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

2. 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

3. 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

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

5. 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

6. 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

7. Expected Tracking Error Between the S&P 500 Index and Portfolio Samples of Less Than 500 Stocks Exhibit 17.2 5004003002001000 2.0 1.0 3.0 4.0 Expected Tracking Error (Percent) Number of Stocks

8. 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

9. 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

10. 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

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

12. 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

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

14. 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

15. 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

16. 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

17. 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

18. 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

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

20. 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

21. 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

22. 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

23. 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

24. 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

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

26. 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

27. 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

28. 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

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

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