Chapter 4

Equity Portfolio Management

Dr. Le Quy Duong
Email: duonglq@neu.edu.vn
Phone: 0966973642
Research Interests: efficient stock markets, asset pricing models
Role of the equity portfolio
• As stocks are popular assets in all financial markets around the world,
investing across multiple stock markets offers diversification benefits
• Companies’ earnings tend to increase with inflation, whereas
payments on bonds are fixed in nominal terms
Þcommon equities should offer superior protection against inflation
compared with bonds
• Thanks to equities’ comparatively high historical long-term real rates
of return, stocks play a growth role in a portfolio
Approaches to equity investment

Passive management

Active management

Semiactive management
Passive management
• Passive investment philosophy has its roots in the history of equity
indexing
• Equity portfolio managers frequently evaluate their performance
against equity benchmark indices designed to show how the overall
stock market or some subsector of the market has performed
• Four choices determine a stock index’s characteristics: the boundaries
of the index’s universe, the criteria for inclusion in the index, how the
stocks are weighted, and how returns are calculated.
Passive management
• The boundaries of the stock index’s universe is important in
determining how well the index represents a specific population of
stocks. The greater its number of stocks and the more diversified by
industry and size, the better the index will measure broad market
performance
• The criteria for inclusion, establishes any specific characteristics
desired for stocks within the selected universe
• The weighting of the stocks, is usually a choice among price
weighting, value (or float) weighting, or equal weighting
• Computational method, includes variations such as price only and
total return series that include the reinvestment of dividends
Index Weighting Choices
• In a price-weighted index, each stock in the index is weighted
according to its absolute share price
• In a value-weighted index (also called a market-capitalization
weighted index or a market capitalization index), each stock in the
index is weighted according to its market cap (share price multiplied
by the number of shares outstanding)
• In a float-weighted index, the weight of a stock equals its market-cap
weight multiplied by a free-float adjustment factor (a number
between 0 and 1 representing the fraction of shares that float freely)
• In an equal-weighted index, each stock in the index is weighted
equally
Index Weighting Choices
• In a price-weighted index, each stock in the index is weighted
according to its absolute share price
• In a value-weighted index (also called a market-capitalization
weighted index or a market capitalization index), each stock in the
index is weighted according to its market cap (share price multiplied
by the number of shares outstanding)
• In a float-weighted index, the weight of a stock equals its market-cap
weight multiplied by a free-float adjustment factor (a number
between 0 and 1 representing the fraction of shares that float freely)
• In an equal-weighted index, each stock in the index is weighted
equally
Index Weighting Choices
• Harry is an equity portfolio manager. At the end of 2022, a wealthy
client engaged Harry to manage $10,000,000 for one year in an active
focused (concentrated) equity style. The investment management
contract specified an incentive fee of $10,000 per 100 basis points
(bps) of capital appreciation relative to that of an index of the stocks
selected for investment. The contract leaves open the method by
which the benchmark index will be calculated. Harry invests in shares
of Kodak, McDonald, Intel, Merck, Wal-Mart, and Microsoft.
 Index Weighting Choices
Stock price at 31 Forecasted stock price at Market capitalization at Free float factor
Dec, 2022($) 31 Dec, 2023 ($) 31 Dec, 2022 ($ million)
Kodak 35.04 38.85 10 056 1
McDonald 16.08 24.09 20 406 1
Intel 15.57 31.36 107 703 1
Merck 53.58 55.1 119 216 1
Wal-Matt 50.51 53.05 221 992 0.6
Microsoft 25.85 27.37 277 060 0.85
Index Weighting Choices
• Explain the price-only return calculation on the following indices for
the period December 31, 2022 to December 31, 2023:
Price-weighted index
Value-weighted index
Float-weighted index
Equal-weighted index
• Recommend the appropriate benchmark index for calculating the
performance incentive fee on the account and determine the amount
of that fee
Passive management
• Three passive investment vehicles:
Indexed portfolios
A long position in cash plus a long position in futures contracts on the
underlying index
A long position in cash plus a long position in a swap on the index
Active management
• The active equity portfolio manager’s primary job is to deliver the
best possible performance relative to the benchmark’s performance
working within the risk and other constraints specified in the client’s
mandate.
• Indexing, discussed earlier, sprang from the efficient markets theory
initiated in academia during the 1960s. In the subsequent three
decades, however, academic and practitioner research identified a
variety of possible opportunities for active management.
• Many investment managers offer a range of equity investment
products from active to passive to suit the differing interests of a
broad spectrum of investors
Active management
• An investment style is a natural grouping of investment disciplines
that has some predictive power in explaining the future dispersion of
returns across portfolios
• A traditional equity style contrast is between value and growth
• The common characteristics of value stocks include a high book-to-
market (B/M) ratio, low price-to-earnings ratio (P/E) or low price-to-
book ratio (P/B)
• The common characteristics of value stocks include a low book-to-
market (B/M) ratio, high price-to-earnings ratio (P/E) or high price-to-
book ratio (P/B)
Evidence of the value effect in the US in
1973-2015

Source: Jaffe et al., 2020

The growth and value effects in Vietnam in
2011-2021

Source: Le, 2024

Active management
• Certain categories of stocks (e.g., value stocks) can outperform the
overall market for years. A mediocre value stock investor might be
beating a broad market benchmark consistently while actually
underperforming his chosen style as represented by a benchmark for
a value style
• Market-oriented investors: small-cap vs big-cap
• Conservative and Aggressive? (Fama and French, 2015)
• Robust vs Weak? (Fama and French, 2015)
Active management
• A portfolio manager states his objectives of investing for growth and
income, with an orientation to several promising stocks within the
universe of UK companies. He intends to create a three-stock
portfolio.
Calculate the book-to-market (B/M) ratio for each stock.
Which stocks are chosen if the portfolio manager prefers a growth
investing style?
Calculate the value-weighted return of the growth portfolio between
December 31, 2022, and December 31, 2023.
Compare the returns of growth and value portfolios.
Stock code Stock price at 31 Stock price at 31 Outstanding Book value of common equity
Dec, 2022($) Dec, 2023 ($) shares (million) ($ billion)
AAF 107.8 115.2 32 35.78
CNA 117.4 136.3 24 22.31
IAG 130.6 173.7 18 27.80
KGF 183.2 279.1 10 15.51
MNG 230.4 210.1 35 59.62
SDR 350.8 344.2 26 70.08
TWF 160.5 165.5 40 48.62
VPD 80.7 73.88 60 49.21
CCH 114.9 127.8 55 70.85