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16

  1. 1. Passive versus Active Management <ul><li>Passive equity portfolio management </li></ul><ul><ul><li>Long-term buy-and-hold strategy </li></ul></ul><ul><ul><li>Usually tracks an index over time </li></ul></ul><ul><ul><li>Designed to match market performance </li></ul></ul><ul><ul><li>Manager is judged on how well they track the target index </li></ul></ul><ul><li>Active equity portfolio management </li></ul><ul><ul><li>Attempts to outperform a passive benchmark portfolio on a risk-adjusted basis </li></ul></ul>
  2. 2. An Overview of Passive Equity Portfolio Management Strategies <ul><li>Replicate the performance of an index </li></ul><ul><li>May slightly underperform the target index due to fees and commissions </li></ul><ul><li>Costs of active management (1 to 2 percent) are hard to overcome in risk-adjusted performance </li></ul><ul><li>Many different market indexes are used for tracking portfolios </li></ul>
  3. 3. Index Portfolio Construction Techniques <ul><li>Full replication </li></ul><ul><li>Sampling </li></ul><ul><li>Quadratic optimization or programming </li></ul>
  4. 4. Full Replication <ul><li>All securities in the index are purchased in proportion to weights in the index </li></ul><ul><li>This helps ensure close tracking </li></ul><ul><li>Increases transaction costs, particularly with dividend reinvestment </li></ul>
  5. 5. Sampling <ul><li>Buys a representative sample of stocks in the benchmark index according to their weights in the index </li></ul><ul><li>Fewer stocks means lower commissions </li></ul><ul><li>Reinvestment of dividends is less difficult </li></ul><ul><li>Will not track the index as closely, so there will be some tracking error </li></ul>
  6. 6. Expected Tracking Error Between the S&P 500 Index and Portfolio Comprised of Samples of Less Than 500 Stocks Exhibit 16.2 500 400 300 200 100 0 2.0 1.0 3.0 4.0 Expected Tracking Error (Percent) Number of Stocks
  7. 7. Quadratic Optimization (or programming techniques) <ul><li>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 </li></ul><ul><li>This relies on historical correlations, which may change over time, leading to failure to track the index </li></ul>
  8. 8. Methods of Index Portfolio Investing <ul><li>Index Funds </li></ul><ul><ul><li>Attempt to replicate a benchmark index </li></ul></ul><ul><li>Exchange-Traded Funds </li></ul><ul><ul><li>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 </li></ul></ul>
  9. 9. An Overview of Active Equity Portfolio Management Strategies <ul><li>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 </li></ul><ul><li>Practical difficulties of active manager </li></ul><ul><ul><li>Transactions costs must be offset </li></ul></ul><ul><ul><li>Risk can exceed passive benchmark </li></ul></ul>
  10. 10. Fundamental Strategies <ul><li>Top-down versus bottom-up approaches </li></ul><ul><li>Asset and sector rotation strategies </li></ul>
  11. 11. Sector Rotation <ul><li>Position a portfolio to take advantage of the market’s next move </li></ul><ul><li>Screening can be based on various stock characteristics: </li></ul><ul><ul><li>Value </li></ul></ul><ul><ul><li>Growth </li></ul></ul><ul><ul><li>P/E </li></ul></ul><ul><ul><li>Capitalization </li></ul></ul><ul><ul><li>Sensitivity to economic variables </li></ul></ul>
  12. 12. Technical Strategies <ul><li>Contrarian investment strategy </li></ul><ul><li>Price momentum strategy </li></ul><ul><li>Earnings momentum strategy </li></ul>
  13. 13. Anomalies and Attributes <ul><li>The Weekend Effect </li></ul><ul><li>The January Effect </li></ul><ul><li>Firm Size </li></ul><ul><li>P/E and P/BV ratios </li></ul>
  14. 14. Miscellaneous Issues <ul><li>Selection of an appropriate benchmark </li></ul><ul><li>Issues pertaining to the benchmark </li></ul><ul><li>Use of computer screening and other quantitatively based methods of evaluating stocks </li></ul><ul><li>Factor models </li></ul><ul><li>The “long-short” approach to investing </li></ul>
  15. 15. Value versus Growth <ul><li>Growth stocks will outperform value stocks for a time and then the opposite occurs </li></ul><ul><li>Over time value stocks have offered somewhat higher returns than growth stocks </li></ul>
  16. 16. Value versus Growth <ul><li>Growth-oriented investor will: </li></ul><ul><ul><li>focus on EPS and its economic determinants </li></ul></ul><ul><ul><li>look for companies expected to have rapid EPS growth </li></ul></ul><ul><ul><li>assumes constant P/E ratio </li></ul></ul>
  17. 17. Value versus Growth <ul><li>Value-oriented investor will: </li></ul><ul><ul><li>focus on the price component </li></ul></ul><ul><ul><li>not care much about current earnings </li></ul></ul><ul><ul><li>assume the P/E ratio is below its natural level </li></ul></ul>
  18. 18. Style <ul><li>Construct a portfolio to capture one or more of the characteristics of equity securities </li></ul><ul><li>Small-capitalization stocks, low-P/E stocks, etc… </li></ul><ul><li>Value stocks appear to be underpriced </li></ul><ul><ul><li>price/book or price/earnings </li></ul></ul><ul><li>Growth stocks enjoy above-average earnings per share increases </li></ul>
  19. 19. Does Style Matter? <ul><li>Choice to align with investment style communicates information to clients </li></ul><ul><li>Determining style is useful in measuring performance relative to a benchmark </li></ul><ul><li>Style identification allows an investor to diversify by portfolio </li></ul><ul><li>Style investing allows control of the total portfolio to be shared between the investment managers and a sponsor </li></ul>
  20. 20. Determining Style <ul><li>Style grid: </li></ul><ul><ul><li>firm size (large cap, mid cap, small cap) </li></ul></ul><ul><ul><li>Relative value (value, blend, growth) characteristics </li></ul></ul><ul><li>Style analysis </li></ul><ul><ul><li>constrained least squares </li></ul></ul>
  21. 21. Benchmark Portfolios <ul><li>Sharpe </li></ul><ul><ul><li>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 </li></ul></ul>
  22. 22. Benchmark Portfolios <ul><li>Sharpe </li></ul><ul><li>BARRA </li></ul><ul><ul><li>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 </li></ul></ul>
  23. 23. Benchmark Portfolios <ul><li>Sharpe </li></ul><ul><li>BARRA </li></ul><ul><li>Ibbotson Associates </li></ul><ul><ul><li>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 </li></ul></ul>
  24. 24. Timing Between Styles <ul><li>Variations in returns among mutual funds are largely attributable to differences in styles </li></ul><ul><li>Different styles tend to move at different times in the business cycle </li></ul>
  25. 25. Asset Allocation Strategies <ul><li>Integrated asset allocation </li></ul><ul><ul><li>capital market conditions </li></ul></ul><ul><ul><li>investor’s objectives and constraints </li></ul></ul><ul><li>Strategic asset allocation </li></ul><ul><ul><li>constant-mix </li></ul></ul><ul><li>Tactical asset allocation </li></ul><ul><ul><li>mean reversion </li></ul></ul><ul><ul><li>inherently contrarian </li></ul></ul><ul><li>Insured asset allocation </li></ul><ul><ul><li>constant proportion </li></ul></ul>
  26. 26. Asset Allocation Strategies <ul><li>Selecting an allocation method depends on: </li></ul><ul><ul><li>Perceptions of variability in the client’s objectives and constraints </li></ul></ul><ul><ul><li>Perceived relationship between the past and future capital market conditions </li></ul></ul>

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