Equity Portfolio Management MIP, Chapter 7

1. Equity Portfolio ManagementMIP, Chapter 7 Kevin C.H. Chiang

2. Approached to equity investment • Passive management • The dominant approach is indexing • Active management • Seeks to outperform a given benchmark • By overweighting those stocks that deem promising and underweighting those stocks that deem less promising

3. Active return • Active return: the differences between fund returns and benchmark returns. • The goal of active management is try to generate consistent positive active returns (holding other factors constant, higher the better).

4. Tracking ratio and information ratio • Tracking risk: the standard deviation of active returns (the lower the better). • Information ratio: the ratio of mean active return to tracking risk (the higher the better). • Some sponsors impose expectations on managers’ tracking risk and information ratio.

5. Popular equity indices • Exhibit 7-10, pp. 420-421.

6. Investment style • Investment style: a natural grouping of investment disciplines that has some predictive power in explaining the future dispersion of portfolio/fund returns across portfolios/funds. • Why one particular style? (1) Drives fund risk and fund return, (2) allows research to be more focused, (3) aligns with research strengths and philosophy, (4) fund/plan sponsors often requires style specialization.

7. Value style vs. growth style • Value style: investing in high value/price (low price/value) stocks; e.g., high B/M stocks, low P/E stocks. • A stylized value premium. • At least 3 sub-styles: low P/E, contrarian, and high yield. • Growth style: investing in low value/price (high value/price) stocks. • The most popular style among mutual funds. • At least 2 sub-styles: consistent growth (a long-history of sales growth, superior earnings), and earnings momentum.

8. Big-cap style vs. small-cap style • Used to have a small-cap premium. • Small-cap style can impose liquidity/depth risk on large funds.

9. Techniques for identifying styles • 1st category: return-based methods, such as regressions or Sharpe’s style analysis (a special form of regression). • An example of rolling style chart, Exhibit 7-13, p. 439) • 2nd category: holdings-based analysis. • Look into actual stock holdings. • Morningstar uses this method to construct its 3×3 style box for funds (Exhibit 7-18, p.448).

10. Style drift • Drift: inconsistency in investment style over time. • An obstacle to investment planning and risk management from fund/plan sponsors’ perspectives. • Fund/plan sponsors usually monitor for signs of style drift; managers may need to explain for it.

11. SRI • Socially responsible investing: one can consider this to be a special style. • Some fund/plan sponsors today have an SRI mandate. • Some fund/plan sponsors worry that an SRI mandate will reduce diversification benefits.

12. Screening • Screening based on some criteria reflecting investing style and philosophy, e.g., P/E, earnings momentum, etc., is often used by research units so that there is focus and efficiency in research.

13. Structuring research • Top-down: focus research on macroeconomic/industrial factors or investment themes. • The stock holdings in top-down investors’ portfolios reflect their macro insights. • Bottom-up: have little interest in the state of the economy or other macro factors, but rather try to put together the best portfolio of stocks based on company-specific information.

14. Sell-side vs. buy-side research • Sell-side research is generally organized by sector/industry with a regional delineation; e.g., a U.S. banking analyst. • Buy-side research: mainly concerned with assembling a portfolio, so decisions on buy-side research are usually made through a committee structure. • These research reports/essays are not available to outsiders.