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Chapter 15Revision of the Equity Portfolio

Portfolio Construction, Management, & Protection, 5e, Robert A. StrongCopyright ©2009 by South-Western, a division of Thomson Business & Economics. All rights reserved.

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Introduction Portfolios need maintenance and periodic

revision:• Because the needs of the beneficiary will

change• Because the relative merits of the portfolio

components will change• To keep the portfolio in accordance with the

investment policy statement and investment strategy

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Active Managementversus Passive Management

An active management policy is one in which the composition of the portfolio is dynamic• The portfolio manager periodically changes:

– The portfolio components or– The components’ proportion within the portfolio

A passive management strategy is one in which the portfolio is largely left alone

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The Manager’s Choices Leave the Portfolio Alone Rebalance the Portfolio Asset Allocation and Rebalancing within

the Aggregate Portfolio Rebalancing within the Equity Portion Change the Portfolio Components Indexing

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Leave the Portfolio Alone A buy and hold strategy means that the portfolio

manager hangs on to its original investments

Academic research shows that portfolio managers often fail to outperform a simple buy and hold strategy on a risk-adjusted basis• e.g., Barber and Odean show that investors who trade

the most have the lowest gross and net returns

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Rebalance the Portfolio Rebalancing a portfolio is the process of

periodically adjusting it to maintain the original conditions

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Constant Mix Strategy The constant mix strategy:

• 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

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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 40 percent bonds.

The initial portfolio value and the portfolio value after one quarter are shown on the next slide.

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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 Bonds1 Jan $2,000,000 60%/40% $1,200,000 $800,0001 Apr $2,500,000 56%/44% $1,400,000 $1,100,000

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

Solution: a 60 percent/40 percent 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.

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Constant Proportion Portfolio Insurance

A constant proportion portfolio insurance (CPPI) strategy requires the manager to invest a percentage of the portfolio in stocks:

$ in stocks = Multiplier × (Portfolio value – Floor value)

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Constant Proportion Portfolio Insurance (cont’d)

Example

A portfolio has a market value of $2 million. The investment policy statement specifies a floor value of $1.7 million and a multiplier of 2.

What is the dollar amount that should be invested in stocks according to the CPPI strategy?

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Constant Proportion Portfolio Insurance (cont’d)

Example (cont’d)

Solution: $600,000 should be invested in stock:

$ in stocks = 2.0 × ($2,000,000 – $1,700,000)= $600,000

If the portfolio value is $2.2 million one quarter later, with $650,000 in stock, what is the desired equity position under the CPPI strategy? What is the ending asset mix after rebalancing?

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Constant Proportion Portfolio Insurance (cont’d)

Example (cont’d)

Solution: The desired equity position after one quarter should be:

$ in stocks = 2.0 × ($2,200,000 – $1,700,000)= $1,000,000

The portfolio manager should move $350,000 into stock. The resulting percentage would be: $1,000,000/$2,200,000 = 45.5%

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Relative Performance of Constant Mix and CPPI

A constant mix strategy sells stock as it rises

A CPPI strategy buys stock as it rises

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Relative Performance of Constant Mix and CPPI (cont’d)

In a rising market, the CPPI strategy outperforms constant mix

In a declining market, the CPPI strategy outperforms constant mix

In a flat market, neither strategy has an obvious advantage

In a volatile market, the constant mix strategy outperforms CPPI

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Relative Performance of Constant Mix and CPPI (cont’d)

The relative performance of the strategies depends on the performance of the market during the evaluation period

In the long run, the market will probably rise, which favors CPPI

In the short run, the market will be volatile, which favors constant mix

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Rebalancing Within the Equity Portfolio

Constant Proportion Constant Beta Portfolio Change the Portfolio Components Indexing

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Constant Proportion A constant proportion strategy within an

equity portfolio requires maintaining the same percentage investment in each stock• May be mitigated by avoidance of odd lot

transactions

Constant proportion rebalancing requires selling winners and buying losers

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Constant Proportion (cont’d)Example

An investor attempts to invest approximately one third of funds in each of the stocks. Consider the following information:

Stock Price Shares Value % of Total PortfolioFC 22.00 400 8,800 31.15HG 13.50 700 9,450 33.45YH 50.00 200 10,000 35.40Total $28,250 100.00

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Constant Proportion (cont’d)Example (cont’d)

After one quarter, the portfolio values are as shown below. Recommend specific actions to rebalance the portfolio in order to maintain the constant proportion in each stock.

Stock Price Shares Value % of Total PortfolioFC 20.00 400 8,000 21.92HG 15.00 700 10,500 28.77YH 90.00 200 18,000 49.32Total $36,500 100.00

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Constant Proportion (cont’d)Example (cont’d)

Solution: The worksheet below shows a possible revision which requires an additional investment of $1,000:

Stock Price SharesValue Before Action

Value After

% of Portfolio

FC 20.00 400 8,000 Buy 200 12,000 32.00HG 15.00 700 10,500 Buy 100 12,000 32.00YH 90.00 200 18,000 Sell 50 13,500 36.00Total $36,500 $37,500 100.00

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Constant Beta Portfolio A constant beta portfolio requires maintaining

the same portfolio beta It is more likely to have requirements that beta be

within some given range To increase or reduce the portfolio beta, the

portfolio manager can:• Reduce or increase the amount of cash in the portfolio• Purchase stocks with higher or lower betas than the

target figure• Sell high-beta stocks or low-beta stocks• Buy high-beta stocks or low-beta stocks

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Change the Portfolio Components

Changing the portfolio components is another portfolio revision alternative

Events sometimes deviate from what the manager expects:• The manager might sell an investment turned

sour• The manager might purchase a potentially

undervalued replacement security

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Indexing Indexing is a form of portfolio management that

attempts to mirror the performance of a market index• e.g., the S&P 500 or the Russell 1000

Index funds eliminate concerns about outperforming the market

The tracking error refers to the extent to which a portfolio deviates from its intended behavior

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Tactical Asset Allocation What Is Tactical Asset Allocation? How TAA Can Benefit a Portfolio Designing a TAA Program Caveats Regarding TAA Performance Costs of Revision Contributions to the Portfolio

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Tactical Asset Allocation Tactical asset allocation (TAA) managers:

• Seek to improve the performance of their funds by shifting the relative proportion of their investments into and out of asset classes as the relative prospects of those asset classes change

For example, shift to stocks if stocks are expected to outperform bonds

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Definition (cont’d) TAA attempts to take advantage of short-

term deviations from long-term trends

The most difficult part of TAA is asset class appraisal• The process of determining the relative merits

of the various asset classes given current economic conditions

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Intuitive versus Quantitative Techniques

In the intuitive approach, decisions are based on personal opinion and gut feeling• Suffers from hindsight bias

– Portfolio managers remember the times they were correct

In the quantitative approach, managers use an analytical assessment and a system for implementing precise portfolio changes• e.g., use the gap between the S&P 500 dividend yield

and the average yield on AAA corporate bonds

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Overview of the Technique

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Policy Decisions Policy decisions involve:

• Deciding to use a TAA program in the first place

• Establishing the extent to which the program will be employed

• Determining the number of asset classes to employ

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Strategy There are three alternative strategic

functions:• Static strategy maintains a static portfolio mix• Reactive strategy involves decisions based on

events that have already occurred• Anticipatory strategy involves shifting funds

before the markets move

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How TAA Can Benefit a Portfolio

The goal of an anticipatory strategy is to outperform the portfolio without TAA• The potential gains to a clairvoyant manager

from TAA are enormous (see next slide)

The portfolio manager must assess return within a risk/return framework

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How TAA Can Benefit a Portfolio (cont’d)

Source: Ensign Peak Advisors, Inc., Salt Lake City, UT 84150.

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Designing a TAA Program Before implementing a TAA program, a

fund manager must establish:• The normal mix

– The benchmark proportion each asset class constitutes in the portfolio

• The mix (exposure) range– Specifies how much the current mix can deviate

from the normal mix

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Designing a TAA Program (cont’d)

Before implementing a TAA program, a fund manager must establish (cont’d):• The swing component

– The percentage of the total portfolio whose composition by asset class may change

– The key element of TAA is properly investing the swing component

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Efficient Market Implications TAA programs implicitly assume it is

possible to outperform a buy-and-hold strategy by shifting asset classes• Inconsistent with the efficient market

hypothesis Some fund managers have good records

with TAA programs• Might be skill or luck

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Impact of Transaction Costs The portfolio incurs trading fees each time a

trade occurs

If the marginal gains from TAA switching do not exceed transaction costs, the program is not effective

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Costs of Revision Costs of revising a portfolio can:

• Be direct dollar costs• Result from the consumption of management

time• Stem from tax liabilities• Result from unnecessary trading activity

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Commissions Investors pay commissions both to buy and

to sell shares

Commissions at a brokerage firm may be a function of both:• The dollar value of the trade• The number of shares involved in the trade

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Commissions (cont’d) The commission on a trade is split between

the broker and the firm for which the broker works• Brokers with a high level of production keep a

higher percentage than a new broker

Some brokers discount their commissions with their more active clients

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Commissions (cont’d) Discount brokerage firms:

• Offer substantially reduced commission rates• Offer few ancillary services, such as market

research or periodic newsletters

Retail commissions at a full-service firm average about 2 percent of the trade value

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Transfer Taxes Transfer taxes are:

• Imposed by some states on the transfer of securities

• Usually very modest

• Not normally a material consideration in the portfolio management process

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Market Impact The market impact of placing the trade is

the change in market price purely because of executing the trade

Market impact is a real cost of trading

Market impact is especially pronounced for shares with modest daily trading volume

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Management Time Most portfolio managers handle more than

one account

Rebalancing several dozen portfolios is time consuming

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Tax Implications Individual investors and corporate clients

must pay taxes on the realized capital gains associated with the sale of a security

Tax implications are usually not a concern for tax-exempt organizations

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Window Dressing Window dressing refers to cosmetic

changes made to a portfolio near the end of a reporting period

Portfolio managers may sell losing stocks at the end of the period to avoid showing them on their fund balance sheets

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Rising Importance of Trading Fees

Flippancy regarding commission costs is unethical and sometimes illegal

Trading fees are receiving increased attention because of:• Investment banking scandals• Lawsuits regarding churning• Incomplete prospectus information

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Contributions to the Portfolio Periodic additional contributions to the portfolio

from internal or external sources must be invested If an account holds its securities in a street name,

dividends go to the brokerage firm holding the securities on the client’s behalf

If the portfolio manager receives the dividend checks, there needs to be some temporary haven for these funds until they accumulate sufficiently to finance the purchase of more securities or until they are paid as income to the fund beneficiary

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When Do You Sell Stock? Knowing when to sell a stock is a very

difficult part of investing

Behavioral evidence suggests the typical investor sells winners too soon and keeps losers too long

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Rebalancing Rebalancing can cause the portfolio

manager to sell shares even if they are not doing poorly

Profit taking with winners is a logical consequence of portfolio rebalancing

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Upgrading Investors should sell shares when their

investment potential has deteriorated to the extent that they no longer merit a place in the portfolio

It is difficult to take a loss, but it is worse to let the losses grow

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Sale of a Stock Via Stop Orders Stop orders:

• Are usually used to sell but can be used to buy

• A sell stop becomes a market order to sell a set number of shares if shares trade at the stop price

• Can be used to minimize losses or to protect a profit

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Using Stops to Minimize Losses Stop-loss orders can be used to minimize

losses• e.g., you bought a share for $23 and want to sell

it if it falls below $18– Place a stop-loss order at $18

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Using Stops to Protect Profits Stop orders can be used to protect profits

• e.g., a stock you bought for $33 now trades for $48 and you want to protect the profits at $45

– If the stock retreats to $45, you lock in the profit if you place a stop order

– If the stock continues to increase, you can use a crawling stop to increase the stop price

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Change in Client Objectives The client’s investment objectives may

change occasionally:• e.g., a church needs to generate funds for a

renovation and changes the objective for the endowment fund from growth of income to income

– Reduce the equity component of the portfolio

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Change in Market Conditions Many fund managers seek to actively time

the market

When a portfolio manager’s outlook becomes bearish, he may reduce his equity holdings

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Buy-Outs A firm may be making a tender offer for

one of the portfolio holdings• i.e., another firm wants to acquire the security

position

It is generally in the client’s best interest to sell the stock to the potential acquirer

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Caprice Portfolio managers:

• Should be careful about making unnecessary trades

• Must pay attention to their experience, intuition, and professional judgment

An experienced portfolio manager worried about a particular holding should probably make a change

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Final Thoughts Hindsight is an inappropriate perspective for

investment decision making• Everything you do as a portfolio manager must be

logically justifiable at the time you do it

Portfolio managers are torn between a desire to protect profits or minimize further losses and the potential for price appreciation