Tutorial 9 Solutions – Portfolio Management – I

[Readings: Ch11; Ch13]

Q1 Why have passive portfolio management strategies increased in use over time?

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 managed
portfolio are substantial.

Q2 Describe techniques considered active equity portfolio management strategies,

including market timing, sector rotation, quantitative screens, and other specific
anomaly-based strategies.

To engage in market timing, the manager will carry out analysis and predict which asset class is
forecasted to be the best performing one in the subsequent investment period. The fund is then
shifted towards that asset class.

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 undervalued.

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 satisfying linear constraints.

Other specific active management techniques can incorporate fundamental analysis, technical
analysis, or the use the anomalies and attributes. For example, based upon the top-down
fundamental approach, Anomalies and attributes can be used as quantitative screens (e.g., seek
small stocks with low P/E ratios) to identify potential portfolio candidates. Approaches based on
past returns namely momentum and contrarian strategies are also popular among active funds.

Q3 Describe the three techniques used to construct an indexed portfolio.

Three basic techniques 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.

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Q4 Discuss three strategies active managers can use to add value to their portfolios.

Managers attempt to add value to 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) stock selecting mispriced individual issues (buy low, sell high).

Q5 There has been a long-standing debate regarding the existence of a “value-growth”

anomaly in financial economic research. Previous studies have shown that value stocks
(i.e., stocks with low price-to-book ratios) have higher returns than growth stocks (i.e.,
stocks with high price-to-book ratios) in the United States and markets around the world,
even after adjusting for a market-wide risk factor. What are some possible explanations
for why value stocks might outperform growth stocks on a risk-adjusted basis? Is this
value-growth “anomaly” consistent with the existence of an efficient stock market?

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-oriented investors (1) focus on earnings per share (EPS) and what drives that value; (2)
look for companies that expect to exhibit rapid EPS growth in the future; and/or (3) implicitly
assume that the P/E ratio will remain constant over the near term, that is, stock price (in an
efficient market) will rise as forecasted earnings growth is realized.

Another perspective is that beta is not the only risk factor that is priced by the efficient market;
other risk factors explain the difference in risk-adjusted returns between value and growth
portfolios. Perhaps value stock returns reflect additional bankruptcy risk that growth stocks do
not have.

Some argue that the market may not be 100% efficient; investor behaviors pushes down the price
of stocks that become “value” stocks too far while being too optimistic of future growth potential
in “growth” stocks.

Q6 After determining the appropriate asset allocation to meet Lucinda Kennedy’s needs,
Richard Bulloch, CFA, invests a portion of Kennedy’s assets in two fixed-income investment
funds:

Trinity Index Fund: A passively managed portfolio of global bonds designed to track the
Barclays Global Aggregate Bond (LGAB) Index using a pure bond indexing strategy. The
management fee is 15 basis points annually.

Montego Global Bond Fund: An actively managed portfolio of global bonds designed to
outperform the LGAB net of fees. The management fee is 50 basis points annually. Six
months after investing in these funds, Kennedy and Bulloch review the performance data
shown in the following exhibit:

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 Total Returns on Index and Funds

Index or Fund Six-Month Return

LGAB Index 3.21%; Trinity Index Fund* 3.66%; Montego Global Bond Fund* 3.02%; *Net
of Fees

Kennedy makes the following statements regarding her fixed-income investments:

a. “The Trinity Index Fund is being managed well.”

b. “I expected that, as an active manager, Montego would outperform the index;

therefore, the fund should be sold.”

Determine whether you agree or disagree with each of Kennedy’s statements. Justify
your response with one reason for each statement.

a. “The Trinity Fund is being managed well.” Disagree. The fund is not managed properly
because a pure bond indexing strategy should not deviate significantly from its
benchmark.

b. “I expect that, as an active manager, Montego would outperform the index; therefore, the
fund should be sold.” Disagree. Six months is too short a time frame to evaluate an active
bond manager.

Q7 The ability to immunize a bond portfolio is very desirable for bond portfolio managers
in some instances.

a. Discuss the components of interest rate risk. Assuming a change in interest rates over
time, explain the two risks faced by the holder of a bond.

b. Define immunization, and discuss why a bond manager would immunize a portfolio.

c. Explain why a duration-matching strategy is a superior technique to a maturity-

matching strategy for the minimization of interest rate risk.

d. Explain in specific terms how you would use a zero-coupon bond to immunize a bond
portfolio. Discuss why a zero-coupon bond is an ideal instrument in this regard.

e. Explain how contingent immunization, another bond portfolio management technique,

differs from classical immunization. Discuss why a bond portfolio manager would engage
in contingent immunization.

(a) Interest rate risk comprises two risks - a price risk and a coupon reinvestment risk. Price
risk represents the chance that interest rates will differ from the rates the manager
expects to prevail between purchase and target date. Such a change causes the market
price for the bond (i.e., the realized price) to differ from the expected price. Obviously, if
interest rates increase, the realized price for the bond in the secondary market will be
below expectations, while if interest rates decline, the realized price will exceed
expectations.

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 Reinvestment risk arises because interest rates at which coupon payments can be
reinvested are unknown. If interest rates change after the bond is purchased, coupon
payments will be reinvested at rates different than that prevailing at the time of the
purchase. As an example, if interest rates decline, coupon payments will be reinvested at
lower rates than at the time of purchase and their contribution to the ending wealth
position of the investor will be below expectations. Contrariwise, if interest rates increase
there will be a positive impact as coupon payments will be reinvested at rates above
expectations.

(b) A portfolio of investments in bonds is immunized for a holding period if the value of the
portfolio at the end of the holding period, regardless of the course of interest rates during the
holding period, is at least as large as it would have been had the interest rate function been
constant throughout the holding period. Put another way, if the realized return on an investment
in bonds is sure to be at least as large as the computed yield to the investment horizon, then that
investment is immunized. As an example, if an investor acquired a portfolio bond when prevailing
interest rates were 10% and had an investment horizon of four years, then the investor would
expect the value of the portfolio at the end of four years to be 1.4641 x the beginning value. This
particular value is equal to 10% compounded for four years.

A bond manager would want to immunize the portfolio in the instance where he/she had a
specified investment horizon and had a definite required or promised yield for the bond portfolio.
In the case where this required or expected yield was below current prevailing market rates, it
would be worthwhile for the bond managers to immunize the portfolio and therefore “lock in”
the prevailing market yield for this period. Put another way, it is when the bond portfolio manager
is willing to engage in non-active bond portfolio management and accept the current prevailing
rate during the investment horizon.

(c) As set forth by a number of authors, the technique used to immunize a portfolio is to set the
duration of the portfolio equal to the investment horizon for the portfolio. It has been proven that
this technique will work because during the life of the portfolio, the two major interest rate risks
(price risk and reinvestment risk) offset each other at this point in time. The zero coupon bond is
an ideal immunization instrument because, by its very nature, it accomplishes these two purposes
when the maturity of the zero coupon bond equals the investment horizon because the duration
of a zero coupon bond is equal to its maturity period. In contrast, when you match the maturity
of the bond to the investment horizon, you are only taking account of the price risk whereby you
will receive the par value of the bond at the maturity of the bond. The problem is that you are not
sure of how the investment risk will work out. If rates rise, you will receive more in reinvestment
than expected. Alternatively, if rates decline, you will not benefit from the price advantage and, in
fact, will lose in terms of the reinvestment assumptions.

(d) The zero coupon bond is a superior immunization security because it eliminates both interest
rate risks-price and reinvestment.

A zero coupon bond is a perfect immunizer when its duration (or maturity, as they are the same)
is equal to the liability or planning horizon of the portfolio. Given adequate availability, the
portfolio manager would match these elements and no further activity is necessary to the end of
the horizon.

The zero coupon bond is superior to a coupon paying instrument because the lack of cash flow
prior to maturity eliminates any coupon reinvestment and, therefore, the risk of realized return
changes due to uncertainty of these levels. Price risk is also nonexistent regardless of the timing
or nature of yield curve shifts.

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(e) The primary difference between contingent and classical immunization is the role of active
management. Classical immunization precisely matches the duration of the portfolio with the
horizon of the particular liability. Management of such a portfolio is limited to periodic
rebalancing necessitated by yield curve shifts, yield changes, and time effects on duration.
Contingent immunization is an active form of management, initially, and can continue in this
mode until the manager’s results are unfavorable to the extent that a predetermined target return
is unlikely to be achieved. At this point, the active mode is triggered to a classical passive
immunization to “lock-in” the minimum desired return.

Contingent immunization achieves its risk control by establishing two parameters: (1) The
minimum return target for more specifically the difference between the minimum return target
and the immunization return than available in the market, and (2) the acceptable range for the
terminal horizon date of the program. The chart below illustrates the potential rewards from
contingent immunization based on possible moves in interest rates. It is interesting to note the
similarity of this curve to that of option strategies.

Q8 Answer the following questions assuming that at the initiation of an investment

account, the market value of your portfolio is $200 million, and you immunize the portfolio
at 12 percent for six years. During the first year, interest rates are constant at 12 percent.

a. What is the market value of the portfolio at the end of Year 1?

b. Immediately after the end of the year, interest rates decline to 10 percent. Estimate the
new value of the portfolio, assuming you did the required rebalancing (use only modified
duration).

(a) $200 million x (1.06)2 = $224.72 million (assuming semiannual coupon payments in the
bond portfolio).

(b) Since modified duration will equal the remaining horizon (5 years), the change in bond
price must be +10% or (-5)x(-2%). The new value of the portfolio would then be $247.192 million
or $224.72 million x (1.10).

Q9 Compute the Macaulay duration under the following conditions:

a. A bond with a four-year term to maturity, a 10 percent coupon (annual payments),

and a market yield of 8 percent.

b. A bond with a four-year term to maturity, a 10 percent coupon (annual payments),

and a market yield of 12 percent.

c. Compare your answers to Parts a and b. Assuming it was an immediate shift in yields,
discuss the implications of this for classical immunization.

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(a) Computation of Duration (assuming 8% market yield)

(1) (2) (3) (4) (5) (6)

Year Cash Flow PV@8% PVof Flow PV as % of Price (1) x (5)
1 100 .9259 92.59 .0868 .0868
2 100 .8573 85.73 .0804 .1608
3 100 .7938 79.38 .0745 .2234
4 1100 .7350 808.50 .7583 3.0332
1066.24 1.0000 3.5042
Duration = 3.5 years

(b) Computation of Duration (assuming 12% market yield)

(1) (2) (3) (4) (5) (6)

Year Cash Flow PV@12% PV of Flow PV as % of Price (1) x (5)
1 100 .8929 89.29 .0951 .0951
2 100 .7972 79.72 .0849 .1698
3 100 .7118 71.18 .0758 .2274
4 1100 .6355 699.05 .7442 2.9768
939.24 1.0000 3.4691
Duration = 3.47 years

(c) A portfolio of bonds is immunized from interest rate risk if the duration of the portfolio is
always equal to the desired investment horizon. In this example, although nothing changes
regarding the bond, there is a change in market rates, which causes a change in duration which
would mean that the portfolio is no longer perfectly immunized.

Applied Discussion: Discuss the main points in the following article: [BHB, pp.645-646]
In the news
Carving out new frontiers
Follow the lead of the big institutions and invest in an index fund, Barbara Drury
reports.
Index funds were once regarded as the domain of mum and dad investors with neither
the know-how nor the money to access the sophisticated managed investments offered
to wealthy clients. Not anymore. During the Global Financial Crisis, active fund managers
with strategic stock selection and sophisticated trading strategies were no better at
outwitting the market than the rest of us. Once fees were stripped out, many delivered
lower returns than a passive investment in an index fund. Not surprisingly, super funds,
personal investors and their advisers have voted with their feet and shifted money into
low-cost index funds.
‘In bull markets, where people are earning returns of 30 per cent a year, people are
not cost-conscious,’ says Tony Rumble of Alpha Structured Investments. ‘Now we’re back
into a market where the focus is on costs.’ Nigel Baker, of WHK Horvath Wealth
Management, says a decision to use a passive index approach helped clients weather the
crisis: ‘We’re looking for the best return for clients on an after-costs after-tax basis and
active funds don’t consistently provide the best outcome,’ he says.
Doug Turek, of Professional Wealth, also uses index funds in his wealthy clients’
portfolios, although he stresses that while index funds are great building blocks, they are
not the whole story. ‘If someone comes to me and asks where to start, I say they should

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 have an ETF [exchange traded fund] for exposure to the broad market. Maybe half [your
money] in index funds is not a bad compromise,’ he says.
…
Because there is no stock-picking involved and very little turnover of the underlying
shares or securities, index funds are cheaper than actively managed funds where you pay
professionals to pick stocks that will hopefully outperform the market. There’s the rub.
According to figures from Morningstar, barely half of actively managed Australian share
funds outperformed the index last year. That rises to 60 per cent over 15 years, partly due
to survival of the fittest. A handful of fund managers have a good track record, but it’s rare
to find a fund consistently ahead of the herd.
‘The best index investor is someone who has tried active funds and understands
how hard it is to pick managers before they outperform [the market]. The big problem is
that people pick last year’s best managers,’ says the head of retail at Vanguard, Robin
Bowerman. ‘If you have high confidence in a manager to outperform, by all means invest,
but what is disappointing is where people pay high active fees and get below-market
performance.’
…
What the GFC taught advisers and self-directed investors in the most powerful and
painful way possible was that asset allocation is the most important factor for investors.
In 2008 what determined whether you had a good or bad year was the percentage you
had in each asset class,’ [Bowerman] says. This is borne out by Russell Investments in a
study of the average annual return of all major asset classes over the past 30 years. It
turns out that a balanced portfolio with 70 per cent growth assets such as shares and
property and 30 per cent bonds and fixed interest provided a better return than any single
asset class except shares.
Source: Barbara Drury, ‘A low-cost easy winner’, Sydney Morning Herald, 10 March 2010.

Commentary
This article discusses the contentious issue of active versus passive management, by comparing
the performance of passive instrument (ETFs) with active instruments (managed funds). As Nigel
Baker states, ‘We’re looking for the best return for clients on an after-costs after-tax basis.’ As the
article states, as index funds, ETFs ‘are cheaper than actively managed funds where you pay
professionals to pick stocks that will hopefully outperform the market’. However, there is some
contention as to whether managed funds beat the market on a consistent basis. In the words of
Robin Bowerman, ‘what is disappointing is where people pay high active fees and get below-
market performance’. The final issue presented in the market is that of asset allocation versus
stock selection. Interestingly, a majority of the investor’s return appears to be due to the asset
allocation decision, particularly during volatile periods like the GFC. In support of a diversified
asset allocation-based strategy, with the exception of shares, ‘a balanced portfolio with 70 per
cent growth assets such as shares and property and 30 per cent bonds and fixed interest provided
a better return than any single asset’.