Chapter 25

Contemporary Issues in Portfolio

Management

Portfolio Construction, Management, & Protection, 5e, Robert A. Strong

Copyright 2009 by South-Western, a division of Thomson Business & Economics. All rights reserved.

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. Weve got to get back to an honest approach and a
broad-gauged concept of what we really mean by
management performance.
William Donaldson,
Exchange Commission

Chairman, Securities &

Introduction

Some contemporary issues are factual:

The rising importance of Exchange-Traded Funds
Increasingly common practice of certificateless trading
Integration of Islamic society, and Shariah law which does not
permit paying or receiving interest, into the global marketplace

Some contemporary issues 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

Exchange-Traded Funds

Portfolio of stocks, bonds, futures, or other assets

that trade throughout the day
Mutual fund exchanges only take place at the endof-day net asset value
In March 2008, there were 644 ETFs with $571
billion in the United States
ETFs provide transparency and liquidity
Portfolio contents are published
Investors can exit at any given time
4

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
5

Security Analyst Objectivity

(contd)

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 elses
6

Stock Lending

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
7

Stock Lending (contd)

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
8

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
9

Mechanics of
a Short Sale (contd)
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
10

Mechanics of
a Short Sale (contd)

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
11

12

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 finders fee to the stock
loan finder

13

Advantages of Stock Lending

Stock lending is very lucrative

In 1999, the total income to stock lenders approached
$1 billion
In 2005, over $2.4 billion of short-term bonds

Stock lending can be used by brokerage firms to

finance the margin purchases of their customers
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
14

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
15

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
16

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

17

Proxy Voting

Two Corporate Governance Questions

getting Attention:
Do withheld vote count as votes against a
candidate for a board of directors?
Are the CEO and Chairman of the Board
separate individuals?
18

Majority Trading (contd)

Historically, individual investors did not return

proxy ballots
Today, 45% of individuals and nearly all
institutional investors return proxy ballots
Over half the companies in the S&P 500 index
have adopted a majority voting provision
Only 16% had such a provision as recently as February
2007
19

Separation of Board Chairman

and CEO (contd)
Historically, 22 percent had separate
individuals as board chairmen and CEO
Today, the number is up to 36 percent
The importance arises from the fact that the
Board of Directors looks out for the best
interests of the shareholders

20

Role of Derivative Assets

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
21

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
22

Portfolio Margining

Margin is a sum of money invested as a good faith deposit

Improving the chance that any losses will be paid

Historically, margins amount were based on portfolio asset

positions individually
Risk of loss in portfolios with off-setting positions is limited

Today, institutional investors and individuals with large

portfolios are allowed to post margins based upon net
losses arising from the interaction of securities
Less money has to be put into performance bonds
Leaves more money for additional investment

23

Islamic Finance

Islamic law, or Shariah, forbids:

Paying or receiving interest
Hence, Most Muslims rent

Investment in firms dealing in interest products (like

banks)
Investment in firms dealing with alcohol, tobacco,
gambling, pornography, or defense

Muslims enter into somewhat elaborate

partnerships with banks to purchase homes
Instead of paying interest, they buy out the banks
ownership position over time
24

Structured Finance

Generally include options and futures to alter the

risk and return characteristics of some portfolio
Examples include:
Selling a call (for revenue) and holding the stock
Shorting a stock and buying a call
The combination acts like a put

U.S. investors are less likely to invest in structured

products
30% of European and Asian portfolios consist of
structured products

25

Chartered Financial
Analyst Program

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)
26

The CFA Program Exams

To earn the CFA designation, candidates

must pass three separate exams taken at
least a year apart

27

The CFA
Program Exams (contd)

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

28

The CFA
Program Exams (contd)

Level III is essay, valuation, analysis, and

item sets
Covers portfolio management

29

CFA Program Themes

Competence
Presentation Standards
Fiduciary Duties
Ethics

30

Competence

People who complete the CFA program are

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

31

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
32

Fiduciary Duties

Fiduciary duties require conduct that:

Is in the individual clients best interest
Is fair to the collective group of all clients

Research reports are an important part of

fiduciary duties

33

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
34

Regulation Fair Disclosure

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
35

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 Streets
big guns
36

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
37

CFA Institute 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

38

CFA Institute Response (contd)

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

39

The Future of the Regulation

SEC Commissioner Laura Ungers

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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