Investment analysis and portfolio management 8th reilly and brown chapter 16

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Lecture Presentation Software to accompany Investment Analysis and Portfolio Management Eighth Edition by Frank K Reilly & Keith C Brown Chapter 16 Chapter 16 - Equity Portfolio Management Strategies Questions to be answered: • What are the two generic equity portfolio management styles? • What are three techniques for constructing a passive index portfolio? • How does the goal of a passive equity portfolio manager differ from the goal of an active manager? • What is a portfolio’s tracking error and how is it useful in the construction of a passive equity investment? Chapter 16 - Equity Portfolio Management Strategies • What is the difference between an index mutual fund and an exchange-traded fund? • What are the three themes that active equity portfolio managers can use? • What stock characteristics differentiate valueoriented and growth-oriented investment styles? • What is style analysis and what does it indicate about a manager’s investment performance? Chapter 16 - Equity Portfolio Management Strategies • What techniques are used by active managers in an attempt to outperform their benchmark? • What are differences between the integrated, strategic, tactical, and insured approaches to asset allocation? Passive versus Active Management • Passive equity portfolio management – – – – Long-term buy-and-hold strategy Usually tracks 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 An Overview of Passive Equity Portfolio Management Strategies • Replicate the performance of an index • May slightly underperform the target index due to fees and commissions • Costs of active management (1 to percent) are hard to overcome in risk-adjusted performance • Many different market indexes are used for tracking portfolios Index Portfolio Construction Techniques • Full replication • Sampling • Quadratic optimization or programming 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 Sampling • Buys a 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 Expected Tracking Error Between the S&P 500 Index and Portfolio Comprised of Samples of Less Than 500 Stocks Expected Tracking Error (Percent) Exhibit 16.2 4.0 3.0 2.0 1.0 500 400 300 200 100 Number of Stocks Value versus Growth • Growth stocks will outperform value stocks for a time and then the opposite occurs • Over time value stocks have offered somewhat higher returns than growth stocks Value versus Growth • Growth-oriented investor will: – focus on EPS and its economic determinants – look for companies expected to have rapid EPS growth – assumes constant P/E ratio Value versus Growth • Value-oriented investor will: – focus on the price component – not care much about current earnings – assume the P/E ratio is below its natural level Style • Construct a portfolio to capture one or more of the characteristics of equity securities • Small-capitalization stocks, low-P/E stocks, etc… • Value stocks appear to be underpriced – price/book or price/earnings • Growth stocks enjoy above-average earnings per share increases 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 diversify by portfolio • Style investing allows control of the total portfolio to be shared between the investment managers and a sponsor Determining Style • Style grid: – firm size (large cap, mid cap, small cap) – Relative value (value, blend, growth) characteristics • Style analysis – constrained least squares Benchmark Portfolios • Sharpe – T-bills, intermediate-term government bonds, long-term government bonds, corporate bonds, mortgage related securities, large-capitalization value stocks, large-capitalization growth stocks, medium-capitalization stocks, smallcapitalization stocks, non-U.S bonds, European stocks, and Japanese stocks Benchmark Portfolios • Sharpe • BARRA – Uses portfolios formed around 13 different security characteristics, including variability in markets, past firm success, firm size, trading activity, growth orientation, earnings-to-price ratio, book-toprice ratio, earnings variability, financial leverage, foreign income, labor intensity, yield, and low capitalization Benchmark Portfolios • Sharpe • BARRA • Ibbotson Associates – simplest style model uses portfolios formed around five different characteristics: cash (Tbills), large-capitalization growth, smallcapitalization growth, large-capitalization value, and small-capitalization value Timing Between Styles • Variations in returns among mutual funds are largely attributable to differences in styles • Different styles tend to move at different times in the business cycle Asset Allocation Strategies • Integrated asset allocation – capital market conditions – investor’s objectives and constraints • Strategic asset allocation – constant-mix • Tactical asset allocation – mean reversion – inherently contrarian • Insured asset allocation – constant proportion 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 The Internet Investments Online http://www.russell.com http://www.firstquadrant.com http://www.panagora.com End of Chapter 16 –Equity Portfolio Management Strategies Future topics Chapter 17 • Bond Fundamentals .. .Chapter 16 - Equity Portfolio Management Strategies Questions to be answered: • What are the two generic equity portfolio management styles? • What are three... the construction of a passive equity investment? Chapter 16 - Equity Portfolio Management Strategies • What is the difference between an index mutual fund and an exchange-traded fund? • What are... themes that active equity portfolio managers can use? • What stock characteristics differentiate valueoriented and growth-oriented investment styles? • What is style analysis and what does it indicate
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