Investment Analysis and

Portfolio Management
Eighth Edition
by
Frank K. Reilly & Keith C.
Brown
 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
valueoriented 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
 Tracking error
• Goal of passive portfolio: replicate
another stock index
• Success not lie in the absolute rate
of return, but in the level of tracking
to the benchmark’s rate of return
• Goal: minimizing the covariance of
portfolio return to the benchmark
(minimizing tracking error)
• Tracking error: is a measure of the
deviation from the benchmark’s rate
of return
 Eg: Over the last 8 quarters
tracking a particular benchmark
Period Manager Index Difference (∆)
1 2.30% 2.70% -0.40%
2 -3.6 -4.6 1
3 11.2 10.1 1.1
4 1.2 2.2 -1
5 1.5 0.4 1.1
6 3.2 2.8 0.4
7 8.9 8.1 0.8
8 -0.8 0.6 -1.4
• The periodic average and standard
deviation of the manager’s return
differential (i.e., “delta”) relative to
the benchmark are:
)

Average   0.4  1.0  ...  0.8  1.4  8  0.2%

  (0.4  0.2) 2  (1.0  0.2) 2  ...  (1.4  0.2) 2  (8  1)  1.0%

Thus, the manager’s annualized tracking error

for this 2-year period is 2.0 percent (=1.0%x√4)
• It’s an inverse relationship between
tracking error of a passive portfolio
to a benchmark and time and money
to create and maintain the portfolio
• The art of managing a passive
portfolio lies in the ability to balance
costs and benefits
– Costs: larger tracking error
– Benefits: easier management, lower
trading commisions
• Expected Tracking Error Between the S&P 500
Index and Portfolio Comprised of Samples of
Less Than 500 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
 Equity portfolio investment
strategies
Passive Management Strategies Active Management Strategies
1. Efficient Market Hypothesis 2. Fundamental Analysis
Buy and hold "Top down" (eg. Asset class rotaion, sector rotation)
Indexing "bottom up" (eg. Stock undervaluation / overvaluation)

3. Technical analysis

Contrarian (eg., overreaction)

Continuation (eg., price momentum)

4. Anomalies and Attributes

Calendar Effects (eg., weekend, January)

Information effects (eg., neglect)

Security characteristics (eg., P/E, P/B, earnings
momentum, firm size)
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
– Based on the belief that the best time to buy is when other
investors are believing that price is going down, and vice versa.
– The investor of this strategy will buy stock when it gets to
bottom and vice versa.
• Price momentum strategy
– Create a portfolio assuming that the past price movement will
continue
– Assume that hot stocks will stay hot and vice versa.
– Buying and selling decisions are made based on this assumption
• Earnings momentum strategy
– Buy and hold the stocks with increasing earnings and sel the
stocks with bad earnings.
– Expect that the stock price will have the same trend as
earnings.
 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
 Tax efficiency and active
equity management
• More transactions=>2 kinds of cost
– Transaction cost => reduce portfolio
return
This cost is shared among the fund’s
investors
– Sell the stock when it’s price’s up
=>capitall gain =>must pay tax
Only those who hold the taxable
accounts worry about this cost
• The people who don’t worry about
tax:
– pension funds
– university endowment funds
– tax-deferred retirement plans
 Portfolio turnover
• An indirect measure of the amount of trading
that could lead to higher tax bill for a taxable
investor
• Portfolio turn over = total dolar value of
securities sold from the portfolio in the year/
average dollar value of asset managed by the
fund
• Good indicator of overall trading activity
• But not necessarily indicate that majority of
those trades generated capital gains. (many
trades were transacted at losses)
 Tax cost ratio
• More direct measure of how well port. manager
balance the capital gains and losses resulting from
their trades
• Compares a fund’s pretax return (PTR)with the
same return adjusted for tax (TAR)
• Ptak (2002): tax cost ratio represents the
percentage of an investor’s assets that are lost to
taxes on a yearly basis due to the trading
strategy employed by the fun manager
• Exhibit 16.14
• Tax efficiency of passive (Vanguard 500 index
fund) and active (MFS) stock funds
Vanguard 500 Index fund MFS research fund
(VFINX) (MFRFX)
Management Approach Passive Active
Expense Ratio 0.18% 1.04%
Portfolio Turnover 12% 73%
5-year Avg. Pretax return 2.21% 3.56%
Tax adjusted return 1.88% 2.1%
Tax cost ratio 0.32% 1.41%
1-year Avg. Pretax return 14.91% 15.46%
Tax adjusted return 14.50% 8.55%
Tax cost ratio 0.36% 5.98%
– Active:
• higher expense ratio (management, operating,
administrative fees),
• higher turnover ratio =>MFRFX more expensive fund,
more stock trading
• Outperform benchmark (greater PTR and TAR)
– Passive:
• higher TAR
• Lower tax cost ratio => more tax efficient
• Little difference between PRT and TAR => little
trading but balanced in creating capital gains and
losses
 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

• value-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

• growth-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, smallcapitalization
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 (Tbills), large-
capitalization growth, smallcapitalization
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
 As developed by Sharp (1992), returns-
based style analysis is simply an
application of an asset class factor model:

Where:
Rpt= the tth period return to the portfoio of Manager p
Fjt=the tth period return to the jth style factor
bpj=the sensitivity of Portfolio p the style factor j
ept=the portion of the return variability in Portfoio p not
explained by variability in the set of factors
 The coefficient of
determination R2

R2: percentage of manager p’s return variability due to the

portfolio’s style
1-R2: percentage of manager p’s return variability due to
manager’s selection skill
 Asset Allocation
Strategies
• Why must consider these strategies?
• Because equity portfolio does not stand in
isolation, it’s part of investor’s overall
investment portfolio
• The manager must determine the
appropriate mix of asset categories in the
entire portfolio
• 4 general strategies for determining the asset mix of a
portfolio (eg. how much in bond and how much in equity)
• Integrated asset allocation

• Strategic asset allocation

– constant-mix
• Tactical asset allocation

• Insured asset allocation

– constant proportion
Integrated asset
allocation
 Strategic asset
allocation
• Used to determine long-term policy asset weights in a
portfolio
• Long term average asset returns, risk and covariances are
used as estimates of future capital market results. =>
generate efficient frontier => decide asset mix
• Result is a constant-mix asset allocation with periodic
rebalancing to adjust the portfolio to the specified asset
weights
• Once this asset mix is established, the manager does not
attempt to adjust the allocation according to temporary
changes in market and investor circumstances
 Tactical asset allocation
• Frequently adjusts the asset class mix in
the portfolio to take advantage of
changing market conditions
• Adjustments are driven solely by
perceived changes in relative values of
various asset classes
• Investment risk tolerance and investment
constraints assumed to be constant over
time
 Insured asset allocation
• Continual adjustments in the portfolio allocation,
– assuming that expected market returns and risks are
constant over time,
– while the investor’s objectives and constraints change as
his wealth position changes.
• Opposite to tactical asset allocation
– As stock price rise, asset allocation increases the stock
component. If falls, stock component of the mix falls
• Alike integrated approach without feed back loop
on the capital market side
• Sometimes called constant proportion strategy
 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