Lecture Presentation Software

to accompany

Investment Analysis and

Portfolio Management
Eighth Edition
by
Frank K. Reilly & Keith C. Brown

Chapter 16
 Chapter 16 - 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 16 - 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 16 - 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?
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 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 Comprised of Samples of Less
Than 500 Stocks
Expected Tracking Exhibit 16.2
Error (Percent)
4.0

3.0

2.0

1.0

500 400 300 200 100 0

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
 Anomalies and Attributes
• The Weekend Effect
• The January Effect
• Firm Size
• P/E and P/BV ratios
 Miscellaneous Issues
• Selection of an appropriate benchmark
• Issues pertaining to the benchmark
• Use of computer screening and other
quantitatively based methods of evaluating
stocks
• Factor models
• The “long-short” approach to investing
 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 (large cap, mid cap, small cap)
– Relative value (value, blend, 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
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End of Chapter 16
–Equity Portfolio Management
Strategies
 Future topics
Chapter 17
• Bond Fundamentals