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16

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CHAPTER 16

EQUITY PORTFOLIO MANAGEMENT STRATEGIES

Answers to Questions

1.

Passive portfolio management strategies have grown in popularity because investors are

recognizing that the stock market is fairly efficient and that the costs of an actively

man

aged portfolio are substantial.

2.

Numerous studies have shown that the majority of portfolio managers have been unable

to match the risk

-

return performance of stock or bond indexes. Following an indexing

portfolio strategy, the portfolio manager builds

a portfolio that matches the performance

of an index, thereby reducing the costs of research and trading. T

he portfolio manager’s

evaluation is based upon how closely the portfolio tracks the index or “tracking error,”

rather than a risk

-

return performan

ce evaluation.

Another passive portfolio strategy, buy

-

and

-

hold, has the investor purchase securities and

then not trade them

—

i.e., hold them

—

for a period of time. It differs from an indexing

strategy in that indexing does require some limited trading, s

uch as when the composition

of the index changes as firms merge or are added and deleted from the index.

3.

There are a number of active management strategies discussed in the

bookl

including

sector rotation, the use of factor models, quantitative screens

, and linear programming

methods.

Following a sector rotation strategy, the manager over

-

weights certain economic sectors,

industries or other stock attributes in anticipation of an upcoming economic period or the

recognition that the shares are underva

lued.

Using a factor model, portfolio managers examine the sensitivity of stocks to various

economic variables. The managers then “tilt” the portfolios by trading those shares most

sensitive to the analyst’s economic forecast.

Through the use of computer

databases and quantitative screens, portfolio managers are

able to identify groups of stocks based upon a set of characteristics.

Using linear programming techniques, portfolio managers are able to develop portfolios

that maximize objectives while satisf

ying linear constraints.

Any active management technique incorporates fundamental analysis, technical analysis,

or the use the anomalies and attributes. For example, based upon the top

-

down

fundamental approach, a factor model may be used to tilt a portfo

lio’s sensitivity toward

those firms most likely to benefit from the economic forecat. Anomalies and attributes

can be used as quantitative screens (e..g, seek small stocks with low P/E ratios) to

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identify potential portfolio candidates.

4.

Three basic te

chniques exist for constructing a passive portfolio: (1) full replication of an

index, in which all securities in the index are purchased proportionally to their weight in

the index; (2) sampling, in which a portfolio manager purchases only a sample of the

stocks in the benchmark index; and (3) quadratic optimization or programming

techniques, which utilize computer programs that analyze historical security information

in order to develop a portfolio that minimizes tracking error.

These represent tradeoffs

between most accurate tracking of index returns versus cost.

Two investment products that managers may use to track the S&P 500 index include

index mutual funds, such as Vanguard’s 500 Index Fund (VFINX) and SPDRs, an ETF

that tracks the S&P 500. Per th

e textbook, the more accurate means of tracking the S&P

500 index has been VFINX; the SPDR “

shares do not track the index quite as closely as

did the VFINX fund.

”

5.

Managers attempt to add value to their portfolio by: (1) timing their investments in the

various markets in light of market forecasts and estimated risk premiums; (2) shifting

funds between various equity sectors, industries, or investment styles in order to catch the

next “hot” concept; and (3) stockpicking of individual issues (buy low, sell

high).

6.

The job of an active portfolio manager is not easy. In order to succeed, the manager

should maintain his/her investment philosophy, “don’t panic.” Since the transaction costs

of an actively managed portfolio typically account for 1 to 2 perc

ent of the portfolio

assets, the portfolio must earn 1

-

2 percent above the passive benchmark just to keep even.

Therefore, it is recommended that a portfolio manager attempt to minimize the amount of

portfolio trading activity. A high portfolio turnover r

ate will result in diminishing

portfolio profits due to growing commission costs.

7.

The four asset allocation strategies are: (1) integrated asset allocation strategy, which

separately examines capital market conditions and the investor’s objectives and

constraints to establish a portfolio mix

; (2) strategic asset allocation strategy, which

utilizes long

-

run projections; (3) tactical asset allocation strategy, which

adjusts the

portfolio mix as capital market expectations and relative asset valuations cha

nge while

assuming

that

the

investor’s objectives and constraints remain constant over the planning

horizon; and (4) insured asset allocation strategy, which presumes changes in investor’s

objectives and constraints as

his/her wealth changes as a result of

rising or falling

market

asset values

.

8.

Value

-

oriented investors (1) focus on the current price per share, specifically, the price of

the stock is valued as “inexpensive”; (2) not be concerned about current earnings or the

fundamentals that drive earnings

growth; and/or (3) implicitly assume that the P/E ratio is

below its natural level and that the (an efficient) market will soon recognize the low P/E

ratio and therefore drive the stock price upward (with little or no change in earnings).

Growth

-

oriente

d investors (1) focus on earnings per share (EPS) and what drives that