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Equity portfolio management strategies

Equity portfolio management strategies. Objective. Outline. Portfolio management style. Passive Buy and hold strategy, often known as indexing Active Continuos rebalancing. Objective Match the return of a benchmark Approach Replicate the benchmark. Techniques Full replication

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Equity portfolio management strategies

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  1. Equity portfolio management strategies

  2. Objective

  3. Outline

  4. Portfolio management style • Passive • Buy and hold strategy, often known as indexing • Active • Continuos rebalancing

  5. 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 Passive management

  6. Active management • Objective • Outperform a passive benchmark portfolio on a risk adjusted basis • Portfolio return > Benchmark return + transaction costs • Issues • Benchmark • Measuring returns on a risk adjusted basis

  7. Themes in active portfolio management • Sector rotation • Value vs. growth • Earnings & price momentum • Factors models • Identify stocks that are sensitive to _________factors • Long-short approach • Screen & rank; buy the top, sell the bottom

  8. Style analysis • Compare manager’s return to that of different styles of indices • Grid style • Regression analysis

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

  10. Style analysis: Regression analysis • R = b1F1 + b2F2 + ….+ bjFj + …. + e • Where: • R = return on the portfolio under analysis • bj = sensitivity of portfolio to style factor j • Fj = return on a factor j style portfolio

  11. Style analysis: Regression interpretation • Look for (bj)s that are large and significant • They reveal which factor style portfolios are similar to the portfolio under analysis

  12. Asset allocation strategies • Integrated asset allocation • Strategic asset allocation • Tactical asset allocation • Insured asset allocation

  13. Integrated asset allocation • Evaluate and integrate: • Capital market conditions • Investor’s objectives & constraints

  14. Investor’s risk tolerance function Investor’s objectives Predictions Expected returns, risk, correlations Optimized portfolio: asset allocation & security selection Feedback Feedback Return evaluation & feedback Integrated asset allocation Investor’s assets, liabilities, and net worth Capital market conditions

  15. Strategic asset allocation • Classical optimization: It results in a constant asset allocation mix • Similar to integrated asset allocation, without a feedback loop • Exemplification: • Pension plans

  16. Tactical asset allocation • Assumption • Mean reversion • Aka. timing the market • It’s a contrarian strategy: • “Buy low, sell high”

  17. Insured asset allocation • Assumption • Returns & risks constant over time, but investors change • Switch between equity & cash to accommodate investor’s risk tolerance • Similar to integrated asset allocation without feedback on the capital market side

  18. Evaluation of portfolio performance • Requirements of a good portfolio manager: • Derive no less than average returns for a given risk-class (timing & security selection skills) • Diversify away all non-systematic risk

  19. Approaches to measuring performance • Peer-group comparisons • Treynor’s composite measure • Shapre’s measure • Jensen’s measure • Fama’s approach • Attribution analysis • Market timing skills measurement

  20. Peer-group comparisons • Ranking can be random • Most data tracks funds, not individual portfolio managers • See also textbook

  21. Treynor’s composite measure • Comparison of risk premium per unit of relative risk • Measure • Ti = (Ri - Rf)/bi • Benchmark • Tm = (Rm - Rf)bm • Issues • Looks at performance only • Uses realized returns

  22. Sharpe’s measure • Comparison of risk premium per unit of absolute risk • Measure • Si = (Ri - Rf)/si • Benchmark • Sm = (Rm - Rf)sm • Issues • Looks at performance and diversification • Uses realized returns

  23. Jensen’s measure • Measures excess return (above and beyond that required by the market) • (Ri - Rf) = a + (Rm - Rf)bi + e • If a > 0 • Portfolio earned more than the required rate • If a < 0 • Portfolio earned less than the required rate • Issues • Uses realized returns

  24. Fama’s approach • Excess return = Portfolio risk + Selectivity • See also textbook

  25. Attribution analysis • Attribute performance to: • Selection • Tactical asset allocation (market timing) • Allocation effect: • [(wp - wb)stocks(Rbstocks - Rb)] + [(wp - wb) bonds(Rbbonds - Rb)] + … • Selection effect: • [wp(Rp - Rb)]stocks + [wp(Rp - Rb)]bonds + …

  26. Attribution analysis: Exemplification

  27. Attribution analysis: Exemplification

  28. Attribution analysis: Exemplification

  29. Attribution analysis: Exemplification

  30. Attribution analysis: Exemplification

  31. Attribution analysis: Exemplification • Portfolio return = (0.5)(9.7%) + (0.38)(9.1%) + (0.12)(5.65) = 8.98% • Benchmark return = (0.6)(8.6%) + (0.3)(9.2%) + (0.1)(5.4) = 8.46% • Allocation effect • (-0.1)(8.6% -8.46%) + (0.08)(9.2%-8.46%) + (0.2)(5.4% - 8.465) = -0.02% • Selection effect • (0.5)(9.7% - 8.6%) + (0.38)(9.1% - 9.2%) + (0.12)(5.6% - 5.4%) = 0.54% • Allocation effect + Selection effect = -0.02% + 0.54% = 8.98% - 8.46%

  32. Attribution analysis: Interpretation • Manager underperformed benchmark by 0.02% due to deviations from benchmark’s weight • Manager outperformed the benchmark by 0.54%, due to its superior selection skills

  33. Measuring timing skills • Measure the effectiveness of switching between asset classes • Having perfect timing skills (hindsight 20/20) is equivalent to owning a lookback option: • At expiration, it pays the return of the best-performing asset class. • Ri = Rf + max[(Rb- Rf), (Rst- Rf)] • Regression measure: • (Ri - Rf) = a + (Rb- Rf)bib + (Rst - Rf)bist + y max[(Rb- Rf), (Rst- Rf)] + e • a = excess return • y = proportion of the lookback option captured by manager

  34. Factors that affect performance measures • Knowing what is the true return generating process • All the above measures are based on CAPM • Finding the real market portfolio • Changing the proxy for the market portfolio completely changes the ranking • Accounting for manager’s style

  35. A question of benchmark • Portfolio managers have different objectives and styles. • Wee need customized benchmarks.

  36. The making of a good benchmark • Unambiguous • Investable • Measurable • Appropriate: Consistent with manager’s style • Reflective of manager’s current investment opinions • Specified in advance

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