Lecture Presentation Software to accompany Investment Analysis and Portfolio Management Eighth Edition by Frank K. Rei

1. Lecture Presentation Softwareto accompanyInvestment Analysis and Portfolio ManagementEighth Editionby Frank K. Reilly & Keith C. Brown Chapter 16

2. Chapter 16 - 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?

3. Chapter 16 - 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?

4. Chapter 16 - 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?

5. 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

6. 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

7. Index Portfolio Construction Techniques • Full replication • Sampling • Quadratic optimization or programming

8. 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

9. 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

10. Expected Tracking Error Between the S&P 500 Index and Portfolio Comprised of Samples of Less Than 500 Stocks Expected Tracking Error (Percent) Exhibit 16.2 4.0 3.0 2.0 1.0 500 400 300 200 100 0 Number of Stocks

11. 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

12. 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 Methods of Index Portfolio Investing

13. 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

14. Fundamental Strategies Top-down versus bottom-up approaches Asset and sector rotation strategies

15. 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

16. Contrarian investment strategy Price momentum strategy Earnings momentum strategy Technical Strategies

17. Anomalies and Attributes • The Weekend Effect • The January Effect • Firm Size • P/E and P/BV ratios

18. Miscellaneous Issues • Selection of an appropriate benchmark • Issues pertaining to the benchmark • Use of computer screening and other quantitatively based methods of evaluating stocks • Factor models • The “long-short” approach to investing

19. 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

20. 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

21. 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

22. 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

23. 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

24. Determining Style • Style grid: • firm size (large cap, mid cap, small cap) • Relative value (value, blend, growth) characteristics • Style analysis • constrained least squares

25. 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

26. 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

27. 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

28. 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

29. 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

30. 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

31. http://www.russell.com http://www.firstquadrant.com http://www.panagora.com The InternetInvestments Online

32. End of Chapter 16 • Equity Portfolio Management Strategies

33. Future topicsChapter 17 • Bond Fundamentals