Stock-Trak Portfolio Report Write-Up Guidelines You may want to follow the guidelines below for the final report of your Stock-Trak portfolio performance during the quarter. Your report is not expected to exceed four pages excluding any tables and appendices. 1. On the first page, replicate the investment policy statement (IPS) including your asset allocation that you submitted to the instructor. 2. Explain the funds allocation among different assets that you actually choose in your Stock-Trak portfolio. If your actual asset allocation is different from the allocation in your policy statement, explain the rationale for changing your asset allocations. Here you may think of strategic asset allocation and tactical asset allocation strategies that we discussed in chapter 16. 3. Provide your rationale for selecting the particular securities such as stock, mutual funds, ETFs, bonds, bond funds, real estate funds, etc. for your Stock-Trak portfolio. That is, explain why you considered these securities to be the most suitable in meeting your return-risk goals and asset allocations in the investment policy statement. You may use the portfolio investment philosophies and strategies from chapter 16 such as passive strategies, indexing, top-down approach, style-based strategies, asset attributes-based strategies, and technical analysis in your explanation (see chapter 16 and Exhibit 16.6). 4. Compare the performance of your portfolio relative to a relevant benchmark you stated in your policy statement. If you did not list a benchmark in your IPS, you may use a broader well-known benchmark such as S&P 500 or NADAQ composite, or create and use a hybrid benchmark of stock and bond markets (weighted average of the returns of a stock market index and bond market index). 5. Describe what worked and what did not work in your Stok-Trak portfolio? Explain what mistakes you made and what lessons did you learn from the Stock-Trak portfolio simulation? If you would have to redo this portfolio investment with your actual money or money from your investment clients, what you would do differently in managing such real money portfolios? © 2012 Cengage Learning. All Rights Reserved. May not scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Chapter 16: Equity Portfolio Management Strategies 1 ‹#› 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”] 16-2 © 2012 Cengage Learning. All Rights Reserved. May not scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Passive versus Active Management Passive equity portfolio management Long-term buy-and-hold strategy Usually tracks an index ove.

1. Stock-Trak Portfolio Report Write-Up Guidelines
You may want to follow the guidelines below for the final
report of your Stock-Trak portfolio performance during the
quarter. Your report is not expected to exceed four pages
excluding any tables and appendices.
1. On the first page, replicate the investment policy statement
(IPS) including your asset allocation that you submitted to the
instructor.
2. Explain the funds allocation among different assets that you
actually choose in your Stock-Trak portfolio. If your actual
asset allocation is different from the allocation in your policy
statement, explain the rationale for changing your asset
allocations. Here you may think of strategic asset allocation and
tactical asset allocation strategies that we discussed in chapter
16.
3. Provide your rationale for selecting the particular securities
such as stock, mutual funds, ETFs, bonds, bond funds, real
estate funds, etc. for your Stock-Trak portfolio. That is, explain
why you considered these securities to be the most suitable in
meeting your return-risk goals and asset allocations in the
investment policy statement. You may use the portfolio
investment philosophies and strategies from chapter 16 such as
passive strategies, indexing, top-down approach, style-based
strategies, asset attributes-based strategies, and technical
analysis in your explanation (see chapter 16 and Exhibit 16.6).
4. Compare the performance of your portfolio relative to a
relevant benchmark you stated in your policy statement. If you
did not list a benchmark in your IPS, you may use a broader
well-known benchmark such as S&P 500 or NADAQ composite,
or create and use a hybrid benchmark of stock and bond markets
(weighted average of the returns of a stock market index and
bond market index).
5. Describe what worked and what did not work in your Stok-

2. Trak portfolio? Explain what mistakes you made and what
lessons did you learn from the Stock-Trak portfolio simulation?
If you would have to redo this portfolio investment with your
actual money or money from your investment clients, what you
would do differently in managing such real money portfolios?
© 2012 Cengage Learning. All Rights Reserved. May not
scanned, copied or duplicated, or posted to a publicly accessible
website, in whole or in part.
Chapter 16: Equity Portfolio
Management Strategies

3. 1
‹#›
Passive versus Active Management
Total Portfolio Return
The total actual return on any equity portfolio can be
decomposed into:
Expected return
Alpha
The Equation

4. Total Actual Return
=[Expected Return] + [“Alpha”]
=[Risk-Free Rate + Risk Premium]+[“Alpha”]
16-2
© 2012 Cengage Learning. All Rights Reserved. May not
scanned, copied or duplicated, or posted to a publicly accessible
website, in whole or in part.

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 by seeking the “alpha” value
See Exhibit 16.1
16-3
© 2012 Cengage Learning. All Rights Reserved. May not
scanned, copied or duplicated, or posted to a publicly accessible
website, in whole or in part.

6. Exhibit 16.1
© 2012 Cengage Learning. All Rights Reserved. May not
scanned, copied or duplicated, or posted to a publicly accessible
website, in whole or in part.
16-4

7. An Overview of Passive Strategies
Attempt to replicate the performance of an index
May slightly underperform the target index due to fees and
commissions
Strong rationale for this approach
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
S&P 500 Index
NASDAQ Composite Index
16-5
© 2012 Cengage Learning. All Rights Reserved. May not
scanned, copied or duplicated, or posted to a publicly accessible
website, in whole or in part.

8. 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
Increases transaction costs, particularly with dividend

9. reinvestment
16-6
© 2012 Cengage Learning. All Rights Reserved. May not
scanned, copied or duplicated, or posted to a publicly accessible
website, in whole or in part.

10. 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, so there will be some
tracking error
16-7
© 2012 Cengage Learning. All Rights Reserved. May not
scanned, copied or duplicated, or posted to a publicly accessible
website, in whole or in part.

11. 7
‹#›
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
This relies on historical correlations, which may change over
time, leading to failure to track the index
16-8
© 2012 Cengage Learning. All Rights Reserved. May not
scanned, copied or duplicated, or posted to a publicly accessible
website, in whole or in part.

12. 8
‹#›
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

13. 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 16.2
16-9
© 2012 Cengage Learning. All Rights Reserved. May not
scanned, copied or duplicated, or posted to a publicly accessible
website, in whole or in part.

14. 9
‹#›
Exhibit 16.2
© 2012 Cengage Learning. All Rights Reserved. May not
scanned, copied or duplicated, or posted to a publicly accessible
website, in whole or in part.
16-10

15. Methods of Index Portfolio Investing
16-11
Index 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
© 2012 Cengage Learning. All Rights Reserved. May not
scanned, copied or duplicated, or posted to a publicly accessible
website, in whole or in part.

16. Methods of Index Portfolio Investing
16-12
Exchange-Traded Funds (ETF)
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
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

17. Standard & Poor’s 500 Depository Receipts (SPDRs)
iShares
Sector ETFs
© 2012 Cengage Learning. All Rights Reserved. May not
scanned, copied or duplicated, or posted to a publicly accessible
website, in whole or in part.

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
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 16.5 and 16.6
16-13
© 2012 Cengage Learning. All Rights Reserved. May not
scanned, copied or duplicated, or posted to a publicly accessible
website, in whole or in part.

19. Exhibit 16.5
© 2012 Cengage Learning. All Rights Reserved. May not
scanned, copied or duplicated, or posted to a publicly accessible
website, in whole or in part.
16-14

20. Exhibit 16.6
© 2012 Cengage Learning. All Rights Reserved. May not
scanned, copied or duplicated, or posted to a publicly accessible
website, in whole or in part.
16-15

21. 16-16
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
© 2012 Cengage Learning. All Rights Reserved. May not
scanned, copied or duplicated, or posted to a publicly accessible

22. website, in whole or in part.
16

23. ‹#›
16-17
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
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
© 2012 Cengage Learning. All Rights Reserved. May not
scanned, copied or duplicated, or posted to a publicly accessible
website, in whole or in part.

24. 17
‹#›
16-18
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
© 2012 Cengage Learning. All Rights Reserved. May not
scanned, copied or duplicated, or posted to a publicly accessible
website, in whole or in part.

25. Technical Strategies
16-19
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 16.9)

26. 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
© 2012 Cengage Learning. All Rights Reserved. May not
scanned, copied or duplicated, or posted to a publicly accessible
website, in whole or in part.

27. Exhibit 16.9
© 2012 Cengage Learning. All Rights Reserved. May not
scanned, copied or duplicated, or posted to a publicly accessible
website, in whole or in part.
16-20

28. Anomalies and Attributes
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
Calendar-Related Anomalies
The Weekend Effect
The January Effect
Firm-Specific Attributes
Firm Size
P/E and P/BV ratios (Exhibit 16.12)
16-21
© 2012 Cengage Learning. All Rights Reserved. May not
scanned, copied or duplicated, or posted to a publicly accessible
website, in whole or in part.

29. 21
‹#›
Exhibit 16.12
© 2012 Cengage Learning. All Rights Reserved. May not
scanned, copied or duplicated, or posted to a publicly accessible
website, in whole or in part.
16-22

30. Tax Efficiency and Active Equity Management
Active portfolio managers especially need to consider taxes
when deciding whether to sell or hold a stock whose value has
increased
If a security is sold at a profit, capital gains are paid and less in
left in the portfolio to reinvest
A new security (the reinvestment security) needs to have a
superior return sufficient to make up for these taxes
The size of the expected return depends on the expected holding

31. period and the cost basis (and amount of the capital gain) of the
original security
16-23
© 2012 Cengage Learning. All Rights Reserved. May not
scanned, copied or duplicated, or posted to a publicly accessible
website, in whole or in part.

32. 23
‹#›
Tax Efficiency and Active Equity Management
Measures of Tax Efficiency
Portfolio Turnover
Measured as the total dollar value of the securities sold from the
portfolio in a year divided by the average dollar value of the
assets
Tax Cost Ratio (%)
The Formula
Tax Cost Ratio = [1 – (1 + TAR)/(1 + PTR)] x 100
where
PTR = pretax return
TAR = tax-adjusted return
See Exhibit 16.14
16-24
© 2012 Cengage Learning. All Rights Reserved. May not
scanned, copied or duplicated, or posted to a publicly accessible
website, in whole or in part.

33. 24
‹#›
Exhibit 16.14
© 2012 Cengage Learning. All Rights Reserved. May not
scanned, copied or duplicated, or posted to a publicly accessible
website, in whole or in part.
16-25

34. 25
‹#›
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

35. market correction and, possibly, improving company
fundamentals.
Value stocks generally have offered somewhat higher returns
than growth stocks, but this does not occur with much
consistency from one investment period to another
16-26
© 2012 Cengage Learning. All Rights Reserved. May not
scanned, copied or duplicated, or posted to a publicly accessible
website, in whole or in part.

36. 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
16-27
© 2012 Cengage Learning. All Rights Reserved. May not
scanned, copied or duplicated, or posted to a publicly accessible
website, in whole or in part.

37. 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 16.20
16-28
© 2012 Cengage Learning. All Rights Reserved. May not
scanned, copied or duplicated, or posted to a publicly accessible
website, in whole or in part.

38. Exhibit 16.20
© 2012 Cengage Learning. All Rights Reserved. May not
scanned, copied or duplicated, or posted to a publicly accessible
website, in whole or in part.
16-29

39. Does Style Matter?
Choice to align with investment style communicates information
to clients
Determining style is useful in measuring performance relative
to a benchmark

40. 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
16-30
© 2012 Cengage Learning. All Rights Reserved. May not
scanned, copied or duplicated, or posted to a publicly accessible
website, in whole or in part.

41. Asset Allocation Strategies
Integrated asset allocation
Capital market conditions (C1-C3)
Investor’s objectives and constraints (IPS or I1-I3)
Continuous adjustment in asset allocations based on feedback
loops from capital markets and IPS (as in Chap 2)
Strategic asset allocation (long-term asset allocation)
Constant-mix; no feedback loops from capital markets or
investor’s policy statement (IPS)
16-31
© 2012 Cengage Learning. All Rights Reserved. May not
scanned, copied or duplicated, or posted to a publicly accessible
website, in whole or in part.

42. Asset Allocation Strategies (Cont.)
Tactical asset allocation (short-term changes in asset mix)
Mean reversion, inherently contrarian, temp change in capital
market conditions (C1-C3)
Feedback loops from capital markets only; none from IPS
Insured asset allocation (continual adjustments)
IPS change with age and wealth; no change in capital market
conditions (C1-C3) and no feedbacks from C1-C3; feedbacks
only from IPS. Also called Constant Proportion strategy; e.g.,
change the percentage allocation between stocks & T-bill.
© 2012 Cengage Learning. All Rights Reserved. May not
scanned, copied or duplicated, or posted to a publicly accessible
website, in whole or in part.
16-32

43. Asset Allocation Strategies
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

44. The investor’s needs and capital market conditions are can be
considered constant and can be considered variable
16-33
© 2012 Cengage Learning. All Rights Reserved. May not
scanned, copied or duplicated, or posted to a publicly accessible
website, in whole or in part.

45. The Internet Investments Online
http://www.russell.com
http://www.firstquadrant.com
http://www.panagora.com
http://www.wilshire.com
16-34
© 2012 Cengage Learning. All Rights Reserved. May not
scanned, copied or duplicated, or posted to a publicly accessible
website, in whole or in part.

46. 34
‹#›