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Lecture Note 6

Active and Passive Portfolio Management

I. Introduction

II. Index Management

III. Tilting or Market Timing

IV. Stock Selection

V. Conclusions
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I. Index Management
A. Motivation: You want to follow a passive portfolio strategy,
but, you do not want to hold the market portfolio because of
transaction costs. So, what should you do?
• Construct a portfolio that mimics as closely as possible the
market portfolio.

B. We find this portfolio by minimizing tracking error.


1. Tracking error is defined as:
Tracking Error = T E = σ(r̃p − r̃m)
Where r̃p is the return of your portfolio and rm is the return
on the market portfolio,(i.e., the portfolio that you want to
mimic — typically the S&P 500)

2. Mathematically the problem can be written as:


  
N
X
min T E = σ 
w1 ,...,wn
wi · r̃i − r̃m
i=1

• The solution to this problem is a set of portfolio weights,


w1, . . . , wn. These portfolio weights give you your track-
ing portfolio.
Active and Passive Portfolio Management 3

3. from the regression:


r̃p = αp + βpr̃m + ũp
we get
r̃p − r̃m = αp + (βp − 1)r̃m + ũp
giving r
T E = σu2 + (βp − 1)2 · σm
2.

• Where the coefficient β here is the same as the CAPM


beta

• Why does this work?

4. This second expression gives some intuition for what the


tracking error is doing. If you have a portfolio with a beta
of one, then the only difference in risk between the market
and your proxy is the proxy’s residual risk.
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C. Security Selection in Indexing


1. The issues involved in equity indexing are:

• Which securities should you include in your tracking port-


folio?

• How many securities should you include?

2. The best securities to include are a set of securities that :

• are individually well diversified (i.e., low residual risk).

• Have low bid-ask spreads

• Have high liquidity.

3. The decision of how many securities is predominately deter-


mined by transaction costs.

• The more securities you include the lower the tracking


error, but the larger the transaction costs.

4. Most index-fund managers claim that they do some perfor-


mance enhancement simply because, if they did not, they
would underperform the index (as a result of transaction
costs).
Active and Passive Portfolio Management 5

D. Performance Enhancement
1. We have presented considerable evidence that traditional in-
dicies are inefficient.

• Chen, Roll and Ross evidence on factors.

• Fama and French (and other) evidence on size, book-to-


market, and momentum.

2. This suggests that a manager can reliably beat the market


index (with some high probability)

3. To maximize the probability of beating the index, the man-


ager wants to solve the problem of maximizing his portfolio
return relative to the benchmark.
  
N
X
max E(rp − rm ) = E 
x1 ,...,xn
xi · ri − rm 
i=1

subject to the constraint that the variance not be above some


level.
  
N
X
σ(rp − rm ) = σ  xi · ri  − rm ≤ σ
i=1

4. Note that this problem is the same as the problem of mini-


mizing the variance of (rp −rm ), subject to achieving a given
expected return.
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5. This means that, since the portfolio weights sum to one, we


can write the manager’s problem as:
 
N
X
min σ 
w1 ,...,wn
wi · (r̃i − r̃m )
i=1
subject to the constraint that:
 
N
X
E(rp − rm) = E  wi · (r̃i − r̃m) ≥ R
i=1

6. Note that this is mathematically identical to the portfolio


problem we solved in Lecture 2

• The solution to this problem is again a set of portfolio


weights, w1, . . . , wn . These portfolio weights give you
your tracking portfolio.

• The only difference is that now, instead of solving the


minimum-variance problem for the asset returns them-
selves (ri ), we are solving the problem for asset returns
relative to a benchmark (ri − rm).

7. If we want to be still more general, we can include transaction


costs (and fees). This makes the constraint above:
 
N
X
E(rp − rm) = E  wi · (r̃i − r̃m ) − C(w1, . . . , wn) ≥ R
i=1
Active and Passive Portfolio Management 7

II. Market Timing and Factor Tilting


A. The definition of market timing is: You believe you can forecast
the market (and probably that other people are not forecasting
correctly).
• You may be using variables like the dividend yield, business
cycle indicators or macroeconomic analysis to forecast re-
turns.

• You shift funds between a market index portfolio and a safe


asset based on your forecasts:
r̃p = wt · r̃m + (1 − wt ) · rf

— What is the beta of rp at time t?

B. The Potential Benefits of Market Timing:


• If you had put $1 into T-Bills in January 1926, and rolled over
the proceeds every month, you would have had
on January 1, 1996.

• If you had put $1 into the value-weighted (VW) index, you


would have had on January 1, 1996.

• If you switched back and forth on a monthly basis between


the bonds and the VW index with perfect foresight, you
would have had on January 1, 1996.
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0.2

−0.2
20 30 40 50 60 70 80 90 100
0.2

−0.2
20 30 40 50 60 70 80 90 100
0.2

−0.2
20 30 40 50 60 70 80 90 100
Active and Passive Portfolio Management 9

C. Market Timing and the CAPM:


1. If you take the CAPM as your benchmark then market timing
presumes you can forecast the return on the market portfolio,
r̃m, better than can the market itself.

2. The return on the market in any month is equal to


r̃m,t = E[rm,t ] + ẽm,t
We typically let E[rm,t] denote what the market expects.

• This means that, if you have superior timing ability, you


can forecast the “unexpected” return ẽm,t

3. You can vary the β of your portfolio by shifting in and out


of the risk-free asset over time. If the beta of your portfolio
is βp,t−1, and the return on your portfolio will be:
r̃p,t − rf,t = βp,t−1([E(r̃m,t) + ẽm,t ] − rf,t) + ẽp,t

4. If, on average βp,t−1 is high when ẽm,t turns out to be high,


you will earn superior returns. Specifically:
E(r̃p,t − rf,t) = βp,t−1(E(r̃m ) − rf ) + cov(ẽm,t , βp,t−1)
where βp,t−1 is the average β of the portfolio.

5. Market Timing ability is as the ability to take high market


sensitivity (β) positions before the market goes up and low
beta positions before the market goes down.
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D. Factor Tilting is more general than market timing because


it presumes a multi-factor structure.
1. Tilting is forming a portfolio to take advantage of a forecast
of a factor, f˜.

2. Like in the market=timing example, we assume that in the


return generating process equation for our portfolio:
r̃p,t = E[r̃p,t] + bp,1f˜1,t + · · · + bp,nf˜n,t + ẽp,t

• E[r̃i,t ] represents the market’s expectation

• E[f˜1,t] = 0 for the market

• But, given our superior information E[f˜1,t] 6= 0 for us!.

— That is, we can forecast f better than the market.

3. Assuming we have this ability, we can earn superior profits


by varying the factor betas/loadings of our portfolio.

• We want to increase the loading when we think that the


factor is likely to have a positive realization

• We want to decrease the loading when we think that the


factor is likely to be negative.
Active and Passive Portfolio Management 11
E. A Factor Tilting Example:
Your analyst gives you the following information on three se-
curities that are correctly priced according to a 2 factor APT
model
r̃A = 0.12 + 1 · f˜1 + 1 · f˜2 + ẽA
r̃B = 0.12 + 1 · f˜1 + 2 · f˜2 + ẽB
r̃C = 0.12 + 3 · f˜1 + 2 · f˜2 + ẽC
• Here, the E[r]’s of 12% are what the market expects - not
what we expect!

• What are the factor risk premia (the λs)?

• Factor 1 in this APT model is a foreign income factor and


factor 2 is a U.S. earnings price ratio factor. The way the
model is constructed these factors are uncorrelated. You
believe very strongly that Japan will finally come out of its
recession in the next few months and therefore exports of
U.S. produced goods will rise more than the market expects.
Moreover, you believe the earnings price ratio factor will not
change at all in this time period, consistent with what ana-
lysts expect.

• Using the above three securities, construct ANY portfolio


that takes advantage of all of these facts. What are (i) the
composition of the portfolio, (ii) the b’s of the portfolio, and
(iii) the expected return on the portfolio.

• We want to construct a portfolio with a lot of factor 1 ex-


posure and no factor 2 exposure. Therefore, lets assume we
want a loading of 10 on factor 1 and 0 on factor 2.
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Therefore, solve the three equations:


1 · wA + 1 · wB + 3 · wC = 10
1 · wA + 2 · wB + 2 · wC = 0
1 · wA + 1 · wB + 1 · wC = 1
• (The last equation is the usual restricution that the sum over
the weights is one.) We can also write these equations as:
1 · wA + 1 · wB + 3 · (1 − wA − wB ) = 10
1 · wA + 2 · wB + 2 · (1 − wA − wB ) = 0
• The solution to this system of equations are the weights
wA = 2, wB = −5.5, and wC = 4.5. Then this portfolio
will have a loading of 10 on factor 1 and a loading of 0 on
factor 2.

— Alternatively, we could have put 1000% of our wealth


into the first factor mimicking portfolio, and -900% of
our wealth into the risk-free portfolio.

— Why would this work?

— Would the weights on A, B and C be different?

• Assuming that you believe that the foreign income factor will
rise by 2%, the expected return on this portfolio is:
2 · 0.12 − 5.5 · 0.12 + 4.5 · 0.12 + 10 · 0.02 = 0.32

— How else could you have calculated the expected return


of this portfolio, conditional on this factor change?

• Is this the highest Sharpe-Ratio portfolio possible?


Active and Passive Portfolio Management 13

III. Stock Selection


A. Stock picking is a portfolio management technique that pre-
sumes superior knowledge about expected returns.
• For the most part we observe portfolio managers spending a
lot of money on information and then selecting stocks they
think are underpriced, i.e. stocks with positive alphas.

• It appears that these portfolio managers attempt to con-


struct a well diversified portfolio of positive alpha stocks.

B. We can rationalize this type of portfolio strategy in our frame-


work based on the fact that (i) the pricing equation is only ap-
proximate, i.e. “noise” and (ii) individual stocks, even though
they are misspriced still have firm specific risk. Therefore, if a
portfolio manager is risk averse they will want to hold a portfolio
of well diversified misspriced securities.
• Thus, we are effectively assuming that the portfolio manager
wants to maximize the portfolio’s Sharpe Ratio.

C. This is the Treynor-Black model of security selection (Section


27.4 in BKM).
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D. The logic of the Treynor-Black model is:


1. Select a small set of securities you think are mispriced (i.e.,
they have positive or negative alphas). This is your active
portfolio A.

2. Combine this active portfolio with the passive benchmark


portfolio (e.g., the market) to diversify.

3. Calculate a new capital allocation line (CAL).

4. Use your utility function to determine you optimal portfolio.

5. The Treynor-Black method is really just an ad-hoc formula-


tion of the Black-Litterman method we looked at in Lecture
3.
Active and Passive Portfolio Management 15

E. Mathematically the Treynor-Black problem is:


E(rp) − rf
max
w
SRp =
σp
where
rp = w · rA + (1 − w) · rm
Assuming a postive αA for the “active” part of the portfolio, it
will plot above the SML:
rAe = αA + βA(rm
e
) + eA
• A negative α security would plot below the SML
1. An α either > 0 or < 0 means that A combination of the
benchmark and A has a higher Sharpe Ratio than the bench-
mark.
E(rE) Greater than CAPM prediction
0.13

0.12 Assets
Minimum Var Frontier
CML
0.11 MVE Portfolio C
E−MVE Combinations
Expected Return

0.1 B

0.09
Market Portfolio

A
0.08
E

0.07

0.06 D

0.1 0.12 0.14 0.16 0.18 0.2 0.22 0.24 0.26 0.28
Return Standard Deviation
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2. The optimal amount to put into the active portfolio is given


by:
w0
w∗ = (1)
1 + (1 − βA)w0
where
αA/σ 2(eA)
w0 = 2
(2)
E[rm − rf ]/σm
• A weight of (1 − w∗) should be put into the benchmark
(market) portfolio.

• What is this for αA = 0?, for σ(eA) = 0?

3. For this investment, the Sharpe Ratio of the resulting port-


folio is maximized, and
r
SRP2 = 2
SRm + 2
ARA 2 + AR2
or SRP = SRm A

where
αA
ARA = .
σ2(eA )
• ARA is called the Appraisal Ratio of portfolio A

4. If you are combining n active sub-portfolios with uncorre-


lated residuals, the net improvement in the Sharpe Ratio
will be the sum of the squared AR’s:
N
X
SRP2 = SRm
2
+ ARi2
i=1

5. Again, these equations are just an shortcut for the full analy-
sis we did earlier.

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