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CHAPTER 16 EQUITY PORTFOLIO MANAGEMENT STRATEGIES Answers to Questions
Passive portfolio management strategies have grown in popularity because investors are recognizing that the stock market is fairly efficient and that the costs of an actively managed portfolio are substantial.
Numerous studies have shown that the majority of portfolio managers have been unable to match the risk-return performance of stock or bond indexes. Following an indexing portfolio strategy, the portfolio manager builds a portfolio that matches the performance of an index, thereby reducing the costs costs of research and trading. The portfolio manager’s evaluation is based upon how closely the portfolio tracks the index or “tracking error,” rather than a risk-return performance evaluation. Another passive portfolio strategy, buy-and-hold, has the investor purchase securities and then not trade them—i.e., hold them—for a period of time. It differs from an indexing strategy in that indexing does require some limited trading, such as when the composition of the index changes as firms merge or are added and deleted from the index.
There are a number of active management strategies discussed in the bookl including sector rotation, the use of factor models, quantitative screens, and linear programming methods. Following a sector rotation strategy, the manager over-weights certain economic sectors, industries or other stock attributes in anticipation of an upcoming economic period or the recognition that the shares are undervalued. Using a factor model, portfolio managers examine the sensitivity of stocks to various economic variables. The managers then “tilt” the portfolios by trading those shares most sensitive to the analyst’s economic forecast. Through the use of computer databases and quantitative screens, portfolio managers are able to identify groups of stocks based upon up on a set of characteristics. Using linear programming techniques, portfolio managers are able to develop portfolios that maximize objectives while satisfying linear constraints. Any active management technique incorporates fundamental analysis, technical analysis, or the use the anomalies and attributes. For example, based upon the top-down fundamental approach, a factor model may be used to tilt a portfolio’s sensitivity toward those firms most likely to benefit from the economic forecat. Anomalies and attributes can be used as quantitative screens (e..g, seek small stocks with low P/E ratios) to 16 - 1
identify potential portfolio candidates. 4.
Three basic techniques exist for constructing a passive portfolio: (1) full replication of an index, in which all securities in the index are purchased proportionally to their weight in the index; (2) sampling, in which a portfolio manager purchases only a sample of the stocks in the benchmark index; and (3) quadratic optimization or programming techniques, which utilize computer programs that analyze historical security information in order to develop a portfolio that minimizes tracking error.
Managers attempt to add value to their portfolio by: (1) timing their investments in the various markets in light of market forecasts and estimated risk premiums; (2) shifting funds between various equity sectors, industries, or investment styles in order to catch the next “hot” concept; and (3) stockpicking of individual issues (buy low, sell high).
The job of an active portfolio manager is not easy. In order to succeed, the manager should maintain his/her investment philosophy, “don’t panic.” Since the transaction costs of an actively managed portfolio typically account for 1 to 2 percent of the portfolio assets, the portfolio must earn 1-2 percent above the passive benchmark just to keep even. Therefore, it is recommended that a portfolio manager attempt to minimize the amount of portfolio trading activity. A high portfolio turnover rate will result in diminishing portfolio profits due to growing commission costs.
The four asset allocation strategies are: (1) integrated asset allocation strategy, which separately examines capital market conditions and the investor’s objectives and constraints to establish a portfolio mix; (2) strategic asset allocation strategy, which utilizes long-run projections; (3) tactical asset allocation strategy, which adjusts the portfolio mix as capital market expectations and relative asset valuations change while assuming that the investor’s objectives and constraints remain constant over the planning horizon; and (4) insured asset allocation strategy, which presumes changes in investor’s objectives and constraints as his/her wealth changes as a result of rising or falling market asset values.
CFA Examination III (1994) Value-oriented investors (1) focus on the current price per share, specifically, the price of the stock is valued as “inexpensive”; (2) not be concerned about current earnings or the fundamentals that drive earnings growth; and/or (3) implicitly assume that the P/E ratio is below its natural level and that the (an efficient) market will soon recognize the low P/E ratio and therefore drive the stock price upward (with little or no change in earnings). Growth-oriented investors (1) focus on earnings per share (EPS) and what drives that value; (2) look for companies that expect to exhibit rapid EPS growth in the future; and/or (3) implicitly assume that the P/E ratio will remain constant over the near term, that is, stock price (in an efficient market) will rise as forecasted earnings growth is realized. Another perspective is that beta is not the only risk factor that is priced by the efficient 16 - 2
market; other risk factors explain the difference in risk-adjusted returns between value and growth portfolios. 9.
A price momentum strategy is based on the assumption that a stock’s recent price behavior will continue to hold. Thus an investor would buy a stock whose price has recently been rising, and sell (or short) a stock whose price has been falling. An earnings momentum strategy rests on the idea that a firm’s stock price will ultimately follow its earnings. The measurement of earnings momentum is usually based on a comparison to expected earnings. Thus an investor would buy a stock that has accelerating earnings relative to expectations and sell (or short) a stock whose earnings fall below expectations. These two approaches may product similar portfolios if company’s P/E ratios remain stable as their earnings (or price) exhibits momentum characteristics.
There are tradeoffs between using the full replication and the sampling method. Fully replicating an index is more difficult to manage and has higher trading commission costs, when compared to the sampling method. However, tracking error occurs from sampling, which should not be the case in the full replication of the index.
The portfolio manager could emphasize or overweight, relative to the benchmark, investments in natural resource stocks. The portfolio manager could also purchase options on natural resource stocks.
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CHAPTER 16 Answers to Problems
Using a spreadsheet and its functions we obtain the following values: 2 R : 0.98 alpha or intercept term: 0.08 beta or slope: 0.96 Average return difference (with signs): 0.08 Average return difference (without signs) 0.28 Portfolio Return Jan 5.0 Feb -2.3 Portfolio Mar -1.8 Apr 2.2 May 0.4 Jun -0.8 Jul 0 Aug 1.5 Sep -0.3 Oct -3.7 Nov Dec 0.3
S&P Return 5.2 -3 -1.6 1.9 0.1 -0.5 0.2 1.6 -0.1 -4 2.4 0.2
S&P 0.0822 500 Intercept Slope 0.9571
0.30 0.30 -0.30 -0.20 -0.10 -0.20 0.30
Difference Absolute in Returns difference in returns -0.20 0.20 0.70 0.70 -0.20 0.20[R i – E(R i)] x
0.30 0.30 0.30 0.20 0.10 0.20 0.30 0.40 0.10 0.28
Foreman R-squared: The R-squared could be low if the S&P 500 is not the proper index to use given the goals of the fund manager. Although Foreman may emphasize large cap stocks it may invest some of its assets in preferred stocks or bonds. Another possibility is that the fund has a value focus whereas at times the S&P 500 has a growth orientation. Thus the average P/E, dividend yield, price/book, or earnings growth estimates for the stocks held by Foreman may differ markedly from the S&P 500 stocks. Copeland may be an actively managed fund that is “gaming” the index. By charging fees for active management but not straying far from the index, the fund can achieve gross returns close to the index and have a high R-squared. Its net fees, however, will fall below the index (as the average equity fund has fees of 1% or more). Another possibility is we have no information on the beta of Copeland. It may have a high Rsquared but its beta can be much different than one. 16 - 4
Risk-adjusted performance: no information is presented on risk, so it is possible that total risk (standard deviation) for Copeland may be much less than the total risk of Foreman; we also have no information on systematic risk (beta) for the two funds. We can only tell that on the basis of gross returns, Foreman outperformed Copeland. We can make no judgment, as no data is presented, on net return and risk-adjusted return performance.
Portfolio turnover is the dollar value of securities sold in a year divided by the average value of the assets: Fund W: 37.2/289.4 = .1285 or 12.85% Fund X: 569.3/653.7 = 0.8709 or 87.09% Fund Y: 1,453.8/1,298.4 = 1.1197 or 111.97% Fund Z: 437.1/5,567.3 = 0.0785 or 7.85%
Passively managed funds will have low portfolio turnover ratios and should have low expenses ratios. On this basis, Funds W and Z are the most likely passively managed portfolios; X and Y are most likely to be actively managed.
The tax cost ratio is compute as [1 - (1 + TAR)/(1+PTR)] x 100 where TAR represents tax-adjusted return and PTR is the pre-tax return. Our c alculations are as follows: Fund W: [1 - (1 + 0.0943)/(1+0.0998)] x 100 = 0.50% Fund X: [1 - (1 + 0.0887)/(1+0.1065)] x 100 = 1.61% Fund Y: [1 - (1 + 0.0934)/(1+0.1012)] x 100 = 0.71% Fund Z: [1 - (1 + 0.0954)/(1+0.0983)] x 100 = 0.26% The tax cost ratio represents the percentage of an investor’s assets that are lost to taxes on a yearly basis due to the trading strategy employed by the fund manager. Funds Z and W are the most tax-efficient (least assets lost to taxes) and Funds X and Y were the least tax-efficient.
CFA Examination III (1992)
The following arguments could be made in favor of active management. Economic diversity – the diversity of the Otunian economy across various sectors may offer the opportunity for the active investor to employ “top down”, sector rotation strategies. High transaction costs – very high transaction costs may discourage trading activity by international investors and lead to inefficiencies that may be exploited successfully by active investors. Good financial disclosure and detailed accounting standards – good financial disclosure and detailed accounting standards may provide the well-trained analyst an opportunity to perform fundamental research analysis to identify inefficiently priced securities. 16 - 5
Capital restrictions – restrictions on capital flows may discourage foreign investor participation and serve to segment the Otunian market, thus creating exploitable market inefficiencies for the active investor. Developing economy and securities market – developing economies and markets are often characterized by inefficiently priced securities and by rapid economic change and growth; these characteristics may be exploited by the active investor, especially one using a ‘top down’, longer-term approach. Settlement problems – long delays in settling trades by non-residents may serve to discourage international investors, leading to inefficiently priced securities that may be exploited by active management. Potential deregulation of capital restrictions – potential deregulation of key industries in Otunia (media and transportation, for example) may be anticipated by active management. Poorly constructed index – a common characteristic of emerging country indices is domination by very large capitalization stocks which may not capture the diversity of the markets or economy; to the extent that the Otunian index exhibits this poor construction, active management would be favored. Marketing appeal – it would be consistent for GAC, and appealing to GAC’s clients, if GAC were to develop local Otunian expertise in a regional office (similar to GAC’s other regional offices) to conduct active management of Otunian stocks. The following arguments could be made in favor of indexation. Economic diversity – economic diversity across a broad sector of industries implies that indexing may provide a diverse representative portfolio that is not subject to the risks associated with concentrated sectors. High transaction costs – indexation would be favored by the implied lower levels of trading activity and thus costs. Settlement problems – indexation would be favored by the implied lower levels of trading activity and thus settlement activity. Financial disclosure and accounting standards – wide public availability of reliable financial information presumably leads to greater market efficiency, reducing the value of both fundamental analysis and active management and favoring indexation. Restrictions of capital flows – indexation would be favored by the implied lower levels of trading activity and thus smaller opportunity for regulatory interference. Lower management fees – clients would receive the benefit of GAC’s cost savings by 16 - 6
paying lower management fees for indexation than for regulatory interference. 4(b).
A recommendation for active management would focus on short-term inefficiencies in and long term prospects for the developing Otunian markets and economy, inefficiencies and prospects which would not be easily found in more developed markets. A recommendation for indexation would focus on the factors of economic diversity, high transaction costs, settlement delays, capital flow restrictions, and lower management fees.
CFA Examination III (1995) Reasons NewSoft shares may not be overvalued compared with shares of Capital Corporation, despite NewSoft’s higher ratios of price to earnings (P/E) and ratios of price to book (P/B) include: Higher P/E
1 . Prices reflect expected future earnings. If NewSoft’s earnings are growing faster than Capital Corp.’s, a higher P/E would be justified. 2.
Different accounting practices. Accounting practices affect P/Es based on accounting profits because companies often have different accounting practices (e.g., LIFO/FIFO, depreciation policy, and expense recognition). Historical accounting decisions (e.g., writeoffs) may also affect P/Es. Adjustments for such differences may be required before relative valuations can be properly assessed.
Cyclical behavior. Given the cyclical nature of the capital goods sector, the P/E ratio for Capital Corp. may have declined below its five-year average only because recent earnings have risen to a level that analysis indicates is unsustainable.
Difference between accounting and economic profits. Accounting profits used to calculate P/Es can differ from economic profits and may or may not be sustainable. NewSoft’s earnings performance may be understated (e.g., by expensing noncash items such as goodwill). Capital Corp.’s earnings performance may be overstated (e.g., by using low-cost tiers of LIFO inventory).
Differences in industries. Different industries have different valuation levels given by the market. NewSoft is a technology company, but Capital Corp. is a capital goods company.
Young versus mature industries. Industries at different points in their life cycles will have different valuations. Young industries often have higher valuations.
1 . Off-balance-sheet assets. NewSoft may have significant off-balance-sheet assets that are reflected in its stock price but not in its book value. P/Bs have little 16 - 7
interpretive value in situations in which intellectual property and human capital are key aspects to company success (e.g., the software industry). Physical plant and equipment are typically small, resulting in high P/Bs.
Nature of assets. Although physical plant and equipment presumably are a larger portion of Capital Corp.’s total value, the nature of its assets will also affect the validity of using book value as a measure of economic value. Assets such as goodwill and plant and equipment may vary greatly in their balance sheet cost versus economic value. For example, Capital Corp.’s balance sheet might include significant goodwill, raising the company’s book value but not its stock price.
Efficient use of assets. The P/B does not show how efficiently either company is using its assets. To the extent that NewSoft is generating a higher margin of profit with its assets, a higher P/B may be justified.
Obsolete assets. Some of Capital Corp.’s assets may be functional but obsolete. The company’s lower P/B may merely reflect the limited market value of its plant and equipment and the prospective costs of replacement.
EU pk = ER p – (σ p2/RTk ) Portfolios 1 2 3 4
Ms. A 8 - (5/8) = 7.38 9 - (10/8) = 7.75 10 - (16/8) = 8.00 11 - (25/8) = 7.88
Mr. B 8 – (5/27) = 7.81 9 – (10/27) = 8.63 10 – (16/27) = 9.41 11 – (25/27) = 10.07
The optimal portfolio is the one with the highest expected utility. Thus, portfolio 3 represents the optimal strategic allocation for Ms. A, while Portfolio 4 is the optimal allocation for Mr. B. Since Mr. B has a higher risk tolerance, he is able to pursue more volatile portfolios with higher expected returns.
For Ms. A:
Portfolio 1 = Portfolio 2 8 – (5/RT) = 9 – (10/RT) RT = 5 In other words, a risk tolerance factor of 5 would leave Ms. A indifferent between having Portfolio 1 or Portfolio 2 as her strategic allocation.
CFA Examination II (1995) Whether active asset allocation among countries could consistently outperform a world market index depends on the degree of international market efficiency and the skill of the portfolio manager. Investment professionals often view the basic issue of international market efficiency in terms of cross-border financial market integration or segmentation. An integrated world financial market would achieve international efficiency in the sense that arbitrage across markets would take advantage of any new information throughout the world. In an efficient integrated international market, prices of all assets would be in line with their relative investment values. 16 - 8
Some claim that international markets are not integrated, but segmented. Each national market might be efficient, but factors might prevent international capital flows from taking advantage of relative mispricing among countries. These factors include psychological barriers, legal restrictions, transaction costs, discriminatory taxation, political risks, and exchange risks. Markets do not appear fully integrated or fully segmented. Markets may or may not become more correlated as they become more integrated since other factors help to determine correlation. Therefore, the degree of international market efficiency is an empirical question that has not yet been answered. 8.
a) The table below shows that Manager A’s average return is less than the index while Manager B’s average exceeded that of the index. But performing several t-tests (matched pairs; t-test on differences assuming equal variances; t-test on the tracking errors) show that neither manager’s performance differed significantly from that of the index. b) The table below shows the difference between Manager A’s performance and the index, as well as the difference between Manager B’s performance and the index. Manager A did the better job of limiting the client’s exposure to unsystematic risk as the difference between A’s returns and those of the index has a smaller standard deviation than that of the difference between B’s returns and those of the index. Period
Manager B 13.90% -4.20% 13.50% 2.90% -5.90% 26.30% -11.20% 5.50% 4.20%
1 2 3 4 5 6 7 8 9
Manager A 12.80% -2.10% 15.60% 0.80% -7.90% 23.20% -10.40% 5.60% 2.30%
Average Std Dev Paired t-
5.89% 11.41% 0.872825
statistic t-test, same var
11.80% -2.20% 18.90% -0.50% -3.90% 21.70% -13.20% 5.30% 2.40%
A minus Index 1.00% 0.10% -3.30% 1.30% -4.00% 1.50% 2.80% 0.30% -0.10%
B minus Index 2.10% -2.00% -5.40% 3.40% -2.00% 4.60% 2.00% 0.20% 1.80%
6.38% 11.77% 0.697977
-0.11% 2.11% -0.16469
0.38% 3.00% 0.400714
t-statistic t-test difference from zero
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