1

Goal: Earn a portfolio return net of transaction costs and expenses that exceeds the return of a passive benchmark portfolio (most often an index) on a risk-adjusted basis. 2

1. Costs & Fees Transaction Costs and fees range from 1% - 2% of assets under management on average. (hurdle) 3

2. Appropriate Evaluation of Performance  Difficulty differentiating Luck from Skill  Appropriate Risk-Adjustment Model? (CAPM vs Fama-French Factor Model vs Other Models) 4

 Asset Allocation  Stocks, Bonds, Money Market  Sector Allocation  Overweighting and underweighting based on industry, size, or value vs. growth  Individual Stock Selection 5

 Test to see if trading rules would have worked using historical data.  Subject to data mining criticisms as you can always find some patterns. It does not mean that they will persist in the future. 6

 Quadratic Programming: Efficient frontier optimization in Mean/Variance Space based on Expected Returns, Standard Deviations, and Correlations 7

 Logic: Market is fairly efficient. Too difficult to overcome 1 - 2% costs of running an active equity portfolio.  Don’t try to beat the market, just equal it and keep expenses to a bare minimum. 8

 Portfolio is built without using technical or fundamental analysis.  Buy & Hold: The securities are purchased and then held with only occasional re- balancing (reinvest dividends, a change in the index etc..) 9

 Passive portfolios that track an index and sell shares to investors are called Index Funds.  (Ex: Vanguard 500 Index which tracks the S&P 500.) 10

 Manager Performance: Judged by how well he/she tracks the index and by the costs generated to do so. 11

1. Full Replication: Buy all stocks in the index in proportion to their weights in the index. 12

2. Sampling: Buy the stocks with larger index weights & hold a representative sample of the others. Benefit Relative Full Replication: Lower commissions (less stocks to purchase and to reinvest dividends).  Drawback Relative Full Replication: Will be Tracking Error 13

1. R-Squared: Measures how closely the fund is moving with the benchmark index. This measures tracking, but not costs! 14

 An alternative to buying shares in an Index Fund.  Depositary receipts with underlying stocks in an index held in deposit by the financial institution that issued certificates.  Shares are traded like a stock but represent a claim on the portfolio. 15

 Example SPDRs: Depositary receipts on the S&P 500.  Buy like a share of stock no fund marketing fees (means lower expenses).  No cash on hand to handle fund flows.  Trade when market open not just at market close price.  Can be shorted or purchased with margin.  Some new ETFs are actively managed 16