This chapter discusses equity portfolio management strategies, including passive and active approaches. For passive strategies, the goal is to match the return of a benchmark index through techniques like full replication, sampling, or quadratic optimization. Index funds and ETFs are common passive vehicles. Active strategies aim to outperform the benchmark through stock picking, market timing, or other techniques. Fundamental strategies include top-down or bottom-up approaches, while technical strategies use past price or earnings trends. Managers also employ value or growth styles and perform asset allocation using integrated, strategic, tactical, or insured approaches. The key is determining whether active managers can consistently achieve superior risk-adjusted returns compared to their expected performance benchmark.

1. Chapter Four
Equity Portfolio
Management Strategies

2. Equity Portfolio Management Strategies
After you read this chapter, you should be able to answer the
following questions:
➤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?
➤What is the difference between an index mutual fund and
an exchange-traded fund?

3. Equity Portfolio Management Strategies
 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?
➤What techniques are used by active managers in an attempt to
outperform their benchmark?
➤What are the differences between the integrated, strategic,
tactical, and insured approaches to asset allocation?
➤How can futures and options be used to help manage an
equity portfolio?

4. • An Overview
• Passive Equity Portfolio Management Strategies
• Active Equity Portfolio Management Strategies
• Investment Styles
• Asset Allocation Strategies
Equity Portfolio Management
Strategies

5. Passive versus Active Management
• Total Portfolio Return
– The total actual return on any equity portfolio can
be decomposed into:
Expected return
Alpha
– The Equation
Total Actual Return
=[Expected Return] + [“Alpha”]
=[Risk-Free Rate + Risk Premium]+[“Alpha”]

6. 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
– is an attempt by the manager to outperform, on a risk-
adjusted basis, a passive benchmark portfolio.
– Attempts to outperform a passive benchmark portfolio
on a risk-adjusted basis by seeking the “alpha” value

7. When deciding whether to follow an active or a passive strategy an investor must assess
the trade-off between the low-cost but less-exciting alternative of indexing versus the
higher-cost but potentially more lucrative alternative of active management.

8. An Overview of Passive Strategies
• Attempts to design a portfolio to replicate the
performance of a specific index- to replicate the
performance of an index
A passive manager earns his or her fee by constructing
a portfolio that closely tracks the performance of a
specified equity index (referred to as the benchmark
index) that meets the client’s needs and objectives.
If the manager attempts to outperform the index
selected, he or she violates the passive premise of
the portfolio.
• May slightly underperform the target index due to fees
and commissions

9. Passive Strategies
• Strong rationale for this approach
–Strong evidence indicates that the stock
market is fairly efficient.
– Costs of active management (1 to 2 percent) are
hard to overcome in risk-adjusted performance
– the S&P 500 index typically outperforms most
equity mutual funds on an annual basis.
• Many different market indexes are used for
tracking portfolios
–S&P 500 Index, NASDAQ Composite Index
15-9

10. Index Portfolio Construction Techniques
• Full Replication
–All securities in the index are purchased in
proportion to weights in the index
–This helps ensure close tracking but it may be
suboptimal for two reasons
– First, the need to buy many securities will increase
transaction costs that will detract from performance.
Second, the reinvestment of dividends will also
result in high commissions when many firms pay
small dividends at different times in the year.

11. Index Portfolio Construction
Techniques
• 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 as will
full replication, so there will be some
tracking error

12. Index Portfolio Construction Techniques
• 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
– Relies on historical correlations, which may
change over time, leading to failure to track the
index

13. Tracking Error and Index Portfolio
Construction
• The goal of the passive manager should be to minimize
the portfolio’s return volatility relative to the index, i.e.,
to minimize tracking error
• Tracking Error Measure
– Return differential in time period t
Δt =Rpt – Rbt
Where Rpt= return to the managed portfolio in Period t
Rbt= return to the benchmark portfolio in Period t
– Tracking error is measured as the standard deviation
of Δt , normally annualized (TE)
– See Exhibit 4.2

14. Exhibit 4.1
15-14

15. Methods of Index Portfolio Investing
• Index Funds(mutual funds)
– In an indexed portfolio, the fund manager will typically
attempt to replicate the composition of the particular
index exactly
– The fund manager will buy the exact securities
comprising the index in their exact weights
– Change those positions anytime the composition of the
index itself is changed
– Low trading and management expense ratios
– The advantage of index mutual funds is that they
provide an inexpensive way for investors to acquire a
diversified portfolio

16. Methods of Index Portfolio Investing
• Exchange-Traded Funds (ETF)
– ETFs 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
– A significant advantage of ETFs over index mutual
funds is that they can be bought and sold (and short
sold) like common stock
– The notable example of ETFs
• Standard & Poor’s 500 Depository Receipts(SPDRs)
• iShares
• Sector ETFs

17. Summary: Passive management
•Objective
•Match the return of a benchmark
•Approach
•Replicate the benchmark
•Techniques
•Full replication
•Issues: Transaction costs
•Sampling
•Issues: Tracking error
•Quadratic optimization
•Issues: Programming
•Completeness funds
•Issues: Special benchmark to complement
active portfolio management

18. An Overview of Active 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
–Portfolio return > Benchmark return + transaction costs
–Need to select an appropriate benchmark
• Practical difficulties of active manager
– Transactions costs must be offset by superior
performance vis-à-vis the benchmark
– Higher risk-taking can also increase needed
performance to beat the benchmark
• See Exhibits 4.2 and 4.3

19. Exhibit4.2

20. Exhibit 4.3

21. Fundamental Strategies
• Top-Down versus Bottom-Up Approaches
– Top-Down
 Broad country and asset class allocations
 Sector allocation decisions
 Individual securities selection
– Bottom-Up
 Emphasizes the selection of securities without any
initial market or sector analysis
 Form a portfolio of equities that can be purchased at
a substantial discount to what his or her valuation
model indicates they are worth

22. Fundamental Strategies
• Three Generic Themes
– Time the equity market by shifting funds into and
out of stocks, bonds, and T-bills depending on
broad market forecasts & risk estimation
– Shift funds among different equity sectors and
industries (e.g., financial stocks, technology stocks)
or among investment styles (e.g., value, growth
large capitalization, small capitalization). This is
basically the sector rotation strategy
– Do stock picking and look at individual issues in an
attempt to find undervalued stocks

23. The Stock Market and the Business Cycle

24. Fundamental Strategies
• The 130/30 Strategy
– Long positions up to 130 percent of the portfolio’s
original capital and short positions up to 30 percent
– The use of the short positions creates the leverage
needed, increasing both risk and expected returns
compared to the fund’s benchmark
– Enable managers to make full use of their
fundamental research to buy stocks they identify as
undervalued as well as short those that are
overvalued

25. Technical Strategies
• Active managers can form equity portfolios on the basis
of past stock price trends by assuming that one of two
things will happen: (1) past stock price trends will
continue in the same direction, or (2) they will reverse
themselves.
• Contrarian Investment Strategy
– The belief that the best time to buy (sell) a stock is when
the majority of other investors are the most bearish
(bullish) about it
– The concept of mean reverting
– The overreaction hypothesis (Exhibit 4.4)
• Price Momentum Strategy
– Focus on the trend of past prices alone and makes
purchase and sale decisions accordingly
– Assume that recent trends in past prices will continue

26. Exhibit 4.4

27. Technical Strategies:
Price Momentum Strategies

28. Anomalies and Attributes
• The price momentum strategies could either be based on
pure price trend analysis or supported by the underlying
economic fundamentals of the company.
• Earnings Momentum Strategy
– Momentum is measured by the difference of actual
EPS to the expected EPS
– Purchases stocks that have accelerating earnings and
sells (or short sells) stocks with disappointing
earnings
– The notion behind this strategy is that, ultimately, a
company’s share price will follow the direction of its
earnings, which is one “bottom line” measure of the
firm’s economic success.

29. Anomalies and Attributes
• Calendar-Related Anomalies
–The Weekend Effect
–The January Effect
• Firm-Specific Attributes
• A more promising approach to active anomaly
investing involves forming portfolios based on
various characteristics of the companies themselves.
• Two such characteristics we have seen to matter in
the stock market are the total capitalization of the
firm’s outstanding equity (i.e., firm size) and the
financial position of the firm,

30. Anomalies and Attributes
Firm Size
P/E and P/BV ratios (Exhibit 4.5)
• Studies came to two general conclusions about these firm
characteristics.
• First, over time, firms with smaller market capitalizations
produce bigger risk-adjusted returns than those with large
market capitalizations.
• Second, over time, firms with lower P/E and P/BV ratios
produce bigger risk-adjusted returns than those with higher
levels of those ratio
• In fact, as we have seen low and high levels of these ratios are
used in practice to define value and growth stocks,
respectively.

31. Exhibit 4.5

32. Value versus Growth
• A growth investor focuses on the current and
future economic “story” of a company, with
less regard to share valuation
• A value investor focuses on share price in
anticipation of a market correction and,
possibly, improving company fundamentals.
• 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

33. 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-oriented investor will:
– Focus on the price component
– Not care much about current earnings
– Assume the P/E ratio is below its natural level

34. Style Analysis
• Construct a portfolio to capture one or more of the
characteristics of equity securities
• Small-cap stocks, low-P/E stocks, etc…
• Value stocks (those that appear to be under-priced
according to various measures)
– Low Price/Book value or Price/Earnings ratios
• Growth stocks (above-average earnings per share
increases)
– High P/E, possibly a price momentum strategy
• See Exhibit 4.6

35. Exhibit 4.6 :Style analysis: Grid style
Value Growth
Small
cap
Large
cap
Wilshire 5000
S&P 5000
Russel midcap
Nasdaq
Russel 2000
Russel 1000
Joe B.
TSE300

36. Exhibit 4.6

37. 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
• Intentional and unintentional style drift

38. Asset Allocation Strategies
• Integrated asset allocation
– Capital market conditions
– Investor’s objectives and constraints
• Selecting an Active Allocation Method
– Perceptions of variability in the client’s objectives
and constraints
– Perceived relationship between the past and future
capital market conditions
– The investor’s needs and capital market conditions
are can be considered constant and can be
considered variable

39. Asset Allocation Strategies
• Strategic asset allocation
–Constant-mix
–Is one in 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

40. 40
Constant Mix Strategy (cont’d)
Example
A portfolio has a market value of $2 million. The investment
policy statement requires a target asset allocation of 60 percent
stock and 30 percent bonds.
The initial portfolio value and the portfolio value after one
quarter are shown on the next slide.

41. 41
Constant Mix Strategy (cont’d)
Example (cont’d)
What dollar amount of stock should the portfolio manager buy
to rebalance this portfolio? What dollar amount of bonds
should he sell?
Date Portfolio Value Actual Allocation Stock Bonds
1 Jan $2,000,000 60%/40% $1,200,000 $800,000
1 Apr $2,500,000 56%/44% $1,400,000 $1,100,000

42. 42
Constant Mix Strategy (cont’d)
Example (cont’d)
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.

43. Asset Allocation Strategies
• Tactical asset allocation
–Mean reversion
–Inherently contrarian
• Insured asset allocation
–Constant proportion (Read!!!!)

44. Annex
Comparison:
Active vs. Passive Equity Portfolio
Management
44

45. Active vs. Passive Equity Portfolio Management
• The “conventional wisdom” held by many investment analysts is that there
is no benefit to active portfolio management because:
– The average active manager does not produce returns that exceed those of
the benchmark
– Active managers have trouble outperforming their peers on a consistent basis
• However, others feel that this is the wrong way to look at the Active vs.
Passive management debate. Instead, investors should focus on ways to:
– Identifying those active managers who are most likely to produce superior
risk-adjusted return performance over time
• This discussion is based on research authored jointly with Van Harlow of
Fidelity Investments titled:
“The Right Answer to the Wrong Question:
Identifying Superior Active Portfolio Management”

46. The Wrong Question
• Stylized Fact:
Most active mutual fund managers cannot outperform the S&P 500 index
on a consistent basis
Beat %
10%
30%
50%
70%
90%
DATE
JAN80 JAN82 JAN84 JAN86 JAN88 JAN90 JAN92 JAN94 JAN96 JAN98 JAN00 JAN02 JAN04

47. Defining Superior Investment Performance
• Over time, the “value added” by a portfolio
manager can be measured by the difference
between the portfolio’s actual return and the
return that the portfolio was expected to
produce.
• This difference is usually referred to as the
portfolio’s alpha.
Alpha = (Actual Return) – (Expected Return)

48. Measuring Expected Portfolio Performance
• In practice, there are three ways commonly used to measure the return that was
expected from a portfolio investment:
– Benchmark Portfolio Return
• Example: S&P 500 or Russell 1000 indexes for a U.S. Large-Cap Blend fund manager
• Pros: Easy to identify; Easy to observe
• Cons: Hypothetical return ignoring taxes, transaction costs, etc.; May not be representative
of actual investment universe; No explicit risk adjustment
– Peer Group Comparison Return
• Example: Median Return to all U.S. Small-Cap Growth funds for a U.S. Small-Cap Growth
fund manager
• Pros: Measures performance relative to manager’s actual competition
• Cons: Difficult to identify precise peer group; “Median manager” may ignore large
dispersion in peer group universe; Universe size disparities across time and fund categories
– Return-Generating Model
• Example: Single Risk-Factor Model (CAPM); Multiple Risk-Factor Model (Fama-French
Three-Factor, Carhart Four-Factor)
• Pros: Calculates expected fund returns based on an explicit estimate of fund risk; Avoids
arbitrary investment style classifications
• Cons: No direct investment typically; Subject to model misspecification and factor
measurement problems; Model estimation error

49. The Wrong Question (Revisited)
• Stylized Fact:
Across all investment styles, the “median manager” cannot produce
positive risk-adjusted returns (i.e., PALPHA using return model)
Monthly Mean PALPHA Value at Percentile (%):
Fund Style # of Obs. 5th 25th Median 75th 95th
% Pos.
Alphas
Overall 19551 -1.56 -0.55 -0.18 0.12 0.79 33.77
LV 2,387 -2.11 -0.57 -0.21 0.07 0.66 23.51
LB 3,377 -1.44 -0.55 -0.22 -0.01 0.38 42.02
LG 3,351 -1.08 -0.38 -0.07 0.17 0.80 30.21
MV 1,413 -2.61 -0.67 -0.23 0.11 0.69 29.10
MB 1,691 -1.86 -0.79 -0.32 0.07 0.64 35.31
MG 3,169 -1.48 -0.63 -0.21 0.19 1.04 32.77
SV 929 -2.02 -0.65 -0.25 0.01 0.57 32.16
SB 1,222 -1.42 -0.59 -0.19 0.12 0.77 48.46
SG 2,012 -1.37 -0.45 -0.02 0.39 1.24 25.62
S&P 500
Index Fund
0.04

50. The Right Answer
• When judging the quality of active fund managers, the important
question is not whether:
– The average fund manager beats the benchmark
– The median manager in a given peer group produces a positive alpha
• The proper question to ask is whether you can select in advance those
managers who can consistently add value on a risk-adjusted basis
– Does superior investment performance persist from one period to the next
and, if so, how can we identify superior managers?

51. Lessons from Prior Research
• Fund performance appears to persist over time
– Original View:
Managers with superior performance in one period are equally likely to produce superior or inferior performance in the next
period
– Current View:
Some evidence does support the notion that investment performance persists from one period to the next
The evidence is particularly strong that it is poor performance that tends to persist (i.e., “icy” hands vs. “hot” hands)
•Security characteristics, return momentum, and fund style appear to influence fund performance
– Security Characteristics:
After controlling for risk, portfolios containing stocks with different market capitalizations, price-earnings ratios, and price-
book ratios produce different returns
Funds with lower portfolio turnover and expense ratios produce superior returns
– Return Momentum:
Funds following return momentum strategies generate short-term performance persistence
When used as a separate risk factor, return momentum “explains” fund performance persistence

52. Lessons from Prior Research (cont.)
• Security characteristics, return momentum, and fund style appear to influence fund performance (cont.)
– Fund Style Definitions:
After controlling for risk, funds with different objectives and style mandates produce different returns
Value funds generally outperform growth funds on a risk-adjusted basis
– Style Investing:
Fund managers make decisions as if they participate in style-oriented return performance “tournaments”
The consistency with which a fund manager executes the portfolio’s investment style mandate affects fund performance, in
both up and down markets
•Active fund managers appear to possess genuine investment skills
– Stock-Picking Skills:
Some fund managers have security selection abilities that add value to investors, even after accounting for fund expenses
A sizeable minority of managers pick stocks well enough to generate superior alphas that persist over time
– Investment Discipline:
Fund managers who control tracking error generate superior performance relative to traditional active managers and passive
portfolios
– Manager Characteristics:
The educational backgrounds of managers systematically influence the risk-adjusted returns of the funds they manage