MBF2253 | Modern Security Analysis Prepared by Dr Khairul Anuar

L7: Equity Portfolio Management Strategies

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Chapter 17 - Equity Portfolio Management Strategies

Questions to be answered:

• What are the two generic equity portfolio management styles?

• What are three techniques for constructing a passive index portfolio?

• How does the goal of a passive equity portfolio manager differ from the goal of an active manager?

• What is a portfolio’s tracking error and how is it useful in the construction of a passive equity investment?

Chapter 17 - Equity Portfolio Management Strategies

• What is the difference between an index mutual fund and an exchange-traded fund?

• What are the three themes that active equity portfolio managers can use?

• What stock characteristics differentiate value-oriented and growth-oriented investment styles?

• What is style analysis and what does it indicate about a manager’s investment performance?

Chapter 17 - Equity Portfolio Management Strategies

• What techniques are used by active managers

in an attempt to outperform their benchmark?

• What are differences between the integrated,

strategic, tactical, and insured approaches to

asset allocation?

• How can futures and options be useful in

managing an equity portfolio?

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

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

Index Portfolio Strategy

Construction Techniques

• Full replication

• Sampling

• Quadratic optimization or

programming

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

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

Expected Tracking Error Between the S&P 500 Index

and Portfolio Samples of Less Than 500 Stocks

Exhibit 17.2

500 400 300 200 100 0

2.0

1.0

3.0

4.0

Expected Tracking

Error (Percent)

Number of Stocks

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

Methods of Index Portfolio

Investing

• Index Funds

– Attempt to replicate a benchmark index

• Exchange-Traded Funds

– 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

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

Fundamental Strategies

• Top-down versus bottom-up approaches

• Asset and sector rotation 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

– Sensitivity to economic variables

Technical Strategies

• Contrarian investment strategy

• Price momentum strategy

• Earnings momentum strategy

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

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 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

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

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

Determining Style

• Style grid:

– firm size

– value-growth characteristics

• Style analysis

– constrained least squares

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

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

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

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

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

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

Using Futures and Options in

Equity Portfolio Management

• Systematic and unsystematic risk of equity

portfolios can be modified by using futures and

options derivatives

• Selling futures on the portfolio’s underlying

assets reduces the portfolio’s sensitivity to price

changes of the asset

• Options do not have symmetrical impact on

returns

The Use of Futures in Asset Allocation

• Allows changing the portfolio allocation quickly

to adjust to forecasts at lower transaction costs

• Futures can maintain an overall balance in a

portfolio

• Futures can gain exposure to international

markets

• Currency exposure can be managed using

currency futures and options

Using Derivatives in Passive

Equity Portfolio Management

• Futures and options can help control cash inflows and outflows from the portfolio

– Inflows - index contracts allow time to make investments

– Outflows - large planned withdrawal is made by selling securities, which causes an increase in cash holdings; futures can counterbalance this until the withdrawal

• Options can be sold to reduce weightings in sectors or individual stocks during rebalancing

Using Derivatives in Active

Equity Portfolio Management

• Modifying systematic risk

• Modifying unsystematic risk