EQUITY PORTFOLIO MANAGEMENT

STRATEGIES
Lame Bakwenabatsile Office 245/234
University of Botswana
Department of Accounting and Finance
 Key Concepts
• An Overview of Equity Portfolio Management
• Passive Equity Portfolio Management Strategies
• Active Equity Portfolio Management Strategies
 An Overview

Total Portfolio Return

• The total actual return on any equity portfolio
can be decomposed into:
 Expected return
 Alpha
• The excess return of the fund relative to the
return of the benchmark index is a fund's alpha.
 An Overview

The Equation
• Total Actual Return
=[Expected Return] + [“Alpha”]
=[Risk-Free Rate + Risk Premium]+[“Alpha”]

Passive

Active
 An Overview

Passive equity portfolio management

• Long-term buy-and-hold strategy
• Usually tracks an index over time
• Designed to match market performance
• Manager is judged on how well they track the
target index
Active equity portfolio management
• Attempts to outperform a passive benchmark
portfolio on a risk-adjusted basis by seeking the
“alpha” value
 Passive Equity Portfolio
Management Strategies
• Attempt to replicate the performance of an
index
• May slightly underperform the target index due
to fees and commissions
• Strong rationale for this approach is that costs
of active management (1 to 2 percent) are hard
to overcome in risk-adjusted performance
• Many different market indexes are used for
tracking portfolios
 Index Portfolio Construction Techniques
Full Replication
• All securities in the index are purchased in
proportion to weights in the index
• This helps ensure close tracking
• Increases transaction costs, particularly with
dividend reinvestment
 Index Portfolio Construction Techniques

Sampling
• Buys a representative sample of stocks in the
benchmark index according to their weights in
the index
• Fewer stocks means lower commissions
• Reinvestment of dividends is less difficult
• Will not track the index as closely, so there will
be some tracking error
 Index Portfolio Construction Techniques
Quadratic Optimization (programming techniques)
• Historical information on price changes and
correlations between securities are input into a
computer program that determines the
composition of a portfolio that will minimize
tracking error with the benchmark
• Relies on historical correlations, which may change
over time, leading to failure to track the index
 Methods of Index Portfolio Investing
Buy shares in a Index Mutual Funds
• For an indexed portfolio, the fund manager will
typically attempt to replicate the composition of the
particular index exactly
• The fund manager will buy the exact securities
comprising the index in their exact weights
• Change those positions anytime the composition of
the index itself is changed
• Changes to index occur sporadically therefore the
fund has low trading and management expense ratios
• Advantage: provide an inexpensive way for investors
to acquire a diversified portfolio
 Methods of Index Portfolio Investing
Buy share in an Exchange Traded Funds (ETFs)
• Depository receipts that give investors a pro rata
claim on the capital gains and cash flows of the
securities that are held in deposit by a financial
institution that issued the certificates
• Advantage of ETFs over index mutual funds is that
they can be bought and sold (and short sold) like
common stock
• The notable example of ETFs in Botswana are
NEWGOLD, NEWPLAT and Bettabeta Equally
Weighted Top 40 ETF
 Active Equity Portfolio
Management Strategies
• Goal is to earn a portfolio return that exceeds the
return of a passive benchmark portfolio, net of
transaction costs, on a risk-adjusted basis
• Need to select an appropriate benchmark
• Practical difficulties of active manager
 Transactions costs must be offset by superior
performance vis-à-vis the benchmark
 Higher risk-taking can also increase needed
performance to beat the benchmark
 Fundamental Strategies
Top-Down versus Bottom-Up Approaches
Top-Down
• Broad country and asset class allocations
• Sector allocation decisions
• Individual securities selection
Bottom-Up
• Emphasizes the selection of securities without any initial
market or sector analysis
• Form a portfolio of equities that can be purchased at a
substantial discount to what his or her valuation model
indicates they are worth
 Fundamental Strategies
Three Generic Themes
• Time the equity market by shifting funds into and out of
stocks, bonds, and T-bills depending on broad market
forecasts
• Shift funds among different equity sectors and
industries (e.g., financial stocks, technology stocks). This
is basically the sector rotation strategy
• Do stock picking and look at individual issues in an
attempt to find undervalued stocks
The Stock Market and the Business Cycle
 Fundamental Strategies
The 130/30 Strategy
• Long positions up to 130% of the portfolio’s original
capital and short positions up to 30%
• Use of the short positions creates the leverage
needed, increasing both risk and expected returns
compared to the fund’s benchmark
• Enable managers to make full use of their
fundamental research to buy stocks they identify as
undervalued as well as short those that are
overvalued
 Technical Strategies
Contrarian Investment Strategy
• The belief that the best time to buy (sell) a
stock is when the majority of other investors
are the most bearish (bullish) about it
Price Momentum Strategy
• Focus on the trend of past prices alone and
makes purchase and sale decisions accordingly
• Assume that recent trends in past prices will
continue
 Anomalies and Attributes
Earnings Momentum Strategy
• Momentum is measured by the difference of
actual EPS to the expected EPS
• Purchases stocks that have accelerating
earnings and sells (or short sells) stocks with
disappointing earnings
 Tracking Error
• The goal of the passive manager should be to
minimize the portfolio’s return volatility
relative to the index, i.e., to minimize tracking
error
• The portfolio’s return volatility to the
benchmark portfolio (Index) is the tracking
error.
• Period t return to managed portfolio is:
𝑁
𝑅 𝑝𝑡 = ∑ 𝑤 𝑖 𝑅 𝑖𝑡
𝑁=1
 Tracking Error Measure
Where
• wi = investment weight of Asset i in the managed
portfolio
• Rit = return to asset in period t
• Rbt = return to the benchmark portfolio in period t
• N = number of assets in the managed portfolio
Differential between the managed portfolio and
benchmark is:
𝑁
Δ t= ∑ 𝑤 𝑖 𝑅𝑖𝑡 − 𝑅𝑏𝑡 =𝑅𝑝𝑡 − 𝑅𝑏 𝑡
𝑁=1
 Tracking Error Measure
• For a sample of T return observations the
variance of Δ can be calculated as follows

(T - 1)
 Tracking Error Measure
• For a sample of T return observations the
standard deviation of Δ can be calculated as
follows:

=Periodic Tracking Error

where P no. of return periods in a year

(e.g. P=12 for monthly returns)
 Tracking Error Measure
An investor formed a portfolio to track a particular
benchmark. Over the past eight quarters, portfolio and
benchmark returns and difference between the two were:
Period Portfolio Benchmark Difference(
1 2.3% 2.7% -0.4%
2 -3.6 -4.6 1.0
3 11.2 10.1 1.1
4 1.2 2.2 -1.0
5 1.5 0.4 1.1
6 3.2 2.8 0.4
7 8.9 8.1 0.8
8 -0.8 0.6 -1.4
 Tracking Error Measure
Using the information from the previous slide
determine the annualised tracking error for the
portfolio manager of the passive portfolio over
the two year period.
 Tracking Error Measure
Answer
Average=(-0.4)+1+1.1+(-1)+1.1+0.4+0.8+(-1.4)
8
= 0.2%
=

= 1%
Annualised tracking error = 1% x = 2%
 Tracking Error and Index Portfolio
Construction
• There is an inverse relationship between a
passive portfolio’s tracking error relative to its
benchmark (index) and the time and expense
necessary to create and maintain the portfolio.
• Full replication of a benchmark will fully reduce
the tracking error but increase reinvesting
expenses, while an index sample will have less
expenses but increases the tracking error.
Tracking Error and Index Portfolio Construction
 Asset Allocation Strategies
• Many portfolios containing equities also
contain other asset categories, so the
management factors are not limited to
equities
• Four asset allocation strategies:
• Integrated asset allocation
 Examine capital market conditions and
investor objectives and constraints
 Determine the allocation that best serves
the investor’s needs while incorporating the
capital market forecast.
 Asset Allocation Strategies
• Strategic asset allocation
– Using historical information, generate optimal portfolio mixes based on
returns, risk, and covariances, adjusting periodically to restore target
allocation
– Its long term buy and hold strategy
• Tactical asset allocation
– Occasionally engaging in short term deviation from the mix (SAA) in
order to capitalize on exceptional investment opportunities.
– Moderately active strategy
• Insured asset allocation
– Establish base portfolio value under which the portfolio is not allowed to
drop.
– Exercise active management as long as the returns are above the set
value in order to maximise returns.
– If portfolio value falls below the base, you invest in risk free securities.
– Suitable for risk averse investor who cannot take losses
 Asset Allocation Strategies
• Selecting an allocation method depends on:
– Perceptions of variability in the client’s objectives
and constraints
– Perceived relationship between the past and
future capital market conditions