Chapter 13 Revision of the Equity Portfolio

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Chapter 13Revision of the Equity Portfolio
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Outline

• Introduction
• Active management versus passive management
• When do you sell stock?

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Introduction

• Portfolios need maintenance and periodic
  revision
• Because the needs of the beneficiary will change
• Because the relative merits of the portfolio
  components will change
• To keep the portfolio in accordance with the
  investment policy statement and investment
  strategy

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Active Management Versus Passive Management

• Definition
• The managers choices
• Costs of revision
• Contributions to the portfolio

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Definition

• An active management policy is one in which the
  composition of the portfolio is dynamic
• The portfolio manager periodically changes
• The portfolio components or
• The components proportion within the portfolio
• A passive management strategy is one in which the
  portfolio is largely left alone

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The Managers Choices

• Leave the portfolio alone
• Rebalance the portfolio
• Asset allocation and rebalancing within the
  aggregate portfolio
• Change the portfolio components
• Indexing

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Leave the Portfolio Alone

• A buy and hold strategy means that the portfolio
  manager hangs on to its original investments
• Academic research shows that portfolio managers
  often fail to outperform a simple buy and hold
  strategy on a risk-adjusted basis
• E.g., Barber and Odean show that investors who
  trade the most have the lowest gross and net
  returns

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Rebalance the Portfolio

• Rebalancing a portfolio is the process of
  periodically adjusting it to maintain the
  original conditions

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Rebalancing Within the Portfolio

• Constant mix strategy
• Constant proportion portfolio insurance
• Relative performance of constant mix and CPPI
  strategies

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Constant Mix Strategy

• The constant mix strategy
• Is one to which the manager makes adjustments to
  maintain the relative weighting of the asset
  classes within the portfolio as their prices
  change
• Requires the purchase of securities that have
  performed poorly and the sale of securities that
  have performed the best

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Constant Mix Strategy (contd)

• Example
• A portfolio has a market value of 2 million. The
  investment policy statement requires a target
  asset allocation of 60 percent stock and 40
  percent bonds.
• The initial portfolio value and the portfolio
  value after one quarter are shown on the next
  slide.

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Constant Mix Strategy (contd)

• Example (contd)
• What dollar amount of stock should the portfolio
  manager buy to rebalance this portfolio? What
  dollar amount of bonds should he sell?

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Constant Mix Strategy (contd)

• Example (contd)
• Solution a 60/40 asset allocation for a 2.5
  million portfolio means the portfolio should
  contain 1.5 million in stock and 1 million in
  bonds. Thus, the manager should buy 100,000
  worth of stock and sell 100,000 worth of bonds.

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Constant Proportion Portfolio Insurance

• A constant proportion portfolio insurance (CPPI)
  strategy requires the manager to invest a
  percentage of the portfolio in stocks
• in stocks Multiplier x (Portfolio value
  Floor value)

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Constant Proportion Portfolio Insurance (contd)

• Example
• A portfolio has a market value of 2 million. The
  investment policy statement specifies a floor
  value of 1.7 million and a multiplier of 2.
• What is the dollar amount that should be invested
  in stocks according to the CPPI strategy?

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Constant Proportion Portfolio Insurance (contd)

• Example (contd)
• Solution 600,000 should be invested in stock
• in stocks 2.0 x (2,000,000
  1,700,000)
• 600,000
• If the portfolio value is 2.2 million one
  quarter later, with 650,000 in stock, what is
  the desired equity position under the CPPI
  strategy? What is the ending asset mix after
  rebalancing?

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Constant Proportion Portfolio Insurance (contd)

• Example (contd)
• Solution The desired equity position after one
  quarter should be
• in stocks 2.0 x (2,200,000
  1,700,000)
• 1,000,000
• The portfolio manager should move 350,000 into
  stock. The resulting asset mix would be
  1,000,000/2,200,000 45.5

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Relative Performance of Constant Mix and CPPI

• A constant mix strategy sells stock as it rises
• A CPPI strategy buys stock as it rises

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Relative Performance of Constant Mix CPPI
(contd)

• In a rising market, the CPPI strategy outperforms
  constant mix
• In a declining market, the CPPI strategy
  outperforms constant mix
• In a flat market, neither strategy has an obvious
  advantage
• In a volatile market, the constant mix strategy
  outperforms CPPI

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Relative Performance of Constant Mix CPPI
(contd)

• The relative performance of the strategies
  depends on the performance of the market during
  the evaluation period
• In the long run, the market will probably rise,
  which favors CPPI
• In the short run, the market will be volatile,
  which favors constant mix

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Rebalancing Within the Equity Portfolio

• Constant proportion
• Constant beta
• Change the portfolio components
• Indexing

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Constant Proportion

• A constant proportion strategy within an equity
  portfolio requires maintaining the same
  percentage investment in each stock
• May be mitigated by avoidance of odd lot
  transactions
• Constant proportion rebalancing requires selling
  winners and buying losers

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Constant Proportion (contd)

• Example
• A portfolio of three stocks attempts to invest
  approximately one third of funds in each of the
  stocks. Consider the following information

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Constant Proportion (contd)

• Example (contd)
• After one quarter, the portfolio values are as
  shown below. Recommend specific actions to
  rebalance the portfolio in order to maintain the
  constant proportion in each stock.

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Constant Proportion (contd)

• Example (contd)
• Solution The worksheet below shows a possible
  revision which requires an additional investment
  of 1,000

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Constant Beta Portfolio

• A constant beta portfolio requires maintaining
  the same portfolio beta
• To increase or reduce the portfolio beta, the
  portfolio manager can
• Reduce or increase the amount of cash in the
  portfolio
• Purchase stocks with higher or lower betas than
  the target figure
• Sell high- or low-beta stocks
• Buy high- or low-beta stocks

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Change the Portfolio Components

• Changing the portfolio components is another
  portfolio revision alternative
• Events sometimes deviate from what the manager
  expects
• The manager might sell an investment turned sour
• The manager might purchase a potentially
  undervalued replacement security

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Indexing

• Indexing is a form of portfolio management that
  attempts to mirror the performance of a market
  index
• E.g., the SP 500 or the DJIA
• Index funds eliminate concerns about
  outperforming the market
• The tracking error refers to the extent to which
  a portfolio deviates from its intended behavior

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Tactical Asset Allocation

• What Is Tactical Asset Allocation?
• How TAA Can Benefit a Portfolio
• Designing a TAA Program
• Caveats Regarding TAA Performance
• Costs of Revision
• Contributions to the Portfolio

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What Is Tactical Asset Allocation?

• Definition
• Intuitive versus Quantitative Techniques
• Overview of the Technique
• Policy Decisions
• Strategy

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Definition

• Tactical asset allocation (TAA) managers
• Seek to improve the performance of their funds by
  shifting the relative proportion of their
  investments into and out of asset classes as the
  relative prospects of those asset classes change
• For example, shift to stocks if stocks are
  expected to outperform bonds

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Definition (contd)

• TAA attempts to take advantage of short-term
  deviations from long-term trends
• The most difficult part of TAA is asset class
  appraisal
• The process of determining the relative merits of
  the various asset classes given current economic
  conditions

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Intuitive versus Quantitative Techniques

• In the intuitive approach, decisions are based on
  personal opinion and gut feeling
• Suffers from hindsight bias
• Portfolio managers remember the times they were
  correct

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Intuitive versus Quantitative Techniques (contd)

• In the quantitative approach, managers use an
  analytical assessment and a system for
  implementing precise portfolio changes
• e.g., use the gap between the SP 500 dividend
  yield and the average yield on AAA corporate bonds

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Overview of the Technique
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Policy Decisions

• Policy decisions involve
• Deciding to use a TAA program in the first place
• Establishing the extent to which the program will
  be employed
• Determining the number of asset classes to employ

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Strategy

• There are three alternative strategic functions
• Static strategy maintains a static portfolio mix
• Reactive strategy involves decisions based on
  events that have already occurred
• Anticipatory strategy involves shifting funds
  before the markets move

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How TAA Can Benefit a Portfolio

• The goal of an anticipatory strategy is to
  outperform the portfolio without TAA
• The potential gains to a clairvoyant manager from
  TAA are enormous (see next slide)
• The portfolio manager must assess return within a
  risk/return framework

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How TAA Can Benefit a Portfolio (contd)
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Designing a TAA Program

• Before implementing a TAA program, a fund manager
  must establish
• The normal mix
• The benchmark proportion each asset class
  constitutes in the portfolio
• The mix (exposure) range
• Specifies how much the current mix can deviate
  from the normal mix

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Designing a TAA Program (contd)

• Before implementing a TAA program, a fund manager
  must establish (contd)
• The swing component
• The percentage of the total portfolio whose
  composition by asset class may change
• The key element of TAA is properly investing the
  swing component

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Caveats Regarding TAA Performance

• Efficient Market Implications
• Impact of Transaction Costs

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Efficient Market Implications

• TAA programs implicitly assume it is possible to
  outperform a buy-and-hold strategy by shifting
  asset classes
• Inconsistent with the efficient market hypothesis
• Some fund managers have good records with TAA
  programs
• Might be skill or luck

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Impact of Transaction Costs

• The portfolio incurs trading fees each time a
  trade occurs
• If the marginal gains from TAA switching do not
  exceed transaction costs, the program is not
  effective

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Costs of Revision

• Introduction
• Trading fees
• Market impact
• Management time
• Tax implications
• Window dressing
• Rising importance of trading fees

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Introduction

• Costs of revising a portfolio can
• Be direct dollar costs
• Result from the consumption of management time
• Stem from tax liabilities
• Result from unnecessary trading activity

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Trading Fees

• Commissions
• Transfer taxes

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Commissions

• Investors pay commissions both to buy and to sell
  shares
• Commissions at a brokerage firm are a function
  of
• The dollar value of the trade
• The number of shares involved in the trade

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Commissions (contd)

• The commission on a trade is split between the
  broker and the firm for which the broker works
• Brokers with a high level of production keep a
  higher percentage than a new broker
• Some brokers discount their commissions with
  their more active clients

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Commissions (contd)

• Discount brokerage firms
• Offer substantially reduce commission rates
• Offer few ancillary services, such as market
  research
• Retail commissions at a full-service firm average
  about 2 percent of the stock value

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Transfer Taxes

• Transfer taxes are
• Imposed by some states on the transfer of
  securities
• Usually very modest
• Not normally a material consideration in the
  portfolio management process

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Market Impact

• The market impact of placing the trade is the
  change in market price purely because of
  executing the trade
• Market impact is a real cost of trading
• Market impact is especially pronounced for shares
  with modest daily trading volume

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Management Time

• Most portfolio managers handle more than one
  account
• Rebalancing several dozen portfolios is time
  consuming

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Tax Implications

• Individual investors and corporate clients must
  pay taxes on the realized capital gains
  associated with the sale of a security
• Tax implications are usually not a concern for
  tax-exempt organizations

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Window Dressing

• Window dressing refers to cosmetic changes made
  to a portfolio near the end of a reporting period
• Portfolio managers may sell losing stocks at the
  end of the period to avoid showing them on their
  fund balance sheets

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Rising Importance of Trading Fees

• Flippancy regarding commission costs is unethical
  and sometimes illegal
• Trading fees are receiving increased attention
  because of
• Investment banking scandals
• Lawsuits regarding churning
• Incomplete prospectus information

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Contributions to the Portfolio

• Periodic additional contributions to the
  portfolio from internal or external sources must
  be invested
• Dividends
• May be automatically reinvested by the fund
  managers broker
• May have to be invested in a money market account
  by the fund manager

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When Do You Sell Stock?

• Introduction
• Rebalancing
• Upgrading
• Sale of stock via stop orders
• Extraordinary events
• Final thoughts

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Introduction

• Knowing when to sell a stock is a very difficult
  part of investing
• Behavioral evidence suggests the typical investor
  sells winners too soon and keeps losers too long

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Rebalancing

• Rebalancing can cause the portfolio manager to
  sell shares even if they are not doing poorly
• Profit taking with winners is a logical
  consequence of portfolio rebalancing

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Upgrading

• Investors should sell shares when their
  investment potential has deteriorated to the
  extent that they no longer merit a place in the
  portfolio
• It is difficult to take a loss, but it is worse
  to let the losses grow

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Sale of Stock Via Stop Orders

• Definition
• Using stops to minimize losses
• Using stops to protect profits

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Definition

• Stop orders
• Are sell stops
• Become a market order to sell a set number of
  shares if shares trade at the stop price
• Can be used to minimize losses or to protect a
  profit

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Using Stops to Minimize Losses

• Stop-loss orders can be used to minimize losses
• E.g., you bought a share for 23 and want to sell
  it if it falls below 18
• Place a stop-loss order for 18

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Using Stops to Protect Profits

• Stop orders can be used to protect profits
• E.g., a stock you bought for 33 now trades for
  48 and you want to protect the profits at 45
• If the stock retreats to 45, you lock in the
  profit if you place a stop order
• If the stock continues to increase, you can use a
  crawling stop to increase the stop price

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Extraordinary Events

• Change in client objectives
• Change in market conditions
• Buy-outs
• Caprice

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Change in Client Objectives

• The clients investment objectives may change
  occasionally
• E.g., a church needs to generate funds for a
  renovation and changes the objective for the
  endowment fund from growth of income to income
• Reduce the equity component of the portfolio

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Change in Market Conditions

• Many fund managers seek to actively time the
  market
• When a portfolio managers outlook becomes
  bearish, he may reduce his equity holdings

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Buy-Outs

• A firm may be making a tender offer for one of
  the funds holdings
• I.e., another firm wants to acquire the fund
  holding
• It is generally in the clients best interest to
  sell the stock to the potential acquirer

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Caprice

• Portfolio managers
• Should be careful about making unnecessary trades
• Must pay attention to their experience,
  intuition, and professional judgment
• An experienced portfolio manager worried about a
  particular holding should probably make a change

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Final Thoughts

• Hindsight is an inappropriate perspective for
  investment decision making
• Everything you do as a portfolio manager must be
  logically justifiable at the time you do it
• Portfolio managers are torn between minimizing
  losses and the potential for price appreciation