Practice investment management pim3 ch18e

Structuring a Stock Portfolio : The Objective Semantics are important in any statement of investment objectives.. Structuring a Stock Portfolio : Asset Allocation An asset class refer

MANAGING THE EQUITY PORTFOLIO

CHAPTER EIGHTEEN

 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

 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

Structuring a Stock Portfolio : The Objective

 Semantics are important in any statement

of investment objectives.

 The four main portfolio objectives are

 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.

Relative Riskiness of Portfolio Objectives

intermediate-term government bonds

long-term government bonds

long-term corporate bonds

large company stocks

small company stocks

stability

of principal

Structuring a Stock Portfolio : The Objective

Insert Figure 18-1 here.

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.

Structuring a Stock Portfolio : Asset Allocation

cash equities foreign

Portfolio

ASSET CLASSES

asset class mix

realized return and risk with the passage

of time

investment results

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.

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.

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

 Window dressing refers to largely cosmetic

portfolio changes made near the end of a

reporting period.

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.

to maintain beta at a prespecified level

This method is not commonly used now.

Portfolio Rebalancing

Insert Table 18-1 here.

Portfolio Rebalancing

Insert Table 18-2 here.

Portfolio Rebalancing

Insert Table 18-3 here.

Portfolio Rebalancing

Insert Table 18-4 here.

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.

Portfolio Rebalancing

Insert Table 18-5 here.

Portfolio Rebalancing

ns

observatio of

number

=

time

at paid price

=

where

mean harmonic

N

i P

P N

1

 The context of dollar cost averaging is one

of the few times in finance when the

mean considers reciprocals of values

rather than the values themselves.

 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.

Writing Options to Generate Income

 When investors write call options against

stock they already own, the call is said to

Writing Options to Generate Income

Insert Table 18-6 here.

Writing Options to Generate Income

Insert Figure 18-4 here.

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

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.

Portfolio Protection

 Portfolio protection basically involves adding

adding components to a portfolio such that

a floor value is established below which the value of the portfolio will not fall.

 Writing covered calls provide downside

protection up to the amount of the premium.

 If an investor owns shares of a particular

stock (long stock position) and buys a put on that same stock (long put position), the put is called a protective put.

Portfolio Protection

Insert Figure 18-5 here.

Portfolio Protection

Insert Table 18-7 here.

Portfolio Protection

 Using index options : An index put can

protect a diversified stock portfolio against

a market downturn If market prices

decline, a gain on the puts can largely

offset the losses on the stock portfolio.

Portfolio Protection

Insert Table 18-8 here.

Portfolio Protection

 Using index futures contracts : A short

futures position can help offset a long

stock position If the market falls, a gain in the futures market can largely offset the

loss on the stock portfolio, and vice versa if the market rises.

Portfolio Protection

Insert Table 18-9 here.

 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

 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

Appendix: Index Overwriting

 Index options

 Put and call options

 have virtually the same characteristics as an

option on common stock

 DIFFERENCE is the underlying security is an

index representing the current level of some set

of stock prices

Appendix: Index Overwriting

 Advantage is they drastically reduce the unsystematic risk usually associated with small portfolios

Appendix: Index Overwriting

 Table 18A-1

Appendix: Index Overwriting

 Risk of index calls is that the index will rise above the strike price

Appendix: Index Overwriting

Appendix: Index Overwriting