Chapter 15 Revision of the Equity Portfolio

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Outline Introduction Active management versus passive management When do you sell stock?

Introduction Portfolios need maintenance and periodic revision: Because the needs of the beneficiary will change Because the relative merits of the portfolio components will change To keep the portfolio in accordance with the investment policy statement and investment strategy

Active Management Versus Passive Management Definition The manager’s choices Costs of revision Contributions to the portfolio

Definition An active management policy is one in which the composition of the portfolio is dynamic The portfolio manager periodically changes: The portfolio components or The components’ proportion within the portfolio A passive management strategy is one in which the portfolio is largely left alone

The Manager’s Choices Leave the portfolio alone Rebalance the portfolio Asset allocation and rebalancing within the aggregate portfolio Change the portfolio components Indexing

Leave the Portfolio Alone A buy and hold strategy means that the portfolio manager hangs on to its original investments Academic research shows that portfolio managers often fail to outperform a simple buy and hold strategy on a risk-adjusted basis E.g., Barber and Odean show that investors who trade the most have the lowest gross and net returns

Rebalance the Portfolio Rebalancing a portfolio is the process of periodically adjusting it to maintain the original conditions

Rebalancing Within the Portfolio Constant mix strategy Constant proportion portfolio insurance Relative performance of constant mix and CPPI strategies

Constant Mix Strategy The constant mix strategy: Is one to which the manager makes adjustments to maintain the relative weighting of the asset classes within the portfolio as their prices change Requires the purchase of securities that have performed poorly and the sale of securities that have performed the best

Constant Mix Strategy (cont’d) Example A portfolio has a market value of $2 million. The investment policy statement requires a target asset allocation of 60 percent stock and 30 percent bonds. The initial portfolio value and the portfolio value after one quarter are shown on the next slide.

Constant Mix Strategy (cont’d) Example (cont’d) What dollar amount of stock should the portfolio manager buy to rebalance this portfolio? What dollar amount of bonds should he sell? Date Portfolio Value Actual Allocation Stock Bonds 1 Jan $2,000,000 60%/40% $1,200,000 $800,000 1 Apr $2,500,000 56%/44% $1,400,000 $1,100,000

Constant Mix Strategy (cont’d) Example (cont’d) Solution: a 60%/40% asset allocation for a $2.5 million portfolio means the portfolio should contain $1.5 million in stock and $1 million in bonds. Thus, the manager should buy $100,000 worth of stock and sell $100,000 worth of bonds.

Constant Proportion Portfolio Insurance A constant proportion portfolio insurance (CPPI) strategy requires the manager to invest a percentage of the portfolio in stocks: $ in stocks = Multiplier x (Portfolio value – Floor value)

Constant Proportion Portfolio Insurance (cont’d) Example A portfolio has a market value of $2 million. The investment policy statement specifies a floor value of $1.7 million and a multiplier of 2. What is the dollar amount that should be invested in stocks according to the CPPI strategy?

Constant Proportion Portfolio Insurance (cont’d) Example (cont’d) Solution: $600,000 should be invested in stock: $ in stocks = 2.0 x ($2,000,000 – $1,700,000) = $600,000 If the portfolio value is $2.2 million one quarter later, with $650,000 in stock, what is the desired equity position under the CPPI strategy? What is the ending asset mix after rebalancing?

Constant Proportion Portfolio Insurance (cont’d) Example (cont’d) Solution: The desired equity position after one quarter should be: $ in stocks = 2.0 x ($2,200,000 – $1,700,000) = $1,000,000 The portfolio manager should move $350,000 into stock. The resulting asset mix would be: $1,000,000/$2,200,000 = 45.5%

Relative Performance of Constant Mix and CPPI A constant mix strategy sells stock as it rises A CPPI strategy buys stock as it rises

Relative Performance of Constant Mix & CPPI (cont’d) In a rising market, the CPPI strategy outperforms constant mix In a declining market, the CPPI strategy outperforms constant mix In a flat market, neither strategy has an obvious advantage In a volatile market, the constant mix strategy outperforms CPPI

Relative Performance of Constant Mix & CPPI (cont’d) The relative performance of the strategies depends on the performance of the market during the evaluation period In the long run, the market will probably rise, which favors CPPI In the short run, the market will be volatile, which favors constant mix

Rebalancing Within the Equity Portfolio Constant proportion Constant beta Change the portfolio components Indexing

Constant Proportion A constant proportion strategy within an equity portfolio requires maintaining the same percentage investment in each stock May be mitigated by avoidance of odd lot transactions Constant proportion rebalancing requires selling winners and buying losers

Constant Proportion (cont’d) Example A portfolio of three stocks attempts to invest approximately one third of funds in each of the stocks. Consider the following information: Stock Price Shares Value % of Total Portfolio FC 22.00 400 8,800 31.15 HG 13.50 700 9,450 33.45 YH 50.00 200 10,000 35.40 Total $28,250 100.00

Constant Proportion (cont’d) Example (cont’d) After one quarter, the portfolio values are as shown below. Recommend specific actions to rebalance the portfolio in order to maintain the constant proportion in each stock. Stock Price Shares Value % of Total Portfolio FC 20.00 400 8,000 21.92 HG 15.00 700 10,500 28.77 YH 90.00 200 18,000 49.32 Total $36,500 100.00

Constant Proportion (cont’d) Example (cont’d) Solution: The worksheet below shows a possible revision which requires an additional investment of $1,000: Stock Price Shares Value Before Action Value After % of Portfolio FC 20.00 400 8,000 Buy 200 12,000 32.00 HG 15.00 700 10,500 Buy 100 YH 90.00 200 18,000 Sell 50 13,500 36.00 Total $36,500 $37,500 100.00

Constant Beta Portfolio A constant beta portfolio requires maintaining the same portfolio beta To increase or reduce the portfolio beta, the portfolio manager can: Reduce or increase the amount of cash in the portfolio Purchase stocks with higher or lower betas than the target figure Sell high- or low-beta stocks Buy high- or low-beta stocks

Change the Portfolio Components Changing the portfolio components is another portfolio revision alternative Events sometimes deviate from what the manager expects: The manager might sell an investment turned sour The manager might purchase a potentially undervalued replacement security

Indexing Indexing is a form of portfolio management that attempts to mirror the performance of a market index E.g., the S&P 500 or the DJIA Index funds eliminate concerns about outperforming the market The tracking error refers to the extent to which a portfolio deviates from its intended behavior

Costs of Revision Introduction Trading fees Market impact Management time Tax implications Window dressing Rising importance of trading fees

Introduction Costs of revising a portfolio can: Be direct dollar costs Result from the consumption of management time Stem from tax liabilities Result from unnecessary trading activity

Trading Fees Commissions Transfer taxes

Commissions Investors pay commissions both to buy and to sell shares Commissions at a brokerage firm are a function of: The dollar value of the trade The number of shares involved in the trade

Commissions (cont’d) The commission on a trade is split between the broker and the firm for which the broker works Brokers with a high level of production keep a higher percentage than a new broker Some brokers discount their commissions with their more active clients

Commissions (cont’d) Discount brokerage firms: Offer substantially reduce commission rates Offer few ancillary services, such as market research Retail commissions at a full-service firm average about 2 percent of the stock value

Transfer Taxes Transfer taxes are: Imposed by some states on the transfer of securities Usually very modest Not normally a material consideration in the portfolio management process

Market Impact The market impact of placing the trade is the change in market price purely because of executing the trade Market impact is a real cost of trading Market impact is especially pronounced for shares with modest daily trading volume

Management Time Most portfolio managers handle more than one account Rebalancing several dozen portfolios is time consuming

Tax Implications Individual investors and corporate clients must pay taxes on the realized capital gains associated with the sale of a security Tax implications are usually not a concern for tax-exempt organizations

Window Dressing Window dressing refers to cosmetic changes made to a portfolio near the end of a reporting period Portfolio managers may sell losing stocks at the end of the period to avoid showing them on their fund balance sheets

Rising Importance of Trading Fees Flippancy regarding commission costs is unethical and sometimes illegal Trading fees are receiving increased attention because of: Investment banking scandals Lawsuits regarding churning Incomplete prospectus information

Contributions to the Portfolio Periodic additional contributions to the portfolio from internal or external sources must be invested Dividends: May be automatically reinvested by the fund manager’s broker May have to be invested in a money market account by the fund manager

When Do You Sell Stock? Introduction Rebalancing Upgrading Sale of stock via stop orders Extraordinary events Final thoughts

Introduction Knowing when to sell a stock is a very difficult part of investing Behavioral evidence suggests the typical investor sells winners too soon and keeps losers too long

Rebalancing Rebalancing can cause the portfolio manager to sell shares even if they are not doing poorly Profit taking with winners is a logical consequence of portfolio rebalancing

Upgrading Investors should sell shares when their investment potential has deteriorated to the extent that they no longer merit a place in the portfolio It is difficult to take a loss, but it is worse to let the losses grow

Sale of Stock Via Stop Orders Definition Using stops to minimize losses Using stops to protect profits

Definition Stop orders: Are sell stops Become a market order to sell a set number of shares if shares trade at the stop price Can be used to minimize losses or to protect a profit

Using Stops to Minimize Losses Stop-loss orders can be used to minimize losses E.g., you bought a share for $23 and want to sell it if it falls below $18 Place a stop-loss order for $18

Using Stops to Protect Profits Stop orders can be used to protect profits E.g., a stock you bought for $33 now trades for $48 and you want to protect the profits at $45 If the stock retreats to $45, you lock in the profit if you place a stop order If the stock continues to increase, you can use a crawling stop to increase the stop price

Extraordinary Events Change in client objectives Change in market conditions Buy-outs Caprice

Change in Client Objectives The client’s investment objectives may change occasionally: E.g., a church needs to generate funds for a renovation and changes the objective for the endowment fund from growth of income to income Reduce the equity component of the portfolio

Change in Market Conditions Many fund managers seek to actively time the market When a portfolio manager’s outlook becomes bearish, he may reduce his equity holdings

Buy-Outs A firm may be making a tender offer for one of the funds holdings I.e., another firm wants to acquire the fund holding It is generally in the client’s best interest to sell the stock to the potential acquirer

Caprice Portfolio managers: Should be careful about making unnecessary trades Must pay attention to their experience, intuition, and professional judgment An experienced portfolio manager worried about a particular holding should probably make a change

Final Thoughts Hindsight is an inappropriate perspective for investment decision making Everything you do as a portfolio manager must be logically justifiable at the time you do it Portfolio managers are torn between minimizing losses and the potential for price appreciation