0. Portfolio Management 3-228-07 Albert Lee Chun
Equity Portfolio Management Strategies
Lecture 9
2 Dec 2007

1. Passive Portfolio Management

2. Management Fees Malkiel (2001) reports that on average that:
Costs of managing a passive fund oscillate between 10 and 20 basis points (Vanguard S&P 500: 20 b.p.)
For active funds the average management fees are 140 b.p. (fees for research, analyzing information, transaction costs).
40 billion dollars are spent each year on management fees.
Passive strategies have a tend to also minimize taxes (Malkiel 2001)

3. Managing and Index Portfolio
Select a benchmark portfolio index to replicate. S&P 500, TSX, etc.
Determine an acceptable tracking error. Which depends on the return differential or total return of the replicating portfolio minus the return of the benchmark index
where the return of the tracking portfolio is given by

4. Portfolio Tracking Error
Return Differential
Average Return Differential
Variance in Return Differential
Tracking Error
Annualize Tracking Error
where P is equal to the number of periods in a year.

5. Portfolio Tracking Error
Objective: Minimize the expected tracking error by optimizing over
1. The number of securities in the portfolio
2. The securities to include in the portfolio

6. Expected Tracking Error
Expected Tracking Error (Percent)
4.0
3.0
2.0
1.0
500
400
300
200
100
Number of Stocks

7. Portfolio Indexation
The number of securities used in the replication determines a tradeoff between transaction costs and tracking errors.
A smaller number of securities will result in lower transaction costs but higher tracking errors and visa versa.
The presence of tracking errors is inevitable.
1. The replication implies irregular lots.
2. The composition of securities in the index may change.
3. The modification of the index: entry and exit of securities, merges, defaults, etc.

8. Techniques for Replicating an Index

9. 1. The simplest method
Purchase all the securities in the index in proportion to the weights in the index.
This helps ensure close tracking
Advantage: Minimizes the tracking errors
Disadvantage: High transaction costs and reinvesting dividends results in high adjustment fees.

10. 2. Method of Market Capitalization
Consider the stocks with the largest market capitalization in the index and purchase them in proportion to their importance 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.

11. 3. Method of Stratified Sampling:
Purchase only the most representative securities in the index portfolio.
Classify the securities in the index into homogeneous categories (by industry or activity sector, beta, total risk, stock market capitalization, etc....).
Select from each category, a few titles which best represents that group, thus forming a representative portfolio for each category.
The replication portfolio is composed by balancing the portfolios for each category according to their importance in the index.

12. 4. Quadratic Optimization
Expected Excess Return
Transaction costs
Required minimum

13. Quadratic Optimization
Historical information on price changes and correlations between securities are used to determine 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 a failure to track the index.

14. Expected Tracking Error
Expected Tracking Error (Percent)
4.0
3.0
2.0
1.0
500
400
300
200
100
Number of Stocks

15. Reference Portfolio Constructing a Reference Portfolio
- Value Weighted
- Price Weighted
- Equal Weighted
It may be necessary to rebalance the portfolio when:
- Mergers and Acquisitions: Companies disappear from the market.
- Changes to the composition of the index
- Stock splits and dividend payments
- New stock issues
- Stock repurchases

16. Replicating an Index Portfolio
Small investors often find it more practical and less expensive to choose a "pre-made" a fund for replicating an index.
- Mutual Funds
- Exchange Traded Funds

17. Exchange Traded Funds (ETFs)
Exchange Traded Funds are less expensive than mutual funds but more diversified than individual stocks. A cross between stocks and mutual funds.
ETFs seek returns of a broad market index or a sector index. They are index-linked rather than actively managed.
ETFs are exchange listed and can be bought and sold throughout the trading day: they are "funds that trade like stocks."
Example: SPY, Cubes, Diamonds, Spiders, Webs, VIPERS, iShares, Ultra Sectors, etc.

18. Active Portfolio Management

19. Active Portfolio Management
Active 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

20. Active Management Strategies
The chose between using and active or passive portfolio management strategy depends on 2 factors:
1. Belief in the efficiency of the markets. An investor who rejects the Efficient Market Hypothesis will tend to adopt an active strategy with the goal of obtaining “abnormal” returns:
where, ARit : is the abnormal return of security i in period t
Rit: is the return of security i in period t
E(Rit): is the expected return
2. Degree of risk aversion of the investor.

21. Performance of Active Mutual Funds
The average fund manager is not able to outperform the index!
In 64 out of the 96 quarters in the sample, less thatn 50 percent of actie fund managers had returns that exceeded that of the S&P 500 index.

22. Broad Overview of Investment Strategies
Passive Management Strategies
1. Efficient Markets Hypothesis
- Buy and Hold
- Indexing
Active Management Strategies
2. Fundamental Analysis
“Top Down” (asset class rotation, sector rotation)
“Bottom Up” (stock undervaluation/overvaluation)
3. Technical Analysis
Contrarian (e.g. overreaction)
Continuation (e.g. price momentum)
4. Anomalies and Attributes
Calendar effects (Weekend, January)
Security Characteristics (P/E,P/B, earnings momentum, firm size)
Investment Style (value, growth)

23. Investment Style and Tracking Error
Tracking error can be used to categorize a particular investment style.

24. Fundamental Strategies
Top down approach involves analysis of broad country and asset class allocations and progresses down through sector allocation decisions to the bottom level where individual securities are selected.
Bottom-up approach emphasizes security selection without any initial market or sector analysis.

25. Top Down Approach Top Down Approach
- Evaluate and forecast the future economy
- Chose the proportions to invest in each country or economic region.
- Identify the sectors and industries that would profit based on your economic outlook and choose proportions to invest in each industy or sector.
- Choose the best securities in each sector selected.

26. Bottom-Up Approach
Security selection is places less importance on the economic cycle.
Securities are selected based on well defined characteristic of individual stocks such as price-dividend ratios, book-to-market ratios, market capitalizations, etc.

27. Fundamental Strategies
Tactical Asset Allocation
- Asset Class Rotation: Shifts funds between stocks, bonds and other securities depending on market forecasts and estimated returns.
Sector, Industry or Style Rotation Strategy
- Shifts funds between different equity sectors and industries (financial stocks, technology stocks, consumer cyclicals, durable goods) or among investment styles (e.g., large capitalization, small capitalization, value growth)
Individual Stock Selection
- Buy low, Sell High

28. Sector, Industry and Style Analysis
How should we choose which sector, industry or style to rotate into next?
Important to look to the underlying nature of the economy. Security markets reflect the strength and weakness of the economy.
Most of the variables that determine security market value are economic variables: monetary policy, interest rates, aggregate output, inflation, etc.
Macro-analysis links up industry effects to business cycles and economic variables.

29. Asset and Sector Performance
Lists annual returns in each of severl asset and sector classes from 1985 to Tremendous volatility during this period. Bonds best performing asset in 2002, worst performing asset in Larger cap stocks best from , but worst in 2000.

30. Macro-market Analysis
A strong relationship exists between the economy and the stock market
Security markets reflect what is expected to go on in the economy because the value of an investment is determined by
its expected cash flows
required rate of return (i.e., the discount rate)

31. Is It A Worm?

32. Is It A Wave?

33. It’s the Business Cycle!
ECONOMIC
CYCLE

34. Business Cycles
The aggregate economy expands and contracts in discernable periods.
Economic trends affect industry performance.
Cyclical or Structural Changes?
Cyclical changes in the economy arise from the ups and downs of the business cycle
Structure changes occur when the economy undergoes a major change in organization or how it functions

35. The Stock Market and the Business Cycle
How can we predict the next peak or trough? E
peak
ECONOMIC
CYCLE
trough

36. Business Cycle Indicators
National Bureau of Economic Research (NBER)
Cyclical indicator categories
leading indicators
coincident indicators
lagging indicators
Composite series and ratio of series

37. Business Cycle Indicators
Leading indicators – economic series that usually reach peaks or troughs before corresponding peaks or troughs in aggregate economy activity
Coincident indicators – economic series that have peaks and troughs that roughly coincide with the peaks and troughs in the business cycle
Lagging indicators – economic series that experience their peaks and troughs after those of the aggregate economy
Selected series – economic series that do not fall into one of the three main groups.

39. Other Indicator Sources...

40. Stock Markets are a Leading Indicator
Stock prices consistently turn before the economy does.
Stock prices are forward looking.
Stock prices reflect expectations of earnings, dividends, and interest rates
Stock market reacts to various leading indicator series

41. Forecasting Business Cycles
The current state of the business cycle has already been incorporated into asset prices.
Investors need to make decisions based on future economic conditions.
To invest properly, it is important to forecast changes in economic variables.
High inflation: high interest rates, bad for stocks in general.

42. Sector Rotation Strategy
Certain industries make attractive investments over the course of the business cycle.
A sector rotation strategy is when one switches from one industry group to another over the course of a business cycle.

43. The Stock Market and the Business Cycle
peak
ECONOMIC
CYCLE
trough
Financial Stocks Excel

44. Financial Stocks
Adversely impacted by interest rates, difficult to pass on to their customers.
Toward the end of a recession, financial stocks rise as investors trade securities, businesses issue debt and equity, increase in merger activity during recovery.
Expecting increases in loan demand, housing construction and companies going public.

45. The Stock Market and the Business Cycle
Consumer Durables Excel
peak
ECONOMIC
CYCLE
trough
Financial Stocks Excel

46. Consumer Durables
Consumer Durables are cars, PCs, Miele washing machines, GE refrigerators, John Deer lawn machinery, cooking ranges, etc.
As the economy begins to come out of the recession, consumer confidence and income increase.

47. The Stock Market and the Business Cycle
Consumer Durables Excel
peak
ECONOMIC
CYCLE
Capital Goods Excel
trough
Financial Stocks Excel

48. Capital Goods
As the economy moves out of recession, businesses begin to modernize, renovate and purchase new equipment.
Heavy equipment manufactures, machine tool makers, airplane manufacturers become attractive.

49. The Stock Market and the Business Cycle
Basic Industries Excel
Consumer Durables Excel
peak
ECONOMIC
CYCLE
Capital Goods Excel
trough
Financial Stocks Excel

50. Basic Industries
End of the business cycle coincides with increases in inflation, as demand outstrips supply.
Inflation doesn’t influence the cost of extracting these products, whereas prices increase. Increasing profit margins.
Basic material industries as oil, metal and lumber are attractive.

51. The Stock Market and the Business Cycle
Basic Industries Excel
Consumer Staples Excel
Consumer Durables Excel
peak
ECONOMIC
CYCLE
Capital Goods Excel
trough
Financial Stocks Excel

52. Consumer Staples
Consumer staples are food, beverages and pharmaceuticals.
People still need to eat, drink, be merry and get sick.

53. The Stock Market and the Business Cycle
Basic Industries Excel
Consumer Staples Excel
Consumer Durables Excel
peak
ECONOMIC
CYCLE
Capital Goods Excel
trough
Financial Stocks Excel

54. Central Banks and Interest Rates
By far the most visible and obvious power of many modern central banks is to influence market interest rates.
When interest rates go down, money supply increases. Businesses and consumers have a lower cost of capital and can increase spending and capital improvement projects. This encourages growth.
When interest rates go up, the money supply falls and slows the economy. Increases in interest rate flight inflation.
The US central-bank lending rate is known as the Fed funds rate.
Bank of Canada sets a target overnight rate, and a band of plus or minus 0.25%.

55. Technical Strategies Contrarian investment strategy
Best time to buy a stock is when the majority of other investors are selling.
Buy low, sell high. Hope asset prices are mean reverting.
Overreaction hypothesis.
Price momentum strategy
Earnings momentum strategy

56. Market Overreaction
If investors overreact to good or bad news, losers would become winners and winners would becomes losers. The chart show that trading on overreaction hypothesis provides superior returns. Chart shows cumulative abnormal returns.

57. Price and Earnings Momentum
Assumes that recent price trends continue. Hot stocks stay hot, and cold stocks stay cold. Company revenues continue to grow faster than expected. Investors periodically underreact to new information. Based on previous 6 month returns and then looked at returns over the following year. The highest level of momentum generated highest subsequent returns. Last column show a long short strategy would have been profitable. Earnings momentum srategy not as sucesseful as price momentum strategy.

58. Anomalies and Attributes
The Weekend Effect
The January Effect
Firm Size
P/E and P/BV ratios

59. Large and Small Cap Returns
Note the firm size rotation over this period. One group outperfomed the over by over 20 percent over certaint periods.Evidence for rotation strategy based on size.

60. Standard Deviation of Returns
Note that small stocks tend to be risker than larger stocks on average.

61. P/E Ratios and Performance
Fama and French formed portfolios based on the lowest and highest 30 percent of each ratios and measured returns and standard deviations over a 20 year period. We have the average annual return differential between low and high.portfolios. Low P/E and P/BV ratio (value firms) that yielded consistently highest returns. Except Italy.

62. Value vs. Growth Stocks
Over time value stocks have offered somewhat higher returns than growth stocks.
However, growth stocks will outperform value stocks from time to time.
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 that P/E ratio is below its natural level for these stock and that the market will soon correct this situation.

63. Value vs. Growth: Mutual Funds

64. Value and Growth Stocks

65. Russell 100 Performance

66. Value vs. Growth

67. 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

68. Style Grid Style grid: firm size (large cap, mid cap, small cap)
Relative value (value, blend, growth) characteristics
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

69. Style Analysis Grid

70. Investment Style

71. Optimal Portfolio Selection

72. Next Week Optional Readings for this week:
(Course Reader) Value and Growth Investing: Review and Update (Chan and Lakonishok)
(Course Reader) Hedge Funds: Risk and Return (Maikiel ad Saha)
For Next Week:
Rappel des concepts de durée et de convexité
La durée des taux clés
Stratégies Barbell et Bullet
Immunisation de portefeuille
Review of Duration and Convexity (Rappel des concepts de durée et de convexité)
Key Rate Duration (La durée des taux clés) Barbell and Bullet Strategies (Stratégies Barbell et Bullet) Portfolio Immunization (Immunisation de portefeuille)
(BKMR) chapter 15
(Course Reader) Fabozzi, Bonds Markets, Analysis and Strategies, 4th edition., p
(Course Reader) Tuckman, Bruce W. Key Rate and Bucket Exposures, Fixed Income Securities: Tools for Today's Markets, 2nd edition, New York, J. Wiley, 2002, p