Lecture Presentation Software

to accompany

Investment Analysis and

Portfolio Management
Seventh Edition
by

Frank K. Reilly & Keith C. Brown

Chapter 17

Chapter 17 - Equity Portfolio

Management Strategies
Questions to be answered:
What are the two generic equity portfolio management
styles?
What are three techniques for constructing a passive
index portfolio?
How does the goal of a passive equity portfolio
manager differ from the goal of an active manager?
What is a portfolios tracking error and how is it
useful in the construction of a passive equity
investment?

Chapter 17 - Equity Portfolio

Management Strategies
What is the difference between an index mutual
fund and an exchange-traded fund?
What are the three themes that active equity
portfolio managers can use?
What stock characteristics differentiate valueoriented and growth-oriented investment
styles?
What is style analysis and what does it indicate
about a managers investment performance?

Chapter 17 - Equity Portfolio

Management Strategies
What techniques are used by active managers
in an attempt to outperform their benchmark?
What are differences between the integrated,
strategic, tactical, and insured approaches to
asset allocation?
How can futures and options be useful in
managing an equity portfolio?

Passive versus Active Management

Passive equity portfolio management

Long-term buy-and-hold strategy

Usually tracks 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

An Overview of Passive Equity

Portfolio Management Strategies
Replicate the performance of an index
May slightly underperform the target index
due to fees and commissions
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

Index Portfolio Strategy

Construction Techniques
Full replication
Sampling
Quadratic optimization or
programming

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

Sampling
Buys a 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

Expected Tracking Error Between the S&P 500 Index

and Portfolio Samples of Less Than 500 Stocks
Expected Tracking
Error (Percent)

Exhibit 17.2

4.0
3.0
2.0
1.0
500

400

300

200

100

Number of Stocks

Quadratic Optimization
(or programming techniques)
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

Methods of Index Portfolio

Investing
Index Funds
Attempt to replicate a benchmark index

Exchange-Traded Funds
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

An Overview of 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
Practical difficulties of active manager
Transactions costs must be offset
Risk can exceed passive benchmark

Fundamental Strategies
Top-down versus bottom-up approaches
Asset and sector rotation strategies

Sector Rotation
Position a portfolio to take advantage of the markets
next move
Screening can be based on various stock
characteristics:

Value
Growth
P/E
Capitalization
Sensitivity to economic variables

Technical Strategies
Contrarian investment strategy
Price momentum strategy
Earnings momentum strategy

Value versus Growth

Growth stocks will outperform value
stocks for a time and then the
opposite occurs
Over time value stocks have offered
somewhat higher returns than growth
stocks

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 versus Growth

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

Style
Construct a portfolio to capture one or more of
the characteristics of equity securities
Small-capitalization stocks, low-P/E stocks, etc
Value stocks appear to be underpriced
price/book or price/earnings

Growth stocks enjoy above-average earnings per

share increases

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 diversify by
portfolio
Style investing allows control of the total portfolio to be
shared between the investment managers and a sponsor

Determining Style
Style grid:
firm size
value-growth characteristics

Style analysis
constrained least squares

Benchmark Portfolios
Sharpe
T-bills, intermediate-term government bonds,
long-term government bonds, corporate bonds,
mortgage related securities, large-capitalization
value stocks, large-capitalization growth stocks,
medium-capitalization stocks, smallcapitalization stocks, non-U.S. bonds, European
stocks, and Japanese stocks

Benchmark Portfolios
Sharpe
BARRA
Uses portfolios formed around 13 different
security characteristics, including variability in
markets, past firm success, firm size, trading
activity, growth orientation, earnings-to-price
ratio, book-to-price ratio, earnings variability,
financial leverage, foreign income, labor
intensity, yield, and low capitalization

Benchmark Portfolios
Sharpe
BARRA
Ibbotson Associates
simplest style model uses portfolios formed
around five different characteristics: cash (Tbills), large-capitalization growth, smallcapitalization growth, large-capitalization
value, and small-capitalization value

Timing Between Styles

Variations in returns
among mutual funds are
largely attributable to
differences in styles
Different styles tend to
move at different times
in the business cycle

Asset Allocation Strategies

Integrated asset allocation
capital market conditions
investors objectives and constraints

Strategic asset allocation

constant-mix

Tactical asset allocation

mean reversion
inherently contrarian

Insured asset allocation

constant proportion

Asset Allocation Strategies

Selecting an allocation method depends on:
Perceptions of variability in the clients
objectives and constraints
Perceived relationship between the past and
future capital market conditions

Using Futures and Options in

Equity Portfolio Management
Systematic and unsystematic risk of equity
portfolios can be modified by using futures and
options derivatives
Selling futures on the portfolios underlying assets
reduces the portfolios sensitivity to price changes
of the asset
Options do not have symmetrical impact on
returns

The Use of Futures in Asset Allocation

Allows changing the portfolio allocation quickly
to adjust to forecasts at lower transaction costs
Futures can maintain an overall balance in a
portfolio
Futures can gain exposure to international
markets
Currency exposure can be managed using
currency futures and options

Using Derivatives in Passive

Equity Portfolio Management
Futures and options can help control cash inflows
and outflows from the portfolio
Inflows - index contracts allow time to make
investments
Outflows - large planned withdrawal is made by selling
securities, which causes an increase in cash holdings;
futures can counterbalance this until the withdrawal

Options can be sold to reduce weightings in sectors

or individual stocks during rebalancing

Using Derivatives in Active

Equity Portfolio Management
Modifying systematic risk
Modifying unsystematic risk

The Internet
Investments Online
www.russell.com
www.firstquadrant.com
www.wilshire.com
www.fool.com
www.dailystocks.com

End of Chapter 17
Equity Portfolio Management
Strategies

Future topics
Chapter 18
Bond Fundamentals