Equity Portfolio Strategies — the ground floor

The first fork in the road

Once the portfolio manager has decided how much money goes into equity, one big choice is left. The workbook puts it simply. She can manage the money actively or passively.

• Active management — she picks the stocks and their weights. Her aim is to outperform an equity benchmark on a risk-adjusted basis.
• Passive management — she copies a benchmark as closely as she can, or buys an ETF built on that benchmark. Her aim is to earn performance close to the benchmark.

Why passive management is popular

The workbook lists four benefits:

• Cost is much lower — both the management fee and transaction costs.
• It is easier to invest in markets where the manager lacks expertise. The workbook's example: an Indian investor investing in US markets.
• Active management needs elaborate, time-consuming analysis that depends heavily on the expert. All of that costs money.
• Benchmarks are generally diversified, well represented, transparent and liquid.

Passive strategy 1: Buy and Hold

You study a company from every angle. Once you are convinced of its long-term prospects, you buy and simply keep it for a very long time. Trading, timing and pricing are not the concern. You expect the risk-reward to be favourable in the long run, and compounding to do its work.

Here is the twist the exam likes. Buy and Hold does not copy any benchmark. It is still classed as passive, because the holding is not traded frequently for tactical gains.

Passive strategy 2: Indexing

When the portfolio mirrors an index, that is indexing. It is the most common form of passive management, and ETFs have played a big role in its growth.

Two ways to build an index portfolio

Full replication means holding all the index stocks in the same (or nearly the same) weights. When the index provider announces a rebalancing, the manager adjusts. It works best when:

1. the index has a limited number of constituents,
2. each constituent is liquid, and
3. the portfolio has the threshold minimum size.

The workbook names Nifty 50 and S&P BSE Sensex as indices that are easy to replicate fully.

Sampling is used when full replication struggles — for example, Nifty500. Some of those stocks are illiquid, and holding so many stocks (and reinvesting dividends) is costly. So the manager swaps some index stocks for similar ones — same sector, similar market cap, similar risk. The portfolio does not hold every index stock, but its mean-variance (return-risk) profile is very close to the index.

Sampling lets you mirror indices with many stocks, indices spread across countries and capitalisations, avoid illiquid constituents, and mirror an index even when AUM is below the full-replication threshold.

Active strategy 1: Market timing

Market timers play the market component of risk. If the manager expects a rising market, she raises portfolio risk — shifting cash into stocks, raising the beta of her equities, or both. If she expects a falling market, she does the reverse: moves to cash, lowers beta, or both. The workbook says market timing is used particularly during short periods of price-value mismatch.

Active strategy 2: Sector rotation

Different sectors shine at different stages of the economic cycle. The workbook's example: Covid-19 helped pharmaceuticals and consumer staples, while airlines, hospitality and white goods saw weak demand.

Sector rotation means shifting weight from one sector to another where an uptrend is visible or expected. It is a top-down strategy: read the macro picture first, find the phase of the cycle, then pick the sectors.

The costs: higher concentration risk, and frequent buying and selling that pushes up trading costs.

The fundamental law of active management

In 1989, Richard Grinold and Ronald Kahn proposed a law to predict, in advance, how productive an active manager will be. It uses two things:

• Skill, measured by the Information Coefficient (IC) — the correlation between the manager's expected and actual outcomes.
• Breadth — how many independent bets the manager made.

IC is a correlation, so it ranges from −1 to +1. +1 means perfect prediction. −1 means always wrong. 0 means a 50-50 hit rate — no better than tossing a coin, and the manager gets no credit. The workbook's formula is IC = 2 × (Right predictions ÷ Total predictions) − 1.

Breadth is number of forecasts per period × number of periods. Each bet must be independent. If a manager predicts two tech stocks will beat the market because tech will do well, that is one bet, not two.

Two relationships to memorise:

• IR rises linearly with IC.
• IR rises only with the square root of breadth. Double the breadth and IR goes up by just √2 ≈ 1.414 times.

The workbook adds two cautions. More bets mean more transaction costs, which the equation ignores. And in India, IC data is almost non-existent and hard to compare across managers.

Choosing and rebalancing an index

A good index for a passive fund should: represent the desired segment; follow a documented methodology without exception; be transparent; hold widely traded, liquid, high-float stocks; and be reviewed and rebalanced periodically.

Indices are rebalanced when companies fall below thresholds, or after corporate actions like mergers, demergers, trading suspensions, a change in category (for example entering or leaving the derivatives segment) or regulatory action.

Big passive funds create two side effects:

• Index inclusion effect — a full-replication fund must fully exit the dropped stock and buy the new one. This adds cost and tracking error.
• Flows — inflows force buying of the heaviest stocks in size, pushing prices up; outflows do the reverse. Active managers often exploit these imbalances, which acts as a counterbalancing force.

Smart beta: between passive and active

Smart beta sits between index-mirroring passive and discretion-based active management. The rules are fixed like passive investing. But the manager chooses the factors — quality, value, volatility, size, momentum — which is like active management. The workbook calls it an enhanced index-based investment.

Two attributes: rule-based index construction and alternative index weights (based on sales, profit, book value, cash flow or dividends, or equal weights, or volatility/momentum).

In July 2017, NSE Indices launched four multi-factor indices: NIFTY Alpha Low-Volatility 30, NIFTY Quality Low-Volatility 30, NIFTY Alpha Quality Low-Volatility 30, and NIFTY Alpha Quality Value Low-Volatility 30.

Factor models

Factor models help build portfolios, and also with attribution analysis, risk analysis and new product decisions (through back-testing). There are three broad kinds:

• Macroeconomic factor model — GDP growth, interest rates, inflation, credit risk, liquidity, geopolitical climate. Growth and inflation hit equities most directly; interest rates, inflation and credit risk hit fixed income.
• Fundamental factor model — quality and value parameters of the securities.
• Statistical factor model — named in the workbook as the third category.

A model-driven portfolio is purely quantitative. Humans only set boundary conditions (for example, cap the maximum loss at −20%) and throw out factors with no cause-effect link.

Momentum investing

Momentum investors believe that even in a random market, prices trend up or down for brief periods — minutes to months. They go long in a rising trend and short in a falling trend. It runs on price-volume data and needs strict discipline on entry and exit levels.

Why it is growing: easy to follow, cheap data, no need for deep company or sector expertise, quick to spot opportunities. Why value investors dislike it: they think its returns are random, there is no theory behind it, and it is hard to explain to clients.

Growth, value and blend

• Growth style — companies expected to grow faster than peers. Signs: high earnings growth, niche or monopoly products, low dividend payout (profits are reinvested), higher valuation than peers, higher risk, early-stage businesses. The aim is capital gain.
• Value style — stocks trading below intrinsic value, often neglected. Signs: steady earnings, high dividend payout (mature business), lower valuation than peers, lower risk. Beware the value trap — the stock may be cheap because it really is worse.
• Blended style — both. Growth brings capital-gain potential; value brings dividend stability. Diversification in one portfolio.

Value screens: low P/E, low PEG, low P/B, low P/S, low price-to-cash-flow, high dividend yield, low debt-to-equity. Growth screens: historical revenue and earnings growth, forecasted growth, industry growth.

ESG and socially responsible investing

ESG stands for Environmental, Social and Corporate Governance. Investing on these lines is called socially responsible, green or ethical investing. Three ways to build the portfolio:

• Negative screening — exclude alcohol, tobacco, gambling, weapons, hazardous chemicals.
• Positive screening — score and rank on ESG, pick those above a threshold.
• Best-in-class screening — like positive screening, but picks the best across sectors, so the portfolio stays diversified.

Core and satellite

A large core (usually passive) plus one or more small satellites (usually active). The core keeps costs down and reflects the long-run risk profile. The satellites chase short-term opportunities. The workbook says a portfolio generally holds about 70% to 80% in the core.

Alpha-beta separation

Return from market (systematic) risk is beta return. Return from non-market (unsystematic) risk is alpha return. A passive portfolio earns only beta. An active one aims for alpha on top. With the right strategies you can separate the two decisions — for example, a long position in an active portfolio with a short market position leaves only alpha, and a separate passive portfolio supplies the desired beta. This is also called portable alpha (when the long and short legs are in different asset classes or markets) or alternate beta.

Derivatives in an equity portfolio

Derivatives help with price risk and volatility. Uses: hedging, acting on short-term views, leverage, adjusting equity exposure without trading cash stocks, and acting on views without disturbing the core portfolio. But they "cut both ways", so discipline and monitoring are critical.

• Generating alpha — buy a call or buy futures on a mid-cap index. A wrong call option loses only the premium; wrong futures lose in line with the index fall.
• Hedging — sell index futures to protect a diversified portfolio against a fall.
• Arbitrage — buy in cash, sell in futures, lock in the gap.
• Protective put — own the portfolio, buy a put. The put costs a premium, and the protected level is the strike price. A put bought with no portfolio behind it is a naked put.

Global investing and home bias

Going global diversifies away country-specific risk. Benefits: diversification, better risk-adjusted return, tactical allocation. Costs: liquidity, geopolitical and currency risk, high regulatory cost if investing directly, and delays in information.

Home (familiarity) bias keeps money at home. The workbook's reasons: familiarity, optimism, risks (currency, geopolitical) and predictability. Its two harms: a concentrated portfolio and missed diversification.

Market cap to GDP is a rough guide to whether a whole country is cheap or expensive. Below 50% reads undervalued; above 110% reads overvalued.

Beyond the book

The $250,000 a year overseas allowance in the workbook is the Reserve Bank of India's Liberalised Remittance Scheme (LRS) limit for resident individuals. That is why an Indian PMS client's global exposure is usually planned "within LRS".