Chapter 7: Equity Portfolio Management

1. Chapter 7: Equity Portfolio Management • For the purpose of this course, can exclude the following sections: • Equity index futures related • Semi-active investing: Enhanced indexing • Indexing using stratified sampling • Indexing using optimization

2. Overview of Process Asset allocation List of portfolio managers for each asset class

3. Key Concepts in Chapter • Passive versus active equity portfolio management • Passive investment vehicles and management process • Active investment styles and style analysis

4. Passive Approach to Equity Management • Best suited for investors who believe markets are relatively efficient • Attempts to match the performance of a benchmark index • Mainly concerned with tracking risk (measured by tracking error) • Aims for lowest tracking error/risk. No “active” return relative to the benchmark index

6. Active Approach to Equity Management • Goal is to outperform the benchmark • Best suited for investors who believe there are market inefficiencies that can be exploited • Opportunities may not be available in all segments of the market • Look for areas where inefficiencies are most likely to exist • Aims to maximize active return relative to the benchmark • Some may set target for tracking risk

7. Price Indices • Standard methods for constructing an index • Price weighted • Value weighted • Equally weighted • Alternative method - Fundamental indexing of Arnott, Hsu, and Moore, Financial Analyst Journal, 2005 (not in text)

8. Price-Weighted Equity Indices • Weigh each stock in the index according to its share price • Best known price weighted index is the Dow Jones Industrial Average • Index value is the sum of the share prices of each stock in the index • Index performance skewed by the performance of the highest-priced stocks • Performance represents the return to buying and holding one share of each stock in the index

9. Business Week article If included Berkshire Hathaway, the DJIA would essentially be a one-stock index

10. Value-Weighted Equity Indices • Weighted according to market capitalization of component stocks (cap-weighted) • Subcategory is float-weighted: weights according to market capitalization of non-restricted (free float) shares only, i.e., exclude portion of shares not readily available for trading • Performance represents returns to a portfolio that buys and holds all the available shares of all the component stocks in the index • CAPM – Market portfolio is a value weighted portfolio • Biased toward performance of the largest companies by market capitalization – which tend to be either mature (or could be overvalued) • The S&P 500, TSX, and most major indices are value-weighted

11. Equal-Weighted Equity Indices • 1/N: Weighs each stock in the index equally • Performance represents return to investing an equal amount of money in each component stock of the index • Must be rebalanced periodically because stock performance differences will cause weights to drift from equality • E.g., 0.5 of the index in company X, 0.5 in company Y. As the price of X and price of Y fluctuate, weights will also change

12. Fundamental Indexing • Issue with market-cap weighted indices • They tend to overweight large, growth stocks • Example: Nortel in the TSE300 in 2000 • FTSE/RAFI indices: Use a proprietary mix of i) total cash dividends, ii) free cash flow, iii) total sales, and iv) book equity value to weigh companies within the index • ETFs of these indices are available • Backtested using data from 1962-2004, beat the S&P500 by 1.97% per annum • Some argue it’s not indexation, but a semi-active strategy that has a value and small-cap tilt

13. Conventional Index Mutual Funds • Return on the index fund should lag the underlying index by the sum of: • Cost of management and administration • Transaction costs related to index composition changes • Transaction costs for investing cash flows, e.g., reinvesting dividends • Drag on performance from any cash position • But revenues from securities lending can offset some of these costs

14. Exchange Traded Index Funds (ETFs) • Shareholders buy and sell ETFs amongst themselves throughout the day (rather than through the fund) • Price is kept close to the NAV through an arbitrage mechanism called in-kind creation and redemption • If Price < NAV, Authorized Participants (APs) can redeem their shares in exchange for a basket of the underlying securities (and vice versa) • APs are major banks and trading desks of large financial institutions • More tax-efficient • Unlike mutual funds, do not need to buy/sell securities based on investor cash flows in and out of the fund

15. Equity Total Return Swaps • One counterparty receives the total return of an equity index portfolio, the other can receive an interest rate or the return on a different index • Motivations include: • Tactical asset allocation – may be more cost effective to use a swap than to change the portfolio

16. Active Portfolio Management • Style • Value • Core or blend • Growth

17. Value Investing Style • More concerned about stock’s relative cheapness than about its growth prospects • Look for low price multiples • Risks faced by the investor • Stocks may be cheap for a good reason (“value trap”) • Correction of mispricing may require longer time than investment horizon

18. Growth Investing Style • Believe future earnings growth justifies higher current price multiples • Requires market to continue paying a premium for the greater growth prospects • Risk that expected growth fails to materialize

19. Sell Discipline • What will trigger the sale of a security in the portfolio? • Part of the portfolio manager’s investment philosophy; need to articulate to clients • Sell discipline examples: • Down-from cost – price decline (%) • Up-from-cost – price increase (%) • Target price – price that represents full valuation • Opportunity cost – another stock becomes more attractive

20. Equity Manager Fee Structures Two major types: • Ad valorem (a tax or duty) – a percentage of assets under management (AUM). Example: • First $100 million at 0.50 percent • Second $100 million at 0.40 percent • Remaining balance at 0.30 percent • Performance based – percentage of the return in excess of benchmark • Charged mostly by hedge funds and alternative investment managers. Example: • 2 % of AUM plus 20% of outperformance versus the benchmark (2&20) • Performance fee is referred to as “carried interest” or “carry”

21. Equity Manager Fee Structures • Asymmetric compensation: If manager underperforms the benchmark, there is no immediate penalty • High watermark: fund value must exceed previous peak before performance fee is collected • Recent trend (post 2008) in performance fee structure: refund investors fees paid in the past if underperform in a given year • Performance based fees may include a fee cap limiting total fee paid to limit incentive to take undue risk • Ad valorem fees are more predictable for investor, but performance fees better align manager’s interests

22. Top-Down Approach to Security Selection • Focuses primarily on macroeconomic factors or investment themes • What themes are affecting the global economy • How do the themes affect various sectors and industries • Are there any special country or currency considerations • Which stocks within the industries or sectors will most likely benefit

23. Bottom-up Approach to Security Selection • Focuses on company-specific fundamentals • Identify factors by which to screen the investment universe, e.g., valuation (P/B, P/E, earnings growth, PEG … etc.) • Collect further information on companies that pass the screen • Identify those that constitute potential investments based on other company-specific criteria, sector outlook, macro trends

24. Sell-side versus Buy-side Analysts • Buy-side • Equity research with the intent of assembling a portfolio, e.g., provide rationale for buying or selling a stock • Generally inaccessible to those outside the company • Sell-side • Produce research reports (on a company or sector) for sale • Investment banks use them to generate revenues and investment banking business