Stocktrak Report

Chapter 16: Equity Portfolio Management Strategies

‹#›

Passive versus Active Management

Total Portfolio Return

The total actual return on any equity portfolio can be decomposed into:

Expected return

Alpha

The Equation

Total Actual Return

=[Expected Return] + [“Alpha”]

=[Risk-Free Rate + Risk Premium]+[“Alpha”]

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 16.1

16-3

Exhibit 16.1

16-4

An Overview of Passive 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

S&P 500 Index

NASDAQ Composite Index

16-5

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, particularly with dividend reinvestment

16-6

Index Portfolio Construction Techniques

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

16-7

‹#›

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 tracking error with the benchmark

This relies on historical correlations, which may change over time, leading to failure to track the index

16-8

‹#›

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

Δt =Rpt – Rbt

where Rpt= return to the managed portfolio in Period t

Rbt= return to the benchmark portfolio in Period t

Tracking error is measured as the standard deviation of Δt , normally annualized (TE)

See Exhibit 16.2

16-9

‹#›

Exhibit 16.2

16-10

Methods of Index Portfolio Investing

16-11

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

The advantage of index mutual funds is that they provide an inexpensive way for investors to acquire a diversified portfolio

Methods of Index Portfolio Investing

16-12

Exchange-Traded Funds (ETF)

EFTs 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 significant advantage of ETFs over index mutual funds is that they can be bought and sold (and short sold) like common stock

The notable example of ETFs

Standard & Poor’s 500 Depository Receipts (SPDRs)

iShares

Sector ETFs

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 16.5 and 16.6

16-13

Exhibit 16.5

16-14

Exhibit 16.6

16-15

16-16

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

‹#›

16-17

Fundamental Strategies

Three Generic Themes

Time the equity market by shifting funds into and out of stocks, bonds, and T-bills depending on broad market forecasts

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

Do stock picking and look at individual issues in an attempt to find undervalued stocks

‹#›

16-18

Fundamental Strategies

The 130/30 Strategy

Long positions up to 130 percent of the portfolio’s original capital and short positions up to 30 percent

The use of the short positions creates the leverage needed, increasing both risk and expected returns compared to the fund’s benchmark

Enable managers to make full use of their fundamental research to buy stocks they identify as undervalued as well as short those that are overvalued

Technical Strategies

16-19

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 concept of mean reverting

The overreaction hypothesis (Exhibit 16.9)

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

Exhibit 16.9

16-20

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

Calendar-Related Anomalies

The Weekend Effect

The January Effect

Firm-Specific Attributes

Firm Size

P/E and P/BV ratios (Exhibit 16.12)

16-21

‹#›

Exhibit 16.12

16-22

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 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 expected return depends on the expected holding period and the cost basis (and amount of the capital gain) of the original security

16-23

‹#›

Tax Efficiency and Active Equity Management

Measures of Tax Efficiency

Portfolio Turnover

Measured as the total dollar value of the securities sold from the portfolio in a year divided by the average dollar value of the assets

Tax Cost Ratio (%)

The Formula

Tax Cost Ratio = [1 – (1 + TAR)/(1 + PTR)] x 100

where

PTR = pretax return

TAR = tax-adjusted return

See Exhibit 16.14

16-24

‹#›

Exhibit 16.14

16-25

‹#›

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

16-26

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

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

16-27

Style Analysis

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

See Exhibit 16.20

16-28

Exhibit 16.20

16-29

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

Intentional and unintentional style drift

16-30

Asset Allocation Strategies

Integrated asset allocation

Capital market conditions (C1-C3)

Investor’s objectives and constraints (IPS or I1-I3)

Continuous adjustment in asset allocations based on feedback loops from capital markets and IPS (as in Chap 2)

Strategic asset allocation (long-term asset allocation)

Constant-mix; no feedback loops from capital markets or investor’s policy statement (IPS)

16-31

Asset Allocation Strategies (Cont.)

Tactical asset allocation (short-term changes in asset mix)

Mean reversion, inherently contrarian, temp change in capital market conditions (C1-C3)

Feedback loops from capital markets only; none from IPS

Insured asset allocation (continual adjustments)

IPS change with age and wealth; no change in capital market conditions (C1-C3) and no feedbacks from C1-C3; feedbacks only from IPS. Also called Constant Proportion strategy; e.g., change the percentage allocation between stocks & T-bill.

16-32