c7 8 equity portfolio management
TRANSCRIPT
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Courses 7, 8
Equity Portfolio Management
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An individual can make a difference; a team can
make a miracle
- 1980 U.S. Olympic hockey team
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THE ROLE OF THE EQUITY
PORTFOLIO
x Equities represent a significant source of wealth in the world todayx As of 30 September 2004: the aggregate market value of the equities
in the Morgan Stanley Capital International All Country World Index(MSCI ACWI) was more than $19 trillion
x
nearly 5 percent, equal to a market value of nearly $950 billion,represented emerging markets.
x U.S. equity typically constitutes about half of the worlds equity.x In the U.S., institutional investors hold about 60% of their portfolio in
equities. In Europe, the percentage is closer to 20%.
x ability to be an inflation hedge (bonds are not) nominal returns arepositively correlated with inflation
x equities have comparatively high historical long-term rates of return in study of 17 countries the long term real rates of return to equities
exceeded that of bonds in all countries (see exhibit 2)
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Passive Managementx no attempt to reflect investment expectations through
changes in security holdings
x indexing
attempt to match the performance of some benchmark in US alone, more than $1 trillion in institutional
indexed equities
indexing is passive in the sense that the manager does
not try to outperform the index, the execution ofindexing requires that the manager buy securities whenthe securitys weight increases in the index or sell stockwhen the securitys weight decreases in the index
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Active Managementxprincipal way historically that investors
manage equities
even with growth of indexing, still accounts foroverwhelming majority of equity assets
managed
x
seek to outperform benchmark
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Semiactive Managementx enhanced indexingorrisk-controlled active
management
A semiactive manager attempts to earn a higherreturn than the benchmark while minimizing the
risk of deviating from the benchmark.
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???x Investors who believe that an equity market is
efficientwill usually favor.x Passive strategies are appropriate in a wide variety of markets.
x When investing in large-cap stocks, indexing is suitable
because these markets are usually informationally efficient. Insmall-cap markets, there may be more mispriced stocks, but the
transactions costs of high turnover, active strategies increases.
x In international equity markets, the foreign investor may lack
information that local investors have. In this case, active
investing would be futile and the manager would be wise to
follow a passive strategy.
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Active return/risk and
information ratiox Active return (alfa) is the portfolios return in
excess of the return on the portfolios benchmark.
x
Tracking risk, the annualized standard deviation ofactive returns, measures active risk (risk relative to
the portfolios benchmark)
x The information ratio equals a portfolios mean
active return divided by tracking risk
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Indexing, Enhanced Indexing, and
Active Approaches: A ComparisonIndexing Enhanced
IndexingActive
ExpectedActive Return
0% 1% - 2% 2% +
Tracking Risk
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Passive Equity Investingx 1971 - Wells Fargo 1st indexed portfoliox 1973 Wells Fargo has commingled index fund for
trust accounts
x 1976 Wells Fargo combines funds and uses S&P500 as template for combined portfolio
x 1981 Wells Fargo has fund to track marketoutside of S&P 500
x 1975 Bogle at Vanguard launches 1st broad-market index fund for retail investors
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Passive Equity Investingx many studies have found that the average
active institutional portfolio fails to beat the
relevant comparison index after expensesx Advantages of indexed portfolios:
Low portfolio turnover
Low management fees
- High tax efficiencyExposure to markets with which an investor may be
unfamiliar (e.g., an overseas market)
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Equity Indicesx Three basic index weighting methods:
price-weighted each stock is weighted according to its
absolute share price (DJIA, NIKKEI); simply an
arithmetic average of the prices of the securities included
in the index
value-weighted each stock is weighted according to its
market cap (CAC40, S&P500, DAX, FTSE100);
calculated by summing the total market value (current
stock price times the number of shares outstanding) of
all the stocks in the index - float-weighted index
equal-weighted each stock is weighted equally (Value
Line Arithmetic Composite Index); must be periodically
rebalanced to maintain equal representation of the
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Biases of weighting schemes
PW: biased towards highest priced stocks
VW: biased towards the shares of firms with the
largest market caps EW: biased towards small firms
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Problem of Benchmark Index
SelectionxExample 1
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Passive Equity Portfolio Management
StrategiesxNot a simple process to track a market
index closely
x Three basic techniques: Full replication
Sampling
Quadratic optimization or programming
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Passive Equity Portfolio Management
StrategiesFull Replication
xAll securities in the index are purchased in
proportion to weights in the indexx This helps ensure close tracking
x Increases transaction costs, particularly with
dividend reinvestment
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Passive Equity Portfolio Management
StrategiesSampling
x Buys representative sample of stocks in thebenchmark index according to their weights in theindex
x Fewer stocks means lower commissions
x Reinvestment of dividends is less difficult
x Will not track the index as closely, so there will besome tracking error Tracking error will diminish as the number of stocks
grows, but costs will grow (tradeoff)
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Passive Equity Portfolio Management
StrategiesQuadratic Optimization
x Historical information on price changes and
correlations between securities are input into acomputer program that determines the composition
of a portfolio that will minimize tracking error with
the benchmark
x This relies on historical correlations, which maychange over time, leading to failure to track the
index
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Passive Portfolio Construction Methods
x Example 2
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Active Equity InvestingEquity styles:
Value
Growth Market-oriented
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Value and Growth Stylesx Value substyles
low P/E
contrarian high yield
x Growth substyles
consistent growth earnings momentum
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Value stylex Value investors focus on the numeratorin the P/E
or P/B ratio, desiring a low stock price relative toearnings or book value of assets.
x The two main justifications for a value strategy are(1) although a firms earnings are depressed now,the earnings will rise in the future as they revert tothe mean, and
(2) value investors argue that growth investorsexpose themselves to the risk that earnings andprice multiples will contract for high-priced growthstocks.
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Growth stylex Growth investors focus on the denominatorin the P/E ratio,
searching for firms and industries where high expectedearnings growth will drive the stock price up even higher.
x
The riskfor growth investors is that the earnings growthdoes not occur, the price-multiple falls, and stock pricesplunge. Growth investors may do better during an economiccontraction than during an expansion. In a contraction, thereare few firms with growth prospects, so the growth stocks
may see their valuations increase. In an expansion, manyfirms are doing well, so the valuation premiums for growthstocks decline.
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market-oriented stylex The term market-oriented investing is used to
describe investing that is neither value nor growth.It is sometimes referred to as blendorcore
investing.x Market-oriented investors have portfolios that
resemble a broad market average over time. Theymay sometimes focus on stock prices and othertimes focus on earnings.
x The riskfor a market-oriented manager is that shemust outperform a broad market index or investorswill turn to lower cost indexing strategies.
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Identifying investment stylesx 2 techniques for identifying investment
styles:
x Returns-based style analysisx Holdings-based style analysis
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Returns-based style analysis
x Involves regressing portfolio returns (generally monthlyreturns) on return series of a set of securities indices.
x the security indices used should be mutually exclusive,exhaustive, and represent distinct, uncorrelated sources ofrisk.
x The coefficient of determination in returns-based styleanalysis measures the style fit.
x Returns-based style analysis has the advantage of being alow cost, quick, and consistent method of characterizing anentire portfolio.
x Its disadvantages are that it may lead to misleading results ifmisspecified and it may detect style changes slowly.
x Example 6
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Holdings-based style analysis
x Holdings-based style analysis evaluates portfoliocharacteristics using the following attributes: valueor growth, expected earnings growth, earningsvolatility, and industry representation.
x Holdings-based style analysis has the advantagethat it can characterize individual securities andwill detect style changes more quickly than returns-
based analysis.
x Its disadvantage is that it subjectively classifiessecurities, requires more data, and is not consistentwith how most managers invest.
x Example 8 &9
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Style boxx A style box is a method of characterizing a
portfolio's style. This method is used by
Morningstar to characterize mutual funds and
stocks. In this approach, a matrix is formed with
value/growth characteristics across the top and
market cap along the side. Morningstar uses
holdings-based style analysis to classify securities.x See Exhibit 18 (Style Box for Vanguard Mid-Cap
Growth Fund)
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Style driftx Style drift is when a portfolio manager strays from his
original, stated style objective.
x There are two reasons why this can be problematic for an
investor.x First, the investor will not receive the desired style
exposure. This is a concern because value and growthstocks will perform quite differently over time and over thecourse of business cycles.
x Second, if a manager starts drifting from the intended style,she may be moving into an area outside her expertise.
x Example 10 (p.243)
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Socially responsible investing (SRI)x Socially responsible investing (SRI), also known as
ethical investing, is the use of ethical, social, orreligious concerns to screen investment decisions.
x The screens can be negative, where the investorrefuses to invest in a company they believe is
unethical; orpositive, where the investor seeks outfirms with ethical practices.x An example of a negative screen is an investor who
avoids tobacco and alcohol stocks.x
An example of a positive screen would be when theinvestor seeks firms with good labor andenvironmental practices.
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Socially responsible investing (SRI)x Most SRI portfolios utilize negative screens, some use both
negative and positive screens, and even less use onlypositive screens. An increasing number of portfoliomanagers have clients with SRI concerns.
x A SRI screen may have an effect on a portfolios style. Forexample, some screens exclude basic industries and energycompanies, which typically are value stocks. SRI portfoliosthus tend to be tilted towards growth stocks. SRI screenshave also been found to have a bias toward small-cap
stocks.
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Semiactive equity investingx An enhanced indexingstrategy can be executed using either
actual stocks orderivative contracts such as equity futures.x Using a stock-based enhanced indexing strategy, the
manager underweights or overweights index stocks based onbeliefs about the stocks prospects. Risk is controlled by
monitoring factor risk and industry exposures. The portfolioresembles the index, except where the manager has a specific
belief about the value of an index security.x Semiactive versus active investing: If the manager does not
have an opinion about an index stock in full blown active
management, she doesnt hold the stock. If the manager doesnot have an opinion about an index stock in a stock-basedenhanced indexing strategy, she holds the stock at the samelevel as the benchmark.
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Th f d t l l f ti
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The fundamental law of active
managementx The fundamental law of active management states that an investors
information ratio is a function of his depth of knowledge aboutindividual securities and the number of investment decisions.
x
x The IC is measured by comparing the investors forecasts againstactual outcomes. The closer they are, the higher the correlationbetween them, and the greater the IC. More skillful managers willhave a higher IC.
x Example 12 (p 252)
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Managing a portfolio of managersx The equity investment decision focuses on the tradeoff between active risk
and active return. Investors are usually more risk averse when facing activerisk than they are when facing total risk.
x The investor must decide how much active risk he is willing to accept andwhat the best combination of equity managers is to achieve that active riskwhile maximizing active return.
x In the first step in deciding how much equity to allocate to a group of equitymanagers, the investor will want to maximize the utility of his active return.The utility function for active return is similar to the utility function forexpected return.
x The utility of the active return increases as active return increases, as activerisk decreases, and as the investors risk aversion to active risk decreases.Next, given his utility function, the investor needs to investigate the
performance characteristics of available equity managers. An efficient frontieranalysis is useful here, except instead of using expected return and risk, thisefficient frontier plots expected active return and active risk usingcombinations of available equity managers.
x P.254 (see example) core satellite
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core-satellitex In a core-satellite approach to managing active
equity managers, the investor has a core holding ofa passive index and/or an enhanced index that is
complemented by a satellite of active managerholdings. The idea behind a core-satellite approachis that active risk is mitigated by the core, whileactive return is added by the satellites. The core is
benchmarked to the asset class benchmark, whereasthe satellites are benchmarked to a more specific
benchmark.
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core-satellitex To minimize the differences in risk exposures between the
portfolio and the benchmark, the investor can use acompleteness fund. The completeness fund complementsthe active portfolio, so that the combined portfolios have arisk exposure similar to the benchmark. The advantage ofthe completeness fund approach is that the active returnfrom the managers can be maintained, while active risk isminimized. The completeness fund must be rebalanced
regularly as the active managers exposures change. Thefund can be managed passively or semiactively.
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The components of total active returnx true active return = total active return normal
portfolio returnx misfit active return = normal portfolio return
investors benchmark returnx The true active return is "true" in the sense that it
measures what the manager earned relative to thecorrect benchmark.
x
The misfit active return is "misfit" in the sensethat it measures that part of the managers returnfrom using a benchmark that is not suited to themanagers style.
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The components of active riskx Using these components of return, we candecompose the managers total active risk into thetrue risk and misfit risk. The total active riskis the
volatility of the managers portfolio relative to theinvestors portfolio.x
x
Using the true active return and true active risk, wecan define an information ratio that betterrepresents the managers skills:
x true information ratio = true active return / trueactive risk
h l i f f f
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the analysis of fee structures for
equity managersx
Fees can be charged on an ad valorem basis orbased onperformance.x Ad valorem fees are also referred to as asset under
management fees (AUM) and are charged based on the assetvalue managed and may be on a sliding schedule.
x Aperformance-based fee is often charged as a base fee plussome percentage of the alpha.x The performance-based fee may also includefee caps and
high water marks.x A fee cap specifies a maximum performance fee. The intent
is to prevent managers from undertaking too much risk toearn higher fees.x A high water mark condition requires the manager to
compensate for past underperformance before receiving aperformance-based fee.