Lecture Presentation Software
to accompany
Investment Analysis and
Portfolio Management
Seventh Edition
by
Frank K. Reilly & Keith C. Brown
Chapter 17
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
• 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
• Full replication
• Sampling
• Quadratic optimization or
programming
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
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
Expected Tracking Error Between the S&P 500 Index
and Portfolio Samples of Less Than 500 Stocks
Expected Tracking
Error (Percent)
Exhibit 17.2
4.0
3.0
2.0
1.0
500
400
300
200
100
0
Number of Stocks
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
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
• Top-down versus bottom-up approaches
• Asset and sector rotation strategies
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
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 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 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
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
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
• Style grid:
– firm size
– value-growth characteristics
• Style analysis
– constrained least squares
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, smallcapitalization stocks, non-U.S. bonds, European
stocks, and Japanese stocks
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
Benchmark Portfolios
• Sharpe
• BARRA
• Ibbotson Associates
– simplest style model uses portfolios formed
around five different characteristics: cash (Tbills), large-capitalization growth, smallcapitalization growth, large-capitalization
value, and small-capitalization value
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
• 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 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
• 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
• 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
• 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
Using Derivatives in Active
Equity Portfolio Management
• Modifying systematic risk
• Modifying unsystematic risk
The Internet
Investments Online
www.russell.com
www.firstquadrant.com
www.wilshire.com
www.fool.com
www.dailystocks.com