© 2012 Cengage Learning. All Rights Reserved. May not scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Chapter 16: Equity Portfolio Management Strategies

Equity Portfolio Management Strategies © 2012 Cengage Learning. All Rights Reserved. May not scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 16-2

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 by seeking the “alpha” value See Exhibit © 2012 Cengage Learning. All Rights Reserved. May not scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Exhibit 16.1 © 2012 Cengage Learning. All Rights Reserved. May not scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part Should High talented managers pursue an active or passive management strategy? Does both active and passive management strategies assume market efficiency ?

An Overview of Passive Strategies Attempt to replicate the performance of an index that meet the client needs and obj. –May slightly underperform the target index due to fees and commissions –If the manager try to outperform the selected index, he or she violates the premise of the passive portfolio. Strong rationale for this approach –Strong evidence indicates that the stock market is fairly efficient –Costs of actively managing the portfolio (1 to 2 percent) are hard to overcome. It’s hard to overcome the S&P © 2012 Cengage Learning. All Rights Reserved. May not scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

An Overview of Passive Strategies Many different market indexes are used for tracking portfolios –The daily values of indexes for the organized exchanges, OTC market, are published. –S&P 500 Index –NASDAQ Composite Index –Russell growth index for growth stocks Because of the cash inflows and outflows and company mergers and bankruptcies, securities must be bought and sold, which mean that there will be differences between portfolio and benchmark returns overtime. © 2012 Cengage Learning. All Rights Reserved. May not scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 16-6

Passive Index Portfolio Construction Techniques Full Replication –All securities in the index are purchased in proportion to weights in the index –This helps ensure close tracking –Increases transaction costs, because of the need to buy many securities and because of dividend reinvestment that result in high commissions, if many firms pay small dividends at different times in the year © 2012 Cengage Learning. All Rights Reserved. May not scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Passive Index Portfolio Construction Techniques Sampling –Buys a representative sample of stocks in the benchmark index –Stocks with larger index weight are purchased according to their weights in the index, while small issues are purchased so their aggregate characteristic, such as beta and dividends, approximate the benchmark. –Fewer stocks means lower commissions –Reinvestment of dividends is less difficult –Will not track the index returns as closely, so there will be some tracking error 16-8 © 2012 Cengage Learning. All Rights Reserved. May not scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Passive Index Portfolio Construction Techniques 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 return deviation from the benchmark –This relies on historical stock price changes and correlations, which may change over time, leading to failure to track the return of the index 16-9 © 2012 Cengage Learning. All Rights Reserved. May not scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Passive Portfolio Construction Techniques Some passive portfolios are not based on a published index, such as completeness funds. These funds are constructed to complement active portfolios that don’t cover the entire market. The performance of the completeness fund is compared to a customized benchmark that incorporates the characteristics of the stocks not covered by the active managers. © 2012 Cengage Learning. All Rights Reserved. May not scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part

Passive Portfolio Construction Techniques Suppose for example a pension fund hires three active managers to invest part of the fund’s money. One manager invest in small- capitalization Saudi stocks, the second invest in gulf countries only, and the third invest in Saudi stocks with low P/E ratio. To ensure diversification, the fund sponsor invest passively in the remaining assets to complete the fund. The completeness fund will have a benchmark that includes the stocks not covered by the active managers. © 2012 Cengage Learning. All Rights Reserved. May not scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part

Passive Portfolio Construction Techniques Other passive portfolios and benchmarks exist for investors with certain unique needs and preferences. Some investors may want their funds to be invested only in stocks that pay dividends or in a company that produces a unique product or service. Benchmarks can be produced to reflect these desired attributes, and passive portfolios can be constructed to track the performance of the customized benchmark over time so investor’s special needs can be satisfied. © 2012 Cengage Learning. All Rights Reserved. May not scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part

Tracking Error and Index Portfolio Construction The goal of the passive manager should be to minimize the portfolio’s return volatility relative to the index, i.e., to minimize tracking error Tracking Error Measure –Return differential in time period t Δ t =R pt – R bt where R pt = return to the managed portfolio in Period t R bt = return to the benchmark portfolio in Period t –Tracking error is measured as the standard deviation of Δ t, normally annualized (TE) –See Exhibit © 2012 Cengage Learning. All Rights Reserved. May not scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Exhibit 16.2 © 2012 Cengage Learning. All Rights Reserved. May not scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part

Methods of Index Portfolio Investing Index Funds –In an indexed portfolio, the fund manager will typically attempt to replicate the composition of the particular index exactly –The fund manager will buy the exact securities comprising the index in their exact weights –Change those positions anytime the composition of the index itself is changed –Low trading and management expense ratios, because changes to most equity indexes occur infrequently. © 2012 Cengage Learning. All Rights Reserved. May not scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Methods of Index Portfolio Investing The advantage of index mutual funds is that they provide an inexpensive way for investors to acquire a diversified portfolio The disadvantages are that the investors can only liquidate their positions at the end of the trading day. An example of index funds is the Vanguard's 500 Index fund (VFINX), which mimic the S&P 500 index. © 2012 Cengage Learning. All Rights Reserved. May not scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part

Methods of Index Portfolio Investing Exchange-Traded Funds (ETF) –ETFs 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 –A portfolio of securities is placed on deposit at a financial institution or into a unit trust, which issue a single type of certificate representing ownership of the underlying portfolio. –A significant advantage of ETFs over index mutual funds is that they can be bought and sold (and short sold) like common stock through an organized exchange or in an OTC market. © 2012 Cengage Learning. All Rights Reserved. May not scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Methods of Index Portfolio Investing –Other advantages relative to index funds are no payment of management fees, the ability of continuous trading while the market is open, and the ability to time capital gain tax realization. –The notable example of ETFs Standard & Poor’s 500 Depository Receipts (SPDRs), which are based on a basket of all the securities held in an index. Sector ETFs, which invest in a basket of stocks from specific industry sectors © 2012 Cengage Learning. All Rights Reserved. May not scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part

An Overview of Active 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 See Exhibits © 2012 Cengage Learning. All Rights Reserved. May not scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Exhibit 16.5 © 2012 Cengage Learning. All Rights Reserved. May not scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part

16-21 Fundamental Strategies Top-Down versus Bottom-Up Approaches –Top-Down  Broad country and asset class allocations  Sector allocation decisions  Individual securities selection –Bottom-Up  Emphasizes the selection of securities without any initial market or sector analysis  Form a portfolio of equities that can be purchased at a substantial discount to what his or her valuation model indicates they are worth to beat the benchmark © 2012 Cengage Learning. All Rights Reserved. May not scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

16-22 Fundamental Strategies Three Generic Themes active managers can apply to add value to their portfolios relative to the benchmark –Time the equity market by shifting funds into and out of stocks, bonds, and T-bills depending on broad market forecasts, tactical asset allocation. –Shift funds among different equity sectors and industries (e.g., financial stocks, technology stocks) or among investment styles (e.g., value, growth large capitalization, small capitalization). This is basically the sector rotation strategy © 2012 Cengage Learning. All Rights Reserved. May not scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Exhibit 13.3 © 2012 Cengage Learning. All Rights Reserved. May not scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part

Fundamental Strategies –Do stock picking and look at individual issues in an attempt to find undervalued stocks on a bottom-up bases. Buy low and sell high. The choice of stocks is based on absolute judgments about the future of the company, such as discounted cash flow analysis. Or based on a comparison with other similar shares. –Which is more reliable, Timing the equity market or stock picking? © 2012 Cengage Learning. All Rights Reserved. May not scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part

Technical Strategies One of the primary tools of technical analysis relies on assessing the past stock price trends in an effort to assume what information they imply about future price movement Contrarian Investment Strategy –The belief that the best time to buy (sell) a stock is when the majority of other investors are the most bearish (bullish) about it –The contrarian investor purchase the stock when it’s near its lowest price and sell it when it’s near its peak –Such as Mutual fund cash positions © 2012 Cengage Learning. All Rights Reserved. May not scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Technical Strategies Contrarian Investment Strategy (cont.) –The concept of mean reverting indicates that over time stocks will be priced to produce returns consistent with their risk-adjusted returns. –The overreaction hypothesis indicates that superior returns can be generated followed by price corrections (Exhibit 16.9) © 2012 Cengage Learning. All Rights Reserved. May not scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part

Exhibit 16.9 © 2012 Cengage Learning. All Rights Reserved. May not scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part

Technical Strategies Price Momentum Strategy –Focus on the trend of past prices alone and makes purchase and sale decisions accordingly –Assume that recent trends in past prices will continue Breadth of market –Measures the number of issues increased and the number of issues declined each day –The advance–decline index is typically a cumulative index of net advances or net declines –See Exhibit © 2012 Cengage Learning. All Rights Reserved. May not scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part

Exhibit © 2012 Cengage Learning. All Rights Reserved. May not scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part

Technical Strategies Stocks above their 200-day moving average –The market is considered to be overbought and subject to a negative correction when more than 80 percent of the stocks are trading above their 200-day moving average © 2012 Cengage Learning. All Rights Reserved. May not scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part

Technical Strategies Follow the smart money Strategy -follow the path of sophisticated, and assumed smart, investors The Barron’s Confidence Index –Measures the yield spread between high-grade bonds and intermediate grade bonds –Declining (increasing) yield spreads increase (decrease) this index, and are a bullish (bearish) indicator T-Bill - Eurodollar yield spread –Decreases in this spread indicates greater confidence, and is a bullish indicator © 2012 Cengage Learning. All Rights Reserved. May not scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part

Technical Strategies Importance of Volume –Technicians watch volume changes along with price movements as an indicator of changes in supply and demand –The technician looks for a price increase on heavy volume relative to the stock’s normal trading volume as an indication of bullish activity –Conversely, a price decline with heavy volume is considered bearish –Technicians also use a ratio of upside–downside volume as an indicator of short-term momentum for the aggregate stock market © 2012 Cengage Learning. All Rights Reserved. May not scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part

Technical Strategies Support and Resistance Levels –A support level is the price range at which the technician would expect a substantial increase in the demand for a stock –A resistance level is the price range at which the technician would expect an increase in the supply of stock and a price reversal –It is also possible to envision a rising trend of support and resistance levels for a stock © 2012 Cengage Learning. All Rights Reserved. May not scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part

Technical Strategies Moving Average Lines –MA lines are meant to reflect the overall trend for the price series –The shorter MA line (the 50-day versus 200-day) reflecting shorter trends –If prices reverse and break through the moving- average line from below accompanied by heavy trading volume, most technicians would consider this a positive change; and vice verse –If the 50-day MA line crosses the 200-day MA line from below on good volume, this would be a bullish indicator –See Exhibit © 2012 Cengage Learning. All Rights Reserved. May not scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part

Technical Strategies © 2012 Cengage Learning. All Rights Reserved. May not scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part

Technical Strategies Relative Strength –Relative Strength (RS) Ratio is defined as the price of an individual stock or an industry index divided by some stock market indexes like S&P 500 –Technicians believe that once a trend begins it’ll continue until some major events causes a change in direction. –If this ratio increases over time, it shows that the stock or industry is outperforming the overall stock market and technicians would expect this superior performance to continue (bullish sign). © 2012 Cengage Learning. All Rights Reserved. May not scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part

Anomalies and Attributes Earnings Momentum Strategy –Momentum is measured by the difference of actual EPS to the expected EPS –Purchases stocks that have accelerating earnings and sells (or short sells) stocks with disappointing earnings. The stock price of a firm follows its earnings Calendar-Related Anomalies –The Weekend Effect –The January Effect Firm-Specific Attributes –Total capitalization of the firm’s outstanding equity(size). Firms with small caps. Outperform large caps. firms –P/E and P/BV ratios. Firms with lower ratios produce bigger risk-adjusted returns (Exhibit 16.12) © 2012 Cengage Learning. All Rights Reserved. May not scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Exhibit © 2012 Cengage Learning. All Rights Reserved. May not scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part

Miscellaneous Issues An important issue for active managers is the selection of the appropriate benchmark. One key of success for active managers is to be consistent with their area of expertise. Another key to success is to minimize the trading activity of the portfolio to reduce the commission. Computer-assisted portfolio formation procedures can be quite useful for active managers. © 2012 Cengage Learning. All Rights Reserved. May not scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part

Tax Efficiency and Active Equity Management 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 is 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 expected return depends on the expected holding period and the cost basis (and amount of the capital gain) of the original security © 2012 Cengage Learning. All Rights Reserved. May not scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Value versus Growth A growth investor focuses on the current and future economic “story” of a company, with less regard to share valuation A value investor focuses on share price in anticipation of a market correction and, possibly, improving company fundamentals. Value stocks generally have offered somewhat higher returns than growth stocks, but this does not occur with much consistency from one investment period to another © 2012 Cengage Learning. All Rights Reserved. May not scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Value versus Growth styles 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-oriented investor will: –Focus on the price component –Not care much about current earnings –Assume the P/E ratio is below its natural level Which is cheaper value or growth stocks?? © 2012 Cengage Learning. All Rights Reserved. May not scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Style Analysis Construct a portfolio to capture one or more of the characteristics of equity securities Compare the variability of the returns of a security portfolio to the returns of a series of benchmark portfolios designed to capture the essence of a particular security characteristics Small-cap stocks, low-P/E stocks, etc… © 2012 Cengage Learning. All Rights Reserved. May not scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Style Analysis 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 See Exhibit © 2012 Cengage Learning. All Rights Reserved. May not scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part

Exhibit © 2012 Cengage Learning. All Rights Reserved. May not scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part

Style Analysis The S&P 500 index can be characterized as a large-cap, blend (between value and growth) fund. As such, it is not the appropriate performance benchmark for someone managing a mid-cap, growth-oriented portfolio. © 2012 Cengage Learning. All Rights Reserved. May not scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part

Does Style Matter? Style analysis can determine whether a manager can maintain a consistent investment style over time Determining style is useful in measuring performance relative to a benchmark Define if the fund has a style drift, and whether this drift is Intentional or unintentional Investors need to be aware of managers whose their portfolios exhibits unintentional style drift © 2012 Cengage Learning. All Rights Reserved. May not scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Asset Allocation Strategies If the portfolio contains different securities, the portfolio manager should determine the appropriate mix of asset categories in the entire portfolio There are four general strategies that determine the asset mix of a portfolio. Integrated asset allocation: examine separately –Capital market conditions –Investor’s objectives and constraints –The actual returns from the portfolio are then used along with any changes in investor’s objectives and constraints and changes in capital market expectations as inputs to the process of portfolio revision. © 2012 Cengage Learning. All Rights Reserved. May not scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part

Asset Allocation Strategies Strategic asset allocation –Result in a Constant-mix of assets for the long-run with periodic rebalancing to adjust the portfolio to the specified asset weights –Equivalent to the integrated asset allocation process but without the feedback loop. Tactical asset allocation –Constantly adjusts the asset class mix in the portfolio to take advantage of changing market conditions. –Equivalent to the integrated asset allocation process but without the feedback loop involving the investor specific information, because it assume that it’s constant © 2012 Cengage Learning. All Rights Reserved. May not scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Asset Allocation Strategies –Mean reversion of security returns to its long-term average value. –Inherently contrarian Insured asset allocation –Constantly adjusts the asset class mix in the portfolio to follow any changes in the investor objectives and constraints. –Equivalent to the integrated asset allocation process but without the feedback loop involving the market conditions, because it assume that it’s constant. –For example, an increase in portfolio value increase the investor's ability to take risk, which can increase the portion of stocks in the portfolio over T-bills. © 2012 Cengage Learning. All Rights Reserved. May not scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part

The Internet Investments Online © 2012 Cengage Learning. All Rights Reserved. May not scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.