Courses 7, 8

Equity Portfolio Management

An individual can make a difference; a team can make a miracle

- 1980 U.S. Olympic hockey team

THE ROLE OF THE EQUITY PORTFOLIO

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Equities represent a significant source of wealth in the world today As of 30 September 2004: the aggregate market value of the equities in the Morgan Stanley Capital International All Country World Index (MSCI ACWI) was more than $19 trillion nearly 5 percent, equal to a market value of nearly $950 billion, represented emerging markets. U.S. equity typically constitutes about half of the worlds equity. In the U.S., institutional investors hold about 60% of their portfolio in equities. In Europe, the percentage is closer to 20%. ability to be an inflation hedge (bonds are not) nominal returns are positively correlated with inflation equities have comparatively high historical long-term rates of return
in study of 17 countries the long term real rates of return to equities exceeded that of bonds in all countries (see exhibit 2)
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APPROACHES TO EQUITY INVESTMENT

passive management - indexing x active management x semiactive management (enhanced indexing or risk-controlled active management)
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Passive Management
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no attempt to reflect investment expectations through changes in security holdings indexing attempt to match the performance of some benchmark in US alone, more than $1 trillion in institutional indexed equities indexing is passive in the sense that the manager does not try to outperform the index, the execution of indexing requires that the manager buy securities when the securitys weight increases in the index or sell stock when the securitys weight decreases in the index
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Active Management
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principal way historically that investors manage equities

even with growth of indexing, still accounts for overwhelming majority of equity assets managed

seek to outperform benchmark

Semiactive Management
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enhanced indexing or risk-controlled active management

A semiactive manager attempts to earn a higher return than the benchmark while minimizing the risk of deviating from the benchmark.

???
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Investors who believe that an equity market is efficient will usually favor.
Passive strategies are appropriate in a wide variety of markets. When investing in large-cap stocks, indexing is suitable because these markets are usually informationally efficient. In small-cap markets, there may be more mispriced stocks, but the transactions costs of high turnover, active strategies increases. In international equity markets, the foreign investor may lack information that local investors have. In this case, active investing would be futile and the manager would be wise to follow a passive strategy.
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Active return/risk and information ratio

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Active return (alfa) is the portfolios return in excess of the return on the portfolios benchmark. Tracking risk, the annualized standard deviation of active returns, measures active risk (risk relative to the portfolios benchmark) The information ratio equals a portfolios mean active return divided by tracking risk

Indexing, Enhanced Indexing, and Active Approaches: A Comparison

Indexing Expected Active Return Tracking Risk Information Ratio 0% Enhanced Indexing 1% - 2% Active 2% +

<1% 0

1% - 2% 0.75

4% + 0.50
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Passive Equity Investing

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1971 - Wells Fargo 1st indexed portfolio 1973 Wells Fargo has commingled index fund for trust accounts 1976 Wells Fargo combines funds and uses S&P 500 as template for combined portfolio 1981 Wells Fargo has fund to track market outside of S&P 500 1975 Bogle at Vanguard launches 1st broadmarket index fund for retail investors
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Passive Equity Investing

many studies have found that the average active institutional portfolio fails to beat the relevant comparison index after expenses x Advantages of indexed portfolios:
x Low portfolio turnover Low management fees - High tax efficiency Exposure to markets with which an investor may be unfamiliar (e.g., an overseas market)
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Equity Indices
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Three basic index weighting methods:

price-weighted each stock is weighted according to its absolute share price (DJIA, NIKKEI); simply an arithmetic average of the prices of the securities included in the index value-weighted each stock is weighted according to its market cap (CAC40, S&P500, DAX, FTSE100); calculated by summing the total market value (current stock price times the number of shares outstanding) of all the stocks in the index - float-weighted index equal-weighted each stock is weighted equally (Value Line Arithmetic Composite Index); must be periodically 14 rebalanced to maintain equal representation of the

Biases of weighting schemes

PW: biased towards highest priced stocks VW: biased towards the shares of firms with the largest market caps EW: biased towards small firms

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Problem of Benchmark Index Selection

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Example 1

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Passive Equity Portfolio Management Strategies

Not a simple process to track a market index closely x Three basic techniques:
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Full replication Sampling Quadratic optimization or programming

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Passive Equity Portfolio Management Strategies

Full Replication x All securities in the index are purchased in proportion to weights in the index x This helps ensure close tracking x Increases transaction costs, particularly with dividend reinvestment
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Passive Equity Portfolio Management Strategies

Sampling x Buys representative sample of stocks in the benchmark index according to their weights in the index x Fewer stocks means lower commissions x Reinvestment of dividends is less difficult x 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)
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Passive Equity Portfolio Management Strategies

Quadratic Optimization x 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 x This relies on historical correlations, which may change over time, leading to failure to track the index
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Passive Portfolio Construction Methods

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Example 2

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Active Equity Investing

Equity styles:
Value Growth Market-oriented

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Value and Growth Styles

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Value substyles
low P/E contrarian high yield

Growth substyles
consistent growth earnings momentum
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Value style
Value investors focus on the numerator in the P/E or P/B ratio, desiring a low stock price relative to earnings or book value of assets. x The two main justifications for a value strategy are (1) although a firms earnings are depressed now, the earnings will rise in the future as they revert to the mean, and (2) value investors argue that growth investors expose themselves to the risk that earnings and price multiples will contract for high-priced growth stocks.
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Growth style
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Growth investors focus on the denominator in the P/E ratio, searching for firms and industries where high expected earnings growth will drive the stock price up even higher. The risk for growth investors is that the earnings growth does not occur, the price-multiple falls, and stock prices plunge. Growth investors may do better during an economic contraction than during an expansion. In a contraction, there are few firms with growth prospects, so the growth stocks may see their valuations increase. In an expansion, many firms are doing well, so the valuation premiums for growth stocks decline.

market-oriented style
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The term market-oriented investing is used to describe investing that is neither value nor growth. It is sometimes referred to as blend or core investing. Market-oriented investors have portfolios that resemble a broad market average over time. They may sometimes focus on stock prices and other times focus on earnings. The risk for a market-oriented manager is that she must outperform a broad market index or investors will turn to lower cost indexing strategies.

Identifying investment styles

2 techniques for identifying investment styles: x Returns-based style analysis x Holdings-based style analysis
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Returns-based style analysis

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Involves regressing portfolio returns (generally monthly returns) on return series of a set of securities indices. the security indices used should be mutually exclusive, exhaustive, and represent distinct, uncorrelated sources of risk. The coefficient of determination in returns-based style analysis measures the style fit. Returns-based style analysis has the advantage of being a low cost, quick, and consistent method of characterizing an entire portfolio. Its disadvantages are that it may lead to misleading results if misspecified and it may detect style changes slowly. Example 6

Holdings-based style analysis

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Holdings-based style analysis evaluates portfolio characteristics using the following attributes: value or growth, expected earnings growth, earnings volatility, and industry representation. Holdings-based style analysis has the advantage that it can characterize individual securities and will detect style changes more quickly than returnsbased analysis. Its disadvantage is that it subjectively classifies securities, requires more data, and is not consistent with how most managers invest. Example 8 &9

Style box
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A style box is a method of characterizing a portfolio's style. This method is used by Morningstar to characterize mutual funds and stocks. In this approach, a matrix is formed with value/growth characteristics across the top and market cap along the side. Morningstar uses holdings-based style analysis to classify securities. See Exhibit 18 (Style Box for Vanguard Mid-Cap Growth Fund)

Style drift
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Style drift is when a portfolio manager strays from his original, stated style objective. There are two reasons why this can be problematic for an investor. First, the investor will not receive the desired style exposure. This is a concern because value and growth stocks will perform quite differently over time and over the course of business cycles. Second, if a manager starts drifting from the intended style, she may be moving into an area outside her expertise. Example 10 (p.243)

Socially responsible investing (SRI)

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Socially responsible investing (SRI), also known as ethical investing, is the use of ethical, social, or religious concerns to screen investment decisions. The screens can be negative, where the investor refuses to invest in a company they believe is unethical; or positive, where the investor seeks out firms with ethical practices. An example of a negative screen is an investor who avoids tobacco and alcohol stocks. An example of a positive screen would be when the investor seeks firms with good labor and environmental practices.

Socially responsible investing (SRI)

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Most SRI portfolios utilize negative screens, some use both negative and positive screens, and even less use only positive screens. An increasing number of portfolio managers have clients with SRI concerns. A SRI screen may have an effect on a portfolios style. For example, some screens exclude basic industries and energy companies, which typically are value stocks. SRI portfolios thus tend to be tilted towards growth stocks. SRI screens have also been found to have a bias toward small-cap stocks.

Semiactive equity investing

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An enhanced indexing strategy can be executed using either actual stocks or derivative contracts such as equity futures. Using a stock-based enhanced indexing strategy, the manager underweights or overweights index stocks based on beliefs about the stocks prospects. Risk is controlled by monitoring factor risk and industry exposures. The portfolio resembles the index, except where the manager has a specific belief about the value of an index security. Semiactive versus active investing: If the manager does not have an opinion about an index stock in full blown active management, she doesnt hold the stock. If the manager does not have an opinion about an index stock in a stock-based enhanced indexing strategy, she holds the stock at the same level as the benchmark.

Semiactive equity investing

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In a derivatives-based enhanced indexing strategy, the manager obtains an equity exposure through derivatives. A common method of doing so is to equitize cash. Here the manager holds a cash position and a long position in an equity futures contract. The manager can then attempt to generate an excess return by altering the duration of the cash position. If the yield curve is upward sloping, the manager invests longer-term, if she thinks the higher yield is worth it. If, on the other hand, the yield curve is flat, the manager invests in short-duration, fixed income securities, because there would be no reward for investing on the long end. Example 13 (p 252)

The fundamental law of active management

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The fundamental law of active management states that an investors information ratio is a function of his depth of knowledge about individual securities and the number of investment decisions.

The IC is measured by comparing the investors forecasts against actual outcomes. The closer they are, the higher the correlation between them, and the greater the IC. More skillful managers will have a higher IC. Example 12 (p 252)

Managing a portfolio of managers

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The equity investment decision focuses on the tradeoff between active risk and active return. Investors are usually more risk averse when facing active risk than they are when facing total risk. The investor must decide how much active risk he is willing to accept and what the best combination of equity managers is to achieve that active risk while maximizing active return. In the first step in deciding how much equity to allocate to a group of equity managers, the investor will want to maximize the utility of his active return. The utility function for active return is similar to the utility function for expected return. The utility of the active return increases as active return increases, as active risk decreases, and as the investors risk aversion to active risk decreases. Next, given his utility function, the investor needs to investigate the performance characteristics of available equity managers. An efficient frontier analysis is useful here, except instead of using expected return and risk, this efficient frontier plots expected active return and active risk using combinations of available equity managers. P.254 (see example) core satellite

core-satellite
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In a core-satellite approach to managing active equity managers, the investor has a core holding of a passive index and/or an enhanced index that is complemented by a satellite of active manager holdings. The idea behind a core-satellite approach is that active risk is mitigated by the core, while active return is added by the satellites. The core is benchmarked to the asset class benchmark, whereas the satellites are benchmarked to a more specific benchmark.

core-satellite
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To minimize the differences in risk exposures between the portfolio and the benchmark, the investor can use a completeness fund. The completeness fund complements the active portfolio, so that the combined portfolios have a risk exposure similar to the benchmark. The advantage of the completeness fund approach is that the active return from the managers can be maintained, while active risk is minimized. The completeness fund must be rebalanced regularly as the active managers exposures change. The fund can be managed passively or semiactively.

The components of total active return

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true active return = total active return normal portfolio return misfit active return = normal portfolio return investors benchmark return The true active return is "true" in the sense that it measures what the manager earned relative to the correct benchmark. The misfit active return is "misfit" in the sense that it measures that part of the managers return from using a benchmark that is not suited to the managers style.

The components of active risk

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Using these components of return, we can decompose the managers total active risk into the true risk and misfit risk. The total active risk is the volatility of the managers portfolio relative to the investors portfolio.

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Using the true active return and true active risk, we can define an information ratio that better represents the managers skills: true information ratio = true active return / true active risk

the analysis of fee structures for equity managers

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Fees can be charged on an ad valorem basis or based on performance. Ad valorem fees are also referred to as asset under management fees (AUM) and are charged based on the asset value managed and may be on a sliding schedule. A performance-based fee is often charged as a base fee plus some percentage of the alpha. The performance-based fee may also include fee caps and high water marks. A fee cap specifies a maximum performance fee. The intent is to prevent managers from undertaking too much risk to earn higher fees. A high water mark condition requires the manager to compensate for past underperformance before receiving a performance-based fee.