Chapter 15

Revision of the Equity Portfolio

Portfolio Construction, Management, & Protection, 5e, Robert A. Strong Copyright 2009 by South-Western, a division of Thomson Business & Economics. All rights reserved.

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
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Active Management versus Passive Management

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 Rebalancing within the Equity Portion Change the Portfolio Components Indexing
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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
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Rebalance the Portfolio

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

Constant Mix Strategy

The constant mix strategy:
Is one in 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 $2 million. The investment policy statement requires a target asset allocation of 60 percent stock and 40 percent bonds. The initial portfolio value and the portfolio value after one quarter are shown on the next slide.

Constant Mix Strategy (contd)

Example (contd)
Date 1 Jan 1 Apr Portfolio Value Actual Allocation $2,000,000 $2,500,000 60%/40% 56%/44% Stock Bonds $1,200,000 $800,000 $1,400,000 $1,100,000

What dollar amount of stock should the portfolio manager buy to rebalance this portfolio? What dollar amount of bonds should he sell?

Constant Mix Strategy (contd)

Example (contd)
Solution: a 60 percent/40 percent 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.

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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:
$ in stocks = Multiplier (Portfolio value Floor value)

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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?

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Constant Proportion Portfolio Insurance (contd)

Example (contd)
Solution: $600,000 should be invested in stock:

$ in stocks = 2.0 ($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?
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Constant Proportion Portfolio Insurance (contd)

Example (contd)
Solution: The desired equity position after one quarter should be: $ in stocks = 2.0 ($2,200,000 $1,700,000) = $1,000,000 The portfolio manager should move $350,000 into stock. The resulting percentage would be: $1,000,000/$2,200,000 = 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 and 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 and 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 Portfolio 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
An investor 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 $28,250 % 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 $36,500

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 $1,000: Value Before 8,000 Value After 12,000 % of Portfolio 32.00

Stock FC

Price 20.00

Shares 400

Action Buy 200

HG
YH Total

15.00
90.00

700
200

10,500
18,000 $36,500

Buy 100
Sell 50

12,000
13,500 $37,500

32.00
36.00 100.00
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Constant Beta Portfolio

A constant beta portfolio requires maintaining the same portfolio beta It is more likely to have requirements that beta be within some given range 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-beta stocks or low-beta stocks Buy high-beta stocks 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 Russell 1000

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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Tactical Asset Allocation

What Is Tactical Asset Allocation? How TAA Can Benefit a Portfolio Designing a TAA Program Caveats Regarding TAA Performance Costs of Revision Contributions to the Portfolio
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Tactical Asset Allocation

Tactical asset allocation (TAA) managers:
Seek to improve the performance of their funds by shifting the relative proportion of their investments into and out of asset classes as the relative prospects of those asset classes change

For example, shift to stocks if stocks are expected to outperform bonds

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Definition (contd)
TAA attempts to take advantage of shortterm deviations from long-term trends The most difficult part of TAA is asset class appraisal
The process of determining the relative merits of the various asset classes given current economic conditions
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Intuitive versus Quantitative Techniques

In the intuitive approach, decisions are based on personal opinion and gut feeling
Suffers from hindsight bias
Portfolio managers remember the times they were correct

In the quantitative approach, managers use an analytical assessment and a system for implementing precise portfolio changes
e.g., use the gap between the S&P 500 dividend yield and the average yield on AAA corporate bonds
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Overview of the Technique

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Policy Decisions
Policy decisions involve:
Deciding to use a TAA program in the first place Establishing the extent to which the program will be employed Determining the number of asset classes to employ

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Strategy
There are three alternative strategic functions:
Static strategy maintains a static portfolio mix Reactive strategy involves decisions based on events that have already occurred Anticipatory strategy involves shifting funds before the markets move
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How TAA Can Benefit a Portfolio

The goal of an anticipatory strategy is to outperform the portfolio without TAA
The potential gains to a clairvoyant manager from TAA are enormous (see next slide)

The portfolio manager must assess return within a risk/return framework

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How TAA Can Benefit a Portfolio (contd)

Source: Ensign Peak Advisors, Inc., Salt Lake City, UT 84150.

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Designing a TAA Program

Before implementing a TAA program, a fund manager must establish:
The normal mix
The benchmark proportion each asset class constitutes in the portfolio

The mix (exposure) range

Specifies how much the current mix can deviate from the normal mix
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Designing a TAA Program (contd)

Before implementing a TAA program, a fund manager must establish (contd):
The swing component
The percentage of the total portfolio whose composition by asset class may change The key element of TAA is properly investing the swing component

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Efficient Market Implications

TAA programs implicitly assume it is possible to outperform a buy-and-hold strategy by shifting asset classes
Inconsistent with the efficient market hypothesis

Some fund managers have good records with TAA programs

Might be skill or luck
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Impact of Transaction Costs

The portfolio incurs trading fees each time a trade occurs If the marginal gains from TAA switching do not exceed transaction costs, the program is not effective

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Costs of Revision
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

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Commissions
Investors pay commissions both to buy and to sell shares Commissions at a brokerage firm may be a function of both:
The dollar 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 reduced commission rates Offer few ancillary services, such as market research or periodic newsletters

Retail commissions at a full-service firm average about 2 percent of the trade 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 If an account holds its securities in a street name, dividends go to the brokerage firm holding the securities on the clients behalf If the portfolio manager receives the dividend checks, there needs to be some temporary haven for these funds until they accumulate sufficiently to finance the purchase of more securities or until they are paid as income to the fund beneficiary
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When Do You Sell Stock?

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 a Stock Via Stop Orders

Stop orders:
Are usually used to sell but can be used to buy

A sell stop becomes 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 $23 and want to sell it if it falls below $18
Place a stop-loss order at $18

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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

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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 portfolio holdings
i.e., another firm wants to acquire the security position

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 a desire to protect profits or minimize further losses and the potential for price appreciation
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