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Transcript
Chapter 15
Revision of the Equity Portfolio
1
An individual can make a difference; a team can
make a miracle
- 1980 U.S. Olympic hockey team
2
Outline
 Introduction
 Active
management versus passive
management
 When do you sell stock?
3
Introduction
 Portfolios
need maintenance and periodic
revision:
• Because the needs of the beneficiary will
change
• Because the relative merits of the portfolio
components will change
• To keep the portfolio in accordance with the
investment policy statement and investment
strategy
4
Active Management Versus
Passive Management
 Definition
 The
manager’s choices
 Costs of revision
 Contributions to the portfolio
5
Definition
 An
active management policy is one in
which the composition of the portfolio is
dynamic
• The portfolio manager periodically changes:
– The portfolio components or
– The components’ proportion within the portfolio
 A passive
management strategy is one in
which the portfolio is largely left alone
6
The Manager’s Choices
 Leave
the portfolio alone
 Rebalance the portfolio
 Asset allocation and rebalancing within the
aggregate portfolio
 Change the portfolio components
 Indexing
7
Leave the Portfolio Alone

A buy and hold strategy means that the portfolio
manager hangs on to its original investments
 Academic
research shows that portfolio managers
often fail to outperform a simple buy and hold
strategy on a risk-adjusted basis
• E.g., Barber and Odean show that investors who trade
the most have the lowest gross and net returns
8
Rebalance the Portfolio
 Rebalancing
a portfolio is the process of
periodically adjusting it to maintain the
original conditions
9
Rebalancing
Within the Portfolio
 Constant
mix strategy
 Constant proportion portfolio insurance
 Relative performance of constant mix and
CPPI strategies
10
Constant Mix Strategy
 The
constant mix strategy:
• Is one to which the manager makes adjustments
to maintain the relative weighting of the asset
classes within the portfolio as their prices
change
• Requires the purchase of securities that have
performed poorly and the sale of securities that
have performed the best
11
Constant Mix Strategy (cont’d)
Example
A portfolio has a market value of $2 million. The
investment policy statement requires a target asset
allocation of 60 percent stock and 30 percent bonds.
The initial portfolio value and the portfolio value after one
quarter are shown on the next slide.
12
Constant Mix Strategy (cont’d)
Example (cont’d)
Date
Portfolio Value Actual Allocation
Stock
Bonds
1 Jan
$2,000,000
60%/40%
$1,200,000 $800,000
1 Apr
$2,500,000
56%/44%
$1,400,000 $1,100,000
What dollar amount of stock should the portfolio
manager buy to rebalance this portfolio? What dollar
amount of bonds should he sell?
13
Constant Mix Strategy (cont’d)
Example (cont’d)
Solution: a 60%/40% asset allocation for a $2.5 million
portfolio means the portfolio should contain $1.5 million
in stock and $1 million in bonds. Thus, the manager
should buy $100,000 worth of stock and sell $100,000
worth of bonds.
14
Constant Proportion
Portfolio Insurance
 A constant
proportion portfolio insurance
(CPPI) strategy requires the manager to
invest a percentage of the portfolio in
stocks:
$ in stocks = Multiplier x (Portfolio value – Floor value)
15
Constant Proportion
Portfolio Insurance (cont’d)
Example
A portfolio has a market value of $2 million. The
investment policy statement specifies a floor value of $1.7
million and a multiplier of 2.
What is the dollar amount that should be invested in
stocks according to the CPPI strategy?
16
Constant Proportion
Portfolio Insurance (cont’d)
Example (cont’d)
Solution: $600,000 should be invested in stock:
$ in stocks = 2.0 x ($2,000,000 – $1,700,000)
= $600,000
If the portfolio value is $2.2 million one quarter later, with
$650,000 in stock, what is the desired equity position
under the CPPI strategy? What is the ending asset mix
after rebalancing?
17
Constant Proportion
Portfolio Insurance (cont’d)
Example (cont’d)
Solution: The desired equity position after one quarter
should be:
$ in stocks = 2.0 x ($2,200,000 – $1,700,000)
= $1,000,000
The portfolio manager should move $350,000 into stock.
The resulting asset mix would be: $1,000,000/$2,200,000 =
45.5%
18
Relative Performance of
Constant Mix and CPPI
 A constant
mix strategy sells stock as it
rises
 A CPPI
strategy buys stock as it rises
19
Relative Performance of
Constant Mix & CPPI (cont’d)
 In
a rising market, the CPPI strategy
outperforms constant mix
 In a declining market, the CPPI strategy
outperforms constant mix
 In a flat market, neither strategy has an
obvious advantage
 In a volatile market, the constant mix
strategy outperforms CPPI
20
Relative Performance of
Constant Mix & CPPI (cont’d)
 The
relative performance of the strategies
depends on the performance of the market
during the evaluation period
 In the long run, the market will probably
rise, which favors CPPI
 In the short run, the market will be volatile,
which favors constant mix
21
Rebalancing Within the
Equity Portfolio
 Constant
proportion
 Constant beta
 Change the portfolio components
 Indexing
22
Constant Proportion
 A constant
proportion strategy within an
equity portfolio requires maintaining the
same percentage investment in each stock
• May be mitigated by avoidance of odd lot
transactions
 Constant
proportion rebalancing requires
selling winners and buying losers
23
Constant Proportion (cont’d)
Example
A portfolio of three stocks attempts to invest approximately one third
of funds in each of the stocks. Consider the following information:
Stock
Price
Shares
Value
% of Total Portfolio
FC
22.00
400
8,800
31.15
HG
13.50
700
9,450
33.45
YH
50.00
200
10,000
35.40
$28,250
100.00
Total
24
Constant Proportion (cont’d)
Example (cont’d)
After one quarter, the portfolio values are as shown below.
Recommend specific actions to rebalance the portfolio in order to
maintain the constant proportion in each stock.
Stock
Price
Shares
Value
% of Total Portfolio
FC
20.00
400
8,000
21.92
HG
15.00
700
10,500
28.77
YH
90.00
200
18,000
49.32
$36,500
100.00
Total
25
Constant Proportion (cont’d)
Example (cont’d)
Solution: The worksheet below shows a possible revision which
requires an additional investment of $1,000:
Stock
Price
Shares
Value
Before
FC
20.00
400
8,000
Buy 200
12,000
32.00
HG
15.00
700
10,500
Buy 100
12,000
32.00
YH
90.00
200
18,000
Sell 50
13,500
36.00
$37,500
100.00
Total
$36,500
Action
Value
After
% of
Portfolio
26
Constant Beta Portfolio
A constant beta portfolio requires maintaining the
same portfolio beta
 To increase or reduce the portfolio beta, the
portfolio manager can:

• Reduce or increase the amount of cash in the portfolio
• Purchase stocks with higher or lower betas than the
target figure
• Sell high- or low-beta stocks
• Buy high- or low-beta stocks
27
Change the
Portfolio Components
 Changing
the portfolio components is
another portfolio revision alternative
 Events sometimes deviate from what the
manager expects:
• The manager might sell an investment turned
sour
• The manager might purchase a potentially
undervalued replacement security
28
Indexing

Indexing is a form of portfolio management that
attempts to mirror the performance of a market
index
• E.g., the S&P 500 or the DJIA
Index funds eliminate concerns about
outperforming the market
 The tracking error refers to the extent to which a
portfolio deviates from its intended behavior

29
Costs of Revision
 Introduction
 Trading
fees
 Market impact
 Management time
 Tax implications
 Window dressing
 Rising importance of trading fees
30
Introduction
 Costs
of revising a portfolio can:
• Be direct dollar costs
• Result from the consumption of management
time
• Stem from tax liabilities
• Result from unnecessary trading activity
31
Trading Fees
 Commissions
 Transfer
taxes
32
Commissions
 Investors
pay commissions both to buy and
to sell shares
 Commissions
at a brokerage firm are a
function of:
• The dollar value of the trade
• The number of shares involved in the trade
33
Commissions (cont’d)
 The
commission on a trade is split between
the broker and the firm for which the broker
works
• Brokers with a high level of production keep a
higher percentage than a new broker
 Some
brokers discount their commissions
with their more active clients
34
Commissions (cont’d)
 Discount
brokerage firms:
• Offer substantially reduce commission rates
• Offer few ancillary services, such as market
research
 Retail
commissions at a full-service firm
average about 2 percent of the stock value
35
Transfer Taxes
 Transfer
taxes are:
• Imposed by some states on the transfer of
securities
• Usually very modest
• Not normally a material consideration in the
portfolio management process
36
Market Impact
 The
market impact of placing the trade is
the change in market price purely because
of executing the trade
 Market
impact is a real cost of trading
 Market
impact is especially pronounced for
shares with modest daily trading volume
37
Management Time
 Most
portfolio managers handle more than
one account
 Rebalancing
several dozen portfolios is time
consuming
38
Tax Implications
 Individual
investors and corporate clients
must pay taxes on the realized capital gains
associated with the sale of a security
 Tax
implications are usually not a concern
for tax-exempt organizations
39
Window Dressing
 Window
dressing refers to cosmetic
changes made to a portfolio near the end of
a reporting period
 Portfolio
managers may sell losing stocks at
the end of the period to avoid showing them
on their fund balance sheets
40
Rising Importance
of Trading Fees
 Flippancy
regarding commission costs is
unethical and sometimes illegal
 Trading
fees are receiving increased
attention because of:
• Investment banking scandals
• Lawsuits regarding churning
• Incomplete prospectus information
41
Contributions to the Portfolio
 Periodic
additional contributions to the
portfolio from internal or external sources
must be invested
 Dividends:
• May be automatically reinvested by the fund
manager’s broker
• May have to be invested in a money market
account by the fund manager
42
When Do You Sell Stock?
 Introduction
 Rebalancing
 Upgrading
 Sale
of stock via stop orders
 Extraordinary events
 Final thoughts
43
Introduction
 Knowing
when to sell a stock is a very
difficult part of investing
 Behavioral
evidence suggests the typical
investor sells winners too soon and keeps
losers too long
44
Rebalancing
 Rebalancing
can cause the portfolio
manager to sell shares even if they are not
doing poorly
 Profit
taking with winners is a logical
consequence of portfolio rebalancing
45
Upgrading
 Investors
should sell shares when their
investment potential has deteriorated to the
extent that they no longer merit a place in
the portfolio
 It
is difficult to take a loss, but it is worse to
let the losses grow
46
Sale of Stock Via Stop Orders
 Definition
 Using
stops to minimize losses
 Using stops to protect profits
47
Definition
 Stop
orders:
• Are sell stops
• Become a market order to sell a set number of
shares if shares trade at the stop price
• Can be used to minimize losses or to protect a
profit
48
Using Stops to Minimize Losses
 Stop-loss
orders can be used to minimize
losses
• E.g., you bought a share for $23 and want to
sell it if it falls below $18
– Place a stop-loss order for $18
49
Using Stops to Protect Profits
 Stop
orders can be used to protect profits
• E.g., a stock you bought for $33 now trades for
$48 and you want to protect the profits at $45
– If the stock retreats to $45, you lock in the profit if
you place a stop order
– If the stock continues to increase, you can use a
crawling stop to increase the stop price
50
Extraordinary Events
 Change
in client objectives
 Change in market conditions
 Buy-outs
 Caprice
51
Change in Client Objectives
 The
client’s investment objectives may
change occasionally:
• E.g., a church needs to generate funds for a
renovation and changes the objective for the
endowment fund from growth of income to
income
– Reduce the equity component of the portfolio
52
Change in Market Conditions
 Many
fund managers seek to actively time
the market
 When
a portfolio manager’s outlook
becomes bearish, he may reduce his equity
holdings
53
Buy-Outs
 A firm
may be making a tender offer for
one of the funds holdings
• I.e., another firm wants to acquire the fund
holding
 It
is generally in the client’s best interest to
sell the stock to the potential acquirer
54
Caprice
 Portfolio
managers:
• Should be careful about making unnecessary
trades
• Must pay attention to their experience,
intuition, and professional judgment
 An
experienced portfolio manager worried
about a particular holding should probably
make a change
55
Final Thoughts
 Hindsight
is an inappropriate perspective
for investment decision making
• Everything you do as a portfolio manager must
be logically justifiable at the time you do it
 Portfolio
managers are torn between
minimizing losses and the potential for
price appreciation
56