mbf2253 | modern security analysis - · pdf file · 2015-11-29mbf2253 | modern...
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MBF2253 | Modern Security Analysis Prepared by Dr Khairul Anuar
L7: Equity Portfolio Management Strategies
www.notes638.wordpress.com
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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?
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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?
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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?
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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
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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
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Index Portfolio Strategy
Construction Techniques
• Full replication
• Sampling
• Quadratic optimization or
programming
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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
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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
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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
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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
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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
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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
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Fundamental Strategies
• Top-down versus bottom-up approaches
• Asset and sector rotation strategies
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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
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Technical Strategies
• Contrarian investment strategy
• Price momentum strategy
• Earnings momentum strategy
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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
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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
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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
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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
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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
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Determining Style
• Style grid:
– firm size
– value-growth characteristics
• Style analysis
– constrained least squares
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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
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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
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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
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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
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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
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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
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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
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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
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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
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Using Derivatives in Active
Equity Portfolio Management
• Modifying systematic risk
• Modifying unsystematic risk