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

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

Active Management Versus Passive Management

Definition The managers choices Costs of revision Contributions to the portfolio

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
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The Managers Choices

Leave the portfolio alone Rebalance the portfolio Asset allocation and rebalancing within the aggregate portfolio Change the portfolio components Indexing

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

Rebalance the Portfolio

Rebalancing a portfolio is the process of periodically adjusting it to maintain the original conditions

Rebalancing Within the Portfolio

Constant mix strategy Constant proportion portfolio insurance Relative performance of constant mix and CPPI strategies

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

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Constant Mix Strategy (contd)

Example
A portfolio has a market value of Rs2 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.

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Constant Mix Strategy (contd)

Example (contd)
Date Portfolio Value Actual Allocation Stock Bonds

1 Jan

Rs2,000,000

60%/40%

Rs1,200,00 Rs800,000 0

1 Apr Rs2,500,000 56%/44% Rs1,400,00 Rs1,100,000 What Rs amount of stock should the portfolio 0 manager buy to rebalance this portfolio? What Rs amount of bonds should he sell?

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Constant Mix Strategy (contd)

Example (contd)
Solution: a 60%/40% asset allocation for a Rs2.5 million portfolio means the portfolio should contain Rs1.5 million in stock and Rs1 million in bonds. Thus, the manager should buy Rs100,000 worth of stock and sell Rs100,000 worth of bonds.

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Constant Proportion Portfolio Insurance

A constant proportion portfolio insurance (CPPI) strategy requires the manager to invest a percentage of the portfolio in stocks:
Rs in stocks = Multiplier x (Portfolio value Floor value)

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Constant Proportion Portfolio Insurance (contd)

Example
A portfolio has a market value of Rs2 million. The investment policy statement specifies a floor value of Rs1.7 million and a multiplier of 2. What is the Rs amount that should be invested in stocks according to the CPPI strategy?

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Constant Proportion Portfolio Insurance (contd)

Example (contd) Solution: Rs600,000 should be invested in stock: Rs in stocks = 2.0 x (Rs2,000,000 Rs1,700,000) = Rs600,000 If the portfolio value is Rs2.2 million one quarter later, with Rs650,000 in stock, what is the desired equity position under the CPPI strategy? What is the ending asset mix after rebalancing?

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Constant Proportion Portfolio Insurance (contd)

Example (contd)
Solution: The desired equity position after one quarter should be:

Rs in stocks = 2.0 x (Rs2,200,000 Rs1,700,000) = Rs1,000,000 The portfolio manager should move Rs350,000 into stock. The resulting asset mix would be: Rs1,000,000/Rs2,200,000 = 45.5%

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Relative Performance of Constant Mix and CPPI

A constant mix strategy sells stock as it rises A CPPI strategy buys stock as it rises

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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

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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

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Rebalancing Within the Equity Portfolio

Constant proportion Constant beta Change the portfolio components Indexing

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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

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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: Stock FC HG YH Total Price 22.00 13.50 50.00 Shares 400 700 200 Value 8,800 9,450 10,000 Rs28,25 0 % of Total Portfolio 31.15 33.45 35.40 100.00

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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.

Stock FC

Price 20.00

Shares 400

Value 8,000

% of Total Portfolio 21.92

HG
YH Total

15.00
90.00

700
200

10,500
18,000 Rs36,500

28.77
49.32 100.00
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Constant Proportion (contd)

Example (contd)
Solution: The worksheet below shows a possible revision which requires an additional investment of Rs1,000:

Stock FC

Price 20.00

Shares 400

Value Before 8,000

Action Buy 200

Value After 12,000

% of Portfolio 32.00

HG
YH Total

15.00
90.00

700
200

10,500
18,000 Rs36,500

Buy 100
Sell 50

12,000
13,500 Rs37,500

32.00
36.00 100.00
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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
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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

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Indexing

Indexing is a form of portfolio management that attempts to mirror the performance of a market index
E.g., the S&P 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

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

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Introduction

Costs of revising a portfolio can:

Be direct Rs costs
Result from the consumption of

management time Stem from tax liabilities Result from unnecessary trading activity

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Trading Fees
Commissions Transfer taxes

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Commissions

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

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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

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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

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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

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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

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Management Time

Most portfolio managers handle more than one account Rebalancing several dozen portfolios is time consuming

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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

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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

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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

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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

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When Do You Sell Stock?

Introduction Rebalancing Upgrading Sale of stock via stop orders Extraordinary events Final thoughts

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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

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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

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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

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Sale of Stock Via Stop Orders

Definition Using stops to minimize losses Using stops to protect profits

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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

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Using Stops to Minimize Losses

Stop-loss orders can be used to minimize losses

E.g., you bought a share for Rs23 and want

to sell it if it falls below Rs18

Place a stop-loss order for Rs18

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Using Stops to Protect Profits

Stop orders can be used to protect profits

E.g., a stock you bought for Rs33 now

trades for Rs48 and you want to protect the profits at Rs45
If the stock retreats to Rs45, 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

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

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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

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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

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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

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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

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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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