Lecture Presentation Software to accompany Investment Analysis and Portfolio Management Sixth Edition by Frank K. Reilly & Keith C. Brown Chapter 22.

Lecture Presentation Software to accompany Investment Analysis and Portfolio Management Sixth Edition by Frank K. Reilly & Keith C. Brown Chapter 22 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

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.

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.

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.

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 Frequently used in conjunction with quadratic optimization (see below) 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 Expected Tracking Error (Percent) Figure 22.1 4.0 3.0 2.0 1.0 500 400 300 200 100 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 Variation of Markowitz Portfolio Theory, but … Rather than maximize E(R) while minimizing , Maximize  while minimizing  Copyright © 2000 by Harcourt, Inc. All rights reserved.

Efficient Frontier for Enhanced/Optimized Index Funds
 Efficient Frontier p p Tracking Error () 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 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 (sector rotation) or among investment styles (e.g., theme investing) 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 note: P/Book is probably a better measure of value than is P/E 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.

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.

Chapter 27 - Evaluation of Portfolio Performance
What is the Treynor portfolio performance measure? What is the Sharpe portfolio performance measure? What is the critical difference between the Treynor and Sharpe portfolio performance measures? What is the Jensen portfolio performance measure, and how does it relate to the Treynor measure? Copyright © 2000 by Harcourt, Inc. All rights reserved.

What is Required of a Portfolio Manager?
1.The ability to derive above-average returns for a given risk class Superior risk-adjusted returns can be derived from either superior timing or superior security selection 2. The ability to diversify the portfolio completely to eliminate unsystematic risk Copyright © 2000 by Harcourt, Inc. All rights reserved.

Composite Portfolio Performance Measures
Portfolio evaluation before 1960 rate of return within risk classes Peer group comparisons no explicit adjustment for risk difficult to form comparable peer group Treynor portfolio performance measure market risk individual security risk introduced characteristic line Copyright © 2000 by Harcourt, Inc. All rights reserved.

Treynor Portfolio Performance Measure
Treynor recognized two components of risk Risk from general market fluctuations Risk from unique fluctuations in the securities in the portfolio His measure of risk-adjusted performance focuses on the portfolio’s undiversifiable risk: market or systematic risk Copyright © 2000 by Harcourt, Inc. All rights reserved.

The numerator is the risk premium The denominator is a measure of risk The expression is the risk premium return per unit of risk Risk averse investors prefer to maximize this value This assumes a completely diversified portfolio leaving systematic risk as the relevant risk Copyright © 2000 by Harcourt, Inc. All rights reserved.

Comparing a portfolio’s T value to a similar measure for the market portfolio indicates whether the portfolio would plot above the SML Calculate the T value for the aggregate market as follows: Copyright © 2000 by Harcourt, Inc. All rights reserved.

Treynor versus Sharpe Measure
Sharpe uses standard deviation of returns as the measure of risk Treynor measure uses beta (systematic risk) Sharpe therefore evaluates the portfolio manager on the basis of both rate of return performance and diversification The methods agree on rankings of completely diversified portfolios Produce relative not absolute rankings of performance Copyright © 2000 by Harcourt, Inc. All rights reserved.

Jensen Portfolio Performance Measure
Also based on CAPM Expected return on any security or portfolio is Where: E(Rj) = the expected return on security RFR = the one-period risk-free interest rate j= the systematic risk for security or portfolio j E(Rm) = the expected return on the market portfolio of risky assets Copyright © 2000 by Harcourt, Inc. All rights reserved.

Lecture Presentation Software to accompany Investment Analysis and Portfolio Management Sixth Edition by Frank K. Reilly & Keith C. Brown Chapter 22.

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Lecture Presentation Software to accompany Investment Analysis and Portfolio Management Sixth Edition by Frank K. Reilly & Keith C. Brown Chapter 22.

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