1. Lecture Presentation Software to accompany Investment Analysis and Portfolio Management Seventh Edition by Frank K. Reilly & Keith C. Brown
Chapter 17

2. Chapter 17 - 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?
What is a portfolio’s tracking error and how is it useful in the construction of a passive equity investment?

3. Chapter 17 - Equity Portfolio Management Strategies
What is the difference between an index mutual fund and an exchange-traded fund?
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?

4. Chapter 17 - Equity Portfolio Management Strategies
What techniques are used by active managers in an attempt to outperform their benchmark?
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?

5. Passive versus Active Management
Passive equity portfolio management
Long-term buy-and-hold strategy
Usually tracks 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. 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

7. Index Portfolio Strategy Construction Techniques
Full replication
Sampling
Quadratic optimization or programming

8. 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. 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

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. 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

12. Methods of Index Portfolio Investing
Index Funds
Attempt to replicate a benchmark index
Exchange-Traded Funds
EFTs are depository receipts that give investors a pro rata claim on the capital gains and cash flows of the securities that are held in deposit by a financial institution that issued the certificates

13. 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

14. Fundamental Strategies
Top-down versus bottom-up approaches
Asset and sector rotation strategies

15. 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

16. Technical Strategies Contrarian investment strategy
Price momentum strategy
Earnings momentum strategy

17. 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

18. 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

19. 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

20. 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

21. 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

22. Determining Style Style grid: Style analysis firm size
value-growth characteristics
Style analysis
constrained least squares

23. 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

24. 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

25. 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

26. 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

27. 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

28. 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

29. 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

30. 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

31. Using Derivatives in Passive Equity Portfolio Management
Futures and options can help control cash inflows and outflows from the portfolio
Inflows - index contracts allow time to make investments
Outflows - large planned withdrawal is made by selling securities, which causes an increase in cash holdings; futures can counterbalance this until the withdrawal
Options can be sold to reduce weightings in sectors or individual stocks during rebalancing

32. Using Derivatives in Active Equity Portfolio Management
Modifying systematic risk
Modifying unsystematic risk

33. The Internet Investments Online

34. End of Chapter 17
Equity Portfolio Management Strategies

35. Future topics Chapter 18
Bond Fundamentals