Equity portfolio management strategies Objective

Equity portfolio management strategiesEquity portfolio management strategies

ObjectiveObjective

OutlineOutline

Portfolio management stylePortfolio management style

PassivePassive

Buy and hold strategy, often known as indexing

ActiveActive

Continuos rebalancing

Passive managementPassive management

ObjectiveObjectiveMatch the return of a benchmark

ApproachApproachReplicate the benchmark

TechniquesTechniques

Full replicationIssues: Transaction costs

SamplingIssues: Tracking error

Quadratic optimizationIssues: Programming

Completeness fundsIssues: Special benchmark to complement active portfolio management

Active managementActive management

ObjectiveObjectiveOutperform a passive benchmark portfolio on a risk adjusted basison a risk adjusted basis

Portfolio return > Benchmark return + transaction costs

IssuesIssuesBenchmark

Measuring returns on a risk adjusted basis

Themes in active portfolio managementThemes in active portfolio management

Sector rotation

Value vs. growth

Earnings & price momentum

Factors modelsIdentify stocks that are sensitive to _________factors

Long-short approachScreen & rank; buy the top, sell the bottom

Style analysisStyle analysis

Compare manager’s return to that of different styles of indices

• Grid style• Regression analysis

Style analysis: Grid styleStyle analysis: Grid style

ValueValue GrowthGrowth

Small Small capcap

Large Large capcap

Wilshire 5000Wilshire 5000

S&P 5000S&P 5000

Russel midcapRussel midcap

NasdaqNasdaq

Russel 2000Russel 2000

Russel 1000Russel 1000

Joe B.Joe B.

TSE300TSE300

Style analysis: Regression analysisStyle analysis: Regression analysis

R = b1F1 + b2F2 + ….+ bjFj + …. + e

Where:

R = return on the portfolio under analysis

bj = sensitivity of portfolio to style factor j

Fj = return on a factor j style portfolio

Style analysis: Regression interpretationStyle analysis: Regression interpretation

Look for (bj)s that are large and significant

They reveal which factor style portfolios are similar to the portfolio under analysis

Asset allocation strategiesAsset allocation strategies

Integrated asset allocation

Strategic asset allocation

Tactical asset allocation

Insured asset allocation

Integrated asset allocationIntegrated asset allocation

Evaluate and integrate:

• Capital market conditions• Investor’s objectives & constraints

Integrated asset allocationIntegrated asset allocation

Capital market conditionsCapital market conditions

Investor’s assets, liabilities, and net worth

Investor’s assets, liabilities, and net worth

PredictionsPredictionsPredictionsPredictions

Expected returns, risk, Expected returns, risk, correlationscorrelations

Expected returns, risk, Expected returns, risk, correlationscorrelations

Investor’s risk tolerance Investor’s risk tolerance functionfunction

Investor’s risk tolerance Investor’s risk tolerance functionfunction

Return evaluation & feedbackReturn evaluation & feedbackReturn evaluation & feedbackReturn evaluation & feedback

FeedbackFeedbackFeedbackFeedback

Investor’s objectivesInvestor’s objectivesInvestor’s objectivesInvestor’s objectives

Optimized portfolio: asset allocation & security selectionOptimized portfolio: asset allocation & security selectionOptimized portfolio: asset allocation & security selectionOptimized portfolio: asset allocation & security selection

Strategic asset allocationStrategic asset allocation

Classical optimization: It results in a constant asset allocation mix

Similar to integrated asset allocation, without a feedback loop

Exemplification: • Pension plans

Tactical asset allocationTactical asset allocation

AssumptionAssumption

Mean reversion

Aka. timing the market

It’s a contrarian strategy:

“Buy low, sell high”

Insured asset allocationInsured asset allocation

AssumptionAssumption

Returns & risks constant over time, but investors change

• Switch between equity & cash to accommodate investor’s risk tolerance

• Similar to integrated asset allocation without feedback on the capital market side

Evaluation of portfolio performanceEvaluation of portfolio performance

Requirements of a good portfolio manager:

• Derive no less than averageno less than average returns for a given risk-class (timing & security selection skills)

• Diversify away all non-systematic riskall non-systematic risk

Approaches to measuring performanceApproaches to measuring performance

• Peer-group comparisons• Treynor’s composite measure• Shapre’s measure• Jensen’s measure• Fama’s approach• Attribution analysis• Market timing skills measurement

Peer-group comparisonsPeer-group comparisons

Ranking can be random

Most data tracks funds, not individual portfolio managers

See also textbook

Treynor’s composite measureTreynor’s composite measure

Comparison of risk premium per unit of relative risk

Measure

Ti = (Ri - Rf)/bi

Benchmark

Tm = (Rm - Rf)bm

Issues

• Looks at performance only

• Uses realized returns

Sharpe’s measureSharpe’s measure

Comparison of risk premium per unit of absolute risk

Measure

Si = (Ri - Rf)/si

Benchmark

Sm = (Rm - Rf)sm

Issues

• Looks at performance and diversification


Jensen’s measureJensen’s measure

Measures excess return (above and beyond that required by the market)

(Ri - Rf) = a + (Rm - Rf)bi + e

If a > 0

Portfolio earned more than the required rate

If a < 0

Portfolio earned less than the required rate

Issues


Fama’s approachFama’s approach

Excess return = Portfolio risk + Selectivity

See also textbook

Attribution analysisAttribution analysis

Attribute performance to:

• Selection

• Tactical asset allocation (market timing)

Allocation effect:

[(wp - wb)stocks(Rbstocks - Rb)] + [(wp - wb) bonds(Rbbonds - Rb)] + …

Selection effect:

[wp(Rp - Rb)]stocks + [wp(Rp - Rb)]bonds + …

Attribution analysis: ExemplificationAttribution analysis: Exemplification

Asset class Portfolio weights Benchmark weights DifferenceStock 0.5 0.6 -0.1Bonds 0.38 0.3 0.08Cash 0.12 0.1 0.02





Asset class Portfolio return Benchmark return DifferenceStock 9.7% 8.6% 1.1%Bonds 9.1% 9.2% -0.1%Cash 5.6% 5.4% 0.2%








Portfolio return = (0.5)(9.7%) + (0.38)(9.1%) + (0.12)(5.65) = 8.98%

Benchmark return = (0.6)(8.6%) + (0.3)(9.2%) + (0.1)(5.4) = 8.46%

Allocation effect

(-0.1)(8.6% -8.46%) + (0.08)(9.2%-8.46%) + (0.2)(5.4% - 8.465) = -0.02%

Selection effect

(0.5)(9.7% - 8.6%) + (0.38)(9.1% - 9.2%) + (0.12)(5.6% - 5.4%) = 0.54%

Allocation effect + Selection effect = -0.02% + 0.54% = 8.98% - 8.46%Allocation effect + Selection effect = -0.02% + 0.54% = 8.98% - 8.46%

Attribution analysis: InterpretationAttribution analysis: Interpretation

Manager underperformed benchmark by 0.02% due to deviations from benchmark’s weight

Manager outperformed the benchmark by 0.54%, due to its superior selection skills

Measuring timing skillsMeasuring timing skills

Measure the effectiveness of switching between asset classesHaving perfect timing skills (hindsight 20/20) is equivalent to owning a lookback optionlookback option:

At expiration, it pays the return of the best-performing asset class.

Ri = Rf + max[(Rb- Rf), (Rst- Rf)]

Regression measure:

(Ri - Rf) = a + (Rb- Rf)bib + (Rst - Rf)bist + y max[(Rb- Rf), (Rst- Rf)] + e

a = excess return

y = proportion of the lookback option captured by manager

Factors that affect performance measuresFactors that affect performance measures

Knowing what is the true return generating processAll the above measures are based on CAPM

Finding the real market portfolioChanging the proxy for the market portfolio completely changes the ranking

Accounting for manager’s style

A question of benchmarkA question of benchmark

Portfolio managers have different objectives and styles.

Wee need customized benchmarks.

The making of a good benchmarkThe making of a good benchmark

• Unambiguous• Investable• Measurable• Appropriate: Consistent with manager’s style• Reflective of manager’s current investment opinions• Specified in advance

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Equity portfolio management strategies Objective