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Chapter 23

Contemporary Issues in Portfolio Management

Portfolio Construction, Management, & Protection, 4e, Robert A. StrongCopyright ©2006 by South-Western, a division of Thomson Business & Economics. All rights reserved.

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There are clearly some real bad people out there who have done bad things, but there are also 15,000 companies out there, the great majority of which are run by honest people. Having said

that, there has been a general erosion of professional standards [fueled by] an attitude that “everybody else is doing it” and a perceived need to meet quarterly earnings numbers.

We’ve got to get back to an honest approach and a broad-gauged concept of what we really mean by management

performance.

William Donaldson, Chairman, Securities & Exchange Commission

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Outline Introduction Security Analyst Objectivity Stock Lending Program Trading Alternative Investments Role of Derivative Assets The Chartered Financial Analyst Program Regulation Fair Disclosure

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Introduction Some emerging areas are controversial:

• Security analyst objectivity has been the subject of numerous Congressional hearings

• Stock lending and program trading have image problems

• Derivatives are not permitted in some portfolios

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Security Analyst Objectivity There is a theoretical “fire wall” between the

investment banking function of an investment house and its research department• A conflict of interest may arise if an investment bank is

courting a firm for some underwriting business at the same time that its analysts are developing an investment opinion

• In the late 1990s, less than 2 percent of analyst opinions were “sell”

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Security Analyst Objectivity (cont’d)

In 2001 and 2002, there were some highly visible breaches of this fire wall

In March 2002, the NASD filed rules with the SEC that address the lack of objectivity

The CFA Institute issued a document on Research Objectivity Standards for public comment

The SEC adopted Regulation Analyst Certification in April 2003• Requires analysts to certify that their reports reflect

their opinions and not someone else’s

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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 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 the 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 their margin accounts

• 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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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 and can be transferred from buyer to seller with a few strokes at the keyboard

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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 orders 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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Alternative Investments Introduction Long/Short Portfolios Hedge Funds Managed Futures

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Introduction Alternative assets are a relatively new

investment class, which includes about anything outside the ordinary stock, bonds, cash, and real estate classes

Endowments and foundations are the leaders in the use of this asset class

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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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Hedge Funds Hedge funds:

• Are largely unregulated investment funds

• Usually have less than 100 investors

• Generally require a substantial minimum investment

• Do not register with the SEC and are often organized as a partnership

• Use leverage to magnify returns

• Often advertise some specialized investment style

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Hedge Funds (cont’d) The Investment Company Act of 1940

enables hedge funds to avoid registration and regulation as investment companies

However, hedge funds cannot advertise in the traditional sense

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Managed Futures Managed futures include a portfolio of

long or short speculative futures contracts• The manager buys that which he feels is cheap,

sells that which is expensive, and may do both to somehow hedge the aggregate risk

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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• 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 Chartered Financial Analyst 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

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The CFA Program Exams (cont’d)

Level I is entirely item sets• Covers basic tools and inputs to the investment

valuation process

Level II is also entirely item sets• Emphasizes security valuation and specialized topics

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The CFA Program Exams (cont’d)

Level III is essay, valuation, analysis, and item 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 CFA Institute requirements

From a fiduciary perspective, compliance with CFA Institute 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 duties

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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 historically 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 CFA Institute study when Regulation FD

was first announced anticipated that:• “to avoid any possible SEC enforcement

actions, corporations will reduce their communications to ‘sound bites’ and ‘boilerplate’ disclosures, which contain little information to analysts and the public at large”

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AIMR Response (cont’d) CFA Institute study one year later found

that:• “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