1. Equity Portfolio Strategies - Week 5

2. Topics Today - Passive Equity Strategies - Active Equity Strategies

3. Generic Portfolio Management Strategies Passive equity portfolio management –Usually tries to track an index over time –Hope to match market performance of the selected index –Portfolio only needs to change as composition of index changes. –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

4. Exhibit 16.1

5. Passive Equity Portfolio Management Strategies Since trying to replicate the performance of an index, process of stock selection is largely automatic. No need for analysts or other expensive research. Costs of passive approach tiny compared to costs of active approach Costs of active management (1 to 2 percent p.a.) make it difficult for active to beat passive on a risk-adjusted basis Thus the main rationale for the passive approach is its substantial cost advantage over the active approach

6. Passive Equity Portfolio Management Strategies Investors are unable to purchase the market index directly Not a simple process to track a market index closely Three basic techniques: –Full replication –Sampling –Quadratic optimization or programming

7. Passive Equity Portfolio Management Strategies Full Replication To ensure close tracking, all securities in the index are purchased in proportion to their weights in the index This leads to numerous transactions, especially as dividends have to be reinvested. Numerous transactions leads to more transaction costs

8. Passive Equity Portfolio Management Strategies Sampling Fund invests in a ‘representative’ sample of the stocks in the index in proportion to the stocks’ weights in that index This leads to less transactions than with full replication, resulting in lower commissions Sampling creates ‘tracking errors’ (the differences between portfolio returns and the corresponding index returns) Tracking errors can be reduced by using a larger sample, but costs will then be larger

9. Passive Equity Portfolio Management Strategies Quadratic Optimization Uses historical return data on the stocks in the index to find a portfolio with less stocks than the index that will minimize tracking error Suffers from the problem that the portfolio weights that minimise past tracking error may not minimise future tracking error So there are no guarantees of close tracking with this method.

10. Methods of Index Portfolio Investing Index Funds –In an indexed portfolio, the fund manager will typically attempt to replicate the composition of the particular index exactly –The fund manager will buy the exact securities comprising the index in their exact weights –Change those positions anytime the composition of the index itself is changed –Low trading and management expense ratios –The advantage of index mutual funds is that they provide an inexpensive way for investors to acquire a diversified portfolio

11. Methods of Index Portfolio Investing Exchange-Traded Funds (ETF) –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 –A significant advantage of ETFs over index mutual funds is that they can be bought and sold (and short sold) like common stock –The notable example of ETFs Standard & Poor’s 500 Depository Receipts (SPDRs) iShares Sector ETFs

12. Active Equity Portfolio Management Strategies Active managers are successful for their investors if they consistently earn a portfolio return that exceeds the return of an appropriate passive benchmark portfolio, net of transaction costs, on a risk-adjusted basis Why? Success is not easy. Active managers have the burden of higher costs than passive managers Need to choose an appropriate benchmark

13. Fundamental Strategies Top-Down versus Bottom-Up Approaches –Top-Down Broad country and asset class allocations Sector allocation decisions Individual securities selection

14. Fundamental Strategies Top-Down versus Bottom-Up Approaches –Top-Down Broad country and asset class allocations Sector allocation decisions Individual securities selection –Bottom-Up Emphasizes the selection of securities without any initial market or sector analysis Form a portfolio of equities that can be purchased at a substantial discount to what his or her valuation model indicates they are worth

15. Active Equity Portfolio Management Strategies Three basic Strategies Market timing – tactical asset allocation: shifting funds into and out of stocks, bonds, and T-bills depending on broad market forecasts and estimated risk premiums sector rotation: Shifting funds among different equity sectors and industries or among investment styles to catch hot concepts before the market does (a ‘top-down’ strategy) Style Investing: Selecting individual stocks, based on on one or more characteristics of each company

16. Active Equity Portfolio Management Strategies Two Global Strategies Identify countries with markets that appear undervalued or overvalued and weight the portfolio accordingly (another ‘top-down’ strategy) Manage a global portfolio from an industry perspective rather than from a country perspective

17. Active Equity Portfolio Management Strategies Sector Rotation Tries to take advantage of the herd mentality of many investors by exiting popular sectors and seeking to identify and invest in other sectors that might become popular next. May base on macroeconomic trends or forecasts Difficult to do well. E.g. Tech stocks have become expensive (in P/E terms) again, but drug stocks look cheap. e.g., housing sector vulnerable to interest rate increases which seem more likely than not.

18. Style Investing Tests of efficient market models have uncovered anomalies that suggest that the market does not behave as one market but rather is segmented (e.g. low P/B do better) Market segments are groups of stocks with similar characteristics that tend to perform similarly market segments can be divided into top-down (sectors and industries) and bottom-up classifications (e.g., P/E ratio)

19. Bottom-Up Market Segments Category Possible Measure Size Market value, Sales, Assets Value P/E, P/B, P/CF, P/S Growth High EPS growth, stable growth, EPS surprise, EPS momentum Risk Beta, Debt/Equity ratio, Volatility of earnings

20. Hypothetical value of $1 invested at year-end 1925. Assumes reinvestment of income and no transaction costs or taxes. 1925-2001 $10 Ending Wealth 3.1% Average Return Inflation Small versus Large Stocks $.10 $1 $10 $100 $1,000 $10,000 $17 3.8% Treasury Bills $51 5.3% Government Bonds $7,860 12.5% Small Company Stocks 10.7% Large Company Stocks $2,279 1925193519451955 1965 1975 19852001

21. Fama and French Portfolios. 1963-2002 annual returns% and std.deviation High P/B Low P/B “Glamour” “Value” Book-to-market equity Low234High Small 10.216.217.220.121.5 37.831.326.625.326.7 2 10.213.617.518.718.8 28.622.923.922.922.8 3 10.314.714.817.219.1 24.721.119.221.222.1 4 11.911.714.416.717.7 22.118.318.019.821.3 Big 11.511.412.113.713.7 19.716.915.816.819.0

22. Style Investing Construct a portfolio that invests in one of these market segments e.g. Small-cap stocks, low-P/E stocks, etc… Value stocks (those that appear to be under- priced according to various measures) –e.g. Low Price/Book value or Price/Earnings ratios Growth stocks (above-average earnings per share increases) –High P/E, possibly a price momentum strategy

23. Growth Stocks Growth stocks are stocks of companies that have historically been able to grow their businesses faster than the average company and are expected to continue that growth. Growth is measured by observing the growth of company earnings, sales, or other factors. Because growth companies are expected to grow faster than average, investors are willing to pay more for the stock of these companies than for value stocks relative to current earnings. These companies often pay little or no dividend because they are using most of their available cash to re-invest in the business to help it continue to grow.

24. Value Stocks Value stocks are stocks of companies that have had historically slower growth of earnings or sales, or have recently experienced trouble of some kind causing a fall in stock price. Many investors consider value companies to include turnaround opportunities, where a change in management, business strategy, or other factors could increase prospects and earnings for the company.

25. Value Stocks 2 Because current prospects for value stocks are not as robust as for growth stocks, value stocks sell for lower multiples of price-to-book and price-to-earnings. Since growth prospects for value stocks are judged by the market to be relatively modest, the dividend yield is typically higher, which helps to attract and retain investors.

26. What Are Growth and Value Stocks? Growth Stocks High growth rate of earnings, sales Usually have high price-to-book, price-to-earnings ratios Paying lower or no dividends Risks Future growth does not occur as expected Price-to-book, price-to-earnings ratios decline unexpectedly Value Stocks Slower growth of earnings and sales Low price-to-book, price-to- earnings ratios Higher dividend yields Turnaround opportunities Risks Evaluation of stock as good value is misread Difficult to stick to value policy when prices are beaten down

27. 1927-2001 Growth and Value Investing 19271937194719571967197719872001 $857 Ending Wealth $5,095 9.6% Average Return 12.2% Large Growth Large Value $.10 $1 $10 $100 $1,000 $10,000 $100,000 $7319.3% Small Growth Small Value $22,55314.5%

28. Growth and Value Stocks 1928-2001 Standard Deviation Risk versus Return 9% 11% 13% 15% Return Large Value Stocks Small Growth Stocks Small Value Stocks Large Growth Stocks 19%21%23%25%27%29%31%33%35%37%

29. Growth and Value Stocks 1970-2001 Standard Deviation Risk versus Return Return 7% 9% 15% 17% 19% 17%19%21%23%25%27%29% Small Growth Stocks Small Value Stocks Large Growth Stocks Large Value Stocks 11% 13%

30. *1920s based on the years 1928-1929. **Based on the years 2000-2001. Compound Annual Rates of Return by Decade Growth and Value by Decade -15% -10% -5% 0% 5% 10% 15% 20% 25% 1920s*1930s1940s1950s1960s1970s1980s1990s2000s** All Growth Stocks All Value Stocks

31. One-Year Growth and Value Trends 1928-2001 Based on the period 1928-2001. Data calculated using 12-month returns. Large Growth Annual Premiums Growth versus Value Stocks 0% 40% 80% 120% 160% 200% 1928193819481958196819781988 Large Value 2001

32. Annual Premiums 0% 5% 10% 15% 20% 25% 30% 1930 1940 1950 1960 1970 1980 1990 2001 Three-Year Growth and Value Trends 1928-2001 Large Growth Based on the period 1928-2001. Data calculated using 36-month returns. Growth versus Value Stocks Large Value

33. 12-month Excess Returns Relative to the S&P 500 1970-2001 -2.0% -1.0% 0.0% 1.0% 2.0% 3.0% 19701973197619791982198519881991199419972001 Excess Returns Large Growth Large Value Growth and Value Excess Returns

34. Year-end 1998–February 2001 $1,021 $1,136 $900 $1,000 $1,100 $1,200 $1,300 $1,400 Dec-98Jun-99Dec-99Jun-00Feb-01 $1,094 Diversified Portfolio Large Value Large Growth Diversified portfolio represented by 50% growth stocks and 50% value stocks. Growth and Value Diversification Benefits

35. Major ‘Bottom-Up’ Investment Styles Common styles are based around size and value- growth distinctions: Large Cap-Value, Large Cap- Growth, Small Cap-Value and Small Cap-Growth GARP (growth at a reasonable price) GARP attempts to cross the growth/value boundary by searching for growth stocks that appear undervalued, or undervalued stocks that have unappreciated growth potential Style-Neutral: tries to construct a portfolio with an even balance of value and growth stocks, small and large stocks

36. Exhibit 16.20

37. Other Investment Styles Some styles based on Technical Analysis Most common of these is Momentum Investing. Uses measures of relative strength such as relative return over the last six months. In such a case, the fund might only invest in stocks within the highest 6-month return decile, for example.

38. More on Value and Growth Investment Styles Classifications such as Value = Low P/B are too simplistic and naïve An intelligent investor will pay more (in P/B terms, for example, or P/E etc.) the better the business is. Thus there should be a trade-off between the quality of the business and its price. Value is not a one-dimensional concept

39. QARP Some of the more successful investors (e.g. Warren Buffett) employ a more-sophisticated investment style that can be described as Quality at a Reasonable Price (QARP). This name implies that the higher the quality of the business the higher the price you should be prepared to pay. Such investors recognise that there is a tradeoff between quality and price. They usually leave themselves a margin of safety in case their analysis is wrong. (The price they are prepared to pay is always less than what they think it is worth.)

40. QARP But what is the “quality of a business” ? What are the features of a high quality business?

41. Buffett on Growth and Value Most analysts feel they must choose between two approaches customarily thought to be in opposition: ‘value’ and ‘growth’. Many investment professionals see any mixing of the two as a form of intellectual cross- dressing. We view that as fuzzy thinking in which, it must be confessed, I myself engaged some years ago. In our opinion, the two approaches are joined at the hip: growth is always a component in the calculation of value, constituting a variable whose importance can range from negligible to enormous and whose impact can be negative as well as positive.

42. Buffett on Growth and Value (2) In addition, we think the very term ‘value investing’ is redundant. What is ‘investing’ if it is not the act of seeking value at least sufficient to justify the amount paid? Consciously paying more for a stock than its calculated value--in the hope that it can soon be sold for a still-higher price--should be labeled speculation which is neither illegal, immoral nor, in our view, financially fattening. Whether appropriate or not, the term ‘value investing’ is widely used. Typically it connotes the purchase of stocks having attributes such as a low ratio of price to book value, a low P/E ratio, or a high dividend yield.

43. Buffett on Growth and Value (3) Unfortunately, such characteristics, even if they appear in combination, are far from determinative as to whether an investor is indeed buying something for what it is worth and is therefore truly operating on the principle of obtaining value in his investments. Correspondingly, opposite characteristics--a high P/E ratio, price to book and low dividend yield--are in no way inconsistent with a ‘value’ purchase. Similarly, business growth, per se, tells us little about value. It’s true that growth often has a positive impact on value. But such an effect is far from certain. For example investors have poured money into the domestic airline business to finance profitless growth.