Practice investment management pim3 ch18e

CHAPTER EIGHTEEN

MANAGING
THE EQUITY PORTFOLIO

Practical Investment Management
Robert A. Strong


Outline
 Structuring a Stock Portfolio
 The Portfolio Objective
 Asset Allocation
 Active vs. Passive Management

 Portfolio Rebalancing







What’s Wrong with Buy and Hold?
The Costs of Revision
Constant Proportion Rebalancing
Constant Beta Rebalancing
Indexing
Dollar Cost Averaging

South-Western / Thomson Learning © 2004

18 - 2


Outline
 Overwriting
 Writing Options to Generate Income
 Improving on the Market

 Portfolio Protection





Writing Covered Calls for Downside Protection
Protective Puts
Using Index Options
Using Index Futures Contracts

South-Western / Thomson Learning © 2004

18 - 3


Structuring a Stock Portfolio : The Objective
 Semantics are important in any statement
of investment objectives.
 The four main portfolio objectives are
stability of principal, income, growth of

income, and capital appreciation.
 In a world with taxes, one dollar in capital
gains is worth more than one dollar in
income.
 The overriding investment objective is
utility maximization.
South-Western / Thomson Learning © 2004

18 - 4


Relative Riskiness of Portfolio Objectives
20
18

capital appreciation

small
company
stocks

expected return

16
14
large company stocks

12
10 intermediateterm
8 government

bonds
6
4 T-bills

long-term
corporate bonds
long-term
government bonds

inflation

stability
of principal

2
0

growth
of income

0

6

income
12

18

24

standard deviation (%)

South-Western / Thomson Learning © 2004

30

36

18 - 5


Structuring a Stock Portfolio : The Objective

Insert Figure 18-1 here.

South-Western / Thomson Learning © 2004

18 - 6


Structuring a Stock Portfolio : Asset Allocation
 An asset class refers to a broad category
of investments.
 U.S. equities, foreign equities, bonds, and
cash are four widely used asset classes.
 The relative distribution of funds across
asset classes is called asset allocation.

South-Western / Thomson Learning © 2004

18 - 7


Structuring a Stock Portfolio : Asset Allocation
Portfolio
attitude
toward risk

need for
return
individual choice

stocks
bonds

real
estate

ASSET
CLASSES
foreign
cash
equities
asset class mix

South-Western / Thomson Learning © 2004

realized
return

and risk
with the
passage
of time

investment results

18 - 8


Structuring a Stock Portfolio :
Active vs. Passive Management
 A strategy of passive management is one in
which, once established, the portfolio is
largely left alone.
 An active management policy, in contrast,
is one in which the composition of the
portfolio is dynamic.

South-Western / Thomson Learning © 2004

18 - 9


What’s Wrong with Buy and Hold ?


With a passive buy and hold strategy
(a naive strategy), investors simply
select their investments and hang on

to them.

 Portfolio managers often fail to outperform
a passive buy and hold strategy.
 When tested statistically, trading systems
also do not have a good long-term batting
average.

South-Western / Thomson Learning © 2004

18 - 10


The Costs of Revision


There are costs to revising a portfolio.

 Trading fees : Historically, stock
commissions are a function of the number
of shares and the dollar amount involved.
 Even relatively simple portfolio revisions
take up management time.
 Selling securities can involve tax
implications.
 Window dressing refers to largely cosmetic
portfolio changes made near the end of a
reporting period.
South-Western / Thomson Learning © 2004

18 - 11


Portfolio Rebalancing
 Rebalancing a portfolio is the process of
periodically adjusting the portfolio so that
certain original conditions of the portfolio
are maintained.
 In a constant proportion portfolio,
adjustments are made so as to maintain the
relative weighting of the portfolio
components as their price change.
 A constant beta rebalancing scheme seeks
to maintain beta at a prespecified level.
This method is not commonly used now.
South-Western / Thomson Learning © 2004

18 - 12


Portfolio Rebalancing

Insert Table 18-1 here.

South-Western / Thomson Learning © 2004

18 - 13


Portfolio Rebalancing

Insert Table 18-2 here.

South-Western / Thomson Learning © 2004

18 - 14


Portfolio Rebalancing

Insert Table 18-3 here.

South-Western / Thomson Learning © 2004

18 - 15


Portfolio Rebalancing

Insert Table 18-4 here.

South-Western / Thomson Learning © 2004

18 - 16


Portfolio Rebalancing
 Indexing : Some funds seek to mirror the
performance of a market index such as the
S&P 500 or the Dow Jones Industrial

Average.
 Dollar cost averaging : The idea is to invest
a fixed amount on a regular interval into the
same security, regardless of current market
conditions.

South-Western / Thomson Learning © 2004

18 - 17


Portfolio Rebalancing

Insert Table 18-5 here.

South-Western / Thomson Learning © 2004

18 - 18


Portfolio Rebalancing
 The context of dollar cost averaging is one
of the few times in finance when the
harmonic mean is useful. The harmonic
mean considers reciprocals of values
rather than the values themselves.
harmonic mean =

1

1 N 1
∑
N i =1 Pi
where Pi = price paid at time i
N = number of observations

South-Western / Thomson Learning © 2004

18 - 19


Overwriting
 Option overwriting refers to the creation
and sale of stock options in conjunction
with a stock portfolio.
 The most common purpose is to generate
additional portfolio income.
 The second motivation for writing options
is to permit the purchase or sale of stock at
a better-than-market price.

South-Western / Thomson Learning © 2004

18 - 20


Writing Options to Generate Income
 When investors write call options against
stock they already own, the call is said to
be covered.

South-Western / Thomson Learning © 2004

18 - 21


Writing Options to Generate Income

Insert Table 18-6 here.

South-Western / Thomson Learning © 2004

18 - 22


Writing Options to Generate Income

Insert Figure 18-4 here.

South-Western / Thomson Learning © 2004

18 - 23


Overwriting : Improving on the Market
 Improving on the market involves writing
deep-in-the-money put or call options that
have “substantial” intrinsic value.
 Selling stock:
Current XYZ stock price = $116

Write $100 call premium @ $18
If option is exercised,
total income = $100 + $18 = $118
> income without overwriting = $116

South-Western / Thomson Learning © 2004

18 - 24


Overwriting : Improving on the Market
 Buying stock:
Current Intel stock price = $67.20
Write $75 put premium @ $9
If option is exercised,
total cost = $75 - $9 = $66
< cost without overwriting = $67.20

 Deep-in-the-money options can be used to
improve a buying or selling price at the
cost of a slight increase in risk.

South-Western / Thomson Learning © 2004

18 - 25