1 Solvay Business School – Université Libre de Bruxelles 1 Investments - Lecture n°11 Part 4 : Active Portfolio Management (10 hrs) Case study 2 : manage your own portfolio - requirements 4.1. Active equity portfolio management (17/11) 4.2. Value-at-Risk & Asset allocation : Conference by Dr. Frédéric Flament, Dexia BIL, Luxembourg (24/11) 4.3. Performance analysis of investment portfolios : Conference by Prof. Georges Hübner, Ulg (1/12) 4.4. Behavioural finance and portfolio management (8/12) 4.5. Active Credit Portfolio Management : Conference by Mr. Bruno Raüis, ING Bank, Brussels.

2 Solvay Business School – Université Libre de Bruxelles 2 Performance - Summary Key performances measures 1. Averages Arithmetic Average : for future expected performance Geometric Average : for past performance Example : +10% in year 1 and –10% in year 2 => arithmetic average = 0 geometric average =

3 Solvay Business School – Université Libre de Bruxelles 3 Performance - Summary Key performances measures 2. Ratios Sharpe ratio : unit of excess return per unit of risk  good for the performance of an entire portfolio,  or to compare with other portfolios,  and to the market portfolio  the higher the better  if negative : value destruction (an investment in cash would have been better)

4 Solvay Business School – Université Libre de Bruxelles 4 Performance - Summary Key performances measures - Ratios Information ratio : unit of excess return over the benchmark per unit of risk  same concept as the Sharpe ratio  used by practitioners,  highly dependant of the benchmark chosen,  the higher the better  if negative : a passive strategy would have been better

5 Solvay Business School – Université Libre de Bruxelles 5 Performance - Summary Key performances measures - Ratios Treynor ratio : unit of excess return per unit of systematic risk  suited when a well diversified portfolio is mixed with others  allows to compare the performances of several managers of a well diversified portfolio  the higher the better  if negative : value destruction

6 Solvay Business School – Université Libre de Bruxelles 6 Performance - Summary Key performances measures - Ratios Appraisal ratio : unit of Jensen’s alpha return per unit of non diversifiable risk  suited for parts of portfolios  suited for concentrated portfolios  measure the benefit-to-cost of a not well diversified portfolio  capture the benefits of an active stock selection  if negative : a passive strategy would have been better

7 Solvay Business School – Université Libre de Bruxelles 7 Performance - Summary Key performances measures - Ratios Sharpe ratio of a composite portfolio : unit of excess return per unit of risk for a composite portfolio (C) made of an active part (P) and a passive part (M).

8 Solvay Business School – Université Libre de Bruxelles 8 Performance - Summary Key performances measures - 3. Example : Which one is : Riskier ? Better diversified ? Outperforming the market? Better if a single fund? Better if part of a larger passive fund? Of an active fund?

9 Solvay Business School – Université Libre de Bruxelles 9 Performance - Summary 4. Performance attribution Determination of excess return produced per active management decision taken. A. Basis for comparison : Benchmarks (reference portfolios) Key roles :  point of departure for assessing performance and risk  basis for establishing various management goals or limits: targeted outperformance rates, tracking errors limits, stop- loss procedures etc.  help clarify and communicate the investment objective of a fund.

10 Solvay Business School – Université Libre de Bruxelles 10 Performance - Summary 4.b. Performance attribution procedure Should fit the investment process, following the top-down procedure of the decisions taken by the management. If return of the benchmark portfolio: where w Bi is the weight of the asset class i in the benchmark portfolio, and r Bi is the return of that asset class over the period. And return of the active portfolio: The difference in returns writes :

11 Solvay Business School – Université Libre de Bruxelles 11 Performance - Summary 4.b. Performance attribution procedure It can be rewritten :

12 Solvay Business School – Université Libre de Bruxelles 12 Performance - Summary 5. Performance evaluation standards : AIMR norms  Returns must be total returns (income + capital gain).  Annual returns reported for all years individually, and longer periods.  Time-weighted average rates of return and geometric average linked returns.  Performance reported before fees.  Composite results reflect the record of the firm, not of individual managers.  Composite returns reported for at least a 10-year period.  Risk measures such as beta, duration, or standard deviation are encouraged.

13 Solvay Business School – Université Libre de Bruxelles 13 Behavioral Finance References : Barberis, N, Thaler, R., 2002, “A Survey in Behavioral Finance”, NBER Working Paper No. W 9222 forthcoming in Handbook of Finance Economics, –Definition and scope –Applications : Stock Market - Cross-sections average returns - Funds - Corporate Finance De Grauwe, P., Grimaldi, M., “Exchange Rates in a Behavioural Finance Framework, KUL working paper. –Investors are Chartists or Fundamentalists –Learning process, no Rational Expectations Paradigm –Model explains occurrences of bubbles and crashes Nofsinger, J.R., 2002, The Psychology of Investing, Prentice Hall ed. –Catalogue of psychological biases of Investors

14 Solvay Business School – Université Libre de Bruxelles 14 Behavioral Finance Barberis, N, Thaler, R., 2002 Behavioral Finance : Explanation of phenomena on Financial Markets, when agents are not fully rational Two building blocks in the literature : 1. Limits to arbitrage : difficult for rational traders (“fundamentalists”, EMH) to undo the dislocations caused by less rational traders –“no free lunch” (empirically observed)  “prices are right” (then prices may be wrong) –arbitrage may be costly to implement even when prices are wrong –empirical evidence tends to show limited arbitrage (persistent misalignment of prices and fundamentals)

15 Solvay Business School – Université Libre de Bruxelles 15 Behavioral Finance Barberis, N, Thaler, R., 2002 Two building blocks in the literature : 2. Psychology : catalogues the kinds of deviations from full rationality one might expect to see. –Experimental evidence : bias due to people’s beliefs and preferences. –Examples - beliefs : –Overconfidence (excessive risk-taking) –Optimism and Wishful Thinking –Confirmation bias (insufficient attention paid to new data) –Anchoring (too little review of prior ideas) –Memory biases (more recent events are more salient)

16 Solvay Business School – Université Libre de Bruxelles 16 Behavioral Finance 2. Psychology : Examples - preferences : –Empirical evidence show a systematic violation of classical EU theory when choosing among risky gambles –Development of non-EU theories in the literature: –weighted-utility theory, disappointment aversion, rank- dependent utility theories, prospect theory –most applicable to financial issues : Prospect Theory. Utility function with a kink at the origin, with greater sensitivity to losses than to gains. –Includes the influence of framing, i.e. the way a problem is posed to the decision maker (Ex. Is a subsequent loss, a loss, or a reduction of a gain?), and narrow framing.

17 Solvay Business School – Université Libre de Bruxelles 17 Behavioral Finance Barberis, N, Thaler, R., 2002 Example of Application: cross-section of average returns Explanation of so-called “market anomalies” based on psychological and preferences biases described above : The size premium : return of the smallest stock decile 0.74% per month higher than the largest stock Long-term reversals : 8% average return higher for the “losers portfolio” than the winners, 3 years after their formation. Momentum : 10% average annual return higher for winners, 6 months after portfolio formation. Events studies on various corporate events and related investors reaction.