9. Equity Portfolio Management

BAFI1045Investments

Equity Portfolio Management

Strategies

Slide 2RMIT University Slide 2

Reference

• Reilly, Frank K. and Keith C. Brown, Analysis of Investment and Management Portfolios (9th Edition), Thomson South-Western, 2009. – Chapter 16

• Reasons for investing in a passive portfolio

1. Capital markets are efficient. Ie: current stock prices, absorb & reflect all market information rather quickly

2. There’s an abundance of good analysis, but few superior ones

3. Minimize the cost of research but not necessarily trading costs

4. Generally lower management fees, cost of operation & have lower overall fees to the investors.

Word on equity indices

1. Equity portfolio managers will evaluate their performance against equity benchmark indices.

2. Equity benchmark indices are designed to show how overall stock market or some subsector of the market has performed

For eg: STI index measures performance of Spore equities S&P Global 100 index (rating agency) measures the performance of 100 MNCs. Eg: S&P 500 is a stock market index based on the common stock price of 500 Top

American companies.

3. There are various ways to construct a index. Price weighted –Price of each corporate stock is the only consideration. This every price movement of the stock will have no impact regardless of volume of trade.

RMIT University

Slide 3

• Market value approach/mkt capitalization value = P x # of outstanding shares. have a relatively small shift of a large company will have a big impact on index movements. self corrects for stock splits dividends

3. An index is a mathematical end product. We can use mutual funds or index funds to track an index.

RMIT University Slide 4


Generic Portfolio Management Strategies

Equity-portfolio management styles fall into of two categories

• Passive equity portfolio management– Long-term buy-and-hold strategy– Usually track an index over time

• Occasional rebalancing occur

– Designed to match market performance

• Manager is judged on how well they track the target index


Generic Portfolio Management Strategies- Contd.

• Active equity portfolio management– Attempts to outperform a passive

benchmark portfolio on a risk-adjusted basis• Benchmark Portfolio?

–One whose characteristics match the risk-return objectives of the client and serves as a basis for evaluating the performance of an active manager


Passive Equity Portfolio Management Strategies

• Passive equity portfolio management attempt to replicate the performance of an index– May slightly under-perform the target index due to

fees and commissions– Strong rationale for this approach as the cost of

active management (1 to 2 percent) are hard to overcome in risk-adjusted performance

• Many different market indices are used for tracking portfolios– “Customised” passive portfolios (completeness

funds) constructed to complement active portfolios that do not cover entire market.



• Not a simple process to track a market index closely

• Three (3) basic techniques for constructing a passive index portfolio:– Full replication

– Sampling

– Quadratic optimization or programming



• Full Replication– All securities in the index are purchased in All securities in the index are purchased in

proportion to weights in the indexproportion to weights in the index– Technique helps ensure close trackingTechnique helps ensure close tracking

• Drawbacks– Increases transaction costs, particularly with

dividend reinvestment


Sampling

• Buy representative sample of stocks in the benchmark index

– Stocks with larger index weights bought according to their weight in the index

– Smaller issues bought so that aggregate characteristics approximate the rest of underlying benchmark


Sampling – Contd.• Fewer stocks means proportionally

lower commissions• Reinvestment of dividends is less

difficult• Portfolio returns 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 (trade-off)

Slide 12

Tracking Error and Index Portfolio Construction

• The goal of the passive manager should be to minimize the portfolio’s return volatility relative to the index, i.e., to minimize tracking error

• Tracking Error Measure– Return differential in time period t

Δt = Rpt – Rbt

where Rpt= return to the managed portfolio in Period t

Rbt= return to the benchmark portfolio in Period t

– Tracking error is measured as the standard deviation of Δt , normally annualized (ATE)

RMIT University

Slide 13

Tracking Error Example• You have formed a

portfolio designed to track the STI30 Index.

• Over the last 8 quarters returns and return difference are given as follows

Period Manager Index Difference(∆)1 2.30 2.70 -0.402 -3.60 -4.60 1.003 11.20 10.10 1.104 1.20 2.20 -1.005 1.50 0.40 1.106 3.20 2.80 0.407 8.90 8.10 0.808 -0.80 0.60 -1.40

Average (∆) 0.20STDEV 1.0014ATE 2

Slide 14

Exhibit 16.2

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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

• Drawback– This relies on historical correlations, which

may change over time, leading to failure to track the index

Slide 16

Methods of Index Portfolio Investing• Index Funds

– In an indexed portfolio, the fund manager will typically attempt to replicate the composition of the particular index exactly

– The fund manager will buy the exact securities comprising the index in their exact weights

– Change those positions anytime the composition of the index itself is changed

– Low trading and management expense ratios– The advantage of index mutual funds is that they

provide an inexpensive way for investors to acquire a diversified portfolio

RMIT University

Slide 17

Quote“index funds are worth considering. They match, mirror or

mimic a sharemarket index. With a decade to invest, it makes the most sense as there is plenty of time to ride

out the inevitable market corrections and maximise returns. The beauty of indexing is that there is no risk of picking a dud fund manager who may underperform the

market and the fees for an index fund are much less than those charged by active managers”

John Collett in the Age article “Build a future fund ”

Slide 18

Growth Value

Growth

CFS, CSAM

Value

Perpetual, MBA

Relative Value

LazardGARP

BT, INGNeutral

UBS

Indexed

Vanguard

The Style Universe http://www.vanguard.com.au/personal_investors/

Source: Vanguard Australia

Slide 19

Methods of Index Portfolio Investing• Exchange-Traded Funds (ETF)

– 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

– A significant advantage of ETFs over index mutual funds is that they can be bought and sold (and short sold) like common stock

– The notable example of ETFs• Standard & Poor’s 500 Depository Receipts (SPDRs)• iShares• Sector ETFs

RMIT University

Slide 20

Australian Exchange Traded Funds (ETFs)

• Exchange Traded Funds (ETFs) over Australian indices were launched in 2001

• The current issuers of broad based Australian indexed ETFs are State Street Global Advisers whose ETFs traded under the brand

name SPDRs and Vanguard Investments

The table below lists the ASX code of each domesitc ETF and its respective underlying strategy.

ASX Code Fund Name Underlying Strategy

SFYSPDR S&P/ASX 50 Fund Replicate the performance of the top 50 Australian Shares

STWSPDR S&P/ASX 200 Fund Replicate the performance of the top 200 Australian ` Shares

VAS Vanguard Australian Replicate the performance of the top 300 Shares Index Australian Shares

Slide 21

ETFs

• Watch the following video in class and discuss– http://www.vanguard.com.au/

personal_investors/etfs/etfs_home.cfm

• http://www.nasdaq.com/investing/etfs/


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– Must incorporate average qualities of the client’s portfolio

strategy and risk tolerance

• 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

Slide 23

Fundamental Strategies

• Top-Down versus Bottom-Up Approaches

– Top-Down• Broad country and asset class allocations

• Sector allocation decisions

• Individual securities selection

– Bottom-Up• Emphasizes the selection of securities without any initial

market or sector analysis

• Form a portfolio of equities that can be purchased at a substantial discount to what his or her valuation model indicates they are worth

RMIT University

Slide 24

Fundamental Strategies

• Three Generic Themes– Time the equity market by shifting funds into and out

of stocks, bonds, and T-bills depending on broad market forecasts

– Shift funds among different equity sectors and industries (e.g., financial stocks, technology stocks) or among investment styles (e.g., value, growth large capitalization, small capitalization). This is basically the sector rotation strategy

– Do stock picking and look at individual issues in an attempt to find undervalued stocks

RMIT University

Slide 25

Fundamental Strategies• The 130/30 Strategy

– Long positions up to 130 percent of the portfolio’s original capital and short positions up to 30 percent

– The use of the short positions creates the leverage needed, increasing both risk and expected returns compared to the fund’s benchmark

– Enable managers to make full use of their fundamental research to buy stocks they identify as undervalued as well as short those that are overvalued

RMIT University

Slide 26

Technical Strategies• Contrarian Investment Strategy

– The belief that the best time to buy (sell) a stock is when the majority of other investors are the most bearish (bullish) about it

– The concept of mean reverting– The overreaction hypothesis (Exhibit 16.9)

• Price Momentum Strategy– Focus on the trend of past prices alone and makes

purchase and sale decisions accordingly– Assume that recent trends in past prices will continue

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Slide 27

Exhibit 16.9

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Slide 28

Anomalies and Attributes

• Earnings Momentum Strategy– Momentum is measured by the difference of actual

EPS to the expected EPS– Purchases stocks that have accelerating earnings and

sells (or short sells) stocks with disappointing earnings

• Calendar-Related Anomalies– The Weekend Effect– The January Effect

• Firm-Specific Attributes– Firm Size– P/E and P/BV ratios (Exhibit 16.12)

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Slide 29

Exhibit 16.12

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Slide 30

Tax Efficiency and Active Equity Management

• 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

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Slide 31

Tax Efficiency and Active Equity Management

• Measures of Tax Efficiency– Portfolio Turnover

• Measured as the total dollar value of the securities sold from the portfolio in a year divided by the average dollar value of the assets

– Tax Cost Ratio (%)• The Formula

Tax Cost Ratio = [1 – (1 + TAR)/(1 + PTR)] x 100 where

PTR = pretax return

TAR = tax-adjusted return

• See Exhibit 16.14RMIT University

Slide 32

Exhibit 16.14

RMIT University

Slide 33

Value versus Growth• A growth investor focuses on the current and

future economic “story” of a company, with less regard to share valuation

• A value investor focuses on share price in anticipation of a market correction and, possibly, improving company fundamentals.

• Value stocks generally have offered somewhat higher returns than growth stocks, but this does not occur with much consistency from one investment period to another

RMIT University

Slide 34

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-oriented investor will: – Focus on the price component

– Not care much about current earnings

– Assume the P/E ratio is below its natural level

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Slide 35

Asset Allocation Strategies

• Selecting an Active Allocation Method– Perceptions of variability in the client’s

objectives and constraints – Perceived relationship between the past and

future capital market conditions– The investor’s needs and capital market

conditions are can be considered constant and can be considered variable

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Documents

9. Equity Portfolio Management