Portfolio Construction, Management, and Protection

Portfolio Construction, Management, and Protection Robert A. Strong, CFA University of Maine f SOUTH-WESTERN i» CENGAGE Learning- Australia Brazil Japan Korea Mexico Singapore Spain United Kingdom United States

Preface xiii PART ONE BACKGROUND, BASIC PRINCIPLES, AND INVESTMENT POLICY 1 Chapter 1 Chapter 2 The Process of Portfolio Management 3 3 Part One: Background, Basic Principles, and Investment Policy 5 Part Two: Portfolio Construction 8 Part Three: Portfolio Management 9 Part Four: Portfolio Protection and Contemporary Issues 11 12 Valuation, Risk, Return, and Uncertainty 14 14 14 Valuation 15 Crowing Income Streams 15 Safe Dollars and Risky Dollars 17 Choosing Among Risky Alternatives 17 Defining Risk 20 Relationship Between Risk and Return, 23 Direct Relationship 23 Concept of Utility 24 Diminishing Marginal Utility of Money 24 St. Petersburg Paradox 26 Fair Bets 27 The Consumption Decision 27 Other Considerations 28 The Concept of Return 30 Measurable Return 30 Return on Investment 33 Some Statistical Facts of Life 36 Definitions 36 Properties of Random Variables 40 Linear Regression 45 R Squared and Standard Errors 45 48 49 Chapter 3 Appendix s Setting Portfolio Objectives Why Setting Objectives Can Be Difficult Semantics 55 Indecision 56 Subjectivity 57 Multiple Beneficiaries 57 Investment Policy versus Investment Strategy 57 Portfolio Objectives Preconditions 58 Traditional Portfolio Objectives 59 Special Situation of Tax-Free Income Portfolio Objectives and Expected Utility 63 The Importance of Primary and Secondary Objectives Other Factors to Consider in Establishing Objectives Inconsistent Objectives 65 Infrequent Objectives 66 Portfolio Splitting 66 Liquidity 67 The Role of Cash 67 Portfolio Dedication Cash Matching 68 Duration Matching 68 s Mutual Fund Evaluation Term Project Classification of Mutual Funds Open End versus Closed End 76 Net Asset Value versus Market Value Load versus No Load 77 61 50 52 53 77 54 54 54 55 57 64 65 68 70 71 72 74 75 76 76 76 76

Management Fees 79 Buying Mutual Fund Shares 79 Mutual Fund Objectives 80 Term Assignment 80 Part One 81 Part Two 81 Part Three 81 Part Four 82 Part Five 82 82 Chapter 4 Investment Policy 84 Appendix 84 84 The Purpose of Investment Policy 85 Outline Expectations and Responsibilities 85 Identify Objectives and Constraints 87 Outline Eligible Asset Classes and Their Permissible Uses 91 Provide a Mechanism for Evaluation 91 Elements of a Useful Investment Policy 92 Return 92 Risk 93 Constraints 94 Risk and Return Considerations: Different Investors 97 Individual Investors 97 Institutional Investors 97 Critiquing and Revising the Investment Policy Statement 101 Characteristics of a Good Statement 101 Revising the Policy 102 103 103 104 112 ' 112 Sample Statements of Investment Policy 113 All Souls Congregational Church 113 All Souls Congregational Church Endowment Fund Investment Policy March 2003 113 General Purpose and Philosophy 113 Responsibilities 114 Objectives 114 Constraints 114 Reporting 115 The Philadelphia Foundation, Inc. Investment Policy 115 APPROVED November 15,2006 115 I. Mission 115 II. Investment Goals 115 III. Spending Policy 116 IV. Asset Allocation Strategy 116 V. Investment Guidelines 116 VI. Administrative and Review Procedures 117 VII. Investment Responsibility 117 Statement of Investment Objectives and Policy Guidelines for Eastern Maine Healthcare Systems 118 Pension Plan Endowment Fund Self Insurance Trust April 1998 118 Last Amended by Eastern Maine Healthcare Systems Board of Directors February 28, 2006 118 I. Purpose 118 II. Endowment Fund Spending Policy 119 III. Objectives 120 IV. Asset Allocation/Manager Structure 121 V. Investment Guidelines 122 VI. Performance Standards 125 VII. Defined Contribution Pension Plans 126 VIII. Responsibilities 128 IX. Amendments 130 PART TWO PORTFOLIO CONSTRUCTION Chapter 5 Chapter 6 The Mathematics of Diversification Linear Combinations Return 134 Variance 135 Single-Index Model Computational Advantages 140 Portfolio Statistics with the Single-Index Model 142 Multi-Index Model Why Diversification Is a Good Idea 131 133 133 133 134 140 143 143 144 144 147 147 148 148 148 Carrying Your Eggs in More Than One Basket 148

vu Appendix Investments in Your Own Ego 149 The Concept of Risk Aversion Revisited 149 Multiple Investment Objectives 150 Role of Uncorrelated Securities 150 Variance of a Linear Combination: The Practical Meaning 150 Portfolio Programming in a Nutshell 151 Concept of Dominance 152 Harry Markowitz: The Founder of Portfolio Theory 156 Lessons from Evans and Archer 163 Methodology 163 Results 164 Implications 165 Words of Caution 167 Diversification and Beta 167 Capital Asset Pricing Model 168 Systematic and Unsystematic Risk 168 Fundamental Risk/Return Relationship Revisited 168 Equity Risk Premium 171 Using a Scatter Diagram to Measure Beta 172 Correlation of Returns 172 Linear Regression and Beta 173 Importance of Logarithms 175 Statistical Significance 175 Arbitrage Pricing Theory 175 APT Background 177 The APT Mode! 177 Example of the APT 179 Comparison of the CAPM and the APT 179 Future Prospects for APT 180 180 181 182 s 184 185 Stochastic Dominance Efficiency Revisited First-Degree Stochastic Dominance Second-Degree Stochastic Dominance Stochastic Dominance and Utility 187 187 187 187 188 192 194 Chapter 7 Chapter 8 Practical with Stochastic Dominance 197 197 197 198 International Investment and Diversification 199 199 199 Why International Diversification Makes Theoretical Sense 200 Remembering Evans and Archer 200 Remembering Capital Market Theory 201 Foreign Exchange Risk 204 Business Example 204 An Investment Example 205 Whence Cometh the Risk? 205 Dealing with the Risk 210 The Eurobond Market 215 Combining the Currency and Market Decisions 215 Key Issues in Foreign Exchange Risk Management 217 Investments in Emerging Markets 217 Background 218 Adding Value 219 Reducing Risk 219 Following the Crowd 219 Special Risks 220 Asymmetric Correlations 224 Market Microstructure Considerations 225 Political Risk 227 Factors Contributing to Political Risk 228 Subclasses of Political Risk 229 Dealing with Political Risk 229 Other Topics Related to International Diversification 231 Multinational Corporations 231 American Depository Receipts 231 International Mutual Funds 232 s 233 234 235 237 237 The Capital Markets and Market Efficiency 240 Stochastic Dominance and Mean Return 196 Higher Orders of Stochastic Dominance 196 Role of the Capital Markets 240 240 240

Economic Function 241 Continuous Pricing Function 241 Fair Price Function 242 Efficient Market Hypothesis 243 Types of Efficiency 243 Weak Form 244 Semi-Strong Form 248 Strong Form 249 Semi-Efficient Market Hypothesis 250 Security Prices and Random Walks 253 Anomalies 253 Low-PE Effect 253 Low-Priced Stocks 254 Small-Firm and Neglected-Firm Effects 255 Market Overreaction 256 January Effect 257 Day-of-the-Week Effect 258 Turn-of-the-Calendar Effect 259 Persistence of Technical Analysis 259 Chaos Theory 260 261 262 262 263 263 Chapter 9 Picking the Equity Players 266 266 266 Stock Selection Philosophy: Fundamental and Technical Analysis 267 Dividends and Why They Really Do Not Matter 267 Types of Dividends 267 Why Dividends Do Not Matter 273 Theory versus Practice 274 Stock Splits versus Stock Dividends 276 Investment Styles 280 Value Investing 280 Growth Investing 284 Capitalization 285 Integrating Style and Size 287 Categories of Stock 288 Blue-Chip Stock 288 Income Stocks 289 Cyclical Stocks 289 Defensive Stocks 290 Growth Stocks 290 Speculative Stocks 290 Penny Stocks 291 Categories Are Not Mutually Exclusive 291 A Note on Stock Symbols 291 293 293 Chapter 10 Chapter 11 Equity Valuation Tools The Stock Price as a Present Value 294 295 295 296 296 296 296 The Present Value as a Ratio 297 The Numerator: Future Earnings 297 The Denominator: Uncertainty, Confidence, Inflation, and Psychology 300 Changes in the Stock Price and Relative Valuation 302 Short and Long Term 302 Equity Risk Premium 303 Greenspan Model 303 Changing PE Multiples 304 305 306 306 307 307 Security Screening 308 308 308 Why Screening Is Necessary 308 Time Constraints 308 Everyday Examples of Screens 309 What Constitutes a Good Screen? 310 Ease of Administration 310 Relevance and Appropriateness 310 Acceptance by the User 311 Ordinal Ranking of Screening Criteria 311 Screening Processes 311 Multiple-Stage Screening 311 Subjective Screening 312 Positive and Negative Social Screens 315 Popular Screening Variables 316 A Quick Risk Assessment Screen with the Stock Report 319 Library Information 319 Value Line 320 Standard & Poor's 321 Mergent 322 Internet Resources 322 Morningstar 322 Yahoo! 323 WSJ.com 323 326

IX 326 327 328 328 Chapter 12 Bond Pricing and Selection 329 329 329 Review of Bond Principles 330 Identification of Bonds 330 Classification of Bonds 330 Terms of Repayment 332 Bond Cash Flows 333 Convertible Bonds 333 Registration 334 Bond Pricing and Returns 334 Valuation Equations 335 Yield to Maturity 336 Realized Compound Yield 337 Current Yield 338 Term Structure of Interest Rates 339 Spot Rates 341 The Conversion Feature 343 The Matter of Accrued Interest 344 Bond Risk 346 Price Risks 346 Convenience Risks 348 Malkiel's Interest Rate Theorems 349 Duration as a Measure of Interest-Rate Risk 352 The Meaning of Bond Diversification 354 Default Risk 354 Dealing with the Yield Curve 354 Bond Betas 355 Choosing Bonds Client Psychology and Bonds Selling at a Premium-355 Call Risk 356 Constraints 357 Example: Monthly Retirement Income The Problem 359 Unspecified Constraints 360 Finding Bonds 360 Solving the Problem 360 Chapter 13 The Role of Real Assets 355 359 365 366 367 370 370 372 372 Chapter 14 372 Real Estate in General 373 Investment Characteristics 373 Developed and Undeveloped Property 3 74 Pension Fund Investment in Real Estate 375 Timberland in Particular 376 Institutional Interest in Timberland 3 76 A Timberland Investment Primer 377 Real Estate Investment Trusts 386 Types of REITs 387 Types of Real Estate Value 387 Gold 388 Motivation for Gold Investment 389 Determinants of the Price of Gold 390 The London Fix 392 Investing in Gold 394 Alternative Assets Infrastructure Investment Characteristics 402 Hedge Funds Long/Short Portfolio 404 Hedge Fund-of-Funds 406 Commodities Private Equity Forms of Private Equity 408 J Curve 409 Opportunistic Real Estate 396 397 397 398 400 400 400 400 403 407 408 410 410 411 412 412 412 PART THREE PORTFOLIO MANAGEMENT 413 Chapter 15 Revision of the Equity Portfolio 415 415 415 Active Management versus Passive Management 415 The Manager's Choices 416

Chapter 16 Chapter 17 Tactical Asset Allocation 426 What Is Tactical Asset Allocation? 426 How TAA Can Benefit a Portfolio 428 Designing a TAA Program 429 Caveats Regarding TAA Performance 430 Costs of Revision 430 Contributions to the Portfolio 435 When Do You Sell Stock? 435 Rebalancing 436 Upgrading 436 Sale of Stock via Stop Orders 436 Extraordinary Events 43 7 Final Thoughts 438 Revision of the Fixed-Income Portfolio 439 439 440 442 442 444 444 444 Passive versus Active Management Strategies 444 Passive Strategies 444 Active Strategies 445 Risk of Barbells and Ladders 449 Bullets versus Barbells 451 Swaps 451 Forecasting Interest Rates 452 Volunteering Callable Municipal Bonds 453 Bond Convexity (Advanced Topic) 453 The Importance of Convexity 453 Calculating Convexity 454 An Example 457 Using Convexity 458 460 461 461 463 463 Principles of Options and Option Pricing 465 465 465 Option Principles 466 Why Options Are a Good Idea 466 What Options Are 466 Standardized Option Characteristics 467 Where Options Come From 468 Where and How Options Trade 469 The Option Premium 470 Sources of Profits and Losses with Options 472 Option Pricing Determinants of the Option Premium 473 Black-Scholes Option Pricing Model Development and Assumptions of the Model 478 Insights into the Black-Scholes Model 481 Delta 481 Theory of Put/Call Parity 482 Stock Index Options 484 Option Overwriting 477 473 485 485 487 488 488 489 489 489 Using Options to Generate Income 489 Writing Calls to Generate Income 489 Writing Puts to Generate Income 493 Writing Index Options 497 A Comparative Example 501 Combined Hedging/Income Generation Strategies 505 Writing Calls to Improve on the Market 505 Writing Puts to Acquire Stock 507 Writing Covered Calls for Downside Protection 507 Multiple Portfolio Managers 508 Separate Responsibilities 508 Distinction Between Option Overwriting and Portfolio Splitting 508 Integrating Options and Equity Management 509 510 510 511 512 512 Chapter 19 Performance Evaluation 513 513 513 Importance of Measuring Portfolio Risk 513 A Lesson from History: The 1968 Bank Administration Institute Report 514 A Lesson from a Few Mutual Funds 515 Why the Arithmetic Mean Is Often Misleading: A Review 516

Chapter 20 Why Dollars Are More Important Than Percentages 517 Traditional Performance Measures 517 Sharpe and Treynor Measures 517 Jensen Measure 521 Performance Measurement in Practice 521 Dollar-Weighted and Time-Weighted Rates of Return 527 Performance Evaluation with Cash Deposits and Withdrawals 528 Daily Valuation Method 528 Modified Bank Administration Institute (BAI) Method 531 An Example 531 An Approximate Method 532 Performance Evaluation When Options Are Used 533 Incremental Risk-Adjusted Return from Options 533 Residual Option Spread 538 Final Comments on Performance Evaluation with Options 539 539 539 540 542 542 Fiduciary Duties and Responsibilities 544 544 544 545 History Prudent Man Rule 546 The Spitzer Case 547 Prudent Expert Standard 548 Uniform Management of Institutional Funds Act 549 Uniform Prudent Investor Act 549 Fiduciary Duties 550 Care 550 Loyalty 551 Prohibited Transactions 553 Emerging Areas Due Diligence 555 Social Investing 555 Proxy Voting 555 Soft Dollars 560 555 563 564 565 565 PART FOUR PORTFOLIO PROTECTION AND EMERGING TOPICS 567 Chapter 21 Principles of the Futures Market Futures Contracts 569 569 569 570 What Futures Contracts Are 570 Why We Have Futures Contracts 571 How to Fulfill the Futures Contract Promise 571 Market Mechanics 573 The Marketplace 573 Creation of a Contract 575 Market Participants 576 The Clearing Process 579 Matching Trades 579 Accounting Supervision 581 Intramarket Settlement 581 Settlement Prices 582 Delivery 582 Principles of Futures Contract Pricing 583 Expectations Hypothesis 583 Normal Backwardation 584 Full Carrying Charge Market 585 Reconciling the Three Theories 586 Foreign Currency Futures 587 Hedging and Speculating with Foreign Currency Futures 587 Pricing of Foreign Exchange Futures Contracts 588 589 589 590 591 591 Chapter 22 Benching the Equity Players 592 592 592 Using Options 592 Equity Options with a Single Security 592 Index Options 596 Using Futures Contracts 598 Importance of Financial Futures 598 Stock Index Futures Contracts 598 S&P 500 Stock Index Futures Contracts 599 Hedging with Stock Index Futures 599 Calculating a Hedge Ratio 601

xn Contents Hedging in Retrospect 604 Single Stock Futures 605 Hedging with SSF 605 Dynamic Hedging Dynamic Hedging Example 606 The Dynamic Part of the Hedge 608 Dynamic Hedging with Futures Contracts 608 Chapter 23 Removing Interest-Rate Risk Interest-Rate Futures Contracts Categories of Interest-Rate Futures Contracts 615 U.S. Treasury Bills and Their Futures Contracts 615 Treasury Bonds and Their Futures Contracts 618 Concept of Immunization Duration Matching 621 Immunizing with Interest-Rate Future s 626 Immunizing with Interest-Rate Swaps 627 Disadvantages of Immunizing 631 Chapter 24 Integrating Derivative Assets and Portfolio Management Setting the Stage Portfolio Objectives 635 Portfolio Construction 636 Meeting an Income Constraint Determining Unmet Income Needs 640 Writing Index Calls 640 Risk Management Stock Portfolio 642 Hedging Company Risk 645 Fixed-Income Portfolio 646 Managing Cash Drag 606 610 610 611 612 612 614 614 614 614 621 632 632 633 633 634 635 635 635 635 640 642 651., Chapter 2 5 Contemporary Issues in Portfolio Management Glossary 679 Index 697 Exchange-Traded Funds Security Analyst Objectivity Stock Lending Mechanics of a Short Sale 659 How a Stock Lending Transaction Works 661 > Stock Lending's Lucrative Nature 66* Regulatory Concerns 663 Certificateless Trading Proxy Voting Majority Voting 665 Separation of Chairman and CEO 665 Role of Derivative Assets Process of Education 666 Getting Board Approval 666 Portfolio Margining Islamic Finance Principles-based versus Rules-based Financial Oversight Structured Products The Chartered Financial Analyst Program History 669 The CFA Program Exams 670 CFA Program Themes 671 Regulation Fair Disclosure The SEC Position 673 The Industry Position 674 CFA Institute Response 674 The Future of the Regulation 674 652 653 653 654 654 656 656 656 656 657 658 664 665 666 667 667 668 669 669 673 675 676 676 611 611