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Chapter 25 Contemporary Issues in Portfolio Management

Chapter 25 Contemporary Issues in Portfolio Management. Life is my college; may I graduate well and earn some honors. - Louisa May Alcott. Outline. Introduction Tactical asset allocation Stock lending Program trading Role of derivative assets The chartered financial analyst program

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Chapter 25 Contemporary Issues in Portfolio Management

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  1. Chapter 25Contemporary Issues in Portfolio Management

  2. Life is my college; may I graduate well and earn some honors. - Louisa May Alcott

  3. Outline • Introduction • Tactical asset allocation • Stock lending • Program trading • Role of derivative assets • The chartered financial analyst program • Regulation Fair Disclosure • Security analyst independence

  4. Introduction • Some emerging areas are controversial: • Tactical asset allocation contradicts the EMH • Stock lending and program trading have image problems • Derivatives are not permitted in some portfolios

  5. Tactical Asset Allocation • What is tactical asset allocation? • How TAA can benefit a portfolio • Designing a TAA program • Caveats regarding TAA performance

  6. What Is Tactical Asset Allocation? • Definition • Intuitive versus quantitative techniques • Overview of the technique • Policy decisions • Strategy

  7. Definition • Tactical asset allocation (TAA) managers: • Seek to improve the performance of their funds • By shifting the relative proportion of their investments into and out of asset classes • As the relative prospects of those asset classes change • For example, shift to stocks if stocks are expected to outperform bonds

  8. Definition (cont’d) • TAA attempts to take advantage of short-term deviations from long-term trends • The most difficult part of TAA is asset class appraisal • The process of determining the relative merits of the various asset classes given current economic conditions

  9. Intuitive Versus Quantitative Techniques • In the intuitive approach, decisions are based on personal opinion and gut feeling • Suffers from hindsight bias • Portfolio managers remember the times they were correct

  10. Intuitive Versus Quantitative Techniques (cont’d) • In the quantitative approach, managers use an analytical assessment and a system for implementing precise portfolio changes • E.g., use the gap between the S&P 500 dividend yield and the average yield on AAA corporate bonds

  11. Overview of the Technique

  12. Policy Decisions • Policy decisions involve: • Deciding to use a TAA program in the first place • Establishing the extent to which the program will be employed • Determining the number of asset classes to employ

  13. Strategy • There are three alternative strategic functions: • Static strategy maintains a static portfolio mix • Reactive strategy involves decisions based on events that have already occurred • Anticipatory strategy involves shifting funds before the markets move

  14. How TAA Can Benefit A Portfolio • The goal of an anticipatory strategy is to outperform the portfolio without TAA • The potential gains to a clairvoyant manager from TAA are enormous (see next slide) • The portfolio manager must assess return within a risk/return framework

  15. How TAA Can Benefit A Portfolio (cont’d)

  16. Designing A TAA Program • Before implementing a TAA program, a fund manager must establish: • The normal mix • The benchmark proportion each asset class constitutes in the portfolio • The mix (exposure) range • Specifies how much the current mix can deviate from the normal mix

  17. Designing A TAA Program (cont’d) • Before implementing a TAA program, a fund manager must establish (cont’d): • The swing component • The percentage of the total portfolio whose composition by asset class may change • The key element of TAA is properly investing the swing component

  18. Caveats Regarding TAA Performance • Efficient market implications • Impact of transaction costs

  19. Efficient Market Implications • TAA program implicitly assume it is possible to outperform a buy-and-hold strategy by shifting asset classes • Inconsistent with the efficient market hypothesis • Some fund managers have good records with TAA programs • Might be skill or luck

  20. Impact of Transaction Costs • The portfolio incurs trading fees each time a trade occurs • If the marginal gains from TAA switching do not exceed transaction costs, the program is not effective

  21. Stock Lending • Definition • Mechanics of a short sale • How a stock lending transaction works • Stock lending’s lucrative nature • Regulatory concerns • Long/short portfolios • Certificateless trading

  22. Definition • Stock lending: • Is the practice by which one institution loans stock to another institution • Is often used to support short-selling by customers of the second institution • Can earn substantial income with very little risk

  23. Definition (cont’d) • Stock lending is similar to a repurchase agreement: • The institution wanting to borrow stock • Puts up collateral (about 102 percent of the securities lent) • Agrees to return the securities at a later date • The lender can earn interest on the cash collateral

  24. Mechanics of A Short Sale • A short sale: • Involves borrowing securities from someone • Selling the securities to another market participant • Eventually purchasing shares from another market participant and • Returning the substitute shares to the original lender

  25. Mechanics of A Short Sale (cont’d) • A short sale is normally motivated by a bearish sentiment • The actual lender in a short sale is normally an unknowing participant • A hypothecation agreement gives the broker the right to lend shares to someone else • The investor can still trade the shares and continues to earn dividends

  26. Mechanics of A Short Sale (cont’d) • The short seller: • Has an obligation to return what was borrowed at some point in the future • Must pay dividends to the lender • Eventually covers short by repurchasing shares to replace the shares borrowed earlier • If the purchase price is below the selling price, the short seller makes a profit

  27. How A Stock Lending Transaction Works • If the customer wants to short sell: • The brokerage firm first checks if other customers have the stock in a margin account • The brokerage firm may use a stock loan finder to locate another firm with the needed shares • The first firm deposits collateral with the second firm (T-bills or cash) • Part of the interest is used to pay a finder’s fee to the stock loan finder

  28. Stock Lending’s Lucrative Nature • Advantages of stock lending • Disadvantages of stock lending

  29. Advantages of Stock Lending • Stock lending is very lucrative • In 1999, the total income to stock lenders approached $1 billion • Stock lending is popular when markets see increased merger and acquisition activity: • Merger arbitrage involves buying shares of likely takeover candidates and short selling shares of the anticipated acquirer

  30. Advantages of Stock Lending (cont’d) • Stock lending can be used by brokerage firms to finance the margin purchases of their customers

  31. Disadvantages of Stock Lending • A customer potentially gives up the right to vote: • The short seller is essentially a negative owner • Some risk is associated with the possibility that the stock borrower might not return the securities • Stock loans are “marked to market”

  32. Regulatory Concerns • Stock lending does technically not fall under SEC jurisdiction • Does not involve the purchase or sale of securities • A possible area of abuse lies in the lending of shares in cash accounts • Cash account holders do not sign hypothecation agreements

  33. Long/Short Portfolios • Short selling is an element of a hedging strategy called building a long/short portfolio: • Combines elements of speculation, fundamental stock analysis, and hedging to reduce risk • Sells overvalued shares and buys undervalued shares

  34. Certificateless Trading • The difference in settlement procedures across countries can cause significant problems • E.g., U.S. settlement takes 3 business days versus 6 weeks in France • Computer automation makes it possible to process some types of transactions almost immediately • E.g., newly issued U.S. government bonds are registered in book entry form only

  35. Program Trading • Program trading: • Is not easy to define • Can be used to mean any computer-aided buying or selling activity in the stock market

  36. Program Trading (cont’d) • The Wall Street Journal defines program trading as the simultaneous purchase or sale of at least 15 different securities with a total value of $1 million or more

  37. Program Trading (cont’d) • Stoll and Whaley elements of program trading: • Portfolio trading • Computerized trading • Computer decision making

  38. Program Trading (cont’d) • Program trading is also the generic term used to describe any strategy that instantaneously recommends buy or sell order because of apparent arbitrage • E.g., buy futures and sell stock if the basis is theoretically too small • E.g., buy stock and sell futures if the basis is theoretically too wide

  39. Program Trading (cont’d) • Program traders fall into one of two groups: • Institutions that buy stock index futures and T-bills to create the equivalent of an index portfolio • Institutions that combine a well-diversified stock portfolio with short position in stock index futures to create synthetic T-bills

  40. Program Trading (cont’d) • Program trading has a bad name as it may increase security price volatility • Many professional traders and investment managers believe that program trading benefits the public • Helps reduce commission costs

  41. Role of Derivative Assets • Process of education • Getting board approval

  42. Process of Education • People think derivatives are speculative • Various exchanges offer seminars on ways in which derivative assets can be used in conservative portfolios • E.g., risk management conferences by CBOE, CBOT, CME, LIFFE • Derivative asset education is designed to give people more choices

  43. Getting Board Approval • Once the portfolio manager is convinced of futures and/or options, he must convince: • Boards of trustees • Supervisors or • Fund beneficiaries • The manager should be able to explain the merits of derivatives using everyday language

  44. The Chartered Financial Analyst Program • History • The CFA program exams • CFA program themes

  45. History • The CFA program began in 1959 when the Institute of Chartered Financial Analysts (ICFA) was formed • Promotes investment education and ethical behavior • Awarded the first charter in 1963 • The Financial Analysts Federation (FAF) merged with the ICFA in 1990 to form the Association for Investment Management and Research (AIMR)

  46. The CFA Program Exams • To earn the CFA designation, candidates must pass three separate exams taken at least a year apart • Each CFA exam is given only once per year

  47. The CFA Program Exams (cont’d) • Level I is multiple choice: • Covers basic tools and inputs to the investment valuation process • Level II is essay, valuation, analysis, and problem sets • Emphasizes security valuation and specialized topics

  48. The CFA Program Exams (cont’d) • Level III is essay, valuation, analysis, and problem sets • Covers portfolio management

  49. CFA Program Enrollment

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