1. Equity portfolio management strategies

2. Objective

3. Outline

4. Portfolio management style
Passive
Buy and hold strategy, often known as indexing
Active
Continuos rebalancing

5. Passive management Techniques Objective Approach
Full replication
Issues: Transaction costs
Sampling
Issues: Tracking error
Quadratic optimization
Issues: Programming
Completeness funds
Issues: Special benchmark to complement active portfolio management
Objective
Match the return of a benchmark
Approach
Replicate the benchmark

6. Active management Objective Issues
Outperform a passive benchmark portfolio on a risk adjusted basis
Portfolio return > Benchmark return + transaction costs
Issues
Benchmark
Measuring returns on a risk adjusted basis

7. Themes in active portfolio management
Sector rotation
Value vs. growth
Earnings & price momentum
Factors models
Identify stocks that are sensitive to _________factors
Long-short approach
Screen & rank; buy the top, sell the bottom

8. Style analysis
Compare manager’s return to that of different styles of indices
Grid style
Regression analysis

9. Style analysis: Grid style
Value
Growth
Small cap
Large cap
S&P 5000
Russel 1000
Wilshire 5000
TSE300
Russel midcap
Nasdaq
Joe B.
Russel 2000

10. Style analysis: Regression analysis
R = b1F1 + b2F2 + ….+ bjFj + …. + e
Where:
R = return on the portfolio under analysis
bj = sensitivity of portfolio to style factor j
Fj = return on a factor j style portfolio

11. Style analysis: Regression interpretation
Look for (bj)s that are large and significant
They reveal which factor style portfolios are similar to the portfolio under analysis

12. Asset allocation strategies
Integrated asset allocation
Strategic asset allocation
Tactical asset allocation
Insured asset allocation

13. Integrated asset allocation
Evaluate and integrate:
Capital market conditions
Investor’s objectives & constraints

14. Integrated asset allocation
Investor’s assets, liabilities, and net worth
Capital market conditions
Investor’s risk tolerance function
Predictions
Feedback
Expected returns, risk, correlations
Investor’s objectives
Optimized portfolio: asset allocation & security selection
Return evaluation & feedback

15. Strategic asset allocation
Classical optimization: It results in a constant asset allocation mix
Similar to integrated asset allocation, without a feedback loop
Exemplification:
Pension plans

16. Tactical asset allocation
Assumption
Mean reversion
Aka. timing the market
It’s a contrarian strategy:
“Buy low, sell high”

17. Insured asset allocation
Assumption
Returns & risks constant over time, but investors change
Switch between equity & cash to accommodate investor’s risk tolerance
Similar to integrated asset allocation without feedback on the capital market side

18. Evaluation of portfolio performance
Requirements of a good portfolio manager:
Derive no less than average returns for a given risk-class (timing & security selection skills)
Diversify away all non-systematic risk

19. Approaches to measuring performance
Peer-group comparisons
Treynor’s composite measure
Shapre’s measure
Jensen’s measure
Fama’s approach
Attribution analysis
Market timing skills measurement

20. Peer-group comparisons
Ranking can be random
Most data tracks funds, not individual portfolio managers
See also textbook

21. Treynor’s composite measure
Comparison of risk premium per unit of relative risk
Measure
Ti = (Ri - Rf)/bi
Benchmark
Tm = (Rm - Rf)bm
Issues
Looks at performance only
Uses realized returns

22. Sharpe’s measure Comparison of risk premium per unit of absolute risk
Si = (Ri - Rf)/si
Benchmark
Sm = (Rm - Rf)sm
Issues
Looks at performance and diversification
Uses realized returns

23. Jensen’s measure
Measures excess return (above and beyond that required by the market)
(Ri - Rf) = a + (Rm - Rf)bi + e
If a > 0
Portfolio earned more than the required rate
If a < 0
Portfolio earned less than the required rate
Issues
Uses realized returns

24. Fama’s approach Excess return = Portfolio risk + Selectivity
See also textbook

25. Attribution analysis Attribute performance to: Selection
Tactical asset allocation (market timing)
Allocation effect:
[(wp - wb)stocks(Rbstocks - Rb)] + [(wp - wb) bonds(Rbbonds - Rb)] + …
Selection effect:
[wp(Rp - Rb)]stocks + [wp(Rp - Rb)]bonds + …

26. Attribution analysis: Exemplification

27. Attribution analysis: Exemplification

28. Attribution analysis: Exemplification

29. Attribution analysis: Exemplification

30. Attribution analysis: Exemplification

31. Attribution analysis: Exemplification
Portfolio return = (0.5)(9.7%) + (0.38)(9.1%) + (0.12)(5.65) = 8.98%
Benchmark return = (0.6)(8.6%) + (0.3)(9.2%) + (0.1)(5.4) = 8.46%
Allocation effect
(-0.1)(8.6% %) + (0.08)(9.2%-8.46%) + (0.2)(5.4% ) = -0.02%
Selection effect
(0.5)(9.7% - 8.6%) + (0.38)(9.1% - 9.2%) + (0.12)(5.6% - 5.4%) = 0.54%
Allocation effect + Selection effect = -0.02% % = 8.98% %

32. Attribution analysis: Interpretation
Manager underperformed benchmark by 0.02% due to deviations from benchmark’s weight
Manager outperformed the benchmark by 0.54%, due to its superior selection skills

33. Measuring timing skills
Measure the effectiveness of switching between asset classes
Having perfect timing skills (hindsight 20/20) is equivalent to owning a lookback option:
At expiration, it pays the return of the best-performing asset class.
Ri = Rf + max[(Rb- Rf), (Rst- Rf)]
Regression measure:
(Ri - Rf) = a + (Rb- Rf)bib + (Rst - Rf)bist + y max[(Rb- Rf), (Rst- Rf)] + e
a = excess return
y = proportion of the lookback option captured by manager

34. Factors that affect performance measures
Knowing what is the true return generating process
All the above measures are based on CAPM
Finding the real market portfolio
Changing the proxy for the market portfolio completely changes the ranking
Accounting for manager’s style

35. A question of benchmark
Portfolio managers have different objectives and styles.
Wee need customized benchmarks.

36. The making of a good benchmark
Unambiguous
Investable
Measurable
Appropriate: Consistent with manager’s style
Reflective of manager’s current investment opinions
Specified in advance