R24 Equity Portfolio Management

Reading 24
Equity Portfolio Management
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Graphs, charts, tables, examples, and figures are copyright 2014, CFA Institute. Reproduced
and republished with permission from CFA Institute. All rights reserved.
Contents Equity Portfolio Management
1. Introduction
2. The Role of the Equity Portfolio
3. Approaches to Equity Investing
4. Passive Equity Investing
5. Active Equity Investing
6. Semi-Active Equity Investing
7. Managing a Portfolio of Managers
8. Identifying Selecting and Contracting with Equity Portfolio
Mangers
9. Structuring Equity Research and Security Selection
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2. The Role of the Equity Portfolio
Equity represents a significant source of wealth
Equity can be found in both individual and institutional portfolios
Investing across multiple markets offers diversification benefits
Equities offer superior protection against unanticipated inflation
High historical long term rates of return
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3. Approaches to Equity Investment
Passive Management
Investor does not attempt to reflect his investment expectations through
changes in security holding
Equity market is efficient indexing is the best strategy
Not really passive because portfolio needs to change when index is
reconstituted or when weight of a stock changes because of corporate
action
Active Management
Outperform benchmark portfolio by investing in underpriced securities
Dominant management style
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3. Approaches to Equity Investment
Semiactive Management
Also called enhanced indexing or risk-controlled active management
Variant of active management
Outperform benchmark but keep tracking risk in control
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4. Passive Equity Investing
According to William Sharpe:
4.1 Equity Indices
4.2 Passive Investment Vehicles
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4.1 Equity Indices
Stock indexs characteristics are determined by
1. Boundaries of stock indexs universe
2. Criteria for inclusion
3. How stocks are weighted
4. How returns are calculated
Listen to this lecture if you need a refresher on security market indices
http://www.youtube.com/watch?v=23qEK_mtMHo
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The S&P 500 also seeks to make sure the industry sectors in the S&P 500 represent the
industries in the economy. The sector percentages in the S&P 500 in 2010 were:
Information Technology (17.8%), Financial (15.1%), Energy (12.7%), Industrials (11.3%),
Consumer Staples (10.6%), Consumer Discretionary (10.6%), Materials (3.7%), Utilities
(3.4%), Telecom Services (3.1%). (Source: S&P 500 Factsheet)
To be included in the S&P 500, a company must meet the following minimum criteria:
Be a U.S. company.
Have a market cap of at least $4 billion.
At least 50% of its stock must be held by the public.
Four consecutive quarters of positive earnings.
A stock price of at least $1 per share.
Contribute to the overall balance of sectors within the S&P 500, to help it represent the overall
market sector make-up.
Be listed on either the New York Stock Exchange or the NASDAQ. Real Estate Investment
Trusts (REITs) and business development companies can also be included.
The top 10 largest companies in the S&P 500 in 2011 were: Exxon Mobil, Apple, IBM,
Chevron, General Electric, Microsoft, AT&T, Johnson & Johnson, Procter & Gamble and Pfizer.
The market cap of these 10 companies represent 20% of the market cap of the total S&P 500.
http://useconomy.about.com/od/glossary/g/SP500.htm
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Price Weighted Value Weighted Equal Weighted
Each stock weighted Each stock weighted All stocks treated the
according to absolute share according to market cap same
price
Float-weighted Small company bias
Biased towards highest because such indices
price share Biased towards high include many more small
market-cap stocks large companies
Effectively investing in companies, overvalued
proportion to share price stocks Requires frequent
rebalancing
Simple to construct Suggestion: adjust
component weights based
DJIA is the most prominent on fundamentals (such as
example P/E)
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Price Weighted
Value Weighted
Float Weighted
Equal Weighted
4.2 Passive Investment Vehicles
Refresher on swaps
http://www.youtube.com/watch?v=lFV3S1PCQoM&feature=youtu.be
Indexed Portfolios
Conventional (Open End) Index Mutual Exchange Traded Funds
Funds
Buy/sell shares at market close NAV Buy/sell any time during trading day
Shareholder accounting at the fund level can No fund level shareholder accounting
be a significant expense
Low index license fees Higher index license fees
Less tax efficient (selling shares capital Tax efficient due to in-kind redemption
gains taxes) process (fewer taxable events)
Cost associated with providing liquidity to Transaction costs for those buying/selling ETF
shareholders who are selling fund shares but those holding shares have protection
Can NOT short Short trades allowed
Indexed institutional portfolios could be managed as separate or pooled accounts
Pooling means having multiple portfolios under the same management (cost effective but
performance management is more difficult)
Indexed institutional portfolios have very low cost compared to both conventional index mutual
funds and exchange traded funds
How do we create an index portfolio? Do we replicate the entire index?
If index has less than 1000 stocks which are liquid Full Replication
Otherwise use stratified sampling or optimization
Full replication is common for indices like S&P 500. Why?
Index return portfolio return = sum of:
Stratified Sampling: Allows manager to build a portfolio that retains the basic
characteristics of the index without having to buy all stocks in the index
Define multiple dimensions Small Cap Mid Cap Large Cap
Industry A
Identify weights for each cell
Industry B
Randomly select/sample
Industry C
Include based on weights

Industry D
Lower cost but higher tracking

More dimensions and finer divisions closer replication
error compared to full replication
Optimization is a mathematical approach to index fund creation involving the use of:
Optimization Stratified Sampling

Takes into account covariances among factors Simplistically assumes factors are uncorrelated
used to explain returns on stocks
Even the best models are likely to be imperfectly

specified
Even in the absence of index changes this method

requires periodic trading to keep risk of portfolio
aligned with risks of index
Results compare well with those of optimization
Predicted tracking error is often understated
Stock index futures are low cost vehicles for obtaining for obtaining equity
market exposure must rollover to maintain long term
Portfolio trades (basket trades) are an alternative to index futures

Trade basket of stocks (i.e. entire portfolio)
Do not have to roll over as with futures contracts
Trading can be cumbersome at least with short sales
Equity total return swaps are a relatively low cost way of obtaining long term exposure to
an equity market
Major applications:
1) Receive total return of non-domestic equity index in return for an interest payment to a
counterparty that holds underlying equities more tax efficiently
2) Use equity swaps to rebalance portfolios (actually trading securities might be more costly)
5. Active Equity Investing
5.1 Equity Styles
5.2 Socially Responsible Investing
5.3 Long-Short Investing
5.4 Sell Disciplines/Trading
5.1 Equity Styles
Value vs. Growth
Market Capitalization
Value Investment Styles
Buy stocks which are relatively cheap in terms of purchase price of earnings or assets
Most investors over-pay for glamour (growth) stocks so avoid them; look for value in the not-
so-glamorous stocks
Empirical studies show that value style may earn positive return premium relative to market
Main risk is to misinterpret a stocks cheapness
Questions to ask:
Low P/E
Sub- Contrarian: Look for stocks which are in trouble and selling at low P/Bs (less than 1)
styles
High Yield
Growth Investment Style
Buy stocks which high earnings growth
If earnings up and P/E stays the same stock prices goes up
Growth stocks have high sales growth relative to the market and tend to trade at high P/Es,
P/Bs and P/Ss ratios
If stocks is trading at a premium, growth investor expects this premium to remain
Main risk is that growth does not materialize
Sub-styles:
Consistent Growth (Ex: Dell)
Earnings Momentum (Use relative strength indicators)
Other Active Management Styles
Market-oriented style falls between value and growth; buy if market value < intrinsic value
Sub-styles:
Market-oriented with value-bias
Market-oriented with growth-bias
Growth-at-a-reasonable price
Style rotators
Techniques for Identifying Investment Styles
Two major approaches to identifying style:
1) Returns-Based Style Analysis (RBSA)
2) Holdings-Based Style Analysis (also called composition-based style analysis)
Returns-Based Style Analysis (RBSA)
Regress portfolio returns on return series of a set of securities indices
Indices should be mutually exclusive and exhaustive and should have distinct sources
of risk (ideally should not be highly correlated)
Regression coefficients or betas should be non-negative and sum to 1
Rp = 0.75 x LCVI + 0 x LCGI + 0.25 x SCVI + 0 x SCGI + error
Are we meeting the constraints? What can we conclude?
Read Example 5
The regression R-squared (coefficient of determination) measures style fit
1 style fit variation not explained by style, referred to as selection
Style fit + selection = 1

Holdings-based style analysis categorizes individual securities by their characteristics and
aggregates results to reach a conclusion about the overall style of the portfolio
An analyst may examine the following variables:
1. Valuation levels
2. Forecast EPS growth rate
3. Earnings variability
4. Industry sector weighting
Example 8: Is the portfolio manager
following a value investment style?
A security may be assigned:
Equity Style Indices
How can we distinguish between value and growth. No clear definition; however, trend is towards
using multiple variables: price, earnings, book value, dividends, growth rates, etc.
Buffering: rules for maintaining previous style when stock has not clearly moved to new style
Style index publishers use growth and value either as categories (no overlap) or as quantities (with
overlap)
Excerpt from Exhibit 16. MCSI Index Family:
Example 9. Returns-
Based and Holdings-
Based Style Analysis
Interpret style analysis

results from both
approaches.
Holdings
-Based
Style
Analysis
The Style Box
Style Drift Professional investors view inconsistency in style, or style drift, as an obstacle
to investment planning and risk control
Example 10. Style

Drift or Not?
50
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5.2 Socially Responsible Investing
SRI criteria may include:
Understand impact on portfolios financial characteristics
If you know the potential biases introduced by SRI, you can take appropriate actions
determine the appropriate benchmark
5.3 Long-Short Investing
Style investing is concerned with portfolio characteristics, long-
short investing focuses on a constraint
Pairs trade (long-short trade)

Major risk stems from excessive leverage
Price inefficiency on the short sale side why?

Many investors only look for undervalued stocks
Management fraud, window dressing, negligence
Bias towards buy recommendations
Sell-side analysts may be reluctant to issue negative opinions
Equitizing a Market-Neutral Long-Short Portfolio
Equitize a market-neutral long-short position by holding a permanent stock index futures

position (essentially you are giving equity market systematic risk exposure)
Notional principal on futures contract = cash position from shorting securities
With this strategy investor has three sources of return:
1) Return from long-short strategy

2) Gain on forward contract
3) Interest on cash position
Appropriate when investor wants to add an equity beta to the return
Note: in some markets ETFs may be a more attractive way than futures to equitize
The long-only constraint limits an investors ability to benefit from an extreme
negative view on a stock
Short extension strategies (partial long-short) strategies partially relax the

long-only constraint. Example: 130/30. Short 30 and go long 130.
Equitized long-short strategy Short extension strategy

Needs a liquid futures, swaps or ETF Does not need a liquid futures, swaps or
market ETF market
Appreciable increase in the proportion of

a mangers investment insight that is
incorporated in the portfolio
Gain market return and earn alpha from

the same source
Zero-beta alternative investment Substitute to long-only strategy (not an

alternative investment!)
Read
Example 11
5.4 Sell Disciplines/Trading
Substitution: replace existing holding when another stock offers higher risk-
adjusted return
Rule based: Sell when a certain rule or criteria is met for example a value
investor might sell if P/E comes back to historical level
Implications of sell discipline need to be evaluated on a after-tax basis
Value investors generally have relatively low turnover; they buy cheap
stocks hoping to reap relatively long term reward
6. Semiactive Equity Investing
Also called enhanced index or risk-controlled active
Variant of active management
Outperform benchmark but keep tracking risk in control
High information ratio
Semiactive equity strategies come in two forms
Derivatives based (synthetic) Stock based
Exposure to desired equity market Generate alpha through underpriced
through a derivative and overpriced stocks
Enhanced return through something Limit degree to which you will

other than equity underweight or overweight
Fundamental Law of Active Management
IC = Information Coefficient correlation between forecast return and actual return
Breadth Number of independent, active investment decisions made each year
7. Managing a Portfolio of Managers
Exhibit 23
Manager Allocation by
Active Risk Level
Exhibit 24
Pension Fund Manager

Mix assuming active risk
of 1.51%
IR = 1.92 / 1.51 = 1.27
7.1 Core-Satellite
This is a core-satellite
portfolio
Index and semi-active at the

core
Ring of active managers

around the core
Core-satellite portfolio can be constructed using the rigorous approach show on previous
slides or a much simpler approach show in Example 14
True/misfit distinction has two main uses:
Performance appraisal
Optimizing portfolio of managers
7.2 Completeness Fund
The completeness fund is a simpler strategy to manage overall
portfolio risk and return
A manager may want to incorporate specific views with respect
to the benchmark creating active return, however, the risk also
goes up
The manager then identifies a basket or a number of trades
which complete the fund, i.e. minimize the active risk of the
portfolio
7.3 Other Approaches: Alpha and Beta Separation
8. Identifying, Selecting and Contracting with Equity Portfolio
Managers
Developing a universe of suitable manager candidates
The predictive power of past performance
Ad Valorem Fees Performance-Based Fees Fee Structure
Percentage of assets under Typically a combination of base fee

management (AUM) plus sharing percentage
Also called AUM fees 0.2% of AUM plus 20% of

performance in excess of benchmark
0.6% of first $50 mil
0.4% above that Can include features like:
Fee Cap
Simple and predictable High Water Mark
Needs precise definition
Call option to the investment

manager
Equity Manager Questionnaire
9. Structuring Equity Research and Security Selection
Top-down versus bottom up approaches
Buy-side versus sell-side research
Industry classification
Top Down and Bottom Up Analysis
Top Down: Country Industry Security Selection
Bottom Up: Focus on security selection
Buy-Side versus Sell-Side Research
Buy Side: Research with intent of assembling a portfolio
Might use sell-side research
Typically committee decisions
Sell Side: Independent researchers who sell their work or

investment banks/brokerage firms which use research as a
means to generate business
Industry Classification
Global Industry Classification Standard (GICS) developed by Standard and
Poors and MCSI
Conclusion
Learning objectives
Summary
Examples
Practice Problems

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Reading 24

Equity Portfolio Management

Equity can be found in both individual and institutional portfolios

Investing across multiple markets offers diversification benefits

Equities offer superior protection against unanticipated inflation

High historical long term rates of return

4.1 Equity Indices

4.2 Passive Investment Vehicles

Listen to this lecture if you need a refresher on security market indices

Low index license fees Higher index license fees

Can NOT short Short trades allowed

Otherwise use stratified sampling or optimization

Full replication is common for indices like S&P 500. Why?

Index return portfolio return = sum of:

Define multiple dimensions Small Cap Mid Cap Large Cap

Include based on weights

Lower cost but higher tracking

Optimization Stratified Sampling

Even the best models are likely to be imperfectly

Even in the absence of index changes this method

Portfolio trades (basket trades) are an alternative to index futures

5.2 Socially Responsible Investing

5.3 Long-Short Investing

5.4 Sell Disciplines/Trading

Value vs. Growth

Main risk is to misinterpret a stocks cheapness

Buy stocks which high earnings growth

If earnings up and P/E stays the same stock prices goes up

If stocks is trading at a premium, growth investor expects this premium to remain

Main risk is that growth does not materialize

Consistent Growth (Ex: Dell)

Earnings Momentum (Use relative strength indicators)

Market-oriented with value-bias

Market-oriented with growth-bias

Two major approaches to identifying style:

1) Returns-Based Style Analysis (RBSA)

2) Holdings-Based Style Analysis (also called composition-based style analysis)

Regress portfolio returns on return series of a set of securities indices

Regression coefficients or betas should be non-negative and sum to 1

Rp = 0.75 x LCVI + 0 x LCGI + 0.25 x SCVI + 0 x SCGI + error

Are we meeting the constraints? What can we conclude?

The regression R-squared (coefficient of determination) measures style fit

1 style fit variation not explained by style, referred to as selection

Style fit + selection = 1

An analyst may examine the following variables:

2. Forecast EPS growth rate

4. Industry sector weighting

Excerpt from Exhibit 16. MCSI Index Family:

Interpret style analysis

Example 10. Style

Understand impact on portfolios financial characteristics

Pairs trade (long-short trade)

Price inefficiency on the short sale side why?

Equitize a market-neutral long-short position by holding a permanent stock index futures

Notional principal on futures contract = cash position from shorting securities

With this strategy investor has three sources of return:

1) Return from long-short strategy

Appropriate when investor wants to add an equity beta to the return

Short extension strategies (partial long-short) strategies partially relax the

Equitized long-short strategy Short extension strategy

Appreciable increase in the proportion of

Gain market return and earn alpha from

Zero-beta alternative investment Substitute to long-only strategy (not an

Implications of sell discipline need to be evaluated on a after-tax basis