FINM 3008/6016, Applied Portfolio Construction Tutorial #11

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FINM 3008/6016, Applied Portfolio Construction

Tutorial #11 – Outline

Note: The excel file “Tutorial #11 – Analysis File.xlsx” is set up to facilitate calculations for Questions 1 and 4.

Question 1 - Capacity

Consider an Australian equity manager who is benchmarked against the S&P/ASX200 (an index of the top 200 companies). The manager’s process involves spreading their funds equally amongst what they consider the 25 most attractive companies. This means placing 4% of their portfolio in each stock. Below are the rankings and market capitalizations for selected stocks following the rebalancing of the index for June 2013:

Calculate what percentage of each of these companies that the manager would need to purchase to achieve a standard 4% position at 5 levels of funds under management (FUM): $250 million, $500 million, $1 billion, $2 billion and $4 billion.

Discussion point: 

What do these simple calculations imply about the capacity of the manager’s investment process? Specifically think about what might happen as FUM increases for this manager.

Question 2 - Breadth vs skill

Do these processes rely on high breath or high skill for success?

(a) Asset allocator that engages in strategic tilting or dynamic strategic asset allocation (DSAA), i.e. occasional shifts away from SAA when markets appear to be at some extreme

(b) Stock picker with a high tracking error of 7%-10% that holds 10-15 stocks

(c) Quant equity fund that holds 50-60 stocks which are turned over often

(d) Fixed income manager that forms their portfolio around a view on interest rates

(e) Fund of hedge funds

(f) Private equity fund

Question 3 – Impact of Capital Gains Tax

This question investigates how capital gains tax (CGT) might influence expected returns and hence the management of a portfolio under differing assumptions. A model is provided to facilitate the analysis. It is contained in the file “Tutorial #11 – Analysis File.xlsx” on the course Wattle website. First read the outline of the model below and examine the file, as understanding how the model works will help you discuss the results. The model compares two strategies over investment horizons varying from 1 to 10 years:

Strategy 1: Retain the existing stock, and liquidate at the end of the holding period, paying the CGT at that time. The existing stock is assumed to generate a return of 10% pa over the holding period.

Strategy 2: Sell the existing stock now and incur the CGT; reinvest the net proceeds into a new stock; and then liquidate the new stock at the end of the holding period, incurring CGT on the new stock.

The basic idea behind the model is that if the investor sells an existing asset now, the proceeds available for reinvestment will be net of any CGT effects. If a capital profit is incurred, the amount reinvested will be lowered by the CGT paid (vice versa for a capital loss). The difference between the two strategies going forward then becomes a function of: (1) the relative amounts being invested, (2) the relative rates of return, (3) the holding period over which returns are earned, and (4) the CGT rate. The CGT rate has been set at 23.5%, based on the 47% top marginal tax rate paid by Australian private investors (45% income tax, plus 2.0% Medicare levy to apply from 1 July 2014), allowing for CGT at 50% of the marginal tax rate.

For simplicity, the model assumes constant rates of return over time; both stocks have a share price of $1; both stocks are of equivalent risk; and that any capital loss can be claimed immediately.

The output of focus is the value difference between the two strategies at the end of holding periods of 1 through to 10 years. This output appears in cells E24 to N24. You are to run the model for two tax cost bases on the existing stock ($0.50 and $2.00), and expected returns on the new stock ranging from 8% to 12% (see list below). (Key input cells are colored in bold blue.) An output section sits below the model into which you can copy the output.

· Tax cost base of $0.50; expected return on new stock of 8%, 9%, 10%, 11% and 12% pa.

· Tax cost base of $2.00, expected return on new stock of 8%, 9%, 10%, 11% and 12% pa.

Discussion questions:

(a) With reference to the model output, comment of the significance of tax to portfolio outcomes. (Hint: Examine the value difference where existing stock and new stock generate the same expected return.)

(b) In what way might an existing capital gains tax liability (or asset) influence the decision to trade?

(c) With reference to the model output, can you suggest any general guidelines for how a portfolio manager could manage their portfolio to maximize after-tax value for their investors?

(d) Can you glean anything from the analysis that hints at how inflation might influence how portfolios are managed in a tax-effective manner? (Hint: Think about how inflation interacts with returns and hence CGT over the long run. You might use the model to investigate different return environments.)