Chapter 17
EQUITY-PORTFOLIO
MANAGEMENT
Chapter 17 Questions
What are the two generic equity portfolio
management styles?
What are three techniques for constructing a
passive index portfolio?
What three generic strategies can active
equity-portfolio managers use?
How does the goal of a passive equityportfolio manager differ from the goal of an
active manager?
Chapter 17 Questions
What investment styles may portfolio
managers follow?
In what ways can investors use
information about a portfolio manager’s
style?
What skills should a good value portfolio
manager possess? A good growth
portfolio manager?
Chapter 17 Questions
How can futures and options be useful
in managing an equity portfolio?
What strategies can be used to manage
a taxable investor’s portfolio in a taxefficient way?
What are four asset allocation
strategies?
Generic Portfolio
Management Strategies
Passive equity portfolio management




Long-term buy-and-hold strategy
Usually track an index over time
Designed to match market performance
Manager is judged on how well they track the
target index
Active equity portfolio management

Attempts to outperform a passive benchmark
portfolio on a risk-adjusted basis
Passive Equity Portfolio
Management Strategies
Attempt to replicate the performance of an
index

May slightly underperform the target index due to
fees and commissions
Strong rationale for this approach

Costs of active management (1 to 2 percent) are
hard to overcome in risk-adjusted performance
Many different market indexes are used for
tracking portfolios
Passive Equity Portfolio
Management Strategies
Not a simple process to track a market
index closely
Three basic techniques:
Full replication
 Sampling
 Quadratic optimization or programming

Passive Equity Portfolio
Management Strategies
Full Replication
All securities in the index are purchased
in proportion to weights in the index
This helps ensure close tracking
Increases transaction costs, particularly
with dividend reinvestment
Passive Equity Portfolio
Management Strategies
Sampling
Buys representative sample of stocks in the
benchmark index according to their weights 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”

Tracking error will diminish as the number of
stocks grows, but costs will grow (tradeoff)
Expected Tracking Error Between the
S&P 500 Index and Portfolio Samples of
Less Than 500 Stocks
Expected Tracking
Error (Percent)
Exhibit 17.2
4.0
3.0
2.0
1.0
500
400
300
200
100
0
Number of Stocks
Passive Equity Portfolio
Management Strategies
Quadratic Optimization
Historical information on price changes and
correlations between securities are input into
a computer program that determines 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 failure to
track the index
Passive Equity Portfolio
Management Strategies
Completeness Funds
Passive portfolio customized to
complement active portfolios which do
not cover the entire market
Performance compared to a specialized
benchmark that incorporates the
characteristics of stocks not covered by
the active managers
Passive Equity Portfolio
Management Strategies
Dollar-cost averaging
Purchasing fixed dollar investments per
period over time
 Prevents buying too many shares at high
prices and too few shares when prices are
low
 Often part of a passively managed portfolio
strategy

Active Equity 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

Need to select an appropriate benchmark
Practical difficulties of active manager


Transactions costs must be offset by superior
performance vis-à-vis the benchmark
Higher risk-taking can also increase needed
performance to beat the benchmark
Active Equity Portfolio
Management Strategies
Three Strategies
Market timing - shifting funds into and out of
stocks, bonds, and T-bills depending on
broad market forecasts and estimated risk
premiums
Shifting funds among different equity sectors
and industries or among investment styles to
catch hot concepts before the market does
Stockpicking - individual issues, attempt to
buy low and sell high
Active Equity Portfolio
Management Strategies
Global Investing: Three Strategies
Identify countries with markets undervalued
or overvalued and weight the portfolio
accordingly
Manage the global portfolio from an industry
perspective rather than from a country
perspective
Focus on global economic trends, industry
competitive forces, and company strengths
and strategies
Active Equity Portfolio
Management Strategies
Sector Rotation
Position a portfolio to take advantage of the
market’s next move
Screening can be based on various stock
characteristics:




Value
Growth
P/E
Capitalization
Key is to determine what to “rotate into”
Active Equity Portfolio
Management Strategies
Style Investing
Construct a portfolio to capture one or more
of the characteristics of equity securities
Small-cap stocks, low-P/E stocks, etc…
Value stocks (those that appear to be underpriced according to various measures)

Low Price/Book value or Price/Earnings ratios
Growth stocks (above-average earnings per
share increases)

High P/E, possibly a price momentum strategy
Active Equity Portfolio
Management Strategies
Does Style Matter?
Choice to align with investment style
communicates information to clients
Determining style is useful in measuring
performance relative to a benchmark
Style identification allows an investor to fully
diversify a portfolio
Style investing allows control of the total
portfolio to be shared between the investment
managers and a sponsor
Active Equity Portfolio
Management Strategies
Value versus Growth
Growth investing focuses on earnings
and changes in company fundamentals
Value investing focuses on the pricing
of stocks
Over time value stocks have offered
somewhat higher returns than growth
stocks
Active Equity Portfolio
Management Strategies
Expectational Analysis and Value/Growth
Investing
Analysts recommending stocks to a portfolio
manager need to identify and monitor key
assumptions and variables
Value investors focus on one key set of
assumptions and variables while growth
investors focus on another

Such an analysis can help determine timing
strategy for buying/selling
Asset Allocation
Strategies
Many portfolios containing equities also
contain other asset categories, so the
management factors are not limited to
equities
Four asset allocation strategies:
Integrated asset allocation
Examine capital market conditions and investor
objectives and constraints
Determine the allocation that best serves the
investor’s needs while incorporating the capital
market forecast
Asset Allocation
Strategies
Strategic asset allocation

Using historical information, generate optimal
portfolio mixes based on returns, risk, and
covariances, adjusting periodically to restore
target allocation
Tactical asset allocation

Often a contrarian asset allocation strategy
dependent on expectations
Insured asset allocation

Adjust risk exposure for changing portfolio values;
more value means more ability to absorb losses
Asset Allocation
Strategies
Selecting an allocation method depends
on:
Perceptions of variability in the client’s
objectives and constraints
 Perceived relationship between the past
and future capital market conditions
