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BAFI1045 Investments

Equity Portfolio Management Strategies

Reilly, Frank K. and Keith C. Brown, Analysis of Investment and Management Portfolios (9th Edition), Thomson SouthWestern, 2009. Chapter 16

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Reasons for investing in a passive portfolio 1. Capital markets are efficient. Ie: current stock prices, absorb & reflect all market information rather quickly 2. Theres an abundance of good analysis, but few superior ones 3. Minimize the cost of research but not necessarily trading costs 4. Generally lower management fees, cost of operation & have lower overall fees to the investors. Word on equity indices 1. Equity portfolio managers will evaluate their performance against equity benchmark indices. 2. Equity benchmark indices are designed to show how overall stock market or some subsector of the market has performed For eg: STI index measures performance of Spore equities S&P Global 100 index (rating agency) measures the performance of 100 MNCs. Eg: S&P 500 is a stock market index based on the common stock price of 500 Top American companies. 3. There are various ways to construct a index. Price weighted Price of each corporate stock is the only consideration. This every price movement of the stock will have no impact regardless of volume of trade. RMIT University
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Market value approach/mkt capitalization value = P x # of outstanding shares. have a relatively small shift of a large company will have a big impact on index movements. self corrects for stock splits dividends 3. An index is a mathematical end product. We can use mutual funds or index funds to track an index.

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Generic Portfolio Management Strategies

Equity-portfolio management styles fall into of two categories Passive equity portfolio management
Long-term buy-and-hold strategy Usually track an index over time
Occasional rebalancing occur

Designed to match market performance

Manager is judged on how well they track the target index

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Generic Portfolio Management StrategiesContd.

Active equity portfolio management

Attempts to outperform a passive benchmark portfolio on a risk-adjusted basis
Benchmark Portfolio? One whose characteristics match the risk-return objectives of the client and serves as a basis for evaluating the performance of an active manager
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Passive Equity Portfolio Management Strategies

Passive equity portfolio management attempt to replicate the performance of an index
May slightly under-perform the target index due to fees and commissions Strong rationale for this approach as the cost of active management (1 to 2 percent) are hard to overcome in risk-adjusted performance

Many different market indices are used for tracking portfolios

Customised passive portfolios (completeness funds) constructed to complement active portfolios that do not cover entire market.
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Passive Equity Portfolio Management Strategies

Not a simple process to track a market index closely Three (3) basic techniques for constructing a passive index portfolio:
Full replication Sampling Quadratic optimization or programming
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Passive Equity Portfolio Management Strategies Full Replication

All securities in the index are purchased in proportion to weights in the index Technique helps ensure close tracking

Increases transaction costs, particularly with dividend reinvestment

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Buy representative sample of stocks in the benchmark index Stocks with larger index weights bought according to their weight in the index Smaller issues bought so that aggregate characteristics approximate the rest of underlying benchmark

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Sampling Contd.
Fewer stocks means proportionally lower commissions Reinvestment of dividends is less difficult Portfolio returns will not track the index as closely, so there will be some tracking error
Tracking error will diminish as the number of stocks grows, but costs will grow (trade-off)
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Tracking Error and Index Portfolio Construction

The goal of the passive manager should be to minimize the portfolios return volatility relative to the index, i.e., to minimize tracking error Tracking Error Measure
Return differential in time period t

t = Rpt Rbt
where Rpt= return to the managed portfolio in Period t
Rbt= return to the benchmark portfolio in Period t

Tracking error is measured as the standard deviation of t , normally annualized (ATE)

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Tracking Error Example

You have formed a portfolio designed to track the STI30 Index. Over the last 8 quarters returns and return difference are given as follows
Period 1 2 3 4 5 6 7 8 Manager 2.30 -3.60 11.20 1.20 1.50 3.20 8.90 -0.80 Index 2.70 -4.60 10.10 2.20 0.40 2.80 8.10 0.60 Average () STDEV ATE Difference() -0.40 1.00 1.10 -1.00 1.10 0.40 0.80 -1.40 0.20 1.0014 2

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Exhibit 16.2

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Passive Equity Portfolio Management

Strategies Quadratic Optimization or Programming

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
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Methods of Index Portfolio Investing

Index Funds
In an indexed portfolio, the fund manager will typically attempt to replicate the composition of the particular index exactly The fund manager will buy the exact securities comprising the index in their exact weights Change those positions anytime the composition of the index itself is changed 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
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index funds are worth considering. They match, mirror or mimic a sharemarket index. With a decade to invest, it makes the most sense as there is plenty of time to ride out the inevitable market corrections and maximise returns. The beauty of indexing is that there is no risk of picking a dud fund manager who may underperform the market and the fees for an index fund are much less than those charged by active managers John Collett in the Age article Build a future fund

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The Style Universe


CFS, CSAM Relative Value Lazard GARP

Perpetual, MBA

Neutral UBS


Source: Vanguard Australia

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Methods of Index Portfolio Investing

Exchange-Traded Funds (ETF)
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 A significant advantage of ETFs over index mutual funds is that they can be bought and sold (and short sold) like common stock The notable example of ETFs
Standard & Poors 500 Depository Receipts (SPDRs) iShares Sector ETFs
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Australian Exchange Traded Funds (ETFs)

Exchange Traded Funds (ETFs) over Australian indices were launched in 2001 The current issuers of broad based Australian indexed ETFs are State Street Global Advisers whose ETFs traded under the brand name SPDRs and Vanguard Investments
The table below lists the ASX code of each domesitc ETF and its respective underlying strategy. ASX Code SFYSPDR STWSPDR VAS Fund Name S&P/ASX 50 Fund S&P/ASX 200 Fund ` Vanguard Australian Shares Index Underlying Strategy Replicate the performance of the top 50 Australian Shares Replicate the performance of the top 200 Australian Shares Replicate the performance of the top 300 Australian Shares

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Watch the following video in class and discuss
http://www.vanguard.com.au/personal_invest ors/etfs/etfs_home.cfm


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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
Need to select an appropriate benchmark Must incorporate average qualities of the clients portfolio strategy and risk tolerance

Practical difficulties of active manager

Transactions costs must be offset by superior performance vis--vis the benchmark Higher risk-taking can also increase needed performance to beat the benchmark
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Fundamental Strategies
Top-Down versus Bottom-Up Approaches

Broad country and asset class allocations Sector allocation decisions

Individual securities selection

Emphasizes the selection of securities without any initial market or sector analysis Form a portfolio of equities that can be purchased at a substantial discount to what his or her valuation model indicates they are worth
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Fundamental Strategies
Three Generic Themes
Time the equity market by shifting funds into and out of stocks, bonds, and T-bills depending on broad market forecasts
Shift funds among different equity sectors and industries (e.g., financial stocks, technology stocks) or among investment styles (e.g., value, growth large capitalization, small capitalization). This is basically the sector rotation strategy Do stock picking and look at individual issues in an attempt to find undervalued stocks
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Fundamental Strategies
The 130/30 Strategy
Long positions up to 130 percent of the portfolios original capital and short positions up to 30 percent The use of the short positions creates the leverage needed, increasing both risk and expected returns compared to the funds benchmark Enable managers to make full use of their fundamental research to buy stocks they identify as undervalued as well as short those that are overvalued

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Technical Strategies
Contrarian Investment Strategy
The belief that the best time to buy (sell) a stock is when the majority of other investors are the most bearish (bullish) about it The concept of mean reverting The overreaction hypothesis (Exhibit 16.9)

Price Momentum Strategy

Focus on the trend of past prices alone and makes purchase and sale decisions accordingly Assume that recent trends in past prices will continue
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Exhibit 16.9

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Anomalies and Attributes

Earnings Momentum Strategy
Momentum is measured by the difference of actual EPS to the expected EPS Purchases stocks that have accelerating earnings and sells (or short sells) stocks with disappointing earnings

Calendar-Related Anomalies
The Weekend Effect The January Effect

Firm-Specific Attributes
Firm Size P/E and P/BV ratios (Exhibit 16.12)
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Exhibit 16.12

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Tax Efficiency and Active Equity Management

Active portfolio managers especially need to consider taxes when deciding whether to sell or hold a stock whose value has increased
If a security is sold at a profit, capital gains are paid and less in left in the portfolio to reinvest A new security (the reinvestment security) needs to have a superior return sufficient to make up for these taxes The size of the expected return depends on the expected holding period and the cost basis (and amount of the capital gain) of the original security
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Tax Efficiency and Active Equity Management

Measures of Tax Efficiency
Portfolio Turnover
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

Tax Cost Ratio (%) The Formula Tax Cost Ratio = [1 (1 + TAR)/(1 + PTR)] x 100
where PTR = pretax return TAR = tax-adjusted return

See Exhibit 16.14

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Exhibit 16.14

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Value versus Growth

A growth investor focuses on the current and future economic story of a company, with less regard to share valuation A value investor focuses on share price in anticipation of a market correction and, possibly, improving company fundamentals. Value stocks generally have offered somewhat higher returns than growth stocks, but this does not occur with much consistency from one investment period to another
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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-oriented investor will:

Focus on the price component Not care much about current earnings Assume the P/E ratio is below its natural level

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Asset Allocation Strategies

Selecting an Active Allocation Method
Perceptions of variability in the clients objectives and constraints Perceived relationship between the past and future capital market conditions The investors needs and capital market conditions are can be considered constant and can be considered variable

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