EQUITY-PORTFOLIO MANAGEMENT Chapter 17 EQUITY-PORTFOLIO MANAGEMENT

Chapter 17 Questions What are the two generic equity portfolio management styles? What are three techniques for constructing a passive index portfolio? What three generic strategies can active equity-portfolio managers use? How does the goal of a passive equity-portfolio manager differ from the goal of an active manager?

Chapter 17 Questions What investment styles may portfolio managers follow? In what ways can investors use information about a portfolio manager’s style? What skills should a good value portfolio manager possess? A good growth portfolio manager?

Chapter 17 Questions How can futures and options be useful in managing an equity portfolio? What strategies can be used to manage a taxable investor’s portfolio in a tax-efficient way? What are four asset allocation strategies?

Generic Portfolio Management Strategies 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

Passive Equity Portfolio Management Strategies Attempt to replicate the performance of an index May slightly underperform the target index due to fees and commissions Strong rationale for this approach 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

Passive Equity Portfolio Management Strategies Not a simple process to track a market index closely Three basic techniques: Full replication Sampling Quadratic optimization or programming

Passive Equity Portfolio Management Strategies 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

Passive Equity Portfolio Management Strategies Sampling Buys 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” Tracking error will diminish as the number of stocks grows, but costs will grow (tradeoff)

Passive Equity Portfolio Management Strategies Quadratic Optimization 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

Passive Equity Portfolio Management Strategies 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

Passive Equity Portfolio Management Strategies Dollar-cost averaging Purchasing fixed dollar investments per period over time Prevents buying too many shares at high prices and too few shares when prices are low Often part of a passively managed portfolio strategy

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 Need to select an appropriate benchmark Practical difficulties of active manager Transactions costs must be offset by superior performance vis-à-vis the benchmark Higher risk-taking can also increase needed performance to beat the benchmark

Active Equity Portfolio Management Strategies 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, attempt to buy low and sell high

Active Equity Portfolio Management Strategies Global Investing: Three Strategies 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

Active Equity Portfolio Management 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 Key is to determine what to “rotate into”

Active Equity Portfolio Management Strategies Style Investing Construct a portfolio to capture one or more of the characteristics of equity securities Small-cap stocks, low-P/E stocks, etc… Value stocks (those that appear to be under-priced according to various measures) Low Price/Book value or Price/Earnings ratios Growth stocks (above-average earnings per share increases) High P/E, possibly a price momentum strategy

Active Equity Portfolio Management Strategies 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 fully diversify a portfolio Style investing allows control of the total portfolio to be shared between the investment managers and a sponsor

Active Equity Portfolio Management Strategies Value versus Growth Growth investing focuses on earnings and changes in company fundamentals Value investing focuses on the pricing of stocks Over time value stocks have offered somewhat higher returns than growth stocks

Active Equity Portfolio Management Strategies Expectational Analysis and Value/Growth Investing Analysts recommending stocks to a portfolio manager need to identify and monitor key assumptions and variables Value investors focus on one key set of assumptions and variables while growth investors focus on another Such an analysis can help determine timing strategy for buying/selling

Derivatives in Equity-Portfolio Management The risk of equity portfolios can be modified by using futures and options derivatives Selling futures reduces the risk of the investor’s net (portfolio with futures) position to changes in portfolio values Also offsets positive portfolio value changes The choice element of options means that they do not have exact offsetting effects Positive portfolio price effects remain largely intact, but the cost of insuring against negative moves increases by the option premium

Derivatives in Equity-Portfolio Management Derivatives can be used to offset expected adverse changes in an equity portfolio Any bad portfolio movements are mirrored by gains in derivative investments

Derivatives in Equity-Portfolio Management The Use of Futures in Asset Allocation Allows changing the portfolio allocation quickly to adjust to forecasts at lower transaction costs than standard trading Futures can help maintain an overall balance (desired asset allocation) in a portfolio Futures can be used to gain exposure to international markets Currency exposure can be managed using currency futures and options

Derivatives in Equity-Portfolio Management Futures and options can help control cash inflows and outflows from the portfolio Inflows – purchase index futures or options when inflows arrive before individual security investments can be made efficiently Outflow – sell previously purchased futures contracts rather than individual securities to meet a large expected cash outflow; less disruptive to portfolio management

Derivatives in Equity-Portfolio Management The S & P 500 Index Futures Contract Purchasers fund a margin account Initial margin requirements are: $6,000 for speculative buyers and $2,500 for hedging The value is $250 times the index level When the contract expires, delivery is made in cash, not stocks Margin account is marked to market daily Maintenance margins $2,500 and $1,500

Derivatives in Equity-Portfolio Management Determining How Many Contracts to Trade to Hedge a Deposit or Withdrawal In order to appropriate hedge a portfolio deposit or withdrawal, the appropriate number of contracts must be sold The appropriate number depends on the value of the cash flow, the value of one futures contract, and the portfolio beta (the Index has a beta of 1) Number of Contracts = (Cash Flow/Contract Value) x Portfolio Beta Can also adjust the beta

Derivatives in Equity-Portfolio Management 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

Derivatives in Equity-Portfolio Management Using Futures in Active Equity Portfolio Management Modifying systematic risk Investing in various proportion of the futures index (where beta equals one and the underlying portfolio) Modifying unsystematic risk Using options, the portfolio manager can increase exposure to desired industries, sectors, and even individual companies

Derivatives in Equity-Portfolio Management Modifying the Characteristics of an International Equity Portfolio International equity positions involve positions in both securities and currencies Futures allow modifying each exposure separately Can buy or sell currency contracts to change exposures to fluctuating exchange rate to either: Take advantage of expected future exchange rate changes Hedge currency risks and largely remove this exposure

Taxable Portfolios Outside of tax-exempt accounts such as IRAs, 401(k)s and 403(b)s, taxes represent a large expense to manage. Some implications of taxes: Portfolio rebalancing to remain on the “efficient frontier” triggers capital gains, which may offset the benefit of the optimized rebalancing itself Rebalancing for asset allocation purposes likewise results in tax effects

Taxable Portfolios Active portfolio managers especially need to consider taxes when deciding whether to sell or hold a stock whose value has increased If a security is sold at a profit, capital gains are paid and less in left in the portfolio to reinvest A new security (the reinvestment security) needs to have a superior return sufficient to make up for these taxes The size of the necessary return depends on the expected holding period and the cost basis (and amount of the capital gain) of the original security

Taxable Portfolios Tax-Efficient Investing Strategies Will likely become more important to fund managers, as SEC regulations now require mutual funds to disclose after-tax returns Possible tax-efficient strategies: Employ a buy-and-hold strategy since unrealized capital gains are not taxed Loss harvesting, using tax losses to offset capital gains on other investments

Taxable Portfolios Possible tax-efficient strategies: Use options to help convert short-term capital gains into a long-term gain (with more favorable tax treatment) Tax-lot accounting for shares, specifying those with the highest cost basis for sale For some investors, simply focus on growth stocks that will provide long-term gains rather than income from dividends

Taxable Portfolios Diversifying a Concentrated Portfolio Context: An investor has an undiversified portfolio with one or several securities that have experienced large price increases Want to diversify, but the sale of the asset(s) will generate large capital gain taxes; what should be done?

Taxable Portfolios Diversifying a Concentrated Portfolio Concentrated Portfolio Strategies Borrow and invest the proceeds in a diversified portfolio Instead of diversifying the portfolio, reduce its company-specific risk exposure through a collar strategy – a combination of option purchases Variable Prepaid Forwards (VPFs), where the investor receives proceeds in advance of contractual sales of shares in the future Completion funds, where shares are sold and the portfolio is diversified through a “completion fund” Charitable strategies, contribution and limited tax for the charity

Asset Allocation Strategies Many portfolios containing equities also contain other asset categories, so the management factors are not limited to equities Four asset allocation strategies: Integrated asset allocation Examine capital market conditions and investor objectives and constraints Determine the allocation that best serves the investor’s needs while incorporating the capital market forecast

Asset Allocation Strategies Strategic asset allocation Using historical information, generate optimal portfolio mixes based on returns, risk, and covariances, adjusting periodically to restore target allocation Tactical asset allocation Often a contrarian asset allocation strategy dependent on expectations Insured asset allocation Adjust risk exposure for changing portfolio values; more value means more ability to absorb losses

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