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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
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 32887-6777

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?
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Chapter 22 - Equity Portfolio Management Strategies


What are the three themes that active equity portfolio managers can use? What stock characteristics differentiate valueoriented and growth-oriented investment styles? What is style analysis and what does it indicate about a managers investment performance? What techniques are used by active managers in an attempt to outperform their benchmark?
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Chapter 22 - Equity Portfolio Management Strategies


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?

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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
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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
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Passive Equity Portfolio Management Techniques


Full replication Sampling Quadratic optimization or programming
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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
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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

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Expected Tracking Error Between the S&P 500 Index and Portfolio Samples of Less Than 500 Stocks
Expected Tracking Error (Percent) 4.0 3.0 2.0 1.0 500 400 300 200 100 0
Figure 22.1

Number of Stocks
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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
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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
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Other Passive Portfolios


Meet unique needs Socially responsible investments Dollar-cost averaging

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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
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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 or among investment styles to catch hot concepts before the market does Stockpicking - individual issues

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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

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Sector Rotation
Position a portfolio to take advantage of the markets next move Screening can be based on various stock characteristics:
Value Growth P/E Capitalization Sensitivity to economic variables
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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
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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
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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

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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


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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
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Determining Style
Style grid:
firm size value-growth characteristics

Style analysis
constrained least squares

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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, smallcapitalization stocks, non-U.S. bonds, European stocks, and Japanese stocks

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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
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Benchmark Portfolios
Sharpe BARRA Ibbotson Associates
simplest style model uses portfolios formed around five different characteristics: cash (Tbills), large-capitalization growth, smallcapitalization growth, large-capitalization value, and small-capitalization value
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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
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Asset Allocation Strategies


Integrated asset allocation
capital market conditions investors objectives and constraints

Strategic asset allocation


constant-mix

Tactical asset allocation


mean reversion inherently contrarian

Insured asset allocation


constant proportion
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Asset Allocation Strategies


Selecting an allocation method depends on:
Perceptions of variability in the clients objectives and constraints Perceived relationship between the past and future capital market conditions

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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 portfolios underlying assets reduces the portfolios sensitivity to price changes of the asset Options do not have symmetrical impact on returns
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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
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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
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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
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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.

www.russell.com www.firstquadrant.com www.wilshire.com www.mfea.com/planidx.html www.cboe.com www.cboe.com/institutional/testimon.htm www.cboe.com/institutional/portfolio.htm www.cboe.com/institutional/whitepap.htm


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The Internet Investments Online

End of Chapter 22
Equity Portfolio Management Strategies

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Future topics Chapter 23


Forward and Futures Contracts

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