1. E QUITY P ORTFOLIO M ANAGEMENT Portfolio Management Ali Nejadmalayeri

2. Equity Management Indexing –Only changes in the index causes the portfolio composition to change; e.g., additions/deletions Active –The goal is to beat a “benchmark” portfolio; SP400, SP600 Growth, RUSSELL 2000, etc. Semi-Active –Also known as “Enhanced Indexing” or “Risk- Controlled Active Management” aspire to beat a benchmark but limit tracking error

3. Tracking Error –The difference between a portfolio’s performance and a benchmark’s Tracking Error Volatility –The variation of tracking error over a period Information Ratio –The ratio of tracking error over its volatility –Also, known as alpha to sigma ratio; alpha being the abnormal excess return and sigma being its volatility

4. Examples of IR IndexingEnhanced Indexing Active Expected Return 0%1% − 2%2%+ Tracking Risk < 1%1% − 2%4% + Information Ratio 00.750.50

5. Passive Management Full replication –Reconstruct the index exactly Challenges: transaction costs, administration costs, cash-flow management, cash holdings Stratified sampling –Find dimensions of separation (size, value, etc.) –Select few stocks in each dimension Optimization –Optimize tracking error using multi-factor models Factors: size, beta, industry, interest rate, etc.

6. Indexes Price-weighted –Represent buy/hold return of 1 share; like DJIA, add all prices correct for splits and composition Value-weighted –Represent buy/hold return of all shares of the index; like SP500, add all market-values correct for composition Sometimes the index is float-adjusted; supply of shares matters Equal-weighted –Represent buy/hold return of equal dollar amount invested in each component; like ValueLine, add all return correct for composition and valuation drift

7. Examples of Indexers Conventional Index Funds –Net asset value determined daily ETFs –Buy and sales happens all the time; more tax efficient than index funds; more transaction costs and licensing fees than index funds Separate pooled accounts –Mostly institutional clientele

8. Active Management Chose a style i.e. benchmark Beat the benchmark Get paid!

9. Equity Style William Sharpe’s classification: Large Cap Value –Low P/E, Contrarian, high yield Large Cap Growth –Consistent growth, earning momentum, GARP Mid Cap –Blend or core approach Small Cap –Micro-cap

10. Style Index Indexes need to be: –Mutually exclusive No or limited overlaps Unique opportunities –Exhaustive with respect to investment universe Union of all indexes should encompass all assets –Distinct sources of risk Sources of variations in returns are for most part unique Value vs. Size

11. Style Identification Return-based style analysis –How different style indexes contribute to return –Determine how much selection contributes One minus coefficient of determination (RSQR) is selection contribution Holding-based style analysis –Valuation levels, Forecasted EPS growth, Earning variability, Industry sector weightings

12. Return-based Style Analysis Advantages: –Characterizes entire portfolio –Facilitate comparison across portfolios –Aggregates the effect of investment process –Clear theoretical basis and limited minimal inputs –Quick and cost effective Disadvantages: –Maybe ineffective in characterizing current style –Sensitive to definition of style indexes

13. Holding-based Style Analysis Advantages: –Characterizes each position –Facilitate comparison of individual positions –Captures changes in the current style quickly Disadvantages: –Does reflect many portfolio managers approach security selection –Sensitive to classification attributes for styles –More data insensitive than return-base analysis

14. Semi-Active Management Derivative-based –Provide desired exposure to different segment of the market via derivatives Equitize cash: long futures while holding cash Stock-based –Generate alpha (excess return) thru selecting stocks that outperform the index while controlling risk (limiting exposure to industries, sectors, etc.)

15. What to Look for? Grinold and Kahn’s Fundamental Law of Active Management IR is the information ratio IC is the information coefficient or what you know about an investment decision Breadth is the number of independent investment decision in a year

16. Portfolio of Managers Examples are pension plans and other large institutional funds

17. Portfolio of Managers Core-SatelliteCore-Satellite –A large core portfolio perhaps in index funds and semi-active funds plus satellite funds to add value thru active management The index and enhanced index funds should resemble that of the investor’s benchmark asset class The active fund can pegged against either the overall investor’s benchmark (that would make it more restrictive) or pegged to their own benchmarks

18. Core-Satellite Performance Performance has two dimension: –Manager’s “true” active return = Manager’s return minus Manager’s Normal benchmark –Manager’s “misfit” active return = Manager’s normal benchmark return minus Investor’s benchmark Manager’s active risk has also two parts: –Manager’s total active risk = [(Manager’s “true” active risk) 2 + (Manager’s “misfit” active risk) 2 ] ½

19. Portfolio of Managers Completeness FundCompleteness Fund –Construct a portfolio of active managers that has an overall risk exposure as the investor’s benchmark Such an approach limit the amount selection value Alpha & Beta SeparationAlpha & Beta Separation –Obtain desired beta from an index fund and then the desired alpha from a market neutral fund Not all long-short strategies are market neutral and shorting is a costly activity

20. Good Managers Universe of suitable managers –Use data, consultants and resources to sort it out Past performance –There are no predictive power for past performance, hence “past performance is no guarantee for future results” Fee Structure –Ad valorem vs. performance-based –Fee cap and high water mark

21. Equity Research Buy-side –Performing equity research with the intention of actually managing equity portfolios; e.g., research departments in mutual funds Sell-side –Performing equity research for the purpose of selling the results to generate business; e.g., independent research firms like S&P, Moody’s, ValueLine, etc.