CHAPTER SIXTEEN

MANAGING THE EQUITY PORTFOLIO

© 2001 South-Western College Publishing

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Outline

Structuring a Stock Portfolio The Portfolio Objective Asset Allocation Active vs. Passive Management

Portfolio Rebalancing What’s Wrong with Buy and Hold? The Costs of Revision Constant Proportion Rebalancing Constant Beta Rebalancing Indexing Dollar Cost Averaging

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Outline

Overwriting Writing Options to Generate Income Improving on the Market

Portfolio Protection Writing Covered Calls for Downside Protection Protective Puts Using Index Options Using Index Futures Contracts

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Structuring a Stock Portfolio : The Objective

Semantics are important in any statement of investment objectives.

The four main portfolio objectives are stability of principal, income, growth of income, and capital appreciation.

In a world with taxes, one dollar in capital gains is worth more than one dollar in income.

The overriding investment objective is utility maximization.

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Relative Riskiness of Portfolio Objectives

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18

16

14

12

10

8

6

4

2

0

exp

ecte

d r

etu

rn

standard deviation (%)

capital appreciation

growth of income

0 6 12 18 24 30 36

income

inflationT-bills

intermediate-term

governmentbonds

long-termgovernment bonds

long-termcorporate bonds

large company stocks

smallcompany

stocks

stabilityof principal

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An asset class refers to a broad category of investments.

U.S. equities, foreign equities, bonds, and cash are four widely used asset classes.

The relative distribution of funds across asset classes is called asset allocation.

Structuring a Stock Portfolio : Asset Allocation

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Structuring a Stock Portfolio : Asset Allocation

attitudetoward risk

need forreturn

individual choice

stocks

bonds realestate

cash foreignequities

Portfolio

ASSETCLASSES

asset class mix

realizedreturn

and riskwith thepassageof time

investment results

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A strategy of passive management is one in which, once established, the portfolio is largely left alone.

An active management policy, in contrast, is one in which the composition of the portfolio is dynamic.

Structuring a Stock Portfolio : Active vs. Passive Management

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Portfolio managers often fail to outperform a passive buy and hold strategy.

When tested statistically, trading systems also do not have a good long-term batting average.

What’s Wrong with Buy and Hold ?

With a passive buy and hold strategy(a naive strategy), investors simply select their investments and hang on to them.

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Trading fees : Historically, stock commissions are a function of the number of shares and the dollar amount involved.

Even relatively simple portfolio revisions take up management time.

Selling securities can involve tax implications.

Window dressing refers to largely cosmetic portfolio changes made near the end of a reporting period.

The Costs of Revision

There are costs to revising a portfolio.

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Rebalancing a portfolio is the process of periodically adjusting the portfolio so that certain original conditions of the portfolio are maintained.

In a constant proportion portfolio, adjustments are made so as to maintain the relative weighting of the portfolio components as their price change.

A constant beta rebalancing scheme seeks to maintain beta at a prespecified level. This method is not commonly used now.

Portfolio Rebalancing

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Indexing : Some funds seek to mirror the performance of a market index such as the S&P 500 or the Dow Jones Industrial Average.

Dollar cost averaging : The idea is to invest a fixed amount on a regular interval into the same security, regardless of current market conditions.

Portfolio Rebalancing

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Portfolio Rebalancing

nsobservatio of number =

timeat paid price = where

mean harmonic

N

iP

PN

i

N

i i

1

111

The context of dollar cost averaging is one of the few times in finance when the harmonic mean is useful. The harmonic mean considers reciprocals of values rather than the values themselves.

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Option overwriting refers to the creation and sale of stock options in conjunction with a stock portfolio.

The most common purpose is to generate additional portfolio income.

The second motivation for writing options is to permit the purchase or sale of stock at a better-than-market price.

Overwriting

When investors write call options against stock they already own, the call is said to be covered.

Writing Options to Generate Income

Initial XYZ stock price = $116$120 call premium = $6

Stock price at option

expiration

Profit

Loss

10

0

-110

120110

maximum loss = $110

maximum gain = $10

breakeven point = $110

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Improving on the market involves writing deep-in-the-money put or call options that have “substantial” intrinsic value.

Selling stock: Current XYZ stock price = $116 Write $100 call premium @ $18 If option is exercised, total income = $100 + $18 = $118 > income without overwriting = $116

Overwriting : Improving on the Market

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Overwriting : Improving on the Market

Buying stock: Current Intel stock price = $67 Write $75 put premium @ $9 If option is exercised, total cost = $75 - $9 = $66 < cost without overwriting = $67

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Deep-in-the-money options can be used to improve a buying or selling price at the cost of a slight increase in risk.

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Portfolio protection basically involves adding adding components to a portfolio such that a floor value is established below which the value of the portfolio will not fall.

Writing covered calls provide downside protection up to the amount of the premium.

If an investor owns shares of a particular stock (long stock position) and buys a put on that same stock (long put position), the put is called a protective put.

Portfolio Protection

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Using index options : An index put can protect a diversified stock portfolio against a market downturn. If market prices decline, a gain on the puts can largely offset the losses on the stock portfolio.

Using index futures contracts : A short futures position can help offset a long stock position. If the market falls, a gain in the futures market can largely offset the loss on the stock portfolio, and vice versa if the market rises.

Portfolio Protection

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Review

Structuring a Stock Portfolio The Portfolio Objective Asset Allocation Active vs. Passive Management

Portfolio Rebalancing What’s Wrong with Buy and Hold? The Costs of Revision Constant Proportion Rebalancing Constant Beta Rebalancing Indexing Dollar Cost Averaging

21

Review

Overwriting Writing Options to Generate Income Improving on the Market

Portfolio Protection Writing Covered Calls for Downside Protection Protective Puts Using Index Options Using Index Futures Contracts