Investment Analysis and Portfolio Management
Seventh Editionby
Frank K. Reilly & Keith C. Brown
Chapter 17
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
The InternetInvestments Online
www.russell.com
www.firstquadrant.com
www.wilshire.com
www.fool.com
www.dailystocks.com
End of Chapter 17–Equity Portfolio Management Strategies
Future topicsChapter 18
• Bond Fundamentals