1. Chapter 15 Revision of the Equity Portfolio Portfolio Construction, Management, & Protection , 5e,Robert A. Strong Copyright 2009 by South-Western, a division of Thomson Business & Economics. All rights reserved.

2.

An individual can make a difference; a team can make a miracle

1980 U.S. Olympic hockey team

3. 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

4. Active Management versus Passive Management

Anactive managementpolicy 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

Apassive managementstrategy is one in which the portfolio is largely left alone

5. The Managers 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

6. Leave the Portfolio Alone

Abuy and hold strategymeans 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

7. Rebalance the Portfolio

Rebalancinga portfolio is the process of periodically adjusting it to maintain the original conditions

8. Constant Mix Strategy

Theconstant mix strategy :

• Is one in 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

9. Constant Mix Strategy (contd)

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.

10. Constant Mix Strategy (contd)

Example (contd)

What dollar amount of stock should the portfolio manager buy to rebalance this portfolio? What dollar amount of bonds should he sell?

$1,100,000 $1,400,000 56%/44% $2,500,000 1 Apr $800,000 $1,200,000 60%/40% $2,000,000 1 Jan Bonds Stock Actual Allocation Portfolio Value Date 11. Constant Mix Strategy (contd)

Example (contd)

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.

12. Constant ProportionPortfolio Insurance

Aconstant proportion portfolio insurance(CPPI) strategy requires the manager to invest a percentage of the portfolio in stocks:

$ in stocks = Multiplier(Portfolio value Floor value)

13. Constant ProportionPortfolio Insurance (contd)

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?

14. Constant ProportionPortfolio Insurance (contd)

Example (contd)

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?

15. Constant ProportionPortfolio Insurance (contd)

Example (contd)

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%

16. Relative Performance of Constant Mix and CPPI

A constant mix strategysellsstock as it rises

A CPPI strategybuysstock as it rises

17. Relative Performance of Constant Mix and CPPI (contd)

In arising market , the CPPI strategy outperforms constant mix

In adeclining market , the CPPI strategy outperforms constant mix

In aflat market , neither strategy has an obvious advantage

In avolatile market , the constant mix strategy outperforms CPPI

18. Relative Performance of Constant Mix and CPPI (contd)

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

19. Rebalancing Within theEquity Portfolio

Constant Proportion

Constant Beta Portfolio

Change the Portfolio Components

Indexing

20. Constant Proportion

Aconstant proportion strategywithin 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

21. Constant Proportion (contd)

Example

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

100.00 $28,250 Total 35.40 10,000 200 50.00 YH 33.45 9,450 700 13.50 HG 31.15 8,800 400 22.00 FC % of Total Portfolio Value Shares Price Stock 22. Constant Proportion (contd)

Example (contd)

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.

100.00 $36,500 Total 49.32 18,000 200 90.00 YH 28.77 10,500 700 15.00 HG 21.92 8,000 400 20.00 FC % of Total Portfolio Value Shares Price Stock 23. Constant Proportion (contd)

Example (contd)

Solution:The worksheet below shows a possible revision which requires an additional investment of $1,000:

100.00 36.00 32.00 32.00 % of Portfolio Sell 50 Buy 100 Buy 200 Action $37,500 $36,500 Total 13,500 18,000 200 90.00 YH 12,000 10,500 700 15.00 HG 12,000 8,000 400 20.00 FC Value After Value Before Shares Price Stock 24. Constant Beta Portfolio

Aconstant beta portfoliorequires maintaining the same portfolio beta

It is more likely to have requirements that beta be within some given range

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

25. Change thePortfolio 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

26. Indexing

Indexingis 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

Thetracking errorrefers to the extent to which a portfolio deviates from its intended behavior

27. 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

28. Tactical Asset Allocation

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

29. Definition (contd)

TAA attempts to take advantage of short-term deviations from long-term trends

The most difficult part of TAA isasset class appraisal

• The process of determining the relative merits of the various asset classes given current economic conditions

30. Intuitive versusQuantitative Techniques

In the intuitive approach, decisions are based on personal opinion and gut feeling

• Suffers fromhindsight bias

• • Portfolio managers remember the times they were correct

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

31. Overview of the Technique 32. 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

33. Strategy

There are three alternative strategic functions:

• Static strategymaintains a static portfolio mix

• Reactive strategyinvolves decisions based on events that have already occurred

• Anticipatory strategyinvolves shifting funds before the markets move

34. How TAA CanBenefit 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

35. How TAA CanBenefit a Portfolio (contd) Source: Ensign Peak Advisors, Inc., Salt Lake City, UT 84150. 36. Designing a TAA Program

Before implementing a TAA program, a fund manager must establish:

• Thenormal mix

• • The benchmark proportion each asset class constitutes in the portfolio

• Themix (exposure) range

• • Specifies how much the current mix can deviate from the normal mix

37. Designing aTAA Program (contd)

Before implementing a TAA program, a fund manager must establish (contd):

• Theswing 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

38. 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

39. 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

40. Costs of Revision

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

41. Commissions

Investors pay commissions both to buy and to sell shares

Commissions at a brokerage firm may be a function of both:

• The dollar value of the trade

• The number of shares involved in the trade

42. Commissions (contd)

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

43. Commissions (contd)

Discount brokerage firms :

• Offer substantially reduced 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 trade value

44. 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

45. Market Impact

Themarket impactof 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

46. Management Time

Most portfolio managers handle more than one account

Rebalancing several dozen portfolios is time consuming

47. 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

48. Window Dressing

Window dressingrefers 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

49. Rising Importanceof 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

50. 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 clients 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

51. When Do You Sell Stock?

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

52. 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

53. 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

54. Sale of a Stock Via Stop Orders

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

55. 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

56. 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 acrawling stopto increase the stop price

57. Change in Client Objectives

The clients 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

58. Change in Market Conditions

Many fund managers seek to actively time the market

When a portfolio managers outlook becomes bearish, he may reduce his equity holdings

59. Buy-Outs

A firm may be making atender offerfor one of the portfolio holdings

• i.e., another firm wants to acquire the security position

It is generally in the clients best interest to sell the stock to the potential acquirer

60. 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

61. 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