Chapter 19

1. Chapter 19 EQUITY-PORTFOLIO MANAGEMENT

2. Chapter 19 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 equity-portfolio manager differ from the goal of an active manager?

3. Chapter 19 Questions • What investment styles may portfolio managers follow? • In what ways can investors use information about a portfolio manager’s style? • What skills should a good value portfolio manager possess? A good growth portfolio manager?

4. Chapter 19 Questions • How can futures and options be useful in managing an equity portfolio? • What strategies can be used to manage a taxable investor’s portfolio in a tax-efficient way?

5. 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

6. 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

7. 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

8. 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

9. Passive Equity Portfolio Management Strategies Sampling • Buy 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)

10. Passive Equity Portfolio Management Strategies Quadratic Optimization or Programming • 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

11. 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

12. 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-à-vis the benchmark • Higher risk-taking can also increase needed performance to beat the benchmark

13. Active Equity Portfolio Management Strategies Global Investing: Different Approaches • 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

14. Active Equity Portfolio Management Strategies Three Strategies • Sector rotation: Shifting funds among different equity sectors and industries • Style investing: Focusing on a particular investment style (large cap/small cap; growth/value) • Stock picking: Looking at individual issues, attempt to buy low and sell high

15. Active Equity Portfolio Management 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 • Key is to determine what to “rotate into”

16. 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 under-priced 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

17. 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

18. 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

19. 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

20. Derivatives in Equity-Portfolio Management • The risk of equity portfolios can be modified by using futures and options derivatives • Selling futures reduces the risk of the investor’s 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

21. Derivatives in Equity-Portfolio 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

22. Derivatives in Equity-Portfolio 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

23. Derivatives in Equity-Portfolio 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

24. Derivatives in Equity-Portfolio 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

25. Derivatives in Equity-Portfolio 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

26. Derivatives in Equity-Portfolio 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

27. Derivatives in Equity-Portfolio 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 unsystematic risk • Using options, the portfolio manager can increase exposure to desired industries, sectors, and even individual companies

28. Derivatives in Equity-Portfolio Management Modifying the Characteristics of a Global 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

29. 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

30. 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 expected return depends on the expected holding period and the cost basis (and amount of the capital gain) of the original security

31. 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

32. 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