1. Version 1.2 Copyright © 2000 by Harcourt, Inc. All rights reserved. Requests for permission to make copies of any part of the work should be mailed to: Permissions Department Harcourt, Inc. 6277 Sea Harbor Drive Orlando, Florida 32887-6777 Investment Analysis and Portfolio Management Sixth Edition by Frank K. Reilly & Keith C. Brown Portfolio Management Process and Strategies (From Chs. 2 & 22)

2. Part 1 The Portfolio Management Process (From Chapter 2)

3. Copyright © 2000 by Harcourt, Inc. All rights reserved. The Portfolio Management Process 1. Policy statement - Focus: Investor’s short-term and long- term needs, familiarity with capital market history, and expectations 2. Examine current and project financial, economic, political, and social conditions - Focus: Short-term and intermediate-term expected conditions to use in constructing a specific portfolio 3. Implement the plan by constructing the portfolio - Focus: Meet the investor’s needs at the minimum risk levels 4. Feedback loop: Monitor and update investor needs, environmental conditions, portfolio performance Figure 2.2

4. Copyright © 2000 by Harcourt, Inc. All rights reserved. The Portfolio Management Process 1. Policy statement –specifies investment goals and acceptable risk levels –should be reviewed periodically –guides all investment decisions

5. Copyright © 2000 by Harcourt, Inc. All rights reserved. The Portfolio Management Process 2. Study current financial and economic conditions and forecast future trends –determine strategies to meet goals –requires monitoring and updates

6. Copyright © 2000 by Harcourt, Inc. All rights reserved. The Portfolio Management Process 3. Construct the portfolio –allocate available funds to meet goals and minimize investor’s risks

7. Copyright © 2000 by Harcourt, Inc. All rights reserved. The Portfolio Management Process 4. Monitor and update –revise policy statement as needed –modify investment strategy accordingly –evaluate portfolio performance

8. Copyright © 2000 by Harcourt, Inc. All rights reserved. The Need For A Policy Statement Understand and articulate realistic investor goals –needs, objectives, and constraints –financial markets and risks of investing

9. Copyright © 2000 by Harcourt, Inc. All rights reserved. Constructing A Policy Statement What are the real risks of an adverse financial outcome, especially in the short run? What probable emotional reactions will I have to an adverse financial outcome? How knowledgeable am I about investments and markets?

10. Copyright © 2000 by Harcourt, Inc. All rights reserved. Constructing A Policy Statement What other capital or income sources do I have? How important is this particular portfolio to my overall financial position? What, if any, legal restrictions may affect my investment needs? What, if any, unanticipated consequences of interim fluctuations in portfolio value might affect my investment policy?

11. Copyright © 2000 by Harcourt, Inc. All rights reserved. Standards For Evaluating Portfolio Performance Benchmark portfolio –risk and return Matches risk preferences and investment needs –analysis of risk tolerance –return objective goals

12. Copyright © 2000 by Harcourt, Inc. All rights reserved. Realistic Investor Goals Capital preservation –minimize risk of real loss –strongly risk-averse or funds needed soon Capital appreciation –capital gains to provide real growth over time for future need –aggressive strategy with accepted risk Current income –generate spendable funds

13. Copyright © 2000 by Harcourt, Inc. All rights reserved. Realistic Investor Goals Total return –capital gains and income reinvestment –moderate risk exposure

14. Copyright © 2000 by Harcourt, Inc. All rights reserved. Investment Constraints Liquidity needs –near-term goals Time horizon –longer time horizon favors risk acceptability –short time horizon favors less risky investments because losses are harder to overcome in a short time frame

15. Copyright © 2000 by Harcourt, Inc. All rights reserved. Investment Constraints Tax concerns –interest and dividends taxed at investor’s marginal tax rate –capital gains may be unrealized –basis and gain or loss realized –revisions to capital gains tax rates –tradeoff with diversification needs for employer’s stock holdings

16. Copyright © 2000 by Harcourt, Inc. All rights reserved. Legal and Regulatory Factors Limitations or penalties on withdrawals Fiduciary responsibilities - “prudent man” rule Investment laws prohibit insider trading

17. Copyright © 2000 by Harcourt, Inc. All rights reserved. Unique Needs and Preferences Personal preferences - socially conscious investments Time constraints or expertise for managing the portfolio may require professional management Large investment in employer may require consideration of diversification needs and realistic liquidity Institutional investors needs

18. Copyright © 2000 by Harcourt, Inc. All rights reserved. Constructing the Policy Statement Objectives - risk and return Constraints - liquidity, time horizon, tax factors, legal and regulatory constraints, and unique needs and preferences Developing a plan depends on understanding the relationship between risk and return and the importance of diversification

19. Copyright © 2000 by Harcourt, Inc. All rights reserved. The Importance of Asset Allocation An investment strategy is based on four decisions –What asset classes to consider for investment –What normal or policy weights to assign to each eligible class –The allowable allocation ranges based on policy weights –What specific securities to purchase for the portfolio

20. Copyright © 2000 by Harcourt, Inc. All rights reserved. The Importance of Asset Allocation Most (85% to 95%) of the overall investment return is due to the first two decisions, not the selection of individual investments

21. Copyright © 2000 by Harcourt, Inc. All rights reserved. The Effect of Taxes and Inflation on Investment Returns, 1926 - 1998 After Taxes and Inflation After Taxes Before Taxes Figure 2.6

22. Copyright © 2000 by Harcourt, Inc. All rights reserved. Returns and Risk of Different Asset Classes Higher returns compensate for risk Policy statements must provide risk guidelines Measuring risk by standard deviation of returns over time indicates stocks are more risky than T-bills

23. Copyright © 2000 by Harcourt, Inc. All rights reserved. Returns and Risk of Different Asset Classes Measuring risk by probability of not meeting your investment return objective indicates risk of equities is small and risk of T-bills is large because of different expected returns Focusing only on return variability ignores reinvestment risk Changes in returns from year to year

24. Copyright © 2000 by Harcourt, Inc. All rights reserved. Asset Allocation Summary Policy statement determines types of assets to include in portfolio Asset allocation determines portfolio return more than stock selection Over long time periods sizable allocation to equity will improve results Risk of a strategy depends on the investor’s goals and time horizon

25. Copyright © 2000 by Harcourt, Inc. All rights reserved. Asset Allocation and Cultural Differences Social, political, and tax environments U.S. institutional investors average 45% allocation in equities In the United Kingdom, equities make up 72% of assets In Germany, equities are 11% In Japan, equities are 24% of assets

26. Copyright © 2000 by Harcourt, Inc. All rights reserved. Summary Develop an investment policy statement –Identify investment needs, risk tolerance, and familiarity with capital markets –Identify objectives and constraints –Investment plans are enhanced by accurate formulation of a policy statement

27. Copyright © 2000 by Harcourt, Inc. All rights reserved. Summary Asset allocation determines long-run returns and risk –Success depends on construction of the policy statement

28. Part 2 Portfolio Management Strategies (From Chapter 22)

29. Copyright © 2000 by Harcourt, Inc. All rights reserved. Passive versus Active Management 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

30. Copyright © 2000 by Harcourt, Inc. All rights reserved. An Overview of Passive Equity Portfolio Management Strategies Replicate the performance of an index May slightly underperform the target index due to fees and commissions 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

31. Copyright © 2000 by Harcourt, Inc. All rights reserved. Passive Equity Portfolio Management Techniques Full replication Sampling Quadratic optimization or programming

32. Copyright © 2000 by Harcourt, Inc. All rights reserved. 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

33. Copyright © 2000 by Harcourt, Inc. All rights reserved. Sampling Buys a 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

34. Copyright © 2000 by Harcourt, Inc. All rights reserved. Expected Tracking Error Between the S&P 500 Index and Portfolio Samples of Less Than 500 Stocks Figure 22.1 5004003002001000 2.0 1.0 3.0 4.0 Expected Tracking Error (Percent) Number of Stocks

35. Copyright © 2000 by Harcourt, Inc. All rights reserved. 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 tracking error with the benchmark This relies on historical correlations, which may change over time, leading to failure to track the index

36. Copyright © 2000 by Harcourt, Inc. All rights reserved. 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

37. Copyright © 2000 by Harcourt, Inc. All rights reserved. Other Passive Portfolios Meet unique needs Socially responsible investments Dollar-cost averaging

38. Copyright © 2000 by Harcourt, Inc. All rights reserved. An Overview of 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 Practical difficulties of active manager –Transactions costs must be offset –Risk can exceed passive benchmark

39. Copyright © 2000 by Harcourt, Inc. All rights reserved. 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

40. Copyright © 2000 by Harcourt, Inc. All rights reserved. Global Investing 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

41. Copyright © 2000 by Harcourt, Inc. All rights reserved. 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 –Sensitivity to economic variables

42. Copyright © 2000 by Harcourt, Inc. All rights reserved. Value versus Growth Growth stocks will outperform value stocks for a time and then the opposite occurs Over time value stocks have offered somewhat higher returns than growth stocks

43. Copyright © 2000 by Harcourt, Inc. All rights reserved. Value versus Growth 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

44. Copyright © 2000 by Harcourt, Inc. All rights reserved. Value versus Growth 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

45. Copyright © 2000 by Harcourt, Inc. All rights reserved. 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

46. Copyright © 2000 by Harcourt, Inc. All rights reserved. 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 diversify by portfolio Style investing allows control of the total portfolio to be shared between the investment managers and a sponsor

47. Copyright © 2000 by Harcourt, Inc. All rights reserved. Determining Style Style grid: –firm size –value-growth characteristics Style analysis –constrained least squares

48. Copyright © 2000 by Harcourt, Inc. All rights reserved. Benchmark Portfolios Sharpe –T-bills, intermediate-term government bonds, long-term government bonds, corporate bonds, mortgage related securities, large-capitalization value stocks, large-capitalization growth stocks, medium-capitalization stocks, small- capitalization stocks, non-U.S. bonds, European stocks, and Japanese stocks

49. Copyright © 2000 by Harcourt, Inc. All rights reserved. Benchmark Portfolios Sharpe BARRA –Uses portfolios formed around 13 different security characteristics, including variability in markets, past firm success, firm size, trading activity, growth orientation, earnings-to-price ratio, book-to-price ratio, earnings variability, financial leverage, foreign income, labor intensity, yield, and low capitalization

50. Copyright © 2000 by Harcourt, Inc. All rights reserved. Benchmark Portfolios Sharpe BARRA Ibbotson Associates –simplest style model uses portfolios formed around five different characteristics: cash (T- bills), large-capitalization growth, small- capitalization growth, large-capitalization value, and small-capitalization value

51. Copyright © 2000 by Harcourt, Inc. All rights reserved. Timing Between Styles 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

52. Copyright © 2000 by Harcourt, Inc. All rights reserved. Asset Allocation Strategies Integrated asset allocation –capital market conditions –investor’s objectives and constraints Strategic asset allocation –constant-mix Tactical asset allocation –mean reversion –inherently contrarian Insured asset allocation –constant proportion

53. Copyright © 2000 by Harcourt, Inc. All rights reserved. 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