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Contents Equity Portfolio Management
1. Introduction
2. The Role of the Equity Portfolio
3. Approaches to Equity Investing
4. Passive Equity Investing
5. Active Equity Investing
6. Semi-Active Equity Investing
7. Managing a Portfolio of Managers
8. Identifying Selecting and Contracting with Equity Portfolio
Mangers
9. Structuring Equity Research and Security Selection
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2. The Role of the Equity Portfolio
Equity represents a significant source of wealth
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3. Approaches to Equity Investment
Passive Management
Investor does not attempt to reflect his investment expectations through
changes in security holding
Equity market is efficient indexing is the best strategy
Not really passive because portfolio needs to change when index is
reconstituted or when weight of a stock changes because of corporate
action
Active Management
Outperform benchmark portfolio by investing in underpriced securities
Dominant management style
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3. Approaches to Equity Investment
Semiactive Management
Also called enhanced indexing or risk-controlled active management
Variant of active management
Outperform benchmark but keep tracking risk in control
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4. Passive Equity Investing
According to William Sharpe:
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4.1 Equity Indices
Stock indexs characteristics are determined by
1. Boundaries of stock indexs universe
2. Criteria for inclusion
3. How stocks are weighted
4. How returns are calculated
http://www.youtube.com/watch?v=23qEK_mtMHo
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The S&P 500 also seeks to make sure the industry sectors in the S&P 500 represent the
industries in the economy. The sector percentages in the S&P 500 in 2010 were:
Information Technology (17.8%), Financial (15.1%), Energy (12.7%), Industrials (11.3%),
Consumer Staples (10.6%), Consumer Discretionary (10.6%), Materials (3.7%), Utilities
(3.4%), Telecom Services (3.1%). (Source: S&P 500 Factsheet)
To be included in the S&P 500, a company must meet the following minimum criteria:
Be a U.S. company.
Have a market cap of at least $4 billion.
At least 50% of its stock must be held by the public.
Four consecutive quarters of positive earnings.
A stock price of at least $1 per share.
Contribute to the overall balance of sectors within the S&P 500, to help it represent the overall
market sector make-up.
Be listed on either the New York Stock Exchange or the NASDAQ. Real Estate Investment
Trusts (REITs) and business development companies can also be included.
The top 10 largest companies in the S&P 500 in 2011 were: Exxon Mobil, Apple, IBM,
Chevron, General Electric, Microsoft, AT&T, Johnson & Johnson, Procter & Gamble and Pfizer.
The market cap of these 10 companies represent 20% of the market cap of the total S&P 500.
http://useconomy.about.com/od/glossary/g/SP500.htm
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Price Weighted Value Weighted Equal Weighted
Each stock weighted Each stock weighted All stocks treated the
according to absolute share according to market cap same
price
Float-weighted Small company bias
Biased towards highest because such indices
price share Biased towards high include many more small
market-cap stocks large companies
Effectively investing in companies, overvalued
proportion to share price stocks Requires frequent
rebalancing
Simple to construct Suggestion: adjust
component weights based
DJIA is the most prominent on fundamentals (such as
example P/E)
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Price Weighted
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Value Weighted
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Float Weighted
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Equal Weighted
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4.2 Passive Investment Vehicles
Refresher on swaps
http://www.youtube.com/watch?v=lFV3S1PCQoM&feature=youtu.be
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Indexed Portfolios
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Conventional (Open End) Index Mutual Exchange Traded Funds
Funds
Buy/sell shares at market close NAV Buy/sell any time during trading day
Shareholder accounting at the fund level can No fund level shareholder accounting
be a significant expense
Less tax efficient (selling shares capital Tax efficient due to in-kind redemption
gains taxes) process (fewer taxable events)
Cost associated with providing liquidity to Transaction costs for those buying/selling ETF
shareholders who are selling fund shares but those holding shares have protection
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Indexed institutional portfolios could be managed as separate or pooled accounts
Pooling means having multiple portfolios under the same management (cost effective but
performance management is more difficult)
Indexed institutional portfolios have very low cost compared to both conventional index mutual
funds and exchange traded funds
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How do we create an index portfolio? Do we replicate the entire index?
If index has less than 1000 stocks which are liquid Full Replication
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Stratified Sampling: Allows manager to build a portfolio that retains the basic
characteristics of the index without having to buy all stocks in the index
Industry A
Identify weights for each cell
Industry B
Randomly select/sample
Industry C
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Optimization is a mathematical approach to index fund creation involving the use of:
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Stock index futures are low cost vehicles for obtaining for obtaining equity
market exposure must rollover to maintain long term
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Equity total return swaps are a relatively low cost way of obtaining long term exposure to
an equity market
Major applications:
1) Receive total return of non-domestic equity index in return for an interest payment to a
counterparty that holds underlying equities more tax efficiently
2) Use equity swaps to rebalance portfolios (actually trading securities might be more costly)
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5. Active Equity Investing
5.1 Equity Styles
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5.1 Equity Styles
Market Capitalization
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Value Investment Styles
Buy stocks which are relatively cheap in terms of purchase price of earnings or assets
Most investors over-pay for glamour (growth) stocks so avoid them; look for value in the not-
so-glamorous stocks
Empirical studies show that value style may earn positive return premium relative to market
Questions to ask:
Low P/E
Sub- Contrarian: Look for stocks which are in trouble and selling at low P/Bs (less than 1)
styles
High Yield
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Growth Investment Style
Growth stocks have high sales growth relative to the market and tend to trade at high P/Es,
P/Bs and P/Ss ratios
Sub-styles:
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Other Active Management Styles
Market-oriented style falls between value and growth; buy if market value < intrinsic value
Sub-styles:
Growth-at-a-reasonable price
Style rotators
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Techniques for Identifying Investment Styles
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Returns-Based Style Analysis (RBSA)
Indices should be mutually exclusive and exhaustive and should have distinct sources
of risk (ideally should not be highly correlated)
Read Example 5
1. Valuation levels
3. Earnings variability
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Example 8: Is the portfolio manager
following a value investment style?
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A security may be assigned:
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Equity Style Indices
How can we distinguish between value and growth. No clear definition; however, trend is towards
using multiple variables: price, earnings, book value, dividends, growth rates, etc.
Buffering: rules for maintaining previous style when stock has not clearly moved to new style
Style index publishers use growth and value either as categories (no overlap) or as quantities (with
overlap)
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Example 9. Returns-
Based and Holdings-
Based Style Analysis
Holdings
-Based
Style
Analysis
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The Style Box
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Style Drift Professional investors view inconsistency in style, or style drift, as an obstacle
to investment planning and risk control
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5.2 Socially Responsible Investing
SRI criteria may include:
If you know the potential biases introduced by SRI, you can take appropriate actions
determine the appropriate benchmark
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5.3 Long-Short Investing
Style investing is concerned with portfolio characteristics, long-
short investing focuses on a constraint
Note: in some markets ETFs may be a more attractive way than futures to equitize
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The long-only constraint limits an investors ability to benefit from an extreme
negative view on a stock
Rule based: Sell when a certain rule or criteria is met for example a value
investor might sell if P/E comes back to historical level
Value investors generally have relatively low turnover; they buy cheap
stocks hoping to reap relatively long term reward
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6. Semiactive Equity Investing
Also called enhanced index or risk-controlled active
Variant of active management
Outperform benchmark but keep tracking risk in control
High information ratio
Semiactive equity strategies come in two forms
Derivatives based (synthetic) Stock based
Exposure to desired equity market Generate alpha through underpriced
through a derivative and overpriced stocks
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Fundamental Law of Active Management
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7. Managing a Portfolio of Managers
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Exhibit 23
Manager Allocation by
Active Risk Level
Exhibit 24
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IR = 1.92 / 1.51 = 1.27
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7.1 Core-Satellite
This is a core-satellite
portfolio
Core-satellite portfolio can be constructed using the rigorous approach show on previous
slides or a much simpler approach show in Example 14
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True/misfit distinction has two main uses:
Performance appraisal
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7.2 Completeness Fund
The completeness fund is a simpler strategy to manage overall
portfolio risk and return
A manager may want to incorporate specific views with respect
to the benchmark creating active return, however, the risk also
goes up
The manager then identifies a basket or a number of trades
which complete the fund, i.e. minimize the active risk of the
portfolio
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7.3 Other Approaches: Alpha and Beta Separation
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8. Identifying, Selecting and Contracting with Equity Portfolio
Managers
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Ad Valorem Fees Performance-Based Fees Fee Structure
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9. Structuring Equity Research and Security Selection
Industry classification
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Top Down and Bottom Up Analysis
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Buy-Side versus Sell-Side Research
Buy Side: Research with intent of assembling a portfolio
Might use sell-side research
Typically committee decisions
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Industry Classification
Global Industry Classification Standard (GICS) developed by Standard and
Poors and MCSI
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Conclusion
Learning objectives
Summary
Examples
Practice Problems
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