Investment Analysis and Portfolio Management

Seventh Editionby

Frank K. Reilly & Keith C. Brown

Chapter 17

Chapter 17 - 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?• What is a portfolio’s tracking error and how is it

useful in the construction of a passive equity investment?

Chapter 17 - Equity Portfolio Management Strategies

• What is the difference between an index mutual fund and an exchange-traded fund?

• What are the three themes that active equity portfolio managers can use?

• What stock characteristics differentiate value-oriented and growth-oriented investment styles?

• What is style analysis and what does it indicate about a manager’s investment performance?

Chapter 17 - Equity Portfolio Management Strategies

• What techniques are used by active managers in an attempt to outperform their benchmark?

• 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?

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

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

Index Portfolio Strategy Construction Techniques

• Full replication

• Sampling

• Quadratic optimization or

programming

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

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

Expected Tracking Error Between the S&P 500 Index and Portfolio Samples of Less Than 500 Stocks

Exhibit 17.2

500 400 300 200 100 0

2.0

1.0

3.0

4.0

Expected Tracking Error (Percent)

Number of Stocks

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

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

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

Fundamental Strategies

• Top-down versus bottom-up approaches

• Asset and sector rotation strategies

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

Technical Strategies

• Contrarian investment strategy

• Price momentum strategy

• Earnings momentum strategy

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

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

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

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

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

Determining Style

• Style grid: – firm size– value-growth characteristics

• Style analysis– constrained least squares

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

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

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

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

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

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

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

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

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

Using Derivatives in Active Equity Portfolio Management

• Modifying systematic risk

• Modifying unsystematic risk

The InternetInvestments Online

www.russell.com

www.firstquadrant.com

www.wilshire.com

www.fool.com

www.dailystocks.com

End of Chapter 17–Equity Portfolio Management Strategies

Future topicsChapter 18

• Bond Fundamentals