Equity

Portfolio
Management
Strategies
CHAPTER 7
Chapter contents
Generic equity portfolio management styles Passive vs active equity portfolio strategy

Techniques for constructing a passive index portfolio

Active equity portfolio management strategies

Determining the tax efficiency of an actively managed portfolio

Value-oriented and growth-oriented investment styles

What is Style analysis

Asset allocation strategies: Integrated, Strategic, Tactical, and Insured approaches

Investment Strategies
➢An investment strategy is a set of rules, behaviours or procedures,
designed to guide an investor's selection of an investment portfolio.
Investment strategies
No strategy
✓Investors who don't have a strategy have been called
Sheep.
✓Arbitrary choices could result in debatable outcomes.
Strategy
There are three alternative strategic functions:
◦Static strategy maintains a static portfolio mix
◦Reactive strategy involves decisions based on events that
have already occurred
◦Anticipatory strategy involves shifting funds before the
markets move
Note: portfolios managers increase an investor’s wealth through sector
and asset allocation strategies
Passive and Active Strategies
Passive Strategies
▪Passive investors have a buy-and-hold mentality
▪Benefits from the overall increase in market prices over time.
▪ Passive investors don't believe it is possible to time the market.
▪involves less buying and selling
▪ minimize transaction costs.
▪Attempts to capture the expected return consistent with the risk level
of their portfolios.
▪Often results in investors buying index funds or other mutual funds.
Passive and Active Strategies
Passive Strategies
▪The portfolio’s returns will track those of a benchmark index over time
➢Accordingly, this approach is referred to as indexing
▪Indexing is long-term buy-and-hold strategy
➢However, occasional rebalancing of the portfolio is necessary as the composition of the
underlying benchmark changes
▪Since the purpose is to mimic an index, the passive manager is judged by how
well he/she tracks the target
➢minimizes the deviation between stock portfolio and index returns
Passive and Active Strategies …
Active investment Strategies
▪involves using the information acquired by expert stock analysts to
actively buy and sell stocks with specific characteristics.
▪The goal is to beat the results of the indices and general stock
market with higher returns and/or lower risk.
▪Active investing such as momentum trading are an attempt to
outperform benchmark indexes.
▪Active investors believe they have the better than average skills.
Passive and Active Strategies

▪to distinguish between these strategies, decompose the total actual return:
Passive and Active Strategies
The active manager can employ two main ways to try to add
alpha:
1. Tactical adjustments (sector timing):
◦ Involves predicting broad market movements
◦ Asset allocation based on information about the asset class that will perform
the best during the coming period

2. Security selection
◦ Stock-picking (identify and choose stocks that are under-priced)
Passive and Active Strategies …
ADVANTAGES OF PASSIVE STRATEGY ADVANTAGES OF ACTIVE STRATEGY

1. Easy to understand — track 1. A chance at bigger rewards.

the index 2. Flexibility: buy undervalued and
sell overvalued stocks
2. Low transaction cost
3. Tax management: it triggers
3. Long-term Growth more capital gains
 ▪Three basic techniques for constructing a passive index
portfolio
1) Full replication
➢all the securities in the index are purchased in
proportion to their weights in the index.
2) Sampling
➢a representative sample of stocks that comprise the
benchmark index.
➢Stocks with larger index weights are purchased
Passive Strategy: according to their weight in the index
Index Portfolio ➢smaller issues are purchased so their aggregate
characteristics approximate the underlying benchmark.
Construction 3) Quadratic optimization (programming)
Techniques ➢historical information on price changes and correlations
between securities are inserted to a computer program
➢The program determines the composition of a portfolio
that will minimize return deviations from the
benchmark
 The purpose of forming a passive portfolio
is to replicate a particular equity index
The success of such a fund lies in how
Tracking Error closely its returns match those of the
and Index benchmark.
Portfolio
Construction
The goal of the passive manager should be
to minimize the portfolio’s return volatility
relative to the index.
the manager should try to minimize tracking
error.
Tracking Error and Index Portfolio
Construction
➢Tracking error is the extent to which return fluctuations in the
managed portfolio are not correlated with return fluctuations in
the benchmark.
➢Tracking error (Δpt) can be measured as follows:
𝑁

∆𝑝𝑡 = ෍ 𝑤𝐼 𝑅𝑖𝑡 − 𝑅𝑏𝑡

𝑖=1
Wi = investment weight of Asset i in the managed portfolio
Rit = return to Asset i in Period t
Rbt = return to the benchmark portfolio in Period t
Methods of Index Portfolio
Investing

Investors can construct their own passive investment

portfolios that mimic a particular equity index

1) Buying shares of
However, there are two pre- index mutual fund
packaged ways which are
typically more convenient and 2) Buying shares of
less expensive. exchange-traded fund
(ETF)
Index mutual funds
Fund managers attempt to exactly They alter the position anytime the
replicate the composition of an index composition of the index changes

Since changes to most equity indexes are infrequent, index funds tend to
generate low trading and management expense ratios.

The advantage of index mutual funds is that they provide an inexpensive

way for investors to acquire a diversified portfolio

The disadvantages are that investors can only liquidate their positions at the
end of the trading day (i.e., no intraday trading), usually cannot short sell
Exchange-Traded Funds (ETFs)
➢ ETFs are depository receipts that
✓give investors a pro rata claim on the return of the securities that
are held in deposit
✓by the financial institution that issued the certificates.
➢A portfolio of securities is placed on deposit at a financial
institution
✓The FI issues a single type of certificate representing ownership of the
underlying portfolio
Exchange-Traded Funds (ETFs)…
Advantages of ETFs over index mutual funds
✓Traded like common stock through an organized
exchange or in an over-the-counter market
✓Backed by a sponsoring organization
✓Smaller management fee
✓Ability for continuous trading while markets are open
Active Equity Portfolio Management Strategies

➢The goal of active equity management is to:

▪ Earn a return that exceeds the return of a passive benchmark portfolio, net
of transaction costs, on a risk-adjusted basis
➢the risk of the active portfolio may exceed that of the
passive benchmark
▪ So, the active portfolio’s return will have to exceed the benchmark
➢Requires fund managers who possess significant stock-
picking skills
Active Equity Portfolio Management Strategies

➢Active strategies can be put into three general

categories:
1. Fundamental strategy
2. Technical strategy
3. Market anomalies and security attributes
Active Strategy:- Fundamental Strategy
➢Generally, active fundamental managers use three generic themes
1. They try to time the equity market by shifting funds into and out of stocks,
bonds, and T-bills depending on broad market forecasts and estimated
risk premiums.
2. they can shift funds among different equity sectors and industries (e.g.,
financial stocks, technology stocks, consumer cyclical) before the rest of
the market.
3. Equity managers can look at individual issues in an attempt to find
undervalued stocks
Active Strategy:- Fundamental Strategy
➢Generally, active fundamental managers applies three important strategies:
1) Tactical Asset Allocation (Asset class rotation strategy)
◦ Shifts funds in and out of the stock market depending on the manager’s
perception of how the stock market is valued compared to the various
alternative asset classes
2) A sector rotation strategy
oemphasizing or overweighting (relative to the benchmark portfolio)
certain economic sectors or industries in response to the next expected
phase of the business cycle
3) Fundamental stock picking
◦ selecting (purchasing) stocks that are under-priced
Active Strategy:- Fundamental Strategy
130/30 strategies (Fowler, 2007)
➢Take long positions up to 130 percent
➢Take short positions up to 30 percent. of the portfolio’s original
capital
➢Relative to “long only” portfolios, these enables managers to
make use of their fundamental research in two ways.
1. Buy stocks they identify as undervalued and
2. Short sell those that are overvalued
Active Strategy:- Technical Strategy
➢Active managers can form equity portfolios based on past stock
price trends by:
➢assuming that one of two things will happen:
(1)past stock price trends will continue in the same
direction (Price Momentum)
(2)they will reverse themselves (Contrarian view)
Active Strategy:- Technical Strategy
Contrarian investment strategy
✓The best time to buy (sell) a stock is when the majority of other
investors are the most bearish (bullish) about it.
✓The contrarian investor will attempt to always purchase the stock
when it is near its lowest price and sell it (or even short sell it)
when it nears its peak.
✓ The belief is that stock returns are mean reverting, indicating
that, over time, stocks will be priced so as to produce returns
consistent with their risk-adjusted expected ( mean) returns.
Active Strategy:- Technical Strategy
Overreaction hypothesis
➢Contrarian investment strategy is based on overreaction hypothesis
➢Under the overreaction hypothesis, subsequent abnormal returns move in
the opposite direction to past performance (news).
➢DeBondt and Thaler (1985) documented that investors overreacts to either
bad news or good news about companies
➢Subsequent cumulative abnormal returns (CARs) has been found to move
in reverse direction
✓Increases for the worst market past performance (i.e., losers) and
decreases for the best past performance (i.e., winners).
Active Strategy:- Technical Strategy
Abnormal Returns to a Market Overreaction Investment Strategy
Active Strategy:- Technical Strategy
Momentum investing strategy
➢Assumes the recent trends in past prices (price momentum) and
trends in earnings (earnings momentum) will continue
➢Involves
✓Buying financial instrument showing upward-trending prices and
✓Selling the respective assets with downward-trending prices.
➢Assumes economic trends will continue and investors underreact
to the arrival of new information.
oThus, a pure price momentum strategy focuses on the trend of past prices
alone and makes purchase and sale decisions accordingly.
Active Strategy:- Technical Strategy
Momentum investing strategy ….
➢Momentum investing can mean two things: price momentum and
earnings momentum.
➢The justifications for these strategies are very different.
➢Price momentum is a technical strategy, while earnings momentum is
ultimately a fundamental approach to investing
✓They can lead to forming very different portfolios.
oA price momentum investor might be attracted to a stock with
consistently strong, positive returns regardless of why they
occurred.
 Active strategy:-Anomalies and Attributes

➢Market anomalies provide opportunities for active equity management

➢Disciplined investors can exploit market anomalies to generate outsized
returns
➢While conceptually viable, these anomalies do not produce particularly
portfolio strategies.
➢However, active portfolio managers can produce alpha focusing on:
✓low-beta stocks (low-beta stocks outperform hight beta stocks)
✓small-cap stocks (small-cap stocks outperform their large-cap peers)
✓value stocks (value stocks tend to do best in weak markets)
✓stocks with significant insider buying (worth attention due to signalling effect)
Tax Efficiency and Active Equity Management

➢Compared to a passively strategy, there are two potential costs

associated with active strategy
1) First, the active fund will incur additional transaction costs,
which will reduce the net return to the portfolio.
2) Second, selling stocks that have appreciated in price will create
a capital gain on which investors may have to pay taxes.
Tax Efficiency and Active Equity Management

➢Portfolio turnover is an indirect measure of the amount of trading

that could lead to a higher tax bill for a taxable investor.
➢Portfolio turnover ratio is measured as the total dollar value of the
securities sold from the portfolio in a year divided by the average dollar
value of the assets managed by the fund.
➢A more direct measure of how well portfolio managers balance the
capital gains and losses resulting from their trades is the tax cost
ratio.
Tax Efficiency and Active Equity Management

➢ Tax cost ratio represents the percentage of an investor’s assets

that are lost to taxes on a yearly basis due to the trading strategy
employed by the fund manager.
(1+𝑇𝐴𝑅)
𝑇𝑎𝑥 𝐶𝑜𝑠𝑡 𝑅𝑎𝑡𝑖𝑜 = [1 − ] x 100%
1+𝑃𝑇𝑅
Where,
TAR = tax adjusted return
PTR = Pre- tax return
Tax Efficiency and Active Equity Management

Tax Efficiency of Passive and Active Stock Funds: An Example

Value Investing
A conservative approach advocated by Benjamin Graham.

Value investing is a long-term strategy that involves buying and holding undervalued
securities,

The primary logic behind value investing is to buy stocks when they are undervalued
and sell them when they reach their inherent value or are overvalued.

Value investors undertake various analyses to determine intrinsic value.

• The analysis includes studying a company’s financial performance, cash flow, earnings,
revenue, business model, target market & future profitability
Value Investing …
Value Investing …
Value investing Strategies
Value investing process
Growth Investing
A style of investment strategy focused on capital appreciation

Growth investors typically invest in growth stocks:

• young or small companies whose earnings are expected to increase

Growth investing is highly attractive to many investors because buying

such stocks can provide impressive returns
• However, such companies are untried, and thus often pose a fairly high risk.
Growth Investing …
Growth investors Most growth-stock
Growth investors look companies reinvest
typically look for
for profits through
investments in rapidly
capital appreciation. their earnings back
expanding industries into the business

The idea is that the company

Growth stocks may
will prosper and expand, and
therefore trade at a
this growth in earnings will
high price/earnings
eventually translate into higher
(P/E) ratio.
stock prices in the future.
 Growth investing vs value investing
The main distinction is the aspects of P/E ratio they
focus on more

GROWTH INVESTING VALUE INVESTING

▪Focus on the price component (i.e., the

▪EPS component (i.e., the denominator)
numerator)
▪Look for companies that exhibit rapid EPS
▪Looks for under-valued companies
growth in the future
▪implicitly assume that the P/E ratio is
▪Implicitly assume that the P/E ratio will
below its natural level
remain constant over the near term
▪The market will soon “correct” this
▪Thus, the stock price will rise as
situation by increasing the stock price with
forecasted earnings growth is realized
little or no change in earnings
Style Analysis
➢Style analysis is the process of determining what type of
investment behaviour an investor or portfolio manager employs
when making investment decisions.
✓it is simply identifying a fund manager's overall investment philosophy.

➢It involves comparing the past returns of the portfolio with indexes
representing different investment styles
✓to determine the relationship between the portfolio and those specific styles
Style Analysis
➢Style analysis relies on the constrained least squares procedure with:
✓the returns of the portfolio as the dependent variable and
✓the returns to the style index portfolios as the independent variables.
➢There are often three constraints employed:
1) No intercept term is specified
2) The coefficients must sum to one
3) All the coefficients must be nonnegative.
 Style Analysis
➢As developed by Sharpe (1992), returns-based style analysis is
simply an application of an asset class factor model:
𝑅𝑝𝑡 = [𝛽𝑝𝑙 𝐹1𝑡 + 𝛽𝑝2 𝐹2𝑡 + … + 𝛽𝑝𝑛 𝐹𝑛𝑡 ] + 𝑒𝑝𝑡
Where
• Rpt = the tth period return to the portfolio of Manager p
• Fjt = the tth period return to the jth style factor
• βpj = the sensitivity of Portfolio p to Style j
• ept = the portion of the return variability in Portfolio p not explained by variability in the set
of factors
 Style Analysis
➢From the least square regression analysis,
➢The R2 in style analysis can be interpreted as the percentage of
portfolio’s return variability due to the investment style and
➢(1 − R2) is due to the manager’s selection skills
➢The benchmark portfolios selected as style analysis factors
should be consistent with the manager’s pronounced style
Style Analysis Grid
 ASSET ALLOCATION STRATEGIES
➢An equity portfolio is part of an investor’s overall investment portfolio
▪ Thus, the manager must also determine the appropriate mix of asset
categories in the entire portfolio.
➢There are four general strategies for determining the asset mix of a portfolio:
1. Integrated
2. Strategic
3. Tactical, and
4. Insured asset allocation methods.
Integrated Asset Allocation Strategy
➢The integrated asset allocation strategy separately examines

(1) capital market conditions and

(2) the investor’s objectives and constraints.

➢These factors are combined to establish the portfolio asset mix that offers the best

opportunity for meeting the investor’s needs.

Integrated Asset Allocation Strategy
➢Sharpe (1987, 1990) describes three key steps to integrated asset
allocation.
✓First, both capital market conditions and investor-specific objectives and
constraints are established
✓Second, the information from the first step is combined to select the single
best portfolio for the investor in question.
✓Third, after enough time has passed, the optimal portfolio’s actual
performance can be compared with the manager’s original expectations.
oFollowing the assessment, the manager can make adjustments to the portfolio
by including new information into the optimization process.
 Strategic asset allocation
➢Determines the long-term policy asset weights in a portfolio
▪Long-term average asset returns, risk, and covariances are used as
estimates of future capital market results.
➢Efficient frontiers are generated using this historical information
➢The investor decides the asset mix appropriate for his/her needs
▪This results in a constant-mix asset allocation with periodic
rebalancing to adjust the portfolio to the specified asset weights
Strategic asset allocation
Similarity to the integrated strategy, manager attempts to
determine the best suited mix by optimizing information from both
the capital market and the investor

However, once the asset mix is established, the manager does

not attempt to adjust the allocation

That is, under this strategy, the manager determines the long-
term asset allocation
Strategic Asset Allocation (SAA)
Strategic asset allocation refers to a long-term portfolio strategy that
involves choosing asset class allocations and rebalancing the
allocations periodically.
Rebalancing occurs when the asset allocation weights materially
deviate from the strategic asset allocation weights

It is similar to a buy-and-hold strategy in that target asset weights

are chosen and maintained over a long period of time.
 Strategic Asset Allocation: Example
Jeff, in his investment policy statement, indicated that he wants a strategic asset allocation of
50% stocks / 40% bonds / 10% cash. Jeff’s portfolio is valued at $1 million, and he rebalances
annually. At the end of the year, his portfolio looks as follows:
Strategic Asset Allocation: Example …
To follow an SAA strategy, Jeff would rebalance the portfolio above to 50% stocks / 40% bonds /
10% cash. He can do so through selling stocks and putting them in bonds and cash. His
rebalanced portfolio would look as follows:

Therefore, at the end of the year, the SAA strategy would involve selling $21,000 worth of stocks
and putting $15,200 in bonds and $5,800 in cash.
 Tactical Asset Allocation (TAA)
➢Tactical asset allocation frequently adjusts the asset class mix in
the portfolio to take advantage of changing market conditions.
➢Adjustments are driven solely by perceived changes in the
relative values of the various asset classes
▪The investor’s risk tolerance and investment constraints are assumed to
be constant over time
➢Tactical asset allocation is often based on the premise of mean
reversion
▪Whatever a security’s return has been in the recent past, it will eventually
revert to its long-term average (mean) value.
Tactical Asset Allocation (TAA)

Tactical asset allocation (TAA)

It is an investment style in
refers to an active portfolio
which asset classes such as
management strategy that
stocks, bonds, cash, etc. are
shifts asset allocations in a
adjusted in the portfolio to
portfolio to take advantage of
account for macroeconomic
market trends or economic
events.
conditions.
Tactical Asset Allocation (TAA)…
The underlying premise behind tactical asset allocation is to first focus on
asset allocation and securities selection second.

TAA looks at the “bigger picture” and believes that the allocation of assets
exerts a greater impact on portfolio returns than individually selecting
securities.

The tactical asset allocation strategy can be used to increase returns, adapt
to market conditions, and provide diversification.
 Insured asset allocation
➢Insured asset allocation results in continual adjustments in the portfolio
allocation
➢Assumes that expected market returns and risks are constant over time
➢But, the investor’s objectives and constraints change as his/her wealth
position changes.
➢Rising portfolio values increase the investor’s wealth and consequently
his/her ability to handle risk
▪which means the investor can increase his or her exposure to risky assets
 Insured asset allocation
➢Declines in the portfolio’s value decrease investor’s ability to handle risk
▪ Thus, the portfolio’s exposure to risky assets must decline.

➢Insured asset allocation involves two assets (common stocks and T-bills)
▪ As stock prices rise, the asset allocation increases the stock component.
▪ As stock prices fall, the stock component of the mix falls while the T-bill
component increases.
▪ This is opposite of what would happen under tactical asset allocation
Constant Proportion Portfolio Insurance (CPPI)

Investor sets a floor on the Apply two asset classes: risky asset
dollar value of their portfolio, (Equities or mutual funds) and a
then structures asset allocation conservative asset (treasury bonds).
around that decision.

The percentage allocated to each A multiplier is used to

depends on the "cushion" value, determine the amount of risk
defined as current portfolio value that an investor is willing to
minus floor value undertake.
Constant Proportion Portfolio Insurance…

❑CPPI strategy requires the manager to invest a percentage of the

portfolio in stocks and will invest the remainder in the conservative
asset
Value in stocks = Multiplier × (Portfolio value – Floor value)
❑The value of the multiplier is based on the investor's risk profile
➢a multiplier coefficient, where a higher number denotes a more
aggressive strategy.
 Constant Proportion Portfolio Insurance
(cont’d)
Example
A portfolio has a market value of $2 million. The investment policy statement
specifies a floor value of $1.7 million and a multiplier of 2.
What is the dollar amount that should be invested in stocks according to the
CPPI strategy?

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Constant Proportion Portfolio Insurance
(cont’d)

Example (cont’d)

Solution: $600,000 should be invested in stock:

$ in stocks = 2.0 × ($2,000,000 – $1,700,000)
= $600,000
If the portfolio value is $2.2 million one quarter later, with $650,000 in stock,
what is the desired equity position under the CPPI strategy? What is the
ending asset mix after rebalancing?

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Constant Proportion Portfolio Insurance
(cont’d)

Example (cont’d)
Solution: The desired equity position after one quarter should be:
$ in stocks = 2.0 × ($2,200,000 – $1,700,000)
= $1,000,000

The portfolio manager should move $350,000 into stock. The resulting
percentage would be: $1,000,000/$2,200,000 = 45.5%

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 Rebalancing the portfolio

Rebalancing a portfolio
A constant proportion
is the process of Constant proportion
strategy requires
periodically adjusting it rebalancing requires
maintaining the same
to maintain the selling winners and
percentage investment
targeted conditions or buying losers
in each stock
weights.
 Rebalancing
Example

An investor attempts to invest approximately one third of funds in each of the stocks.
Consider the following information:

Stock Price Shares Value % of Total Portfolio

FC 22.00 400 8,800 31.15
HG 13.50 700 9,450 33.45
YH 50.00 200 10,000 35.40
Total $28,250 100.00

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 Rebalancing …
Example (cont’d)

After one quarter, the portfolio values are as shown below.

Recommend specific actions to rebalance the portfolio in order to
maintain the constant proportion in each stock.

Stock Price Shares Value % of Total Portfolio

FC 20.00 400 8,000 21.92
HG 15.00 700 10,500 28.77
YH 90.00 200 18,000 49.32
Total $36,500 100.00
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 Rebalancing …
Here is a solution to rebalancing the portfolio to “ideal” weights:

69
Disciplined Investing
 Leave the Portfolio Alone
A buy and hold strategy means that the portfolio manager hangs
on to its original investments
Academic research shows that portfolio managers often fail to
outperform a simple buy and hold strategy on a risk-adjusted
basis
◦ e.g., It has been shown that investors who trade the most tend to have
the lowest returns

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Chapter End