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Investment Analysis and
Portfolio Management
Sixth Edition
by
Frank K. Reilly & Keith C. Brown
Chapter 22
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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?
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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?
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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?
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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
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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
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Passive Equity Portfolio
Management Techniques
• Full replication
• Sampling
• Quadratic optimization or
programming
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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
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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)
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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
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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 
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Efficient Frontier for
Enhanced/Optimized Index Funds

Efficient
Frontier
p
0
p
Tracking Error ()
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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
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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
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Other Passive Portfolios
• Meet unique needs
• Socially responsible investments
• Dollar-cost averaging
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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
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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
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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
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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
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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
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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
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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
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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
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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
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Determining Style
• Style grid:
– firm size
– value-growth characteristics
• Style analysis
– constrained least squares
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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
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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
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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
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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
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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
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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
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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
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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
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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
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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
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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
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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
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End of Chapter 22
–Equity Portfolio Management
Strategies
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Future topics
• Chapter 27 – Evaluation of Portfolio
Performance
• The Inefficient Stock Market (Haugen)
– What Pays Off and Why
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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?
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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
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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
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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
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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
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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

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Treynor Portfolio
Performance Measure
• Comparison to see whether actual return of
portfolio G was above or below expectations
can be made using:
ER G   RFR   i R m  RFR 
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Sharpe Portfolio
Performance Measure
• Risk premium earned per unit of risk
Si 
R i  RFR
i
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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
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Jensen Portfolio
Performance Measure
• Also based on CAPM
• Expected return on any security or portfolio is
ER j   RFR   j ER m   RFR 
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Jensen Portfolio
Performance Measure
• Also based on CAPM
• Expected return on any security or portfolio is
ER j   RFR   j ER 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
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