1. EQUITY-PORTFOLIO MANAGEMENT
Chapter 17
EQUITY-PORTFOLIO MANAGEMENT

2. 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?

3. 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?

4. 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?

5. 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

6. 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

7. 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

8. 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

9. 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)

10. 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

11. 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

12. 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

13. 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

14. 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

15. 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

16. 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”

17. 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

18. 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

19. 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

20. 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

21. 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

22. 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

23. 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

24. 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

25. 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

26. 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

27. 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

28. 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

29. 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

30. 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

31. 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

32. 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

33. 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

34. 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?

35. 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

36. 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

37. 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

38. 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