1. 0 Portfolio Management 3-228-07 Albert Lee Chun The Institutional Environment Lecture 1 09-02-2008

2. Albert Lee Chun Portfolio Management 1 Portfolio Management This course Portfolio Management complements the course Investments (2-201-99) by exploring various issues underlying asset management. This is the most fundamental attribute of any professionally managed portfolio. Even if most of the concepts presented in class are specific to portfolios consisting of shares or stock market indices, the majority of these concepts apply to a wide variety of financial asset categories. In this course, students will become familiar with fundamental concepts of portfolio management including efficient frontier portfolios, multifactor models, financial asset pricing models, market efficiency and the performance evaluation of professionally managed portfolios. This course Portfolio Management complements the course Investments (2-201-99) by exploring various issues underlying asset management. This is the most fundamental attribute of any professionally managed portfolio. Even if most of the concepts presented in class are specific to portfolios consisting of shares or stock market indices, the majority of these concepts apply to a wide variety of financial asset categories. In this course, students will become familiar with fundamental concepts of portfolio management including efficient frontier portfolios, multifactor models, financial asset pricing models, market efficiency and the performance evaluation of professionally managed portfolios.

3. 2 Course Outline Sessions 1 and 2 : The Institutional Environment Sessions 1 and 2 : The Institutional Environment Sessions 3, 4 and 5: Construction of Portfolios Sessions 3, 4 and 5: Construction of Portfolios Sessions 6 and 7: Capital Asset Pricing Model Sessions 6 and 7: Capital Asset Pricing Model Session 8: Market Efficiency Session 8: Market Efficiency Session 9: Active Portfolio Management Session 9: Active Portfolio Management Session 10: Management of Bond Portfolios Session 10: Management of Bond Portfolios Session 11: Performance Measurement of Managed Portfolios Session 11: Performance Measurement of Managed Portfolios

4. Albert Lee Chun Portfolio Management 3 Evaluation You will be evaluated using the following criteria: You will be evaluated using the following criteria: Midterm Exam: (October 21st)40% Midterm Exam: (October 21st)40% Final Exam: (December 14th)40% Final Exam: (December 14th)40% Project:20% Project:20% The midterm and final exams are 3 hours long. The midterm and final exams are 3 hours long. The exams will be closed book. The exams will be closed book. For the exams, you are allowed to have a single- sided, 8.5 x 11 inch “cheat sheet”, where you can write all the information you want. For the exams, you are allowed to have a single- sided, 8.5 x 11 inch “cheat sheet”, where you can write all the information you want. Old exams will not be made available. Old exams will not be made available.

5. Albert Lee Chun Portfolio Management 4 E-mail: albert-lee.chun@hec.ca Phone: 514-340-5661 Office: 4.257 Office hours: By Appointment Only Professor Albert’s Contact Info Please do not be shy about contacting me if you have questions about the material! I will hold individual office hours as needed. I’m happy to chat with you about the course or about your future plans.

6. Albert Lee Chun Portfolio Management 5 Course Information Text Book: Bodie, Kane, Marcus, Perrakis, Ryan. Text Book: Bodie, Kane, Marcus, Perrakis, Ryan. Investments Investments 8th Canadian edition, 8th Canadian edition, 2008, McGraw-Hill Ryerson. 2008, McGraw-Hill Ryerson. Course Reader: Course Reader: “Textbook 3228A” You will need to get a copy You will need to get a copy of this as we will assign readings from it. of this as we will assign readings from it.

7. Albert Lee Chun Portfolio Management 6 Course Information Zonecours.hec.ca: Slides from lectures, exercices, solutions, announcements, etc., will be posted here. Zonecours.hec.ca: Slides from lectures, exercices, solutions, announcements, etc., will be posted here. Prerequisites: It is important that you have taken and passed the course « Investments » and to a lesser extent « Options and Futures ». If you do not have a strong background in finance at the level of « Investments », you may not be prepared to take this course. Prerequisites: It is important that you have taken and passed the course « Investments » and to a lesser extent « Options and Futures ». If you do not have a strong background in finance at the level of « Investments », you may not be prepared to take this course.

8. Albert Lee Chun Portfolio Management 7 Today’s Lecture Objective: (Chapter 4) To give an overview of institutional investing and institutions’ role in portfolio selection and management Investment companies Investment companies Mutual funds Mutual funds Costs of investing in Mutual Funds Costs of investing in Mutual Funds Investment performance of mutual funds Investment performance of mutual funds Index Funds Index Funds 4-7

9. Albert Lee Chun Portfolio Management 8 Investment Companies 4-8

10. Albert Lee Chun Portfolio Management 9 Investment companies pool funds into large portfolios. Advantages include: Diversification & divisibility Diversification & divisibility Administration & record keeping Administration & record keeping Professional management Professional management Reduced costs Reduced costs Commissions/Transaction costs Information costs Services of Investment Companies 4-9

11. Albert Lee Chun Portfolio Management 10 Net Asset Value Per Share: Used as a basis for valuation of investment company shares Net Asset Value Per Share: Used as a basis for valuation of investment company shares Selling new shares Selling new shares Redeeming existing shares Redeeming existing shares Net Asset Value 4-10

12. Albert Lee Chun Portfolio Management 11 Open-end and Closed-end Funds Managed funds Managed funds Closed-end/ Open-end Closed-end/ Open-end Load funds Load funds Shares Outstanding Closed-end: Do not redeem or issues shares Closed-end: Do not redeem or issues shares Open-end: Can sell or redeem shares Open-end: Can sell or redeem sharesPricing Open-end: Net Asset Value (NAV) Open-end: Net Asset Value (NAV) Closed-end: Premium or discount to (NAV) Closed-end: Premium or discount to (NAV) 4-11

13. Albert Lee Chun Portfolio Management 12 Closed-end Funds

14. Albert Lee Chun Portfolio Management 13 Commingled funds Commingled funds Real estate funds Real estate funds Real estate limited partnerships Real estate limited partnerships Mortgage funds Mortgage funds Segregated funds Segregated funds Hedge funds Hedge funds Other Organizations 4-13

15. Albert Lee Chun Portfolio Management 14 Mutual Funds 4-14

16. Albert Lee Chun Portfolio Management 15 Mutual Fund Listings 4-15

17. Albert Lee Chun Portfolio Management 16 Growth of Mutual Funds 4-16

18. Albert Lee Chun Portfolio Management 17 Money Market Money Market Fixed Income Fixed Income Balanced and Income Balanced and Income Asset Allocation Asset Allocation Equity Equity Indexed Indexed Specialized Sector Specialized Sector Investment Policies 4-17

19. Albert Lee Chun Portfolio Management 18 Investment Policies Statement about their objective: Statement about their objective: Aggressive growth equity funds Aggressive growth equity funds Emerging markets equity funds Emerging markets equity funds Growth and income equity funds Growth and income equity funds High yield fixed income funds High yield fixed income funds Mortgage-backed bond funds Mortgage-backed bond funds

20. Albert Lee Chun Portfolio Management 19 Types of Mutual Funds 4-19

21. Albert Lee Chun Portfolio Management 20 Largest Fund Families

22. Albert Lee Chun Portfolio Management 21 Mutual Funds Returns The one-period rate of return on an investment in a open- ended fund is The one-period rate of return on an investment in a open- ended fund is

23. Albert Lee Chun Portfolio Management 22 Example Invest $1000 in a mutual fund Invest $1000 in a mutual fund After 90 days, liquidated at NAV of $1,010. After 90 days, liquidated at NAV of $1,010. During the 90 days you received: During the 90 days you received: A $5 income disbursement A $5 income disbursement A $15 capital gain disbursement A $15 capital gain disbursement

24. Albert Lee Chun Portfolio Management 23 Costs of Investing in Mutual Funds 4-23

25. Albert Lee Chun Portfolio Management 24 Entry fees (Front-end loads) Entry fees (Front-end loads) Diminish investor’s initial NAV Diminish investor’s initial NAV Many no-load funds exist Many no-load funds exist Many load funds charging between 0 and 8.5% exist Many load funds charging between 0 and 8.5% exist Exit fees (redemption or Back-end loads) Exit fees (redemption or Back-end loads) Declines toward zero the longer the fund is held Declines toward zero the longer the fund is held Most funds charge no exit fees Most funds charge no exit fees Costs of Investing in Mutual Funds 4-24

26. Albert Lee Chun Portfolio Management 25 Costs of Mutual Funds Operating expenses Operating expenses Transaction fees Transaction fees Cover the costs of buying/selling securities Cover the costs of buying/selling securities Distribution fees Distribution fees In the US: allowed to deduct up to 1% of their assets per year to pay for sales commissions and promotional expenses In the US: allowed to deduct up to 1% of their assets per year to pay for sales commissions and promotional expenses Management Expense Ratio (MER) Management Expense Ratio (MER)

27. Albert Lee Chun Portfolio Management 26 Example $1,000 in a fund with up-front load fee of 3%. $1,000 in a fund with up-front load fee of 3%. 1% per year annual management fee 1% per year annual management fee Redemption fee of 1.5% Redemption fee of 1.5% After 90 days, liquidated at NAV of $1,010. After 90 days, liquidated at NAV of $1,010. During the 90 days you received: During the 90 days you received: a $5 cash dividend disbursement and a $5 cash dividend disbursement and a $15 capital gain disbursement. a $15 capital gain disbursement.

28. Albert Lee Chun Portfolio Management 27 Costs of Mutual Funds Return over the 90-day period Return over the 90-day period Management fees in dollars over 90 days : Management fees in dollars over 90 days : 0.01 x (90/365) x $970 = $2.4 Redemption fee in dollars Redemption fee in dollars $1,010 x 1.5% = $15.15 90-day return : 90-day return :

29. Albert Lee Chun Portfolio Management 28 Impact of Costs on Performance

30. Albert Lee Chun Portfolio Management 29 Trading Scandal with Mutual Funds Late trading – allowing some investors to purchase or sell later than other investors Late trading – allowing some investors to purchase or sell later than other investors Market timing – allowing investors to buy or sell on stale net asset values Market timing – allowing investors to buy or sell on stale net asset values Example: Exploiting time-zone differences Example: Exploiting time-zone differences Net effect is to transfer wealth from existing owners to the new purchasers or sellers Net effect is to transfer wealth from existing owners to the new purchasers or sellers 4-29

31. Albert Lee Chun Portfolio Management 30 Investment Performance of Mutual Funds 4-30

32. Albert Lee Chun Portfolio Management 31 First Look at Mutual Fund Performance Benchmark portfolio: Wilshire 5000 Index. Benchmark portfolio: Wilshire 5000 Index. Figure 4.4 shows that average mutual fund performance is generally less than broad market performance measured by the index. Figure 4.4 shows that average mutual fund performance is generally less than broad market performance measured by the index. Return on average mutual fund was below the Whilshire 5000 index 21 out of 35 years from 1971 to 2005. Return on average mutual fund was below the Whilshire 5000 index 21 out of 35 years from 1971 to 2005. The average return on the index exceeded that of the mutual fund by 1% The average return on the index exceeded that of the mutual fund by 1% 4-31

33. Albert Lee Chun Portfolio Management 32 Performance vs. the Index 4-32

34. Albert Lee Chun Portfolio Management 33 Is Performance Due to Skill? The must be good mangers and bad managers. The must be good mangers and bad managers. So do good managers consistently outperform the index? So do good managers consistently outperform the index? To test this, we seek evidence of persistence in returns. To test this, we seek evidence of persistence in returns. If good performance is due to skill then those who rank in the top performing half in one period would be expected to do well in the next period. If good performance is due to skill then those who rank in the top performing half in one period would be expected to do well in the next period.

35. Albert Lee Chun Portfolio Management 34 Do winners stay winners? 4-34

36. Albert Lee Chun Portfolio Management 35 Persistence in Fund Performance The Malkiel study suggests that some funds show consistent strong performance but it seems to only be true in the 70s. The Malkiel study suggests that some funds show consistent strong performance but it seems to only be true in the 70s. Other studies using Canadian data are suggestive of good managers outperforming the market this is also inconclusive. Other studies using Canadian data are suggestive of good managers outperforming the market this is also inconclusive. Other studies suggest that bad performance is more likely to persist than good performance. Other studies suggest that bad performance is more likely to persist than good performance.

37. Albert Lee Chun Portfolio Management 36 Survivorship Bias Yet worst performing funds go out of business. Yet worst performing funds go out of business. So when looking at mutual fund rankings of 5 year returns, we should remember there are many funds that failed to survive 5 years. So when looking at mutual fund rankings of 5 year returns, we should remember there are many funds that failed to survive 5 years. Hence, the performance of the surviving firms will be upward biased. Hence, the performance of the surviving firms will be upward biased. This is known as a survivorship bias. This is known as a survivorship bias.

38. Albert Lee Chun Portfolio Management 37 PALTrak (Morningstar) PALTrak (Morningstar) Wiesenberger’s Investment Companies (US) Wiesenberger’s Investment Companies (US) Morningstar (US) Morningstar (US) Investment Company Institute (US) Investment Company Institute (US) Popular press (Globefund) Popular press (Globefund) Investment services (SEI, Comstat, etc.) Investment services (SEI, Comstat, etc.) Sources of Information on Mutual Funds 4-37

39. Albert Lee Chun Portfolio Management 38 Index Funds 4-38

40. Albert Lee Chun Portfolio Management 39 Costs of Index vs. Mutual Funds Index funds do not need as large a staff Index funds do not need as large a staff Decisions about what stock to buy have already been made based on index commitment. Decisions about what stock to buy have already been made based on index commitment. Savings are passed along to investors Savings are passed along to investors Average management fee for a managed common stock mutual fund: 1.4% Average management fee for a managed common stock mutual fund: 1.4% Management fee for Vanguard Index Trust in the US : 0.18% Management fee for Vanguard Index Trust in the US : 0.18%

41. Albert Lee Chun Portfolio Management 40 Example Investments’ performance over the long run Investments’ performance over the long run Initial investment of $100,000 Initial investment of $100,000 Assume a 10% gross annual return for both funds: Assume a 10% gross annual return for both funds: Vanguard Index Trust 500 Mutual Fund charges a 0.18% management fee for a net annual return of 9.82% Vanguard Index Trust 500 Mutual Fund charges a 0.18% management fee for a net annual return of 9.82% The Average Managed Mutual Fund charges a 1.4% management fee for a net annual return of 8.6% The Average Managed Mutual Fund charges a 1.4% management fee for a net annual return of 8.6% Vanguard Index Trust 500 Average Managed Mutual Fund After 10 years $255,000$228,000 After 20 years $651,000$521,000

42. Albert Lee Chun Portfolio Management 41 Index funds Advantages of index funds Advantages of index funds Management expenses are minimized Management expenses are minimized Higher returns Higher returns No load funds No load funds Slow turnover Slow turnover Underlying indexes experience slow turnover; Underlying indexes experience slow turnover; Leads to lower commissions Leads to lower commissions Tax efficiency Tax efficiency Slow turnover leads to unrealized and untaxed capital gains Slow turnover leads to unrealized and untaxed capital gains Taxed when investment is sold Taxed when investment is sold

43. Albert Lee Chun Portfolio Management 42 Index funds Disadvantages of index funds Disadvantages of index funds May be poorly managed May be poorly managed There may be some tracking error: There may be some tracking error: Tracking Error = Return of index – Return on indexed portfolio

44. Albert Lee Chun Portfolio Management 43 Index funds Tracking errors can occur due to: Management fees Management fees Manager didn’t invest in all target index securities. Manager didn’t invest in all target index securities. Weighting scheme differed from that of the target index. Weighting scheme differed from that of the target index. Delayed reaction to changes in targeted index Delayed reaction to changes in targeted index Manager may try to ‘outsmart’ the market (enhanced indexing) Manager may try to ‘outsmart’ the market (enhanced indexing) Use of derivatives of the securities rather than the securities themselves ( lower commissions ) Use of derivatives of the securities rather than the securities themselves ( lower commissions )

45. Albert Lee Chun Portfolio Management 44 Index funds To reduce tracking error, portfolio may contain more of the different securities contained within the target index. To reduce tracking error, portfolio may contain more of the different securities contained within the target index. As the number of different securities held within the portfolio increases, the commissions are likely to be higher. As the number of different securities held within the portfolio increases, the commissions are likely to be higher. Portfolio managers may try to reduce trading costs but this can increase the chance of tracking error. Portfolio managers may try to reduce trading costs but this can increase the chance of tracking error.

46. Albert Lee Chun Portfolio Management 45 Exchange Traded Funds ETFs allow investors to trade index portfolios like shares of stocks. ETFs allow investors to trade index portfolios like shares of stocks. Examples – iShares, SPDRs and Vipers Examples – iShares, SPDRs and Vipers Indexed with same weights used in the target index Indexed with same weights used in the target index Unlike mutual funds: Unlike mutual funds: Order executed immediately—not at market-on-close prices Order executed immediately—not at market-on-close prices Management fees are below 0.18% Management fees are below 0.18% 4-45

47. Albert Lee Chun Portfolio Management 46 ETF Products 4-46

48. Albert Lee Chun Portfolio Management 47 Advantages of exchange index traded funds Advantages of exchange index traded funds Trade continuously. Can be bought/sold throughout the day rather than just market-on-close prices Trade continuously. Can be bought/sold throughout the day rather than just market-on-close prices Can sell short, and can do so on a down-tick Can sell short, and can do so on a down-tick They usually cannot use derivatives so investors are not subject to counterparty risks They usually cannot use derivatives so investors are not subject to counterparty risks i.e. won’t have tracking error from the misuse of derivatives Lower costs Lower costs Advantages of ETFs

49. Albert Lee Chun Portfolio Management 48 Wealth Accumulation 1$ invested in the following from end of 1925 to end of 1999 would have increased to : 1$ invested in the following from end of 1925 to end of 1999 would have increased to : Asset Class Annual Return Ending Wealth S&P 500 11.3%$2,845.6 Small company stock index 12.6%$6,640.7 Long-term corporate bond index 5.6%$56.38 Long-term government bond index 5.1%$40.22 Intermediate-term government bond 5.2%$43.93 U.S. Treasury Bills 3.8%$15.64 Inflation3.1%$9.39 Even a fairly small annual return can create large long- term results Method of computation : (1 + return) n = Ending Wealth

50. Albert Lee Chun Portfolio Management 49 A Note of Inflation Inflation : the purchasing power of $1 is not the same from year- to-year (it decreases) Inflation : the purchasing power of $1 is not the same from year- to-year (it decreases) $1 of purchases made in 1925 would cost $9.39 by 1999 $1 of purchases made in 1925 would cost $9.39 by 1999 $1 x (1 + 0.030728) 74 = $9.39 $1 x (1 + 0.030728) 74 = $9.39 $2,845.63 after adjusting for inflation is worth in real terms: $2,845.63 after adjusting for inflation is worth in real terms: $2,845.63  $9.39 = $303.05 $2,845.63  $9.39 = $303.05 While the accumulated real wealth is much lower than the nominal wealth, it is still an impressive number While the accumulated real wealth is much lower than the nominal wealth, it is still an impressive number

51. Albert Lee Chun Portfolio Management 50 Things to Read Readings for Today’s lecture. Readings for Today’s lecture. Chapter 4 Chapter 4 Readings for Next Week: Readings for Next Week: Chapter 5, sections 5.4 to 5.6 and 5.8 Chapter 5, sections 5.4 to 5.6 and 5.8 Chapter 23, sections 23.1 and 23.2 Chapter 23, sections 23.1 and 23.2