1 chapter 13 revision of the equity portfolio portfolio construction, management, & protection,...
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Chapter 13
Revision of the Equity Portfolio
Portfolio Construction, Management, & Protection, 4e, Robert A. StrongCopyright ©2006 by South-Western, a division of Thomson Business & Economics. All rights reserved.
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Outline Introduction Active Management versus Passive
Management Tactical Asset Allocation When Do You Sell Stock?
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Introduction Portfolios need maintenance and periodic
revision:• Because the needs of the beneficiary will
change• Because the relative merits of the portfolio
components will change• To keep the portfolio in accordance with the
investment policy statement and investment strategy
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Definition An active management policy is one in
which the composition of the portfolio is dynamic• The portfolio manager periodically changes:
– The portfolio components or
– The components’ proportion within the portfolio
A passive management strategy is one in which the portfolio is largely left alone
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The Manager’s Choices Leave the Portfolio Alone Rebalance the Portfolio Asset Allocation and Rebalancing within
the Aggregate Portfolio Rebalancing within the Equity Portion Change the Portfolio Components Indexing
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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., Barber and Odean show that investors who trade
the most have the lowest gross and net returns
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Rebalance the Portfolio Rebalancing a portfolio is the process of
periodically adjusting it to maintain the original conditions
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Asset Allocation and Rebalancing within the Aggregate Portfolio
Constant Mix Strategy Constant Proportion Portfolio Insurance Relative Performance of Constant Mix and
CPPI Strategies
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Constant Mix Strategy The constant mix strategy:
• Is one to which the manager makes adjustments to maintain the relative weighting of the asset classes within the portfolio as their prices change
• Requires the purchase of securities that have performed poorly and the sale of securities that have performed the best
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Constant Mix Strategy (cont’d)Example
A portfolio has a market value of $2 million. The investment policy statement requires a target asset allocation of 60 percent stock and 40 percent bonds.
The initial portfolio value and the portfolio value after one quarter are shown on the next slide.
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Constant Mix Strategy (cont’d)Example (cont’d)
What dollar amount of stock should the portfolio manager buy to rebalance this portfolio? What dollar amount of bonds should he sell?
Date Portfolio Value Actual Allocation Stock Bonds
1 Jan $2,000,000 60%/40% $1,200,000 $800,000
1 Apr $2,500,000 56%/44% $1,400,000 $1,100,000
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Constant Mix Strategy (cont’d)Example (cont’d)
Solution: a 60 percent/40 percent asset allocation for a $2.5 million portfolio means the portfolio should contain $1.5 million in stock and $1 million in bonds. Thus, the manager should buy $100,000 worth of stock and sell $100,000 worth of bonds.
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Constant Proportion Portfolio Insurance
A constant proportion portfolio insurance (CPPI) strategy requires the manager to invest a percentage of the portfolio in stocks:
$ in stocks = Multiplier × (Portfolio value – Floor value)
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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 asset mix would be: $1,000,000/$2,200,000 = 45.5%
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Relative Performance of Constant Mix and CPPI
A constant mix strategy sells stock as it rises
A CPPI strategy buys stock as it rises
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Relative Performance of Constant Mix and CPPI (cont’d)
In a rising market, the CPPI strategy outperforms constant mix
In a declining market, the CPPI strategy outperforms constant mix
In a flat market, neither strategy has an obvious advantage
In a volatile market, the constant mix strategy outperforms CPPI
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Relative Performance of Constant Mix and CPPI (cont’d)
The relative performance of the strategies depends on the performance of the market during the evaluation period
In the long run, the market will probably rise, which favors CPPI
In the short run, the market will be volatile, which favors constant mix
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Rebalancing Within the Equity Portfolio
Constant Proportion Constant Beta Portfolio Change the Portfolio Components Indexing
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Constant Proportion A constant proportion strategy within an
equity portfolio requires maintaining the same percentage investment in each stock• May be mitigated by avoidance of odd lot
transactions
Constant proportion rebalancing requires selling winners and buying losers
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Constant Proportion (cont’d)Example
A portfolio of three stocks 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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Constant Proportion (cont’d)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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Constant Proportion (cont’d)Example (cont’d)
Solution: The worksheet below shows a possible revision which requires an additional investment of $1,000:
Stock Price SharesValue Before Action
Value After
% of Portfolio
FC 20.00 400 8,000 Buy 200 12,000 32.00
HG 15.00 700 10,500 Buy 100 12,000 32.00
YH 90.00 200 18,000 Sell 50 13,500 36.00
Total $36,500 $37,500 100.00
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Constant Beta Portfolio A constant beta portfolio requires maintaining
the same portfolio beta To increase or reduce the portfolio beta, the
portfolio manager can:• Reduce or increase the amount of cash in the portfolio
• Purchase stocks with higher or lower betas than the target figure
• Sell high-beta stocks or low-beta stocks
• Buy high-beta stocks or low-beta stocks
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Change the Portfolio Components
Changing the portfolio components is another portfolio revision alternative
Events sometimes deviate from what the manager expects:• The manager might sell an investment turned
sour• The manager might purchase a potentially
undervalued replacement security
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Indexing Indexing is a form of portfolio management that
attempts to mirror the performance of a market index• e.g., the S&P 500 or the Russell 1000
Index funds eliminate concerns about outperforming the market
The tracking error refers to the extent to which a portfolio deviates from its intended behavior
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Tactical Asset Allocation What Is Tactical Asset Allocation? How TAA Can Benefit a Portfolio Designing a TAA Program Caveats Regarding TAA Performance Costs of Revision Contributions to the Portfolio
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What Is Tactical Asset Allocation?
Definition Intuitive versus Quantitative Techniques Overview of the Technique Policy Decisions Strategy
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Definition Tactical asset allocation (TAA) managers:
• Seek to improve the performance of their funds by shifting the relative proportion of their investments into and out of asset classes as the relative prospects of those asset classes change
For example, shift to stocks if stocks are expected to outperform bonds
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Definition (cont’d) TAA attempts to take advantage of short-
term deviations from long-term trends
The most difficult part of TAA is asset class appraisal• The process of determining the relative merits
of the various asset classes given current economic conditions
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Intuitive versus Quantitative Techniques
In the intuitive approach, decisions are based on personal opinion and gut feeling• Suffers from hindsight bias
– Portfolio managers remember the times they were correct
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Intuitive versus Quantitative Techniques (cont’d)
In the quantitative approach, managers use an analytical assessment and a system for implementing precise portfolio changes• e.g., use the gap between the S&P 500 dividend
yield and the average yield on AAA corporate bonds
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Policy Decisions Policy decisions involve:
• Deciding to use a TAA program in the first place
• Establishing the extent to which the program will be employed
• Determining the number of asset classes to employ
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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
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How TAA Can Benefit a Portfolio
The goal of an anticipatory strategy is to outperform the portfolio without TAA• The potential gains to a clairvoyant manager
from TAA are enormous (see next slide)
The portfolio manager must assess return within a risk/return framework
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How TAA Can Benefit a Portfolio (cont’d)
Source: Ensign Peak Advisors, Inc., Salt Lake City, UT 84150.
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Designing a TAA Program Before implementing a TAA program, a
fund manager must establish:• The normal mix
– The benchmark proportion each asset class constitutes in the portfolio
• The mix (exposure) range– Specifies how much the current mix can deviate
from the normal mix
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Designing a TAA Program (cont’d)
Before implementing a TAA program, a fund manager must establish (cont’d):• The swing component
– The percentage of the total portfolio whose composition by asset class may change
– The key element of TAA is properly investing the swing component
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Efficient Market Implications TAA programs implicitly assume it is
possible to outperform a buy-and-hold strategy by shifting asset classes• Inconsistent with the efficient market
hypothesis Some fund managers have good records
with TAA programs• Might be skill or luck
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Impact of Transaction Costs The portfolio incurs trading fees each time a
trade occurs
If the marginal gains from TAA switching do not exceed transaction costs, the program is not effective
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Costs of Revision Introduction Trading Fees Market Impact Management Time Tax Implications Window Dressing Rising Importance of Trading Fees
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Introduction Costs of revising a portfolio can:
• Be direct dollar costs• Result from the consumption of management
time• Stem from tax liabilities• Result from unnecessary trading activity
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Commissions Investors pay commissions both to buy and
to sell shares
Commissions at a brokerage firm are a function of:• The dollar value of the trade• The number of shares involved in the trade
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Commissions (cont’d) The commission on a trade is split between
the broker and the firm for which the broker works• Brokers with a high level of production keep a
higher percentage than a new broker
Some brokers discount their commissions with their more active clients
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Commissions (cont’d) Discount brokerage firms:
• Offer substantially reduce commission rates• Offer few ancillary services, such as market
research or periodic newsletters
Retail commissions at a full-service firm average about 2 percent of the stock value
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Transfer Taxes Transfer taxes are:
• Imposed by some states on the transfer of securities
• Usually very modest
• Not normally a material consideration in the portfolio management process
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Market Impact The market impact of placing the trade is
the change in market price purely because of executing the trade
Market impact is a real cost of trading
Market impact is especially pronounced for shares with modest daily trading volume
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Management Time Most portfolio managers handle more than
one account
Rebalancing several dozen portfolios is time consuming
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Tax Implications Individual investors and corporate clients
must pay taxes on the realized capital gains associated with the sale of a security
Tax implications are usually not a concern for tax-exempt organizations
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Window Dressing Window dressing refers to cosmetic
changes made to a portfolio near the end of a reporting period
Portfolio managers may sell losing stocks at the end of the period to avoid showing them on their fund balance sheets
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Rising Importance of Trading Fees
Flippancy regarding commission costs is unethical and sometimes illegal
Trading fees are receiving increased attention because of:• Investment banking scandals• Lawsuits regarding churning• Incomplete prospectus information
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Contributions to the Portfolio Periodic additional contributions to the portfolio
from internal or external sources must be invested If an account holds its securities in a street name,
dividends go to the brokerage firm holding the securities on the client’s behalf
If the portfolio manager receives the dividend checks, there needs to be some temporary haven for these funds until they accumulate sufficiently to finance the purchase of more securities or until they are paid as income to the fund beneficiary
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When Do You Sell Stock? Introduction Rebalancing Upgrading Sale of Stock via Stop Orders Extraordinary Events Final Thoughts
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Introduction Knowing when to sell a stock is a very
difficult part of investing
Behavioral evidence suggests the typical investor sells winners too soon and keeps losers too long
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Rebalancing Rebalancing can cause the portfolio
manager to sell shares even if they are not doing poorly
Profit taking with winners is a logical consequence of portfolio rebalancing
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Upgrading Investors should sell shares when their
investment potential has deteriorated to the extent that they no longer merit a place in the portfolio
It is difficult to take a loss, but it is worse to let the losses grow
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Sale of Stock via Stop Orders Definition Using Stops to Minimize Losses Using Stops to Protect Profits
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Definition Stop orders:
• Are usually used to sell but can be used to buy
• A sell stop becomes a market order to sell a set number of shares if shares trade at the stop price
• Can be used to minimize losses or to protect a profit
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Using Stops to Minimize Losses Stop-loss orders can be used to minimize
losses• e.g., you bought a share for $23 and want to sell
it if it falls below $18– Place a stop-loss order at $18
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Using Stops to Protect Profits Stop orders can be used to protect profits
• e.g., a stock you bought for $33 now trades for $48 and you want to protect the profits at $45
– If the stock retreats to $45, you lock in the profit if you place a stop order
– If the stock continues to increase, you can use a crawling stop to increase the stop price
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Change in Client Objectives The client’s investment objectives may
change occasionally:• e.g., a church needs to generate funds for a
renovation and changes the objective for the endowment fund from growth of income to income
– Reduce the equity component of the portfolio
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Change in Market Conditions Many fund managers seek to actively time
the market
When a portfolio manager’s outlook becomes bearish, he may reduce his equity holdings
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Buy-Outs A firm may be making a tender offer for
one of the portfolio holdings• i.e., another firm wants to acquire the security
position
It is generally in the client’s best interest to sell the stock to the potential acquirer
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Caprice Portfolio managers:
• Should be careful about making unnecessary trades
• Must pay attention to their experience, intuition, and professional judgment
An experienced portfolio manager worried about a particular holding should probably make a change
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Final Thoughts Hindsight is an inappropriate perspective for
investment decision making• Everything you do as a portfolio manager must be
logically justifiable at the time you do it
Portfolio managers are torn between a desire to protect profits or minimize further losses and the potential for price appreciation