1. MANAGING THE EQUITY PORTFOLIO CHAPTER EIGHTEEN Practical Investment Management Robert A. Strong

2. South-Western / Thomson Learning © 2004 18 - 2 Outline  Structuring a Stock Portfolio  The Portfolio Objective  Asset Allocation  Active vs. Passive Management  Portfolio Rebalancing  What’s Wrong with Buy and Hold?  The Costs of Revision  Constant Proportion Rebalancing  Constant Beta Rebalancing  Indexing  Dollar Cost Averaging

3. South-Western / Thomson Learning © 2004 18 - 3 Outline  Overwriting  Writing Options to Generate Income  Improving on the Market  Portfolio Protection  Writing Covered Calls for Downside Protection  Protective Puts  Using Index Options  Using Index Futures Contracts

4. South-Western / Thomson Learning © 2004 18 - 4 Structuring a Stock Portfolio : The Objective  Semantics are important in any statement of investment objectives.  The four main portfolio objectives are stability of principal, income, growth of income, and capital appreciation.  In a world with taxes, one dollar in capital gains is worth more than one dollar in income.  The overriding investment objective is utility maximization.

5. South-Western / Thomson Learning © 2004 18 - 5 Relative Riskiness of Portfolio Objectives 20 18 16 14 12 10 8 6 4 2 0 expected return standard deviation (%) capital appreciation growth of income 0 6 12 18 24 30 36 income inflation T-bills intermediate- term government bonds long-term government bonds long-term corporate bonds large company stocks small company stocks stability of principal

6. South-Western / Thomson Learning © 2004 18 - 6 Structuring a Stock Portfolio : The Objective Insert Figure 18-1 here.

7. South-Western / Thomson Learning © 2004 18 - 7 Structuring a Stock Portfolio : Asset Allocation  An asset class refers to a broad category of investments.  U.S. equities, foreign equities, bonds, and cash are four widely used asset classes.  The relative distribution of funds across asset classes is called asset allocation.

8. South-Western / Thomson Learning © 2004 18 - 8 Structuring a Stock Portfolio : Asset Allocation attitude toward risk need for return individual choice stocks bonds real estate cash foreign equities Portfolio ASSET CLASSES asset class mix realized return and risk with the passage of time investment results

9. South-Western / Thomson Learning © 2004 18 - 9 Structuring a Stock Portfolio : Active vs. Passive Management  A strategy of passive management is one in which, once established, the portfolio is largely left alone.  An active management policy, in contrast, is one in which the composition of the portfolio is dynamic.

10. South-Western / Thomson Learning © 2004 18 - 10 What’s Wrong with Buy and Hold ?  With a passive buy and hold strategy (a naive strategy), investors simply select their investments and hang on to them.  Portfolio managers often fail to outperform a passive buy and hold strategy.  When tested statistically, trading systems also do not have a good long-term batting average.

11. South-Western / Thomson Learning © 2004 18 - 11 The Costs of Revision  There are costs to revising a portfolio.  Trading fees : Historically, stock commissions are a function of the number of shares and the dollar amount involved.  Even relatively simple portfolio revisions take up management time.  Selling securities can involve tax implications.  Window dressing refers to largely cosmetic portfolio changes made near the end of a reporting period.

12. South-Western / Thomson Learning © 2004 18 - 12 Portfolio Rebalancing  Rebalancing a portfolio is the process of periodically adjusting the portfolio so that certain original conditions of the portfolio are maintained.  In a constant proportion portfolio, adjustments are made so as to maintain the relative weighting of the portfolio components as their price change.  A constant beta rebalancing scheme seeks to maintain beta at a prespecified level. This method is not commonly used now.

13. South-Western / Thomson Learning © 2004 18 - 13 Portfolio Rebalancing Insert Table 18-1 here.

14. South-Western / Thomson Learning © 2004 18 - 14 Portfolio Rebalancing Insert Table 18-2 here.

15. South-Western / Thomson Learning © 2004 18 - 15 Portfolio Rebalancing Insert Table 18-3 here.

16. South-Western / Thomson Learning © 2004 18 - 16 Portfolio Rebalancing Insert Table 18-4 here.

17. South-Western / Thomson Learning © 2004 18 - 17 Portfolio Rebalancing  Indexing : Some funds seek to mirror the performance of a market index such as the S&P 500 or the Dow Jones Industrial Average.  Dollar cost averaging : The idea is to invest a fixed amount on a regular interval into the same security, regardless of current market conditions.

18. South-Western / Thomson Learning © 2004 18 - 18 Portfolio Rebalancing Insert Table 18-5 here.

19. South-Western / Thomson Learning © 2004 18 - 19 Portfolio Rebalancing  The context of dollar cost averaging is one of the few times in finance when the harmonic mean is useful. The harmonic mean considers reciprocals of values rather than the values themselves.

20. South-Western / Thomson Learning © 2004 18 - 20 Overwriting  Option overwriting refers to the creation and sale of stock options in conjunction with a stock portfolio.  The most common purpose is to generate additional portfolio income.  The second motivation for writing options is to permit the purchase or sale of stock at a better-than-market price.

21. South-Western / Thomson Learning © 2004 18 - 21 Writing Options to Generate Income  When investors write call options against stock they already own, the call is said to be covered.

22. South-Western / Thomson Learning © 2004 18 - 22 Writing Options to Generate Income Insert Table 18-6 here.

23. South-Western / Thomson Learning © 2004 18 - 23 Writing Options to Generate Income Insert Figure 18-4 here.

24. South-Western / Thomson Learning © 2004 18 - 24 Overwriting : Improving on the Market  Improving on the market involves writing deep-in-the-money put or call options that have “substantial” intrinsic value.  Selling stock: Current XYZ stock price = $116 Write $100 call premium @ $18 If option is exercised, total income = $100 + $18 = $118 > income without overwriting = $116

25. South-Western / Thomson Learning © 2004 18 - 25 Overwriting : Improving on the Market  Buying stock: Current Intel stock price = $67.20 Write $75 put premium @ $9 If option is exercised, total cost = $75 - $9 = $66 < cost without overwriting = $67.20  Deep-in-the-money options can be used to improve a buying or selling price at the cost of a slight increase in risk.

26. South-Western / Thomson Learning © 2004 18 - 26 Portfolio Protection  Portfolio protection basically involves adding adding components to a portfolio such that a floor value is established below which the value of the portfolio will not fall.  Writing covered calls provide downside protection up to the amount of the premium.  If an investor owns shares of a particular stock (long stock position) and buys a put on that same stock (long put position), the put is called a protective put.

27. South-Western / Thomson Learning © 2004 18 - 27 Portfolio Protection Insert Figure 18-5 here.

28. South-Western / Thomson Learning © 2004 18 - 28 Portfolio Protection Insert Table 18-7 here.

29. South-Western / Thomson Learning © 2004 18 - 29 Portfolio Protection  Using index options : An index put can protect a diversified stock portfolio against a market downturn. If market prices decline, a gain on the puts can largely offset the losses on the stock portfolio.

30. South-Western / Thomson Learning © 2004 18 - 30 Portfolio Protection Insert Table 18-8 here.

31. South-Western / Thomson Learning © 2004 18 - 31 Portfolio Protection  Using index futures contracts : A short futures position can help offset a long stock position. If the market falls, a gain in the futures market can largely offset the loss on the stock portfolio, and vice versa if the market rises.

32. South-Western / Thomson Learning © 2004 18 - 32 Portfolio Protection Insert Table 18-9 here.

33. South-Western / Thomson Learning © 2004 18 - 33 Review  Structuring a Stock Portfolio  The Portfolio Objective  Asset Allocation  Active vs. Passive Management  Portfolio Rebalancing  What’s Wrong with Buy and Hold?  The Costs of Revision  Constant Proportion Rebalancing  Constant Beta Rebalancing  Indexing  Dollar Cost Averaging

34. South-Western / Thomson Learning © 2004 18 - 34 Review  Overwriting  Writing Options to Generate Income  Improving on the Market  Portfolio Protection  Writing Covered Calls for Downside Protection  Protective Puts  Using Index Options  Using Index Futures Contracts

35. South-Western / Thomson Learning © 2004 18 - 35 Appendix: Index Overwriting  Index options  Put and call options  have virtually the same characteristics as an option on common stock  DIFFERENCE is the underlying security is an index representing the current level of some set of stock prices  OEX  DJX

36. South-Western / Thomson Learning © 2004 18 - 36 Appendix: Index Overwriting  Advantage is they drastically reduce the unsystematic risk usually associated with small portfolios

37. South-Western / Thomson Learning © 2004 18 - 37 Appendix: Index Overwriting  Table 18A-1

38. South-Western / Thomson Learning © 2004 18 - 38 Appendix: Index Overwriting  Risk of index calls is that the index will rise above the strike price

39. South-Western / Thomson Learning © 2004 18 - 39 Appendix: Index Overwriting

40. South-Western / Thomson Learning © 2004 18 - 40 Appendix: Index Overwriting