Chapter 17

EQUITY-PORTFOLIO
MANAGEMENT

Chapter 17 Questions
What are the two generic equity portfolio
management styles?
What are three techniques for constructing a
passive index portfolio?
What three generic strategies can active
equity-portfolio managers use?
How does the goal of a passive equityportfolio manager differ from the goal of an
active manager?

Chapter 17 Questions
What investment styles may portfolio
managers follow?
In what ways can investors use
information about a portfolio managers
style?
What skills should a good value
portfolio manager possess? A good
growth portfolio manager?

Chapter 17 Questions
How can futures and options be useful
in managing an equity portfolio?
What strategies can be used to manage
a taxable investors portfolio in a taxefficient way?
What are four asset allocation
strategies?

Generic Portfolio
Management Strategies
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

Passive Equity Portfolio

Management Strategies
Attempt to replicate the performance of an
index

May slightly underperform the target index due to

fees and commissions

Strong rationale for this approach

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

Passive Equity Portfolio

Management Strategies
Not a simple process to track a market
index closely
Three basic techniques:
Full

replication
Sampling
Quadratic optimization or programming

Passive Equity Portfolio

Management Strategies
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

Passive Equity Portfolio

Management Strategies
Sampling
Buys 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

Tracking error will diminish as the number of stocks

grows, but costs will grow (tradeoff)

Passive Equity Portfolio

Management Strategies
Quadratic Optimization
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

Passive Equity Portfolio

Management Strategies
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

Passive Equity Portfolio

Management Strategies
Dollar-cost averaging
Purchasing

fixed dollar investments per

period over time
Prevents buying too many shares at high
prices and too few shares when prices are
low
Often part of a passively managed portfolio
strategy

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

Need to select an appropriate benchmark

Practical difficulties of active manager

Transactions costs must be offset by superior
performance vis--vis the benchmark
Higher risk-taking can also increase needed
performance to beat the benchmark

Active Equity Portfolio

Management Strategies
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, attempt to buy
low and sell high

Active Equity Portfolio

Management Strategies
Global Investing: Three Strategies
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

Active Equity Portfolio

Management Strategies
Sector Rotation
Position a portfolio to take advantage of the
markets next move
Screening can be based on various stock
characteristics:
Value
Growth
P/E
Capitalization

Key is to determine what to rotate into

Active Equity Portfolio

Management Strategies
Style Investing
Construct a portfolio to capture one or more of
the characteristics of equity securities
Small-cap stocks, low-P/E stocks, etc
Value stocks (those that appear to be underpriced according to various measures)

Low Price/Book value or Price/Earnings ratios

Growth stocks (above-average earnings per

share increases)

High P/E, possibly a price momentum strategy

Active Equity Portfolio

Management Strategies
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 fully
diversify a portfolio
Style investing allows control of the total portfolio
to be shared between the investment managers
and a sponsor

Active Equity Portfolio

Management Strategies
Value versus Growth
Growth investing focuses on earnings
and changes in company fundamentals
Value investing focuses on the pricing
of stocks
Over time value stocks have offered
somewhat higher returns than growth
stocks

Active Equity Portfolio

Management Strategies
Expectational Analysis and Value/Growth
Investing
Analysts recommending stocks to a portfolio
manager need to identify and monitor key
assumptions and variables
Value investors focus on one key set of
assumptions and variables while growth
investors focus on another

Such an analysis can help determine timing

strategy for buying/selling

Derivatives in EquityPortfolio Management

The risk of equity portfolios can be modified by
using futures and options derivatives
Selling futures reduces the risk of the investors
net (portfolio with futures) position to changes in
portfolio values

Also offsets positive portfolio value changes

The choice element of options means that they do

not have exact offsetting effects

Positive portfolio price effects remain largely intact, but

the cost of insuring against negative moves increases
by the option premium

Derivatives in EquityPortfolio Management

Derivatives can be
used to offset
expected adverse
changes in an equity
portfolio
Any bad portfolio
movements are
mirrored by gains in
derivative
investments

Derivatives in EquityPortfolio Management

The Use of Futures in Asset Allocation
Allows changing the portfolio allocation quickly to
adjust to forecasts at lower transaction costs
than standard trading
Futures can help maintain an overall balance
(desired asset allocation) in a portfolio
Futures can be used to gain exposure to
international markets
Currency exposure can be managed using
currency futures and options

Derivatives in EquityPortfolio Management

Futures and options can help control cash
inflows and outflows from the portfolio
Inflows purchase index futures or options
when inflows arrive before individual security
investments can be made efficiently
Outflow sell previously purchased futures
contracts rather than individual securities to
meet a large expected cash outflow; less
disruptive to portfolio management

Derivatives in EquityPortfolio Management

The S & P 500 Index Futures Contract
Purchasers fund a margin account

Initial margin requirements are: $6,000 for

speculative buyers and $2,500 for hedging

The value is $250 times the index level

When the contract expires, delivery is made
in cash, not stocks
Margin account is marked to market daily

Maintenance margins $2,500 and $1,500

Derivatives in EquityPortfolio Management

Determining How Many Contracts to Trade to
Hedge a Deposit or Withdrawal
In order to appropriate hedge a portfolio deposit
or withdrawal, the appropriate number of
contracts must be sold
The appropriate number depends on the value of the
cash flow, the value of one futures contract, and the
portfolio beta (the Index has a beta of 1)
Number of Contracts = (Cash Flow/Contract Value) x
Portfolio Beta
Can also adjust the beta

Derivatives in EquityPortfolio Management

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

Derivatives in EquityPortfolio Management

Using Futures in Active Equity Portfolio
Management
Modifying

systematic risk

Investing

in various proportion of the futures

index (where beta equals one and the
underlying portfolio)

Modifying
Using

unsystematic risk

options, the portfolio manager can

increase exposure to desired industries,
sectors, and even individual companies

Derivatives in EquityPortfolio Management

Modifying the Characteristics of an International
Equity Portfolio
International equity positions involve positions
in both securities and currencies
Futures allow modifying each exposure
separately

Can buy or sell currency contracts to change

exposures to fluctuating exchange rate to either:
Take advantage of expected future exchange rate changes
Hedge currency risks and largely remove this exposure

Taxable Portfolios
Outside of tax-exempt accounts such as
IRAs, 401(k)s and 403(b)s, taxes represent a
large expense to manage.
Some implications of taxes:
Portfolio rebalancing to remain on the efficient
frontier triggers capital gains, which may offset
the benefit of the optimized rebalancing itself
Rebalancing for asset allocation purposes likewise
results in tax effects

Taxable Portfolios
Active portfolio managers especially need to
consider taxes when deciding whether to sell
or hold a stock whose value has increased
If a security is sold at a profit, capital gains are paid
and less in left in the portfolio to reinvest
A new security (the reinvestment security) needs to
have a superior return sufficient to make up for
these taxes
The size of the necessary return depends on the
expected holding period and the cost basis (and
amount of the capital gain) of the original security

Taxable Portfolios
Tax-Efficient Investing Strategies
Will

likely become more important to fund

managers, as SEC regulations now require
mutual funds to disclose after-tax returns

Possible tax-efficient strategies:

Employ

a buy-and-hold strategy since

unrealized capital gains are not taxed
Loss harvesting, using tax losses to offset
capital gains on other investments

Taxable Portfolios
Possible tax-efficient strategies:
Use

options to help convert short-term

capital gains into a long-term gain (with
more favorable tax treatment)
Tax-lot accounting for shares, specifying
those with the highest cost basis for sale
For some investors, simply focus on
growth stocks that will provide long-term
gains rather than income from dividends

Taxable Portfolios
Diversifying a Concentrated Portfolio
Context:

An investor has an undiversified

portfolio with one or several securities that
have experienced large price increases
Want to diversify, but the sale of the
asset(s) will generate large capital gain
taxes; what should be done?

Taxable Portfolios
Diversifying a Concentrated Portfolio

Concentrated Portfolio Strategies

Borrow and invest the proceeds in a diversified portfolio
Instead of diversifying the portfolio, reduce its companyspecific risk exposure through a collar strategy a
combination of option purchases
Variable Prepaid Forwards (VPFs), where the investor
receives proceeds in advance of contractual sales of
shares in the future
Completion funds, where shares are sold and the portfolio
is diversified through a completion fund
Charitable strategies, contribution and limited tax for the
charity

Asset Allocation
Strategies
Many portfolios containing equities also
contain other asset categories, so the
management factors are not limited to equities
Four asset allocation strategies:
Integrated asset allocation
Examine capital market conditions and investor
objectives and constraints
Determine the allocation that best serves the
investors needs while incorporating the capital
market forecast

Asset Allocation
Strategies
Strategic asset allocation

Using historical information, generate optimal portfolio

mixes based on returns, risk, and covariances,
adjusting periodically to restore target allocation

Tactical asset allocation

Often a contrarian asset allocation strategy

dependent on expectations

Insured asset allocation

Adjust risk exposure for changing portfolio values;

more value means more ability to absorb losses

Asset Allocation
Strategies
Selecting an allocation method depends
on:
Perceptions

of variability in the clients

objectives and constraints
Perceived relationship between the past
and future capital market conditions