Chapter 7: Equity Portfolio Management

1. Chapter 7: Equity Portfolio Management • For the purpose of this course, can exclude the following sections: • Equity index futures related • Semi-active investingEnhanced indexing • Indexing using stratified sampling • Indexing using optimization

2. Overview of Process

3. Key Concepts in Chapter • 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 • Attempts to match the performance of a benchmark index • Mainly concerned with tracking risk (measured by tracking error) • Aims for lowest tracking risk. No “active” return relative to the benchmark index

5. 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 • Set target for tracking risk, and aims to maximize active return relative to the benchmark • Target for tracking risk varies according to return objective

6. Price Indices • Standard methods for constructing an index • Price weighted • Value weighted • Equally weighted • New method (Arnott, Hsu, and Moore FAJ 2005) • Fundamental indexing (not in text)

7. Price-Weighted Equity Indices • Weight each stock in the index according to its share price • Best known price weighted index is the Dow Jones Industrial Average • Index value is the sum of the share prices of each stock in the index, so historical data may be available further back than the index was actually available • 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

8. Value-Weighted Equity Indices • Weighted according to market capitalization of component stocks (also called cap-weighted) • Subcategory is float-weighted: weights according to market capitalization of publicly-traded (free float) shares only • Performance represents returns to a portfolio that buys and holds all the available shares of all the component stocks in the index • Biased toward performance of the largest companies by market capitalization – which tend to be either mature or overvalued • The S&P 500, TSX, and most major indices are value-weighted

9. Equal-Weighted Equity Indices • 1/N: Weights each stock in the index equally • Performance represents return to investing an equal amount of money in each component stock • Must be rebalanced periodically because 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

10. Fundamental Indexing • Problem with market-cap weighted indices (most popular benchmarks • They tend to overweight large, growth stocks • Example: Nortel in the TSE300 in 2000) • RAFI index: Use a proprietary mix of sales, cash flow, book value, and dividends to weight the companies within the index (ETFs 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

11. Conventional Index Mutual Funds • Mutual fund shareholders buy shares from the fund and sell them back to the fund • Valued once a day (at market close) • Shareholders subject to taxes even if they do not realize the gains or dividends directly • If index consists of liquid stocks, e.g., S&P 500, manager will typically use full replication: Actually owning all of the underlying assets according to the weights

12. Conventional Index Mutual Funds • Return on the index fund should lag the underling 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

13. Exchange Traded Index Funds (ETFs) • Shareholders buy and sell ETFs amongst themselves throughout the day • Price is kept close to the NAV through an arbitrage mechanism called in-kind creation and redemption • If Price < NAV, Authorized Participants (APs) can redeem their shares in exchange for a basket of the underlying securities (and vice versa) • APs are major banks and trading desks of large financial institutions • More tax-efficient • Unlike mutual funds, do not need to buy/sell securities based on investor cash flows

14. Equity Total Return Swaps • One counterparty receives the total return of an equity index portfolio, the other can receive an interest rate (e.g., LIBOR) or the return on a different index • Motivations include: • Tactical asset allocation – may be more cost effective to use a swap than to change the portfolio • Portable alpha strategy – client can choose any beta exposure.

15. Active Portfolio Management • Style • Value • Core or blend • Growth • Style analysis (Sharpe, 1988, 1992) • Returns based • Holdings based

16. Value Investing Style • More concerned about stock’s relative cheapness than about its growth prospects • Look for low price relative to earnings or book value • Rationales: • Earnings tend to revert to mean, presenting opportunities when earnings are temporarily depressed • Investors overpay for “glamour” stocks, presenting opportunities elsewhere • Risks faced by the investor • Stocks may be cheap for a good reason (“value trap”) – need to consider momentum • Correction of mispricing may require longer time than investment horizon

17. Growth Investing Style • Believe future earnings growth justifies higher current P/E ratio • Requires market to continue paying a premium for the greater growth prospects • Risk that expected growth fails to materialize

18. Returns-Based Style Analysis • A portfolio’s style may be multi-dimensional (e.g., U.S equity fund) • Characterizes the “style” of a portfolio using realized returns (typically monthly) • Regresses portfolio returns against a set of indices that are: • Mutually exclusive • Exhaustive with respect to manager’s universe • Distinct sources of risk (i.e., not highly correlated) • Restrict estimated coefficients to sum to 1 (and non-negative if no leverage is allowed)

19. Returns-Based Style Analysis • The estimated coefficients are called “style weights”, and can be used to construct a benchmark portfolio for performance evaluation • Popular because this type of style analysis is objective, and requires minimal information, and is cost effective • Analysis produces important information for investors because studies found that asset allocation explains 90+ percent of a portfolio’s returns (see chapter 5) • Disadvantages: • May not effectively characterize current style • Misspecifying indices in model may lead to inaccurate conclusions

20. A Sample US Equity Fund

21. Holdings-Based Style Analysis • Categorizes individual securities by their characteristics such as: • Valuation • Forecasted growth • Earnings variability • Industry sector weightings • Requires judgment or threshold levels for each classification

22. Holdings-Based Style Analysis Is this a value or growth portfolio?

23. Holdings-Based Style Analysis • Advantages • Characterizes each position • Facilitates comparisons of individual positions • May capture changes in style more quickly than returns based analysis • Disadvantages • Does not reflect the way many managers approach security selection • Requires judgment in specifying classification attributes • More data intensive than returns-based analysis

24. The Equity Style Box • Popular way of looking at style • Separates universe into nine cells in a matrix according to: • Capitalization (small, mid, large) • Style (value, core/blend, growth) Large Mid Small Example: RBC Canadian Dividend Fund Value Core Growth

25. More Specific Style Boxes • Example: Morningstar style box for Vanguard’s Mid-Cap Growth Fund • By market value of assets falling into each category as defined by Morningstar Large Mid Small Value Core Growth

26. Style Drift in Equity Portfolios • Style drift is the term used to describe inconsistency in management style • Presents an obstacle to investment planning and risk control • If hire a manager because want value exposure, do not want style to drift to core or growth • Manager may not have as much expertise in selecting stocks of a different style

27. Socially Responsible Investing • Integrates ethical or societal concerns with investment decisions • Typically uses stock screens • Negative screens to exclude undesirable characteristics (such as gambling, tobacco, etc) • Positive screens to include desirable characteristics (such as high labor standards or good corporate governance) • Particular screens employed reflect client concerns • Can introduce unintended consequences, as excluding polluters (energy and utilities) may introduce a growth bias • Should choose a benchmark that reflects the exclusions

28. Long-Short Investing • Many portfolios are prohibited from short sales • Value added by manager is called alpha • If short sales are permitted, manager can effectively contribute two alphas • Market neutral strategy is designed to have no beta • True in practice? It’s an empirical quesiton • Can have twice the negative alpha when stock selections go the wrong way • The ability to short sell may generate higher returns, but there is always the risk that short-term movements may force the manager to unwind positions

29. Price Inefficiency and Short Sales • Short sales may better exploit market inefficiencies because: • Fewer investors search for overvalued stocks due to impediments to short selling • Short sale opportunities due to fraud, window-dressing or negligence do not have parallel long-side opportunities • Sell-side equity analysts issue more buy than sell ratings, so there is less information about over-valued stocks

30. Sell Discipline • Opportunity cost discipline sells stocks whenever another stock represents a better opportunity • Deteriorating fundamentals discipline sells whenever business prospects deteriorate • Valuation level sell discipline sells when stock reaches specified valuation (such as historical average P/E) • Down-from cost, up-from-cost or target price disciplines are triggered when specific prices are reached

31. Optimizing Allocations to a Group of Managers • Another application of the Markowitz’s model • Want to maximize active return for a given level of active risk determined by investor’s aversion to active risk • Maximize expected utility: where A = “active” component of the overall portfolio’s return (i.e., given the manager mix)

32. Optimizing Allocations to a Group of Managers

33. Dissecting Active Return and Risk • Consider the following scenario: • An Australian investor wants to hire a global portfolio manager • Reasonable Benchmark may be the MSCI World ex-Australia Index • Suppose the investor chooses a global value manager • The manager’s benchmark may be the MSCI World ex-Australia Value Index

34. Dissecting Active Return and Risk • Suppose in the first year, the returns are: Manager (12%), World Index (10%), World Value Index (15%), so manager beat the investor’s benchmark by 2% (active return = 2%) • Dissect manager’s active return into true + misfit: • True active return = manager return – manager’s normal benchmark (12% - 15% = -3%) • Misfit active return = manager’s normal benchmark – investor’s benchmark (15% - 10% = 5%) • Misfit active returns tells the investor that the manager outperformed the World Index because value stocks did very well that year

35. Dissecting Active Return and Risk • Similarly for active risk – dissect into true + misfit • True active risk = standard deviation of true active return • Misfit risk = standard deviation of misfit active return • Need the monthly returns to calculate the standard deviations

36. Alpha and Beta Separation • Long only active portfolio has exposure to beta (market return) and alpha (manager skill) • Long-short market neutral portfolio designed not to have beta exposure • Can get beta inexpensively from an indexed portfolio and explicitly pay for alpha generated from a long-short portfolio • Separates fees for (cheap) beta and (expensive) alpha

37. Core-Satellite Portfolios • Overall asset allocation strategy in which there is a passive core (that uses indexed or enhanced index portfolios), and several active “satellite” portfolios • Satellite portfolios are in areas where there are price inefficiencies and/or where managers have specific skills

38. Selecting Equity Managers • Qualitative factors • People • Organizational structure • Investment philosophy • Process • Strength of equity research • Quantitative factors • Performance relative to benchmarks and peers • Measured style orientation and valuation characteristics of managed portfolios • Seek consistency between stated and actual practices

39. Predictive Power of Past Performance • Must include disclaimer that “past performance is no guarantee of future results” • Studies indicate that few managers consistently remain in top quartile • Consistency of performance is important – same level of performance more highly valued if comes from consistent people and process

40. Predictive Power of Past Performance Based on a sample of 220 U.S. equity managers (Wood 2006)

41. Equity Manager Fee Structures Two major types: • Ad valorem (a tax or duty) – a percentage of assets under management (AUM) • Example: First $100 million at 0.50 percent Second $100 million at 0.40 percent Remaining balance at 0.30 percent • Performance based – percentage of the return in excess of benchmark • Charged mostly by hedge funds and alternative investment mangers • Example: 2 percent of AUM plus 20% of outperformance versus the benchmark (2&20) Performance fee is referred to as “carry interest”

42. Equity Manager Fee Structures • Asymmetric compensation: If manager underperforms the benchmark, there is no penalty • Performance based fees may include a fee cap limiting total fee paid to limit incentive to take undue risk • Ad valorem fees are more predictable for investor, but performance fees better align manager interests (though poor performance could also cause staff turnover)

43. Equity Manager Questionnaire • Creates formal basis for comparing equity managers • Five key areas: • Organization, structure and personnel • Investment philosophy, policy and process • Research capabilities and resources • Historical performance/risk factors • Fee structure

44. Top-Down Approach to Security Selection • Focuses primarily on macroeconomic factors or investment themes • What themes are affecting the global economy • How do the themes affect various sectors and industries • Are there any special country or currency considerations • Which stocks within the industries or sectors will most likely benefit

45. Bottom-up Approach to Security Selection • Focuses on company-specific fundamentals • Identify factors by which to screen the investment universe, e.g., valuation (P/B, P/E, earnings growth, PEG … etc.) • Collect further information on companies that pass the screen • Identify those that constitute potential investments based on other company-specific criteria, sector outlook, macro trends

46. Sell-side versus Buy-side Analysts • Buy-side • Equity research with the intent of assembling a portfolio, e.g., provide rationale for buying or selling a stock • Generally inaccessible to those outside the company • Sell-side • Produce research reports (on a company or sector) for sale, i.e., a subscription is required • Investment banks use this to generate revenues and business