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Lecture Presentation Software to accompany Investment Analysis and Portfolio Management Seventh Edition by Frank K. Reilly & Keith C. Brown. Chapter 17. Chapter 17 - Equity Portfolio Management Strategies. Questions to be answered: What are the two generic equity portfolio management styles?

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Lecture Presentation Softwareto accompanyInvestment Analysis and Portfolio ManagementSeventh Editionby Frank K. Reilly & Keith C. Brown

Chapter 17

chapter 17 equity portfolio management strategies
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?
chapter 17 equity portfolio management strategies3
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?
chapter 17 equity portfolio management strategies4
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?
passive versus active management
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
an overview of passive equity portfolio management strategies
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
index portfolio strategy construction techniques
Index Portfolio Strategy Construction Techniques
  • Full replication
  • Sampling
  • Quadratic optimization or programming
full replication
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
  • 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
expected tracking error between the s p 500 index and portfolio samples of less than 500 stocks
Expected Tracking Error Between the S&P 500 Index and Portfolio Samples of Less Than 500 Stocks

Expected Tracking Error (Percent)

Exhibit 17.2











Number of Stocks

quadratic optimization or programming techniques
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
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

Methods of Index Portfolio Investing
an overview of active equity portfolio management strategies
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
fundamental strategies
Fundamental Strategies

Top-down versus bottom-up approaches

Asset and sector rotation strategies

sector rotation
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
technical strategies
Contrarian investment strategy

Price momentum strategy

Earnings momentum strategy

Technical Strategies
value versus growth
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
value versus growth18
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
value versus growth19
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
  • 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
does style matter
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
determining style
Determining Style
  • Style grid:
    • firm size
    • value-growth characteristics
  • Style analysis
    • constrained least squares
benchmark portfolios
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
benchmark portfolios24
Benchmark Portfolios
  • Sharpe
    • 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
benchmark portfolios25
Benchmark Portfolios
  • Sharpe
  • 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
timing between styles
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
asset allocation strategies
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
asset allocation strategies28
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
using futures and options in equity portfolio management
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
the use of futures in asset allocation
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
using derivatives in passive equity portfolio management
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
the internet investments online

The InternetInvestments Online
End of Chapter 17
  • Equity Portfolio Management Strategies
future topics chapter 18
Future topicsChapter 18
  • Bond Fundamentals