Lecture Presentation Software to accompany Investment Analysis and Portfolio Management Seventh Edit

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Lecture Presentation Software to
accompanyInvestment Analysis and Portfolio
ManagementSeventh Editionby Frank K. Reilly
Keith C. Brown
Chapter 17
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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

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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

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Index Portfolio Strategy Construction Techniques

• Full replication
• Sampling
• Quadratic optimization or programming

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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

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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

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Expected Tracking Error Between the SP 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
0
Number of Stocks
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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

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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

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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

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Fundamental Strategies

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

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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

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Technical Strategies

• Contrarian investment strategy
• Price momentum strategy
• Earnings momentum strategy

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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

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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

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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

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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

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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

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Determining Style

• Style grid
• firm size
• value-growth characteristics
• Style analysis
• constrained least squares

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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, small-capitalization
  stocks, non-U.S. bonds, European stocks, and
  Japanese stocks

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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

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Benchmark Portfolios

• Sharpe
• BARRA
• Ibbotson Associates
• simplest style model uses portfolios formed
  around five different characteristics cash
  (T-bills), large-capitalization growth,
  small-capitalization growth, large-capitalization
  value, and small-capitalization value

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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

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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

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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

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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

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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

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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

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Using Derivatives in Active Equity Portfolio
Management

• Modifying systematic risk
• Modifying unsystematic risk

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The InternetInvestments Online

• www.russell.com
• www.firstquadrant.com
• www.wilshire.com
• www.fool.com
• www.dailystocks.com