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Equity portfolio management

Equity portfolio management. Chapter 7. Exclude section 6 in this chapter. Overview of decision structure. End result: list of portfolio managers. Key concepts. Passive versus active equity portfolio management Passive investment vehicles and management process

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Equity portfolio management

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  1. Equity portfolio management Chapter 7 Exclude section 6 in this chapter

  2. Overview of decision structure End result: list of portfolio managers

  3. Key concepts • Passive versus active equity portfolio management • Passive investment vehicles and management process • Active investment styles and style analysis

  4. Passive Approach to Equity Management • Best suited for investors who believe markets are relatively efficient in a particular asset class • Attempts to match the performance of a benchmark index • Mainly concerned with tracking risk (measured by tracking error) • Aims for lowest tracking error. No “active” return relative to the benchmark index

  5. Conventional Index Mutual Funds • Return on the index fund should lag the underlying index by the sum of: • Cost of management and administration • Transaction costs related to index composition changes • Transaction costs for investing cash flows, e.g., reinvesting dividends • Drag on performance from any cash position • But revenues from securities lending can offset some of these costs

  6. example

  7. Active Approach to Equity Management • Goal is to outperform the benchmark • Best suited for investors who believe there are market inefficiencies that can be exploited • Opportunities may not be available in all segments of the market • Look for areas where inefficiencies are most likely to exist • Aims to maximize active return relative to the benchmark • Some manager may set target for tracking error

  8. Price Indices • For passive strategies to track or for benchmarking active strategies • Standard methods for constructing an index • Price weighted • Value weighted • Equally weighted • Alternative method - fundamental indexing of Arnott, Hsu, and Moore, Financial Analyst Journal, 2005 (not in text)

  9. Price-Weighted Equity Indices • Weigh each stock in the index according to its share price • Best known price weighted index is the Dow Jones Industrial Average • Dow’s recent shake-up • Index value is the sum of the share prices of each stock in the index • Index performance skewed by the performance of the highest-priced stocks • Performance represents the return to buying and holding one share of each stock in the index

  10. Business week

  11. Value-Weighted Equity Indices • Weighted according to market capitalization of component stocks (constituents) • Subcategory is float-weighted: weights according to market capitalization of non-restricted (free float) shares only, i.e., exclude portion of shares not readily available for trading • Performance represents returns to a portfolio that buys and holds all the available shares of all the stocks in the index • CAPM – Market portfolio is a value weighted portfolio (on the efficient frontier) • Biased toward performance of the largest companies by market capitalization – which tend to be either mature (or could be a stock that is overvalued) • The S&P 500, TSX, and most major indices are value-weighted

  12. Equal-Weighted Equity Indices • 1/N: Weighs each stock in the index equally • Performance represents return to investing an equal amount of money in each component stock of the index • Must be rebalanced periodically because stock performance differences will cause weights to drift from equality • E.g., 0.5 of the index in company X, 0.5 in company Y. As the price of X and price of Y fluctuate, weights will also change

  13. Fundamental Indexing • Issue with market-cap weighted indices • They tend to overweight large, growth stocks • Example: Nortel in the TSE300 in 2000 • FTSE/RAFI indices: Use a proprietary mix of i) total cash dividends, ii) free cash flow, iii) total sales, and iv) book equity value to weigh companies within the index • ETFs of these indices are available • Backtested using data from 1962-2004, beat the S&P500 by 1.97% per annum • Some argue it’s not indexation, but a semi-active strategy that has a value and small-cap tilt

  14. Smart beta • Alternative beta products that do not track the cap-weighted indices • Examples: low volatility, minimum risk, equal weighting, fundamental weighting • Enhanced indices (i.e., not considered active strategies) • Expectation: outperform cap-weighted counterparts

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