1
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
5
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
10
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.
11
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?
12
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.
13
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)
14
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?
15
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?
16
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%
17
Relative Performance of Constant Mix and CPPI
A constant mix strategy sells stock as it rises A CPPI strategy buys stock as it rises
18
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
19
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
20
Rebalancing Within the Equity Portfolio
Constant proportion Constant beta Change the portfolio components Indexing
21
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
22
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
23
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
24
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
25
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
26
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
27
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
28
Costs of Revision
Introduction Trading fees Market impact Management time Tax implications Window dressing Rising importance of trading fees
29
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
30
Trading Fees
Commissions Transfer taxes
31
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
32
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
33
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
34
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
35
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
36
Management Time
Most portfolio managers handle more than one account Rebalancing several dozen portfolios is time consuming
37
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
38
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
39
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
40
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
41
When Do You Sell Stock?
Introduction Rebalancing Upgrading Sale of stock via stop orders Extraordinary events Final thoughts
42
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
43
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
44
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
45
Sale of Stock Via Stop Orders
Definition Using stops to minimize losses Using stops to protect profits
46
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
47
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
48
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
49
Extraordinary Events
Change in client objectives Change in market conditions Buy-outs Caprice
50
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
51
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
52
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
53
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
54
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
55
