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Investment Analysis and Portfolio Management Sixth Edition by Frank K. Reilly & Keith C. Brown Portfolio Management Process and Strategies (From Chs. 2 & 22) 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 Part 1 The Portfolio Management Process (From Chapter 2) Figure 2.2 The Portfolio Management Process 1. Policy statement - Focus: Investor’s short-term and longterm 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 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 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 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 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 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 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? 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? 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 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 Copyright © 2000 by Harcourt, Inc. All rights reserved. Realistic Investor Goals • Total return – capital gains and income reinvestment – moderate risk exposure 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 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 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 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 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 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 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 Copyright © 2000 by Harcourt, Inc. All rights reserved. The Effect of Taxes and Inflation on Investment Returns, 1926 - 1998 Figure 2.6 12 10 8 6 4 Common Stocks Before Taxes After After Taxes Taxes and Inflation Long-Term Government Bonds Treasury Bills 2 Municipal Bonds 0 -2 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 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 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 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 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 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 Copyright © 2000 by Harcourt, Inc. All rights reserved. Part 2 Portfolio Management Strategies (From Chapter 22) 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 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 Copyright © 2000 by Harcourt, Inc. All rights reserved. Passive Equity Portfolio Management Techniques • Full replication • Sampling • Quadratic optimization or programming 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 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 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 Expected Tracking Error (Percent) Figure 22.1 4.0 3.0 2.0 1.0 500 400 300 200 100 0 Number of Stocks 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 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 Copyright © 2000 by Harcourt, Inc. All rights reserved. Other Passive Portfolios • Meet unique needs • Socially responsible investments • Dollar-cost averaging 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 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 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 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 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 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 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 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 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 Copyright © 2000 by Harcourt, Inc. All rights reserved. Determining Style • Style grid: – firm size – value-growth characteristics • Style analysis – constrained least squares 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, smallcapitalization stocks, non-U.S. bonds, European stocks, and Japanese stocks 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 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 (Tbills), large-capitalization growth, smallcapitalization growth, large-capitalization value, and small-capitalization value 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 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 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 Copyright © 2000 by Harcourt, Inc. All rights reserved.