e quity p ortfolio m anagement portfolio management ali nejadmalayeri
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EEQUITY QUITY PPORTFOLIOORTFOLIO
MMANAGEMENTANAGEMENT
Portfolio Management
Ali Nejadmalayeri
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
Tracking Error
• 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
Examples of IR
Indexing Enhanced
Indexing
Active
Expected
Return
0% 1% − 2% 2%+
Tracking Risk
< 1% 1% − 2% 4% +
Information
Ratio
0 0.75 0.50
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.
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
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
Active Management
• Chose a style i.e. benchmark
• Beat the benchmark
• Get paid!
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
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
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
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
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
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.)
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
BreadthICIR
Portfolio of Managers
• Examples are pension plans and other large institutional funds
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Return Active Portfolio
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22Risk Active Portfolio
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
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
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
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
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.
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