Active Equity Portfolio Management 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
Key is to determine what to “rotate into”

18. Active Equity Portfolio Management Strategies
Style Investing
Construct a portfolio to capture one or more of the characteristics of equity securities
Small-cap stocks, low-P/E stocks, etc…
Value stocks (those that appear to be under-priced according to various measures)
Low Price/Book value or Price/Earnings ratios
Growth stocks (above-average earnings per share increases)
High P/E, possibly a price momentum strategy

19. Active Equity Portfolio Management Strategies
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 fully diversify a portfolio
Style investing allows control of the total portfolio to be shared between the investment managers and a sponsor

20. Active Equity Portfolio Management Strategies
Value versus Growth
Growth investing focuses on earnings and changes in company fundamentals
Value investing focuses on the pricing of stocks
Over time value stocks have offered somewhat higher returns than growth stocks

21. Active Equity Portfolio Management Strategies
Expectational Analysis and Value/Growth Investing
Analysts recommending stocks to a portfolio manager need to identify and monitor key assumptions and variables
Value investors focus on one key set of assumptions and variables while growth investors focus on another
Such an analysis can help determine timing strategy for buying/selling

22. Asset Allocation Strategies
Many portfolios containing equities also contain other asset categories, so the management factors are not limited to equities
Four asset allocation strategies:
Integrated asset allocation
Examine capital market conditions and investor objectives and constraints
Determine the allocation that best serves the investor’s needs while incorporating the capital market forecast

24. Asset Allocation Strategies
Strategic asset allocation
Using historical information, generate optimal portfolio mixes based on returns, risk, and covariances, adjusting periodically to restore target allocation
Tactical asset allocation
Often a contrarian asset allocation strategy dependent on expectations
Insured asset allocation
Adjust risk exposure for changing portfolio values; more value means more ability to absorb losses

25. 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