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Lecture Presentation Software to accompany Investment Analysis and Portfolio Management Sixth Edition by Frank K. Reilly & Keith C. Brown Chapter 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 Chapter 22 - 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? Copyright © 2000 by Harcourt, Inc. All rights reserved. Chapter 22 - Equity Portfolio Management Strategies • What are the three themes that active equity portfolio managers can use? • What stock characteristics differentiate valueoriented and growth-oriented investment styles? • What is style analysis and what does it indicate about a manager’s investment performance? • What techniques are used by active managers in an attempt to outperform their benchmark? Copyright © 2000 by Harcourt, Inc. All rights reserved. Chapter 22 - Equity Portfolio Management Strategies • 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? 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 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 • Frequently used in conjunction with quadratic optimization (see below) 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 – Variation of Markowitz Portfolio Theory, but … – Rather than maximize E(R) while minimizing , – Maximize while minimizing Copyright © 2000 by Harcourt, Inc. All rights reserved. Efficient Frontier for Enhanced/Optimized Index Funds Efficient Frontier p 0 p Tracking Error () Copyright © 2000 by Harcourt, Inc. All rights reserved. Quadratic Optimization (or programming techniques) • This is the application for which Markowitz optimization is most frequently used in practice • Suffers from the same problems as mentioned in Ch. 8 on Markowitz optimization, such as: – Relies on historical correlations, which may change over time, leading to failure to track the index – Also, still need to use some type of factor model to provide structure to the correlations and thereby reduce the number of elements that must be estimated 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 (sector rotation) or among investment styles (e.g., theme investing) 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 – note: P/Book is probably a better measure of value than is P/E 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. 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 Copyright © 2000 by Harcourt, Inc. All rights reserved. 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 Copyright © 2000 by Harcourt, Inc. All rights reserved. The Use of Derivatives in Equity Portfolios Futures and options can help control cash inflows and outflows from the portfolio • Inflows - index contracts allows time to make investments • Outflow - large planned withdrawal is made by selling securities, which causes an increase in cash holdings; futures can counterbalance this until the withdrawal Copyright © 2000 by Harcourt, Inc. All rights reserved. Using Futures in • Passive Equity Portfolio Management – Help manage cash inflows and outflows while still tracking the target index – Options can be sold to reduce weightings in sectors or individual stocks during rebalancing • Active Equity Portfolio Management – Modifying systematic risk – Modifying unsystematic risk Copyright © 2000 by Harcourt, Inc. All rights reserved. Modifying the Characteristics of an International Equity Portfolio • Positions in securities and currencies • Futures allow modifying each exposure separately – Traditional currency rebalancing would require rebalancing the country allocation – Each security rebalancing would be costly and time consuming – Currency exposure can be modified without changing country exposures through currency contracts Copyright © 2000 by Harcourt, Inc. All rights reserved. The Internet Investments Online www.russell.com www.firstquadrant.com www.wilshire.com www.mfea.com/planidx.html www.cboe.com www.cboe.com/institutional/testimon.htm www.cboe.com/institutional/portfolio.htm www.cboe.com/institutional/whitepap.htm Copyright © 2000 by Harcourt, Inc. All rights reserved. End of Chapter 22 –Equity Portfolio Management Strategies Copyright © 2000 by Harcourt, Inc. All rights reserved. Future topics • Chapter 27 – Evaluation of Portfolio Performance • The Inefficient Stock Market (Haugen) – What Pays Off and Why Copyright © 2000 by Harcourt, Inc. All rights reserved. Copyright © 2000 by Harcourt, Inc. All rights reserved. Chapter 27 - Evaluation of Portfolio Performance • What is the Treynor portfolio performance measure? • What is the Sharpe portfolio performance measure? • What is the critical difference between the Treynor and Sharpe portfolio performance measures? • What is the Jensen portfolio performance measure, and how does it relate to the Treynor measure? Copyright © 2000 by Harcourt, Inc. All rights reserved. What is Required of a Portfolio Manager? 1.The ability to derive above-average returns for a given risk class Superior risk-adjusted returns can be derived from either – superior timing or – superior security selection 2. The ability to diversify the portfolio completely to eliminate unsystematic risk Copyright © 2000 by Harcourt, Inc. All rights reserved. Composite Portfolio Performance Measures • Portfolio evaluation before 1960 – rate of return within risk classes • Peer group comparisons – no explicit adjustment for risk – difficult to form comparable peer group • Treynor portfolio performance measure – market risk – individual security risk – introduced characteristic line Copyright © 2000 by Harcourt, Inc. All rights reserved. Treynor Portfolio Performance Measure • Treynor recognized two components of risk – Risk from general market fluctuations – Risk from unique fluctuations in the securities in the portfolio • His measure of risk-adjusted performance focuses on the portfolio’s undiversifiable risk: market or systematic risk Copyright © 2000 by Harcourt, Inc. All rights reserved. Treynor Portfolio Performance Measure R T i RFR i • The numerator is the risk premium • The denominator is a measure of risk • The expression is the risk premium return per unit of risk • Risk averse investors prefer to maximize this value • This assumes a completely diversified portfolio leaving systematic risk as the relevant risk Copyright © 2000 by Harcourt, Inc. All rights reserved. Treynor Portfolio Performance Measure • Comparing a portfolio’s T value to a similar measure for the market portfolio indicates whether the portfolio would plot above the SML • Calculate the T value for the aggregate market as follows: Tm R m RFR m Copyright © 2000 by Harcourt, Inc. All rights reserved. Treynor Portfolio Performance Measure • Comparison to see whether actual return of portfolio G was above or below expectations can be made using: ER G RFR i R m RFR Copyright © 2000 by Harcourt, Inc. All rights reserved. Sharpe Portfolio Performance Measure • Risk premium earned per unit of risk Si R i RFR i Copyright © 2000 by Harcourt, Inc. All rights reserved. Treynor versus Sharpe Measure • Sharpe uses standard deviation of returns as the measure of risk • Treynor measure uses beta (systematic risk) • Sharpe therefore evaluates the portfolio manager on the basis of both rate of return performance and diversification • The methods agree on rankings of completely diversified portfolios • Produce relative not absolute rankings of performance Copyright © 2000 by Harcourt, Inc. All rights reserved. Jensen Portfolio Performance Measure • Also based on CAPM • Expected return on any security or portfolio is ER j RFR j ER m RFR Copyright © 2000 by Harcourt, Inc. All rights reserved. Jensen Portfolio Performance Measure • Also based on CAPM • Expected return on any security or portfolio is ER j RFR j ER m RFR Where: E(Rj) = the expected return on security RFR = the one-period risk-free interest rate j= the systematic risk for security or portfolio j E(Rm) = the expected return on the market portfolio of risky assets Copyright © 2000 by Harcourt, Inc. All rights reserved.