Portfolio Management 3-228-07 Albert Lee Chun

1. Portfolio Management3-228-07Albert Lee Chun Equity Portfolio Management Strategies Lecture 9 2 Dec 2007

2. Passive Portfolio Management

3. Management Fees Malkiel (2001) reports that on average that: • Costs of managing a passive fund oscillate between 10 and 20 basis points (Vanguard S&P 500: 20 b.p.) • For active funds the average management fees are 140 b.p. (fees for research, analyzing information, transaction costs). • 40 billion dollars are spent each year on management fees. • Passive strategies have a tend to also minimize taxes (Malkiel 2001)

4. Managing and Index Portfolio • Select a benchmark portfolio index to replicate. S&P 500, TSX, etc. • Determine an acceptable tracking error. Which depends on the return differential or total return of the replicating portfoliominus the return of the benchmark index where the return of the tracking portfolio is given by

5. Portfolio Tracking Error Return Differential Average Return Differential Variance in Return Differential Tracking Error Annualize Tracking Error where P is equal to the number of periods in a year.

6. Portfolio Tracking Error • Objective: Minimize the expected tracking error by optimizing over 1. The number of securities in the portfolio 2. The securities to include in the portfolio

7. Expected Tracking Error Expected Tracking Error (Percent) 4.0 3.0 2.0 1.0 500 400 300 200 100 0 Number of Stocks

8. Portfolio Indexation • The number of securities used in the replication determines a tradeoff between transaction costs and tracking errors. • A smaller number of securities will result in lower transaction costs but higher tracking errors and visa versa. • The presence of tracking errors is inevitable. 1. The replication implies irregular lots. 2. The composition of securities in the index may change. 3. The modification of the index: entry and exit of securities, merges, defaults, etc.

9. Techniques for Replicating an Index

10. 1. The simplest method • Purchase all the securities in the index in proportion to the weights in the index. • This helps ensure close tracking • Advantage: Minimizes the tracking errors • Disadvantage: High transaction costs and reinvesting dividends results in high adjustment fees.

11. 2. Method of Market Capitalization • Consider the stocks with the largest market capitalization in the index and purchase them in proportion to their importance in the index. • Fewer stocks means lower commissions • Reinvestment of dividends is less difficult • Will not track the index as closely, so there will be some tracking error.

12. 3. Method of Stratified Sampling: • Purchase only the most representative securities in the index portfolio. • Classify the securities in the index into homogeneous categories (by industry or activity sector, beta, total risk, stock market capitalization, etc....). • Select from each category, a few titles which best represents that group, thus forming a representative portfolio for each category. • The replication portfolio is composed by balancing the portfolios for each category according to their importance in the index.

13. 4. Quadratic Optimization Expected Excess Return Transaction costs Required minimum

14. Quadratic Optimization • Historical information on price changes and correlations between securities are used to determine 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 a failure to track the index.

15. Expected Tracking Error Expected Tracking Error (Percent) 4.0 3.0 2.0 1.0 500 400 300 200 100 0 Number of Stocks

16. Reference Portfolio • Constructing a Reference Portfolio - Value Weighted - Price Weighted - Equal Weighted • It may be necessary to rebalance the portfolio when: - Mergers and Acquisitions: Companies disappear from the market. - Changes to the composition of the index - Stock splits and dividend payments - New stock issues - Stock repurchases

17. Replicating an Index Portfolio • Small investors often find it more practical and less expensive to choose a "pre-made" a fund for replicating an index. - Mutual Funds - Exchange Traded Funds

18. Exchange Traded Funds (ETFs) • Exchange Traded Funds are less expensive than mutual funds but more diversified than individual stocks. A cross between stocks and mutual funds. • ETFs seek returns of a broad market index or a sector index. They are index-linked rather than actively managed. • ETFs are exchange listed and can be bought and sold throughout the trading day: they are "funds that trade like stocks." • Example: SPY, Cubes, Diamonds, Spiders, Webs, VIPERS, iShares, Ultra Sectors, etc.

19. Active Portfolio Management

20. Active Portfolio Management • Active 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. • Practical difficulties of active manager • Transactions costs must be offset • Risk can exceed passive benchmark

21. Active Management Strategies The chose between using and active or passive portfolio management strategy depends on 2 factors: 1. Belief in the efficiency of the markets. An investor who rejects the Efficient Market Hypothesis will tend to adopt an active strategy with the goal of obtaining “abnormal” returns: where, ARit : is the abnormal return of security i in period t Rit: is the return of security i in period t E(Rit): is the expected return 2. Degree of risk aversion of the investor.

22. Performance of Active Mutual Funds The average fund manager is not able to outperform the index!

23. Broad Overview of Investment Strategies • Passive Management Strategies 1. Efficient Markets Hypothesis - Buy and Hold - Indexing • Active Management Strategies 2. Fundamental Analysis “Top Down” (asset class rotation, sector rotation) “Bottom Up” (stock undervaluation/overvaluation) 3. Technical Analysis Contrarian (e.g. overreaction) Continuation (e.g. price momentum) 4. Anomalies and Attributes Calendar effects (Weekend, January) Security Characteristics (P/E,P/B, earnings momentum, firm size) Investment Style (value, growth)

24. Investment Style and Tracking Error

25. Fundamental Strategies • Top down approach involves analysis of broad country and asset class allocations and progresses down through sector allocation decisions to the bottom level where individual securities are selected. • Bottom-up approach emphasizes security selection without any initial market or sector analysis.

26. Top Down Approach Top Down Approach - Evaluate and forecast the future economy - Chose the proportions to invest in each country or economic region. - Identify the sectors and industries that would profit based on your economic outlook and choose proportions to invest in each industy or sector. - Choose the best securities in each sector selected.

27. Bottom-Up Approach Security selection is places less importance on the economic cycle. Securities are selected based on well defined characteristic of individual stocks such as price-dividend ratios, book-to-market ratios, market capitalizations, etc.

28. Fundamental Strategies • Tactical Asset Allocation - Asset Class Rotation: Shifts funds between stocks, bonds and other securities depending on market forecasts and estimated returns. • Sector, Industry or Style Rotation Strategy - Shifts funds between different equity sectors and industries (financial stocks, technology stocks, consumer cyclicals, durable goods) or among investment styles (e.g., large capitalization, small capitalization, value growth) • Individual Stock Selection - Buy low, Sell High

29. Sector, Industry and Style Analysis • How should we choose which sector, industry or style to rotate into next? • Important to look to the underlying nature of the economy. Security markets reflect the strength and weakness of the economy. • Most of the variables that determine security market value are economic variables: monetary policy, interest rates, aggregate output, inflation, etc. • Macro-analysis links up industry effects to business cycles and economic variables.

30. Asset and Sector Performance

31. Macro-market Analysis • A strong relationship exists between the economy and the stock market • Security markets reflect what is expected to go on in the economy because the value of an investment is determined by • its expected cash flows • required rate of return (i.e., the discount rate)

32. Is It A Worm?

33. Is It A Wave?

34. It’s the Business Cycle! ECONOMIC CYCLE

35. Business Cycles • The aggregate economy expands and contracts in discernable periods. • Economic trends affect industry performance. • Cyclical or Structural Changes? • Cyclical changes in the economy arise from the ups and downs of the business cycle • Structure changes occur when the economy undergoes a major change in organization or how it functions

36. The Stock Market and the Business Cycle How can we predict the next peak or trough? E peak ECONOMIC CYCLE trough

37. Business Cycle Indicators • National Bureau of Economic Research (NBER) • Cyclical indicator categories • leading indicators • coincident indicators • lagging indicators • Composite series and ratio of series

38. Business Cycle Indicators • Leading indicators – economic series that usually reach peaks or troughs before corresponding peaks or troughs in aggregate economy activity • Coincident indicators – economic series that have peaks and troughs that roughly coincide with the peaks and troughs in the business cycle • Lagging indicators – economic series that experience their peaks and troughs after those of the aggregate economy • Selected series – economic series that do not fall into one of the three main groups.

40. Other Indicator Sources...

41. Stock Markets are a Leading Indicator • Stock prices consistently turn before the economy does. • Stock prices are forward looking. • Stock prices reflect expectations of earnings, dividends, and interest rates • Stock market reacts to various leading indicator series

42. Forecasting Business Cycles • The current state of the business cycle has already been incorporated into asset prices. • Investors need to make decisions based on future economic conditions. • To invest properly, it is important to forecast changes in economic variables. • High inflation: high interest rates, bad for stocks in general.

43. Sector Rotation Strategy • Certain industries make attractive investments over the course of the business cycle. • A sector rotation strategy is when one switches from one industry group to another over the course of a business cycle.

44. The Stock Market and the Business Cycle peak ECONOMIC CYCLE trough Financial Stocks Excel

45. Financial Stocks • Adversely impacted by interest rates, difficult to pass on to their customers. • Toward the end of a recession, financial stocks rise as investors trade securities, businesses issue debt and equity, increase in merger activity during recovery. • Expecting increases in loan demand, housing construction and companies going public.

46. The Stock Market and the Business Cycle Consumer Durables Excel peak ECONOMIC CYCLE trough Financial Stocks Excel

47. Consumer Durables • Consumer Durables are cars, PCs, Miele washing machines, GE refrigerators, John Deer lawn machinery, cooking ranges, etc. • As the economy begins to come out of the recession, consumer confidence and income increase.

48. The Stock Market and the Business Cycle Consumer Durables Excel peak ECONOMIC CYCLE Capital Goods Excel trough Financial Stocks Excel

49. Capital Goods • As the economy moves out of recession, businesses begin to modernize, renovate and purchase new equipment. • Heavy equipment manufactures, machine tool makers, airplane manufacturers become attractive.

50. The Stock Market and the Business Cycle Basic Industries Excel Consumer Durables Excel peak ECONOMIC CYCLE Capital Goods Excel trough Financial Stocks Excel