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Chapter 25

Contemporary Issues in Portfolio Management

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Life is my college; may I graduate well and earn some honors.

- Louisa May Alcott

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Outline Introduction Tactical asset allocation Stock lending Program trading Role of derivative assets The chartered financial analyst program Regulation Fair Disclosure Security analyst independence

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Introduction Some emerging areas are controversial:

• Tactical asset allocation contradicts the EMH

• Stock lending and program trading have image problems

• Derivatives are not permitted in some portfolios

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Tactical Asset Allocation What is tactical asset allocation? How TAA can benefit a portfolio Designing a TAA program Caveats regarding TAA performance

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What Is Tactical Asset Allocation?

Definition Intuitive versus quantitative techniques Overview of the technique Policy decisions Strategy

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Definition Tactical asset allocation (TAA) managers:

• Seek to improve the performance of their funds • By shifting the relative proportion of their

investments into and out of asset classes • As the relative prospects of those asset classes

change For example, shift to stocks if stocks are

expected to outperform bonds

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Definition (cont’d) TAA attempts to take advantage of short-

term deviations from long-term trends

The most difficult part of TAA is asset class appraisal• The process of determining the relative merits

of the various asset classes given current economic conditions

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Intuitive Versus Quantitative Techniques

In the intuitive approach, decisions are based on personal opinion and gut feeling• Suffers from hindsight bias

– Portfolio managers remember the times they were correct

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Intuitive Versus Quantitative Techniques (cont’d)

In the quantitative approach, managers use an analytical assessment and a system for implementing precise portfolio changes• E.g., use the gap between the S&P 500

dividend yield and the average yield on AAA corporate bonds

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Overview of the Technique

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Policy Decisions Policy decisions involve:

• Deciding to use a TAA program in the first place

• Establishing the extent to which the program will be employed

• Determining the number of asset classes to employ

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Strategy There are three alternative strategic

functions:• Static strategy maintains a static portfolio mix• Reactive strategy involves decisions based on

events that have already occurred• Anticipatory strategy involves shifting funds

before the markets move

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How TAA Can Benefit A Portfolio

The goal of an anticipatory strategy is to outperform the portfolio without TAA• The potential gains to a clairvoyant manager

from TAA are enormous (see next slide)

The portfolio manager must assess return within a risk/return framework

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How TAA Can Benefit A Portfolio (cont’d)

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Designing A TAA Program Before implementing a TAA program, a

fund manager must establish:• The normal mix

– The benchmark proportion each asset class constitutes in the portfolio

• The mix (exposure) range– Specifies how much the current mix can deviate

from the normal mix

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Designing A TAA Program (cont’d)

Before implementing a TAA program, a fund manager must establish (cont’d):• The swing component

– The percentage of the total portfolio whose composition by asset class may change

– The key element of TAA is properly investing the swing component

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Caveats Regarding TAA Performance

Efficient market implications Impact of transaction costs

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Efficient Market Implications TAA program implicitly assume it is

possible to outperform a buy-and-hold strategy by shifting asset classes• Inconsistent with the efficient market

hypothesis Some fund managers have good records

with TAA programs• Might be skill or luck

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Impact of Transaction Costs The portfolio incurs trading fees each time a

trade occurs

If the marginal gains from TAA switching do not exceed transaction costs, the program is not effective

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Stock Lending Definition Mechanics of a short sale How a stock lending transaction works Stock lending’s lucrative nature Regulatory concerns Long/short portfolios Certificateless trading

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Definition Stock lending:

• Is the practice by which one institution loans stock to another institution

• Is often used to support short-selling by customers of the second institution

• Can earn substantial income with very little risk

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Definition (cont’d) Stock lending is similar to a repurchase

agreement:• The institution wanting to borrow stock

– Puts up collateral (about 102 percent of the securities lent)

– Agrees to return the securities at a later date

• The lender can earn interest on the cash collateral

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Mechanics of A Short Sale A short sale:

• Involves borrowing securities from someone• Selling the securities to another market

participant• Eventually purchasing shares from another

market participant and• Returning the substitute shares to the original

lender

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Mechanics of A Short Sale (cont’d)

A short sale is normally motivated by a bearish sentiment

The actual lender in a short sale is normally an unknowing participant• A hypothecation agreement gives the broker

the right to lend shares to someone else– The investor can still trade the shares and continues

to earn dividends

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Mechanics of A Short Sale (cont’d)

The short seller:• Has an obligation to return what was borrowed

at some point in the future• Must pay dividends to the lender• Eventually covers short by repurchasing shares

to replace the shares borrowed earlier– If the purchase price is below the selling price, the

short seller makes a profit

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How A Stock Lending Transaction Works

If the customer wants to short sell:• The brokerage firm first checks if other

customers have the stock in a margin account• The brokerage firm may use a stock loan finder

to locate another firm with the needed shares• The first firm deposits collateral with the

second firm (T-bills or cash)– Part of the interest is used to pay a finder’s fee to

the stock loan finder

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Stock Lending’s Lucrative Nature

Advantages of stock lending Disadvantages of stock lending

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Advantages of Stock Lending Stock lending is very lucrative

• In 1999, the total income to stock lenders approached $1 billion

Stock lending is popular when markets see increased merger and acquisition activity:• Merger arbitrage involves buying shares of

likely takeover candidates and short selling shares of the anticipated acquirer

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Advantages of Stock Lending (cont’d)

Stock lending can be used by brokerage firms to finance the margin purchases of their customers

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Disadvantages of Stock Lending

A customer potentially gives up the right to vote:• The short seller is essentially a negative owner

Some risk is associated with the possibility that the stock borrower might not return the securities• Stock loans are “marked to market”

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Regulatory Concerns Stock lending does technically not fall under SEC

jurisdiction• Does not involve the purchase or sale of securities

A possible area of abuse lies in the lending of shares in cash accounts• Cash account holders do not sign hypothecation

agreements

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Long/Short Portfolios Short selling is an element of a hedging

strategy called building a long/short portfolio:• Combines elements of speculation, fundamental

stock analysis, and hedging to reduce risk– Sells overvalued shares and buys undervalued

shares

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Certificateless Trading The difference in settlement procedures across

countries can cause significant problems• E.g., U.S. settlement takes 3 business days versus 6

weeks in France

Computer automation makes it possible to process some types of transactions almost immediately• E.g., newly issued U.S. government bonds are

registered in book entry form only

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Program Trading Program trading:

• Is not easy to define

• Can be used to mean any computer-aided buying or selling activity in the stock market

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Program Trading (cont’d) The Wall Street Journal defines program

trading as the simultaneous purchase or sale of at least 15 different securities with a total value of $1 million or more

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Program Trading (cont’d) Stoll and Whaley elements of program

trading:• Portfolio trading

• Computerized trading

• Computer decision making

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Program Trading (cont’d) Program trading is also the generic term

used to describe any strategy that instantaneously recommends buy or sell order because of apparent arbitrage• E.g., buy futures and sell stock if the basis is

theoretically too small• E.g., buy stock and sell futures if the basis is

theoretically too wide

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Program Trading (cont’d) Program traders fall into one of two groups:

• Institutions that buy stock index futures and T-bills to create the equivalent of an index portfolio

• Institutions that combine a well-diversified stock portfolio with short position in stock index futures to create synthetic T-bills

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Program Trading (cont’d) Program trading has a bad name as it may

increase security price volatility

Many professional traders and investment managers believe that program trading benefits the public• Helps reduce commission costs

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Role of Derivative Assets Process of education Getting board approval

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Process of Education People think derivatives are speculative Various exchanges offer seminars on ways

in which derivative assets can be used in conservative portfolios• E.g., risk management conferences by CBOE,

CBOT, CME, LIFFE• Derivative asset education is designed to give

people more choices

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Getting Board Approval Once the portfolio manager is convinced of

futures and/or options, he must convince:• Boards of trustees• Supervisors or• Fund beneficiaries

The manager should be able to explain the merits of derivatives using everyday language

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The Chartered Financial Analyst Program

History The CFA program exams CFA program themes

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History The CFA program began in 1959 when the

Institute of Chartered Financial Analysts (ICFA) was formed

– Promotes investment education and ethical behavior– Awarded the first charter in 1963

The Financial Analysts Federation (FAF) merged with the ICFA in 1990 to form the Association for Investment Management and Research (AIMR)

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The CFA Program Exams To earn the CFA designation, candidates

must pass three separate exams taken at least a year apart• Each CFA exam is given only once per year

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The CFA Program Exams (cont’d)

Level I is multiple choice:• Covers basic tools and inputs to the investment

valuation process

Level II is essay, valuation, analysis, and problem sets• Emphasizes security valuation and specialized

topics

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The CFA Program Exams (cont’d)

Level III is essay, valuation, analysis, and problem sets• Covers portfolio management

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CFA Program Enrollment

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CFA Program Themes Competence Presentation standards Fiduciary duties Ethics

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Competence People who complete the CFA program are

technically very competent and are likely to keep their noses clean during their professional careers

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Presentation Standards CFA candidates learn state-of-the-art

standards and may prepare their own reports in accordance with AIMR requirements

From a fiduciary perspective, compliance with AIMR requirements is on its way to being mandatory

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Fiduciary Duties Fiduciary duties require conduct that:

• Is in the individual client’s best interest• Is fair to the collective group of all clients

Research reports are an important part of fiduciary dutues

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Ethics The coverage of ethics in the CFA program

is very useful:• For example:

– Analysts must distinguish between fact and opinion

– Research reports should be objective, unbiased, and have a reasonable basis

– Bigger clients should not be given preferential treatment

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Regulation Fair Disclosure Introduction The SEC position The industry position AIMR response The future of the regulation

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Introduction Regulation FD was approved by the SEC

in August 2000 The key provision:

• Prevents companies from giving material information to security analysts, mutual funds, or institutional investors

• Unless the company simultaneously issues the same information to the general public

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The SEC Position The purpose of Regulation FD is:

• To increase the quantity and quality of available information to investors

• To eliminate what some perceive as an unfair advantage enjoyed by Wall Street’s big guns

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The Industry Position Evidence indicates that less information is

available to the public:• Companies are reluctant to answer questions

not publicly answered before• Companies have begun to provide less

information between quarterly reports• Quarterly conference calls between firms and

the brokerage industry have become scripted

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AIMR Response AIMR study when Regulation FD was first

announced:• “To avoid any possible SEC enforcement

actions, corporations will reduce their communications to ‘sound bites’ and ‘boilerplate’ disclosures”

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AIMR Response AIMR study one year later:

• “While the overall goal of providing small investors and investment professionals with the same information is being achieved, it has been at the cost of less information in terms of quantity and quality”

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The Future of the Regulation SEC Commissioner Laura Unger’s

recommendations regarding Regulation FD:• The SEC should provide more guidance on

materiality• The SEC should make it easier for issuers to

use technology to comply with Regulation FD• The SEC should analyze what issuers are

saying post-FD

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Security Analyst Independence Introduction Analyst ratings Bullish ratings as the ship sinks Separation of research and investment

banking

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Introduction Some aspects of the security analyst

business have long needed improvement

The Enron collapse brought the issue of security analyst independence in the spotlight

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Analyst Ratings A high proportion of analyst stock ratings

are positive• Firms have little incentive to begin coverage of

a firm that is unlikely to be an attractive investment

– “Buy” recommendations bring in more business than “sell” recommendations

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Analyst Ratings (cont’d) Efforts are beginning to standardize

language used in assigning ratings• E.g., “accumulate” and “market perform”

ratings

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Analyst Ratings (cont’d) NASD proposals in early 2002 require

analysts to:• Better explain their rating system

• Disclose banking relationship with companies they cover

• Not earn a bonus from attracting underwriting business from the firms they cover

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Bullish Ratings as the Ship Sinks

Sudden adverse news that hits a company is difference from a gradual accumulation of negative events coupled with an analyst’s hope that things will improve• E.g., dot.coms in 1999 and 2000

– Some analysts maintained “buy” recommendations four days before the firm went into bankruptcy

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Separation of Research and Investment Banking

The opinion of a security analyst should not be biased by activities elsewhere in the firm

The Security Industries Association list of best practices states:• “Research should not report to investment

banking; it should also not report to any other business unit in a way that compromises its integrity”