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Chapter 15 Revision of the Equity Portfolio

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Title: Chapter 15 Revision of the Equity Portfolio


1
Chapter 15Revision of the Equity Portfolio
2
  • An individual can make a difference a team can
    make a miracle
  • - 1980 U.S. Olympic hockey team

3
Outline
  • Introduction
  • Active management versus passive management
  • When do you sell stock?

4
Introduction
  • Portfolios need maintenance and periodic
    revision
  • Because the needs of the beneficiary will change
  • Because the relative merits of the portfolio
    components will change
  • To keep the portfolio in accordance with the
    investment policy statement and investment
    strategy

5
Active Management Versus Passive Management
  • Definition
  • The managers choices
  • Costs of revision
  • Contributions to the portfolio

6
Definition
  • An active management policy is one in which the
    composition of the portfolio is dynamic
  • The portfolio manager periodically changes
  • The portfolio components or
  • The components proportion within the portfolio
  • A passive management strategy is one in which the
    portfolio is largely left alone

7
The Managers Choices
  • Leave the portfolio alone
  • Rebalance the portfolio
  • Asset allocation and rebalancing within the
    aggregate portfolio
  • Change the portfolio components
  • Indexing

8
Leave the Portfolio Alone
  • A buy and hold strategy means that the portfolio
    manager hangs on to its original investments
  • Academic research shows that portfolio managers
    often fail to outperform a simple buy and hold
    strategy on a risk-adjusted basis
  • E.g., Barber and Odean show that investors who
    trade the most have the lowest gross and net
    returns

9
Rebalance the Portfolio
  • Rebalancing a portfolio is the process of
    periodically adjusting it to maintain the
    original conditions

10
Rebalancing Within the Portfolio
  • Constant mix strategy
  • Constant proportion portfolio insurance
  • Relative performance of constant mix and CPPI
    strategies

11
Constant Mix Strategy
  • The constant mix strategy
  • Is one to which the manager makes adjustments to
    maintain the relative weighting of the asset
    classes within the portfolio as their prices
    change
  • Requires the purchase of securities that have
    performed poorly and the sale of securities that
    have performed the best

12
Constant Mix Strategy (contd)
  • Example
  • A portfolio has a market value of 2 million. The
    investment policy statement requires a target
    asset allocation of 60 percent stock and 30
    percent bonds.
  • The initial portfolio value and the portfolio
    value after one quarter are shown on the next
    slide.

13
Constant Mix Strategy (contd)
  • Example (contd)
  • What dollar amount of stock should the portfolio
    manager buy to rebalance this portfolio? What
    dollar amount of bonds should he sell?

14
Constant Mix Strategy (contd)
  • Example (contd)
  • Solution a 60/40 asset allocation for a 2.5
    million portfolio means the portfolio should
    contain 1.5 million in stock and 1 million in
    bonds. Thus, the manager should buy 100,000
    worth of stock and sell 100,000 worth of bonds.

15
Constant Proportion Portfolio Insurance
  • A constant proportion portfolio insurance (CPPI)
    strategy requires the manager to invest a
    percentage of the portfolio in stocks
  • in stocks Multiplier x (Portfolio value
    Floor value)

16
Constant Proportion Portfolio Insurance (contd)
  • Example
  • A portfolio has a market value of 2 million. The
    investment policy statement specifies a floor
    value of 1.7 million and a multiplier of 2.
  • What is the dollar amount that should be invested
    in stocks according to the CPPI strategy?

17
Constant Proportion Portfolio Insurance (contd)
  • Example (contd)
  • Solution 600,000 should be invested in stock
  • in stocks 2.0 x (2,000,000
    1,700,000)
  • 600,000
  • If the portfolio value is 2.2 million one
    quarter later, with 650,000 in stock, what is
    the desired equity position under the CPPI
    strategy? What is the ending asset mix after
    rebalancing?

18
Constant Proportion Portfolio Insurance (contd)
  • Example (contd)
  • Solution The desired equity position after one
    quarter should be
  • in stocks 2.0 x (2,200,000
    1,700,000)
  • 1,000,000
  • The portfolio manager should move 350,000 into
    stock. The resulting asset mix would be
    1,000,000/2,200,000 45.5

19
Relative Performance of Constant Mix and CPPI
  • A constant mix strategy sells stock as it rises
  • A CPPI strategy buys stock as it rises

20
Relative Performance of Constant Mix CPPI
(contd)
  • In a rising market, the CPPI strategy outperforms
    constant mix
  • In a declining market, the CPPI strategy
    outperforms constant mix
  • In a flat market, neither strategy has an obvious
    advantage
  • In a volatile market, the constant mix strategy
    outperforms CPPI

21
Relative Performance of Constant Mix CPPI
(contd)
  • The relative performance of the strategies
    depends on the performance of the market during
    the evaluation period
  • In the long run, the market will probably rise,
    which favors CPPI
  • In the short run, the market will be volatile,
    which favors constant mix

22
Rebalancing Within the Equity Portfolio
  • Constant proportion
  • Constant beta
  • Change the portfolio components
  • Indexing

23
Constant Proportion
  • A constant proportion strategy within an equity
    portfolio requires maintaining the same
    percentage investment in each stock
  • May be mitigated by avoidance of odd lot
    transactions
  • Constant proportion rebalancing requires selling
    winners and buying losers

24
Constant Proportion (contd)
  • Example
  • A portfolio of three stocks attempts to invest
    approximately one third of funds in each of the
    stocks. Consider the following information

25
Constant Proportion (contd)
  • Example (contd)
  • After one quarter, the portfolio values are as
    shown below. Recommend specific actions to
    rebalance the portfolio in order to maintain the
    constant proportion in each stock.

26
Constant Proportion (contd)
  • Example (contd)
  • Solution The worksheet below shows a possible
    revision which requires an additional investment
    of 1,000

27
Constant Beta Portfolio
  • A constant beta portfolio requires maintaining
    the same portfolio beta
  • To increase or reduce the portfolio beta, the
    portfolio manager can
  • Reduce or increase the amount of cash in the
    portfolio
  • Purchase stocks with higher or lower betas than
    the target figure
  • Sell high- or low-beta stocks
  • Buy high- or low-beta stocks

28
Change the Portfolio Components
  • Changing the portfolio components is another
    portfolio revision alternative
  • Events sometimes deviate from what the manager
    expects
  • The manager might sell an investment turned sour
  • The manager might purchase a potentially
    undervalued replacement security

29
Indexing
  • Indexing is a form of portfolio management that
    attempts to mirror the performance of a market
    index
  • E.g., the SP 500 or the DJIA
  • Index funds eliminate concerns about
    outperforming the market
  • The tracking error refers to the extent to which
    a portfolio deviates from its intended behavior

30
Costs of Revision
  • Introduction
  • Trading fees
  • Market impact
  • Management time
  • Tax implications
  • Window dressing
  • Rising importance of trading fees

31
Introduction
  • Costs of revising a portfolio can
  • Be direct dollar costs
  • Result from the consumption of management time
  • Stem from tax liabilities
  • Result from unnecessary trading activity

32
Trading Fees
  • Commissions
  • Transfer taxes

33
Commissions
  • Investors pay commissions both to buy and to sell
    shares
  • Commissions at a brokerage firm are a function
    of
  • The dollar value of the trade
  • The number of shares involved in the trade

34
Commissions (contd)
  • The commission on a trade is split between the
    broker and the firm for which the broker works
  • Brokers with a high level of production keep a
    higher percentage than a new broker
  • Some brokers discount their commissions with
    their more active clients

35
Commissions (contd)
  • Discount brokerage firms
  • Offer substantially reduce commission rates
  • Offer few ancillary services, such as market
    research
  • Retail commissions at a full-service firm average
    about 2 percent of the stock value

36
Transfer Taxes
  • Transfer taxes are
  • Imposed by some states on the transfer of
    securities
  • Usually very modest
  • Not normally a material consideration in the
    portfolio management process

37
Market Impact
  • The market impact of placing the trade is the
    change in market price purely because of
    executing the trade
  • Market impact is a real cost of trading
  • Market impact is especially pronounced for shares
    with modest daily trading volume

38
Management Time
  • Most portfolio managers handle more than one
    account
  • Rebalancing several dozen portfolios is time
    consuming

39
Tax Implications
  • Individual investors and corporate clients must
    pay taxes on the realized capital gains
    associated with the sale of a security
  • Tax implications are usually not a concern for
    tax-exempt organizations

40
Window Dressing
  • Window dressing refers to cosmetic changes made
    to a portfolio near the end of a reporting period
  • Portfolio managers may sell losing stocks at the
    end of the period to avoid showing them on their
    fund balance sheets

41
Rising Importance of Trading Fees
  • Flippancy regarding commission costs is unethical
    and sometimes illegal
  • Trading fees are receiving increased attention
    because of
  • Investment banking scandals
  • Lawsuits regarding churning
  • Incomplete prospectus information

42
Contributions to the Portfolio
  • Periodic additional contributions to the
    portfolio from internal or external sources must
    be invested
  • Dividends
  • May be automatically reinvested by the fund
    managers broker
  • May have to be invested in a money market account
    by the fund manager

43
When Do You Sell Stock?
  • Introduction
  • Rebalancing
  • Upgrading
  • Sale of stock via stop orders
  • Extraordinary events
  • Final thoughts

44
Introduction
  • Knowing when to sell a stock is a very difficult
    part of investing
  • Behavioral evidence suggests the typical investor
    sells winners too soon and keeps losers too long

45
Rebalancing
  • Rebalancing can cause the portfolio manager to
    sell shares even if they are not doing poorly
  • Profit taking with winners is a logical
    consequence of portfolio rebalancing

46
Upgrading
  • Investors should sell shares when their
    investment potential has deteriorated to the
    extent that they no longer merit a place in the
    portfolio
  • It is difficult to take a loss, but it is worse
    to let the losses grow

47
Sale of Stock Via Stop Orders
  • Definition
  • Using stops to minimize losses
  • Using stops to protect profits

48
Definition
  • Stop orders
  • Are sell stops
  • Become a market order to sell a set number of
    shares if shares trade at the stop price
  • Can be used to minimize losses or to protect a
    profit

49
Using Stops to Minimize Losses
  • Stop-loss orders can be used to minimize losses
  • E.g., you bought a share for 23 and want to sell
    it if it falls below 18
  • Place a stop-loss order for 18

50
Using Stops to Protect Profits
  • Stop orders can be used to protect profits
  • E.g., a stock you bought for 33 now trades for
    48 and you want to protect the profits at 45
  • If the stock retreats to 45, you lock in the
    profit if you place a stop order
  • If the stock continues to increase, you can use a
    crawling stop to increase the stop price

51
Extraordinary Events
  • Change in client objectives
  • Change in market conditions
  • Buy-outs
  • Caprice

52
Change in Client Objectives
  • The clients investment objectives may change
    occasionally
  • E.g., a church needs to generate funds for a
    renovation and changes the objective for the
    endowment fund from growth of income to income
  • Reduce the equity component of the portfolio

53
Change in Market Conditions
  • Many fund managers seek to actively time the
    market
  • When a portfolio managers outlook becomes
    bearish, he may reduce his equity holdings

54
Buy-Outs
  • A firm may be making a tender offer for one of
    the funds holdings
  • I.e., another firm wants to acquire the fund
    holding
  • It is generally in the clients best interest to
    sell the stock to the potential acquirer

55
Caprice
  • Portfolio managers
  • Should be careful about making unnecessary trades
  • Must pay attention to their experience,
    intuition, and professional judgment
  • An experienced portfolio manager worried about a
    particular holding should probably make a change

56
Final Thoughts
  • Hindsight is an inappropriate perspective for
    investment decision making
  • Everything you do as a portfolio manager must be
    logically justifiable at the time you do it
  • Portfolio managers are torn between minimizing
    losses and the potential for price appreciation
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