CHAPTER EIGHTEEN

MANAGING
THE EQUITY PORTFOLIO

Practical Investment Management

Robert A. Strong
 Outline

 Structuring a Stock Portfolio

 The Portfolio Objective
 Asset Allocation
 Active vs. Passive Management
 Portfolio Rebalancing
 What’s Wrong with Buy and Hold?
 The Costs of Revision
 Constant Proportion Rebalancing
 Constant Beta Rebalancing
 Indexing
 Dollar Cost Averaging

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 Outline

 Overwriting
 Writing Options to Generate Income
 Improving on the Market
 Portfolio Protection
 Writing Covered Calls for Downside Protection
 Protective Puts
 Using Index Options
 Using Index Futures Contracts

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 Structuring a Stock Portfolio : The Objective
 Semantics are important in any statement
of investment objectives.
 The four main portfolio objectives are
stability of principal, income, growth of
income, and capital appreciation.
 In a world with taxes, one dollar in capital
gains is worth more than one dollar in
income.
 The overriding investment objective is
utility maximization.

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 Structuring a Stock Portfolio : The Objective

Insert Figure 18-1 here.

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 Structuring a Stock Portfolio : Asset Allocation

 An asset class refers to a broad category

of investments.
 U.S. equities, foreign equities, bonds, and
cash are four widely used asset classes.
 The relative distribution of funds across
asset classes is called asset allocation.

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 Structuring a Stock Portfolio : Asset Allocation
Portfolio

stocks
attitude
toward risk real realized
bonds
estate return
ASSET and risk
CLASSES with the
passage
need for foreign of time
cash
return equities

individual choice asset class mix investment results

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 Structuring a Stock Portfolio :
Active vs. Passive Management
 A strategy of passive management is one
in which, once established, the portfolio is
largely left alone.
 An active management policy, in contrast,
is one in which the composition of the
portfolio is dynamic.

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 What’s Wrong with Buy and Hold ?

 With a passive buy and hold strategy

(a naive strategy), investors simply
select their investments and hang on
to them.
 Portfolio managers often fail to outperform
a passive buy and hold strategy.
 When tested statistically, trading systems
also do not have a good long-term batting
average.

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 The Costs of Revision
 There are costs to revising a portfolio.
 Trading fees : Historically, stock
commissions are a function of the number
of shares and the dollar amount involved.
 Even relatively simple portfolio revisions
take up management time.
 Selling securities can involve tax
implications.
 Window dressing refers to largely cosmetic
portfolio changes made near the end of a
reporting period.

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 Portfolio Rebalancing
 Rebalancing a portfolio is the process of
periodically adjusting the portfolio so that
certain original conditions of the portfolio
are maintained.
 In a constant proportion portfolio,
adjustments are made so as to maintain the
relative weighting of the portfolio
components as their price change.
 A constant beta rebalancing scheme seeks
to maintain beta at a prespecified level.
This method is not commonly used now.

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 Portfolio Rebalancing

Insert Table 18-1 here.

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 Portfolio Rebalancing

Insert Table 18-2 here.

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 Portfolio Rebalancing

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 Portfolio Rebalancing

Insert Table 18-4 here.

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 Portfolio Rebalancing

 Indexing : Some funds seek to mirror the

performance of a market index such as the
S&P 500 or the Dow Jones Industrial
Average.
 Dollar cost averaging : The idea is to invest
a fixed amount on a regular interval into the
same security, regardless of current market
conditions.

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 Portfolio Rebalancing

Insert Table 18-5 here.

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 Portfolio Rebalancing
 The context of dollar cost averaging is one
of the few times in finance when the
harmonic mean is useful. The harmonic
mean considers reciprocals of values
rather than the values themselves.
1
harmonic mean =
1 N 1
∑
N i =1 Pi
where Pi = price paid at time i
N = number of observations

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 Overwriting

 Option overwriting refers to the creation

and sale of stock options in conjunction
with a stock portfolio.
 The most common purpose is to generate
additional portfolio income.
 The second motivation for writing options
is to permit the purchase or sale of stock at
a better-than-market price.

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 Writing Options to Generate Income

 When investors write call options against

stock they already own, the call is said to
be covered.

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 Writing Options to Generate Income

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 Writing Options to Generate Income

Insert Figure 18-4 here.

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 Overwriting : Improving on the Market

 Improving on the market involves writing

deep-in-the-money put or call options that
have “substantial” intrinsic value.
 Selling stock:
Current XYZ stock price = $116
Write $100 call premium @ $18
If option is exercised,
total income = $100 + $18 = $118
> income without overwriting = $116

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 Overwriting : Improving on the Market

 Buying stock:
Current Intel stock price = $67.20
Write $75 put premium @ $9
If option is exercised,
total cost = $75 - $9 = $66
< cost without overwriting = $67.20
 Deep-in-the-money options can be used to
improve a buying or selling price at the cost
of a slight increase in risk.

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 Portfolio Protection
 Portfolio protection basically involves adding
adding components to a portfolio such that
a floor value is established below which the
value of the portfolio will not fall.
 Writing covered calls provide downside
protection up to the amount of the premium.
 If an investor owns shares of a particular
stock (long stock position) and buys a put on
that same stock (long put position), the put is
called a protective put.

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 Portfolio Protection

Insert Figure 18-5 here.

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 Portfolio Protection

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 Portfolio Protection

 Using index options : An index put can

protect a diversified stock portfolio against
a market downturn. If market prices
decline, a gain on the puts can largely
offset the losses on the stock portfolio.

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 Portfolio Protection

Insert Table 18-8 here.

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 Portfolio Protection

 Using index futures contracts : A short

futures position can help offset a long
stock position. If the market falls, a gain in
the futures market can largely offset the
loss on the stock portfolio, and vice versa
if the market rises.

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 Portfolio Protection

Insert Table 18-9 here.

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 Review
 Structuring a Stock Portfolio
 The Portfolio Objective
 Asset Allocation
 Active vs. Passive Management
 Portfolio Rebalancing
 What’s Wrong with Buy and Hold?
 The Costs of Revision
 Constant Proportion Rebalancing
 Constant Beta Rebalancing
 Indexing
 Dollar Cost Averaging

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 Review

 Overwriting
 Writing Options to Generate Income
 Improving on the Market
 Portfolio Protection
 Writing Covered Calls for Downside Protection
 Protective Puts
 Using Index Options
 Using Index Futures Contracts

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 Appendix: Index Overwriting

 Index options
 Put and call options
 have virtually the same characteristics as an
option on common stock
 DIFFERENCE is the underlying security is an
index representing the current level of some set
of stock prices
 OEX

 DJX

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 Appendix: Index Overwriting

 Advantage is they drastically reduce the

unsystematic risk usually associated with
small portfolios

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 Appendix: Index Overwriting

 Table 18A-1

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 Appendix: Index Overwriting

 Risk of index calls is that the index will rise

above the strike price

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 Appendix: Index Overwriting

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 Appendix: Index Overwriting

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