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  • 1. Lecture Presentation Software to accompany Investment Analysis and Portfolio Management Seventh Edition by Frank K. Reilly & Keith C. Brown Chapter 17
  • 2. 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 portfolio’s tracking error and how is it useful in the construction of a passive equity investment?
  • 3. 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 value-oriented and growth-oriented investment styles?
    • What is style analysis and what does it indicate about a manager’s investment performance?
  • 4. 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?
  • 5. 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
  • 6. 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
  • 7. Index Portfolio Strategy Construction Techniques
    • Full replication
    • Sampling
    • Quadratic optimization or programming
  • 8. 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
  • 9. 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
  • 10. Expected Tracking Error Between the S&P 500 Index and Portfolio Samples of Less Than 500 Stocks Exhibit 17.2 500 400 300 200 100 0 2.0 1.0 3.0 4.0 Expected Tracking Error (Percent) Number of Stocks
  • 11. 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
  • 12. 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
  • 13. 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
  • 14. Fundamental Strategies
    • Top-down versus bottom-up approaches
    • Asset and sector rotation strategies
  • 15. Sector Rotation
    • Position a portfolio to take advantage of the market’s next move
    • Screening can be based on various stock characteristics:
      • Value
      • Growth
      • P/E
      • Capitalization
      • Sensitivity to economic variables
  • 16. Technical Strategies
    • Contrarian investment strategy
    • Price momentum strategy
    • Earnings momentum strategy
  • 17. 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
  • 18. 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
  • 19. 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
  • 20. 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
  • 21. 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
  • 22. Determining Style
    • Style grid:
      • firm size
      • value-growth characteristics
    • Style analysis
      • constrained least squares
  • 23. 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
  • 24. 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
  • 25. 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
  • 26. 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
  • 27. Asset Allocation Strategies
    • Integrated asset allocation
      • capital market conditions
      • investor’s objectives and constraints
    • Strategic asset allocation
      • constant-mix
    • Tactical asset allocation
      • mean reversion
      • inherently contrarian
    • Insured asset allocation
      • constant proportion
  • 28. Asset Allocation Strategies
    • Selecting an allocation method depends on:
      • Perceptions of variability in the client’s objectives and constraints
      • Perceived relationship between the past and future capital market conditions
  • 29. 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 portfolio’s underlying assets reduces the portfolio’s sensitivity to price changes of the asset
    • Options do not have symmetrical impact on returns
  • 30. 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
  • 31. 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
  • 32. Using Derivatives in Active Equity Portfolio Management
    • Modifying systematic risk
    • Modifying unsystematic risk
  • 33. The Internet Investments Online
    • www.russell.com
    • www.firstquadrant.com
    • www.wilshire.com
    • www.fool.com
    • www.dailystocks.com
  • 34.
    • End of Chapter 17
      • Equity Portfolio Management Strategies
  • 35. Future topics Chapter 18
    • Bond Fundamentals