Equity Portfolio Management

Role of the Equity Portfolio

significant source of wealth today equities constitute differing proportions of

average portfolio weights in different countries one characteristic important to investors across

markets is ability to be an inflation hedge equities have comparatively high historical long-term

rates of return in study of 17 countries the long term real rates of

return to equities exceeded that of bonds in all countries

Equity Investment

passive management active management semiactive management

Passive Management

no attempt to reflect investment expectations through changes in security holdings

indexingattempt to match the performance of some

benchmark in US alone, more than $1 trillion in

institutional indexed equities

Active Management

principle way historically that investors manage equitieseven with growth of indexing, still accounts for

overwhelming majority of equity assets managed

seek to outperform benchmark

Semiactive Management

enhanced indexing or risk-controlled active managementseek to outperform benchmark but manager

worries more about tracking risk than active manager and builds portfolio that will have limited volatility around benchmark’s return

Indexing, Enhanced Indexing, and Active Approaches: A Comparison

Indexing Enhanced Indexing

Active

Expected Active Return

0% 1% - 2% 2% +

Tracking Risk

<1% 1% - 2% 4% +

Information Ratio

0 0.75 0.50

Passive Equity Investing

1971 - Wells Fargo 1st indexed portfolio 1973 – Wells Fargo has commingled index fund

for trust accounts 1976 – Wells Fargo combines funds and uses

S&P 500 as template for combined portfolio 1981 – Wells Fargo has fund to track market

outside of S&P 500 1975 – Bogle at Vanguard launches 1st broad-

market index fund for retail investors

Indexing

many studies have found that the average active institutional portfolio fails to beat the relevant comparison index after expenses often difference in performance is found to be close to average

expense disadvantage of active management compared with the average actively managed fund that has

similar objectives, a well-run indexed fund’s major advantage is expected superior long-term net-of-expenses performance because of relatively low

portfolio turnover management fees high tax efficiency

Equity Indices

indexes are portfolio management benchmarks also used

to measure return of a market or market segment

as basis for creating an index fund to study factors that influence share price movements to perform technical analysis to calculate a stock’s systematic risk

Equity Indices

characteristics of indexboundaries of index’s universecriteria for inclusion in the indexhow the stocks are weightedhow returns are calculated

Index Weighting

one of greatest differences among indexes due to how components are weighted price-weighted – each stock is weighted according to its absolute share

price value-weighted – each stock is weighted according to its market cap

float-weighted index equal-weighted – each stock is weighted equally

different weighting schemes can lead to different biases PW biased towards highest price stock VW biased towards the shares of firms with the largest market caps

(likely large and mostly mature firms and possibly overvalued firms) EW biased towards small firms because these indexes have many more

small firms than large firms and it must be rebalanced periodically

Problem of Benchmark Index SelectionStephen Alcorn is a portfolio manager at Amanda Asset Management (AAM). At the end

of 2002, a wealthy client engaged Alcorn to manage $10,000,000 for one year in an active focused equity style. the investment management contract specificed a symmetric incentive fee of $10,000 per 100 bps of capital appreciation relative to that of an index of the stocks slected for investment. (Symmetric means that the incentive fee will reduce the investment management fee if benchmark-relative performance is negative.) In an oversight, the contract leaves open the method by which the benchmark index will be calculated. Alcorn invests in shares of Eastman Kodak, McDonald’s, Intel, Merck, Wal-Mart, and Microsoft achieving a 15.9% price return for the year. The table gives information on the 6 stocks. Using only the information given, address the following:

1. For each of the 6 shares, explain the price-only return calculation on the following indices for the period 12/31/2002 to 12/31/2003:1. PW index2. VW index3. Float-weighted index4. EW index

2. Recommend the appropriate benchmark index for calculating the performance incentive fee on the account and determine the amount of that fee.

Equity Market Data for the Shares of Six Companies

Share price Share price Price MV Shares MV Shares Free Float12/31/2002 12/31/2003 Change 12/31/2002 12/31/2003 Factor

(millions) (millions)Kodak 35.04 24.85 -29.10% 10,056 7,132 1McDonald's 16.08 24.09 49.80% 20,406 30,570 1Intel 15.57 31.36 101.40% 101,703 204,844 1Merck 53.58 45.1 -15.80% 119,216 100,348 1Wal-Mart 50.51 53.05 5.00% 221,992 233,154 0.6Microsoft 25.85 27.37 5.90% 277,060 293,352 0.85Total 750,433 869,400

Passive Investment Vehicles

investment in an indexed portfolio a long position in cash plus a long position

in futures contracts on the underlying index

a long position in cash plus a long position in a swap on the index

Indexed Portfolios

conventional index mutual funds exchange-traded funds separate accounts or pooled accounts (mostly

for institutional investors designed to track a benchmark index)

indexing can be done by full replication stratified sampling optimization

Active Equity Investing

equity styles – natural grouping of investment disciplines that has some predictive power in explaining the future dispersion of returns across portfolios value – focused on paying a relatively low share price

in relation to earnings or assets per share growth – focused on investing in high-earnings-growth

companies market-oriented – specified as an intermediate

grouping for investment disciplines that cannot be clearly categorized as value or growth

Value and Growth Styles

Value substyles low P/Econtrarianhigh yield

Growth substylesconsistent growthearnings momentum

Equity Styles

Blend or Core Investormarket-orientedmarket-oriented with a value (growth) biasgrowth-at-a-reasonable-pricestyle rotators

Active Investing

Socially Responsible Investing integrates ethical values and societal

concerns with investment decisionsnegative screens

Long-Short Investingvalue added is alphamarket neutral strategypairs trade/pairs arbitrage

Long-Short Investing

price inefficiency on the short side many investors look for undervalued stocks but because of the

constraints many have on shorting, fewer search for overvalued stocks opportunities to short may arise due to management fraud, window-

dressing, or negligence sell-side analysts issue many more reports with buy recommendations

than with sell recommendations sell-side analysts may be reluctant to issue negative opinions on

companies’ stocks for reasons other than generic ones such as that a stock has become relatively expensive

long-short strategies can make better use of a portfolio manager’s information because both rising and falling stocks offer profit potential rather than simply avoiding a stock with a bad outlook, a long-short

manager can short it thereby earning the full performance spread

Semiactive Equity Investing

enhanced index or risk-controlled active strategies

basic formsderivatives-based strategiesstock-based strategies