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Portfolio Management

. . Key Terms. Passive managementActive managementBuy and holdChurningConstant beta portfolioConstant mix strategyConstant proportionPortfolio insuranceCrawling stopAsset class appraisalchurning. Dollar cost averagingFloor valueIndexingMultiplierNa

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Portfolio Management

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    1. Portfolio Management CHAPTER 13 Revision of the Equity Portfolio

    2. Key Terms Passive management Active management Buy and hold Churning Constant beta portfolio Constant mix strategy Constant proportion Portfolio insurance Crawling stop Asset class appraisal churning Dollar cost averaging Floor value Indexing Multiplier Nave strategy Rebalancing Tracking error Closet indexing

    3. Portfolio Management Construct according to investment policy Monitor performance Relative to a benchmark Total return Revision according to investment policy Evaluate performance Attribution of returns

    4. Portfolio Revision Strategies Balanced Funds (Debt and Equity) Constant Mix (static strategy) Constant Proportion Portfolio Insurance (reactive strategy) Tactical Asset Allocation (anticipatory strategy) All Equity Portfolios Constant proportion Constant beta

    5. Building Equity Portfolios Active (market timing versus stock picking) versus Passive Approaches (indexing through full replication, sampling or quadratic optimization techniques) Top-Down (tactical/strategic asset allocation) versus the Bottom-up (stock-picking) Approaches Management Styles: value versus growth investing

    6. Passive Management Passive equity portfolio management is a long-term buy and hold strategy. Usually stocks are purchased so the portfolios returns will track those of an index over time.because of the goal of tracking an index, this approach to investing is generally referred to as indexing. Occasional rebalancing is required since dividends must be reinvested and because stocks merge or drop out of the target index and other stocks are added. Notably, the purpose of an indexed portfolio is not to beat the target index, but to match its performance.

    7. Passive Management A manager of an equity index portfolio is judged on how well he or she tracks the target index that is, minimizes the deviation between portfolio and index returns (ie. tracking error) similar to the bond index portfolio manager. Measurement of performance of an index fund manager can be done through regression analysisregress the returns of the portfolio against the returns of the target index. The beta of such a portfolio should be close to 1 and the R2 should be high and the alpha should be close to 0. The closer these regression statistics are to these target values, the better the index fund managers performance.

    8. Passive Management The goal of a passive portfolio is to match the returns to the index as closely as possible. Generally, you would expect an index funds performance to lag the performance of the target index.why? Because of cash inflows and outflows (assumes an open-ended fund where further units are sold and outstanding ones are redeemed) and company mergers and bankruptcies, securities must be bought and sold, which means that there inevitably will be differences between portfolio and benchmark returns over time. In addition, even though index funds generally attempt to minimize turnover and the resultant transactions fees, they necessarily have to do some rebalancing, which means in the long-run return performance of index funds will lag the benchmark index. Certainly, substantial or prolonged deviations of the portfolios returns from the indexs returns would be a cause for concern.

    9. Passive Management Three basic techniques for constructing passive index portfolios: Full replication Sampling Quadratic optimization

    10. Full Replication All securities in the index are purchased in proportion to their weights in the index. Ensures close tracking But may be sub-optimal because: The need to buy many securities will increase transactions costs that will detract from performance The reinvestment of dividends will also result in high commissions when many firms pay small dividends at different times in the year

    11. Sampling Only a representative sample of the stocks that make up the index are purchased Tracking error (is the greatest disadvantage to this approach.) Full replication of the S&P 500 would (in theory) have almost no tracking error. As smaller samples are used to replicate the S&P performance, the potential tracking error increases.

    12. Sampling Technique to Building an Index Portfolio

    13. Quadratic Optimization Rather than obtaining a sample based on industry or security characteristics, quadratic optimization or programming techniques can be used to construct a passive portfolio. With quadratic programming, historical information on price changes and correlations between securities are input to a computer program that determines the composition of a portfolio that will minimize tracking error with the benchmark. A problem with this technique is that it relies on historical price changes and correlations, and if these factors change over time, the portfolio may experience very large tracking errors.

    14. Completeness funds Some passive portfolios are not based on a published index. Sometimes customized passive portfolios, called completeness funds are constructed to complement active portfolios that do not cover the entire market. For example, a large pension fund may allocate some of its holdings to active managers expected to outperform the market. Many times these active portfolios are over-weighted in certain market sectors or stock types. In this case, the pension fund sponsor may want the remaining funds to be invested passively to fill the holes left vacant by the active managers. The performance of completeness funds will be compared to a customized benchmark that incorporates the characteristics of the stocks not covered by the active managers.

    15. Rebalancing Portfolios Constant mix strategy Adjustments are made so as to maintain the relative weighting of the asset classes within the portfolio as their prices change Implication: Purchase securities that have performed poorly and sell those that have performed the best.

    16. Rebalancing Portfolios Constant proportion portfolio insurance $ in stocks = Multiplier (portfolio value floor value) CPPI strategy buys stock as it rises. Does best in a rising market because the portfolio manager will be buying stock in a rising market which is logically a moneymaker. If the market falls, CPPI will gradually revert to 100 percent bonds since stock is sold as the market falls.

    17. Other Rebalancing Issues Trading fees: Commissions Transfer taxes Management time Tax Implications Window Dressing

    18. Key Points in the Chapter An important point in this chapter is the distinction between active and passive management. Portfolios can be rebalanced in various ways. The constant beta, constant proportion, and constant proportion portfolio insurance methods illustrate common ways in which this might be done. Dollar cost averaging is a valuable investment technique for the individual. (see the slide set on this web site.)

    19. Question 13 - 1 There is much to be said in favour of buy-and-hold strategies. Ideally, though, such a strategy is used on purpose rather than because of inattention. To the extent that most portfolios require the periodic reinvestment of dividend and interest income received, the statement is true: the portfolio will routinely be revised as cash accumulates. The portfolio also will periodically encounter mergers, tender offers, and rights offerings, and these also have portfolio revision overtones.

    20. Question 13 - 2 Someone who rebalances wants to maintain a portfolio with particular investment characteristics. Whether these characteristics are reasonable or not is another story. The empirical evidence also suggests that managers are not able consistently to time the market or earn a return greater than that associated with the securitys level of risk. In some respects, an active manager does not believe in the efficient market hypothesis.

    21. Question 13 - 3 Commissions must be paid, there may be tax considerations, and it takes time.

    22. Question 13 - 4 A crawling stop provides protection (although incomplete protection in the event of a crash; a stop order activates a market order, and the market price may change quickly) against adverse price movements while leaving open the possibility of further gains. The stop price can be moved behind a rising stock to protect a progressively larger profit.

    23. Question 13 - 5 Ignorance is the primary reason, and stockbrokers seem to forget to recommend them to their customers.

    24. Question 13 - 6 A correlation of .96 is very high. To move closer to 1.00 would be expensive in terms of additional commissions, and probably is not necessary. Still, on a large portfolio, a failure to mimic the market as best as possible might result in unacceptably large deviations in the dollar value of the portfolio from the target value.

    25. Question 15 - 7 If a portfolio states its objective as capital appreciation, it should normally be an equity portfolio. A mutual fund with such an objective probably would not be able to convert completely to cash because of prospectus provisions. Market risk could, however, be reduced via derivative assets such as stock index futures or options.

    26. Question 13 - 8 Probably not, although some people might feel that 15% is too far away from the current price.

    27. Question 13 - 9 This is a debatable point that is routinely argued in courts of law. An important factor is the managers performance; did the unusually high level of turnover result in gains to the customer or only commissions in the brokers pocket?

    28. Question 13 - 10 This is a restrictive covenant. A portfolio might be equally weighted or constant beta, but doing both is more technical. It can be done, but would be expensive in terms of the number of adjustments required.

    29. Question 13 - 11 Most portfolios generate cash because of the receipt of dividends and the occasional tender offer. As the level of cash held increases, the portfolio beta declines because cash has a beta of zero and will water down the risk of the portfolio. If the market value of the equities continues to rise, however, this could offset an increase in the cash proportion.

    30. Question 13 - 12 Security prices will fluctuate. If the market is efficient, though, they will show an appropriate expected return over long term. This means that they should be bought in a period when they perform poorer than their expected return, as they will (on average) make it up in a subsequent period. The converse holds true if they do unusually well.

    31. Problem 13 - 2 The basic approach is to sell some stocks that have appreciated and buy more of those that have declined.

    32. Problem 13 - 3 Portfolio beta = 1.08 = weighted average of the betas of the various stocks that make up the portfolio:

    33. Problem 13 - 3 To bring the portfolio beta back to the target beta of 1.10 could be done by selling low beta securities and buying more of the higher beta securities.

    34. Problem 13 - 4 Cash has a beta of zero. Therefore, selling a proportional amount of every portfolio asset and holding the proceeds in cash will reduce the beta proportionately, too. Solve for X in the following ratio:

    35. Problem 13 - 5 This is a market rise of 100/14000 = .71%. Each security should therefore rise by its beta multiplied by 0.71%

    36. Problem 13 - 7 A. Variance of A = 0.001660 Variance of B = 0.000910 (Note that the variance is of the returns, not of the share price). B. At the end of the period, 121.218 shares would have been accumulated in Fund A. Worth $12,76 apiece, this is a total value of $1,546.74. In Fund B, 122.17 shares would have been accumulated. At $13.08 apiece, this fund value is $1,597.98

    37. Problem 13 - 8 Contributions were made into the funds; if these are not considered, the apparent fund return will be substantially biased upward. A technique for dealing with this issue is discussed in Chapter 19 (Performance Evaluation). Viewed as a two-security portfolio with equal weighting, the return each month is the average of the two individual returns. This produces a portfolio return variance of 0.001118.

    38. Problem 13 - 9 The value of the stocks is $117,380. Unless you know precisely when the dividends are paid you cannot calculate an exact answer. An approximate answer comes from the following logic.

    39. Problem 13 - 9 Note that this figure is approximately half the amount that would have been earned on 4% of the total portfolio value @ 6% for one year. The lower figure reflects the fact that, on average, the dividends are only invested half the year if the dividend payment dates are uniformly spread over the calendar year.

    40. Problem 13 - 10 CFA Guideline Answer: A. The primary characteristics of Constant Mix, Constant Proportion, and Buy and Hold strategies are related to changes in market values follow 1. Constant Mix The constant mix strategy maintains a constant percentage exposure to all asset classes at all levels of wealth. The portfolio must be rebalanced to return to its target mix whenever asset values change significantly. Therefore, assets of one class are purchased when their value falls, while assets of another class are sold when their value rises. This strategy is typical of contrarian investors: More funds are put at risk in the asset class whose values have declined, which implies that the

    41. Problem 13 - 10 ... CFA Guideline Answer: A. The primary characteristics of Constant Mix, Constant Proportion, and Buy and Hold strategies are related to changes in market values follow 1. Constant Mix that the investors risk tolerance is constant. This buy low, sell high strategy supplies liquidity to the markets. Market environment for the best performance. The Constant Mix Strategy will provide the best relative performance when the capital markets are volatile and trendless (alternatively, choppy and featuring mean reversion).

    42. Problem 13 - 10 ... 2. Constant Proportion The Constant Proportion Strategy uses portfolio insurance. Fewer funds are left in the high-risk asset as wealth falls. A floor amount is established, which is invested entirely in low-risk (or risk-free) assets when the market value of the portfolio is equal to the amount of the floor. The remainder of the portfolio is invested in high-risk assets in some multiple of the difference between the floor amount and the market value of the total portfolio. Buying additional high-risk assets is required when their value increases (because portfolio value minus floor amount rises), whereas the sale of high-risk assets is required as their value falls. This liquidity-demanding, trend-following strategy buys the risky asset on strength and sells it on weakness.

    43. Problem 13 - 10 ... 2. Constant Proportion ... Market environment for the best performance. The Constant Proportion Strategy makes sense for investors whose risk tolerance is highly sensitive to changes in wealth. It provides the best relative performance when the markets are in a steady upward or downward trend. 3. Buy and Hold. A Buy and Hold Strategy requires neither purchases nor sales once the original portfolio mix has been implemented. Such a strategy, given the absence of turnover, enjoys the advantage of avoiding postformation transaction costs, requires no asset allocation management (thereby avoiding management fees) and is blind to changes in market levels. Passive investors holding the market mix of

    44. Problem 13 - 10 ... 3. Buy and Hold. A Buy and Hold Strategy requires neither purchases nor sales once the original portfolio mix has been implemented. Such a strategy, given the absence of turnover, enjoys the advantage of avoiding postformation transaction costs, requires no asset allocation management (thereby avoiding management fees) and is blind to changes in market levels. Passive investors holding the market mix of of assets often use this strategy. The strategy implies that investors risk tolerance increases as wealth increases. Market environment for best relative performance. The relative performance of the Buy and Hold Strategy will typically lie between that of the other two alternatives. It enjoys no best relative

    45. Problem 13 - 10 ... 3. Buy and Hold. . Market environment for best relative performance. The relative performance of the Buy and Hold Strategy will typically lie between that of the other two alternatives. It enjoys no best relative performance environment but is a good strategy to follow over long periods in the United States, where the primary long-term trend has been upward. B. Recommendation: Given the boards concern about downside risk, the recommended policy would be the Constant Proportion Strategy, with the Buy and Hold as a second choice. The Constant Mix Strategy provides the best performance only if the capital markets are volatile and trendless. It provides less of what the board considers important,

    46. Problem 13 - 10 ... B. Recommendation: Given the boards concern about downside risk, the recommended policy would be the Constant Proportion Strategy, with the Buy and Hold as a second choice. The Constant Mix Strategy provides the best performance only if the capital markets are volatile and trendless. It provides less of what the board considers important, namely, downside protection, than either of the other two strategies. Justification: If opportunity exists to rebalance on a timely basis, the Constant Proportion (portfolio insurance) Strategy provides the best downside protection. If that assumption is not made, the Buy and Hold Strategy can be recommended. The Buy and Hold Strategy typically performs between the other two (which make opposite bets on the volatility and trend of the market) and will do well when markets

    47. Problem 13 - 10 ... B. Justification: volatility and trend of the market) and will do well when markets follow a long-term , generally upward trend. Because the Buy and Hold Strategy is a relatively costless strategy to operate, the absence of turnover will positively affect the results over time. A secondary reason for considering the Constant Proportion Strategy is that its popularity has waned since the 1987 stock market crash, when the required transactions could not be affected in a timely manner. It may offer a mispricing benefit because of the supply/demand imbalance relative to the Constant Mix Strategy (a portfolio insurance seller).

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