1. McGraw-Hill/Irwin Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. 27-1 The Theory of Active Portfolio Management Chapter 27

2. McGraw-Hill/Irwin Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. 27-2 Lure of Active Management Are markets totally efficient? Some managers outperform the market for extended periods. While the abnormal performance may not be too large, it is too large to be attributed solely to noise. Evidence of anomalies such as the turn of the year exist. The evidence suggests that there is some role for active management.

3. McGraw-Hill/Irwin Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. 27-3 Market Timing Adjust the portfolio for movements in the market. Shift between stocks and money market instruments or bonds. Results: higher returns, lower risk (downside is eliminated). With perfect ability to forecast behaves like an option.

4. McGraw-Hill/Irwin Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. 27-4 rfrfrfrf rfrfrfrf rMrMrMrM Rate of Return of a Perfect Market Timer

5. McGraw-Hill/Irwin Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. 27-5 Returns from 1990 - 1999 YearLg StocksT-Bills 1990-3.207.86 199130.665.65 19927.713.54 19939.872.97 19941.293.91 199537.715.58 199623.075.58 199828.585.11 199921.044.80

6. McGraw-Hill/Irwin Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. 27-6 With Perfect Forecasting Ability Switch to bills in 1990 and 1994 Mean =18.94% Standard Deviation = 12.04% Invested in large stocks for the entire period Mean =17.41% Standard Deviation =14.11% The results are clearly related to the period

7. McGraw-Hill/Irwin Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. 27-7 With Imperfect Ability to Forecast Long horizon to judge the ability Judge proportions of correct calls Bull markets and bear market calls

8. McGraw-Hill/Irwin Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. 27-8 Superior Selection Ability Concentrate funds in undervalued stocks or undervalued sectors or industries. Balance funds in an active portfolio and in a passive portfolio. Active selection will mean some unsystematic risk.

9. McGraw-Hill/Irwin Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. 27-9 Treynor-Black Model Model used to combine actively managed stocks with a passively managed portfolio. Using a reward-to-risk measure that is similar to the the Sharpe Measure, the optimal combination of active and passive portfolios can be determined.

10. McGraw-Hill/Irwin Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. 27-10 Treynor-Black Model: Assumptions Analysts will have a limited ability to find a select number of undervalued securities. Portfolio managers can estimate the expected return and risk, and the abnormal performance for the actively-managed portfolio. Portfolio managers can estimate the expected risk and return parameters for a broad market (passively managed) portfolio.

11. McGraw-Hill/Irwin Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. 27-11 Reward to Variability Measures Passive Portfolio :

12. McGraw-Hill/Irwin Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. 27-12 Appraisal Ratio: Appraisal Ratio: Reward to Variability Measures

13. McGraw-Hill/Irwin Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. 27-13 Reward to Variability Measures Combined Portfolio :

14. McGraw-Hill/Irwin Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. 27-14 Treynor-Black Allocation M A P E(r)  CML CAL RfRf

15. McGraw-Hill/Irwin Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. 27-15 Summary Points: Treynor-Black Model Sharpe Measure will increase with added ability to pick stocks. Slope of CAL>CML (r p -r f )/  p > (r m -r f )/  p P is the portfolio that combines the passively managed portfolio with the actively managed portfolio. The combined efficient frontier has a higher return for the same level of risk.