Equity Portfolio Management

Active vs. Passive Management

Return Risk Active Passive
Market Beta Asset allocation Indexing
Market timing Tracking
Error
Industry Industry Sector rotation
risk
Company Residual Stock selection
specific

Higher Exp. Return & SD in

Return & SD line with Index
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 Passive Management
• Tribute to market efficiency
• Long term buy and hold strategy
• To replicate and not beat the performance of an
index that satisfies the investment objectives
• Rebalancing either at fixed intervals or at specified
level of deviation
• Usually lags index return due to cash holding and
transaction cost
• Investment may be made through Index Mutual
Fund or Exchange Traded Fund (traded at the
exchange, short sale and margin trading, capital
gains timing option, quarterly dividend distribution) 3
 Case For Passive Management
• Market efficiency leads to passive investment
• According to Portfolio Theory, all investors
investing in risky assets buy the market portfolio
• Average expected return on Active Management
is less than the benchmark – actual returns also
are mostly less than the index
• Low management cost due to absence of need for
information generation and transacting
• Advent of new indices to cater to all investment
objectives
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 Case Against Passive Management
• Rebalancing needed due to dividend distribution,
fresh cash inflows and outflows, company mergers
or bankruptcies and changes in the index
• Tax burden and trading costs do not apply to all
investors uniformly
• Without active information gathering and trading
on it to give effect to the information and earning
a positive return in the process, efficient market
cannot exist
• Empirical evidence of market inefficiency 5
Passive portfolio construction
• Full replication – high transaction cost –
reinvestment of large amount of dividend income
• Sampling – replicate the essential attributes of the
index as regards beta, industry, size, PE, Div.
Yield etc. – leads to tracking error
• Quadratic Optimization – past price changes of
index and its components are used to determine
portfolio that will minimize tracking error
• Customized – depending upon investor preference
– Completeness Funds – need customized
benchmark 6
Active portfolio management
• Based on belief of market inefficiency
• Active management is what is not passive
• Objective is to beat, on risk-adjusted basis and
net of cost, rather than match the returns of a
benchmark portfolio
• As many ways to manage a portfolio as the
number of managers
• Active management is a zero sum game

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 Asset Allocation
• Investment decision at the level of basic asset
classes rather than individual assets
• An asset class is distinct in its expected return,
volatility or correlation with returns to other asset
classes
– Small stocks: higher returns, volatility and low
correlation compared to large stocks
– International stocks: low correlation
– REITs: low volatility and returns
– Venture Capital: high returns and volatility and low
correlation 8
Asset allocation
• Allocation of funds between asset categories,
proper blending them in a portfolio and
managing the asset mix
• Economy on input estimation
• Top-down vs. Bottom-up approach
• Constrained optimisation is done with respect
to the benchmark portfolio

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 Integrated Asset Allocation
• Based on expected capital market condition and
investors’ risk aversion
• Market conditions and forecasting method are
used to predict asset class returns and volatility
• Investor’s existing wealth and risk tolerance are
used to measure risk to be assumed
• Optimizer determines the optimal portfolio
• Based on realized returns, market condition and
investor’s wealth and risk tolerance is re-
evaluated in order to fine tune the input data
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 Strategic asset allocation
• Asset mix designed to meet the long-range investment goals
• Market conditions and investor preference thought to be
stable
• The process is to
– Identify assets eligible for the portfolio
– Forecast return and risk for 3-5 year time period using the
historical data available
– Maximize return at acceptable risk level
• Limit the variation in allocation level to an acceptable range
• Re-evaluate the allocation after every 3 to 5 years due to
change in long-term risk and returns of asset classes, risk
tolerance and change in relative weights due to realized
relative returns 11
 Dynamic Asset Allocation
• Buy and Hold Strategy – does not undertake active
rebalancing program – relative weights of asset
classes change with market movement
• Constant Mix Strategy – in strong up or down
markets, this is inferior to buy-and-hold as at higher
prices stocks have to be sold and vice versa –
beneficial in volatile market
• Constant Proportion Strategy – akin to portfolio
insurance [Exposure to stocks = m (Total portfolio
value – Floor value); m > 1] – buys stocks as price
rises and vice versa – performs better with steady up
or down market – inferior in a volatile market
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 Strategy Characteristics
Strategy Market Payoff Favored Liquidity
fall/rise Pattern Market Required
Buy-and- No Bull
Linear Little
hold action Market
Voaltile
Constant Buy fall, and tre- Moder-
Concave
Proportion Sell rise ate
-ndless

Constant Sell fall, Strong

Convex High
Mix Buy rise Trend
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 Tactical asset allocation
• Time horizon is one year or less
• Varying the asset mix in order to achieve higher
return and assuming additional risk within the
ranges set by the strategic allocation
• Based on forecast of short-term return movements
and taking advantage of shifts in relative asset
values over the business cycle
• Any number of forecasting method may be used
including assessing relative attractiveness of
different markets, level of equity risk premium,
business cycle and economic indicators
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 Importance of Asset Allocation
• About 90% of a fund’s variation in returns over time
can be explained by allocation decision
• On average 40% of the variation in fund returns
across all funds is explained by asset allocation
• More than 100% (lower the better) [benchmark
return/fund return] of the level of a fund’s returns
are explained by the target allocation policy
• When S&P 500 is used as the benchmark for all
funds, it goes to explain more than 75% of all fund
return variations
• High R2 does not indicate the importance – variation
explaining ability of timing and selection may be
low, but they are important because of the excess
return 15
 Market Timing
• Attempts to predict equity market movements so as
to decide whether to be in or out of the equity
market
• Usually concerned only with one asset class and
the risk is that of mistiming
• For an expected rising equity market, investor
enters into the market and switches funds usually
from cash or money market and vice versa
• Perfect market timing is quite profitable – returns
range to about 15% over stocks 16
 Market Timing contd. ….
• Exploitation of the opportunity is not easy –
with monthly investment revisions and
transaction costs, 65-70% forecast accuracy is
needed to beat a buy-and-hold stock market
benchmark
• Theoretical Market timing models are able to
achieve only around 2 to 3 percent above the
bye-and-hold strategy
• Market timing managers show mixed ability –
on average 0 to 3 percent excess returns for
about 50 to 70 percent of timers 17
 Active Portfolio Management – a
framework
• Portfolio excess return (over risk-free rate) can be
broken up into α and β components
• Active manager is immune to benchmark risk and
return
• Active management seeks out α - the return in
excess of what is warranted by the benchmark and
the β w.r.t. benchmark (in the absence of
benchmark timing)
• Ex ante α is a forecast of residual return and ex
post it is the average residual return
• α p is the weighted average of individual stock
alphas and α b is zero 18
 Information Ratio
• Residual risk (portfolio risk in excess of systematic
risk generated by the benchmark) is the area of
active manager’s concern
• Information Ratio = Res. Return/Res. Risk
• Ex ante IR is a measure of opportunity and ex post it
is a measure of achievement
• IR (annualised) is independent of manager’s level of
aggressiveness, but depends on time horizon
• Realised IR can be positive or negative
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 Value Added
• Objective of active management is to
maximize the value added from residual return
• Information ratio (opportunity set) and risk
aversion (preference) of the investor determine
the choice
• Tangency point between residual frontier and
the preference curves for a given level of risk
aversion gives the optimal portfolio

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 Value Added continued….
• For a given level of IR and risk aversion, value
added increases with more residual risks before
reaching the peak and then declining
• Desired level of residual risk increases with
opportunities and decreases with risk aversion
• Value added increases as the square of information
ratio and decreases with risk aversion. This
separates the manager selection decision from risk
preference.
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 Fundamental Law of Active
Management
• Information Ratio depends upon two
attributes: skill (correlation between forecasts
and actual outcomes) and breadth (number of
independent investment decisions made
annually)
• Optimum risk taking increases with skill
• For low level of skill, breadth has to increase
disproportionately to lift IR

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 Information
• Key to active portfolio management
• Leads to α prediction
• Generating process can be very varied –
fundamental analysis, technical analysis, factor
model, dividend discounting model, comparative
valuation, statistical analysis ……..
• Contains both signal and noise
• Usefulness of information can be evaluated by
constructing investment portfolios using the
information and measuring their performance
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 Information contd….
• Performance can be measured by statistical
significance of α and IC & IR
• Information, once found to be useful, may be used
to do the forecasting
• Raw forecasts may be refined
• Caution about information processing:
- intuition must guide the search for information
- restraint on backtesting process
- performance should be sensible
- out-of-sample testing 24
 Portfolio Construction
• Portfolios are constructed subject to some
constraints agreed upon with the client
• Constraints like no short selling, cash holding limit,
asset coverage limit, individual stock holding limit
etc. make the portfolio less efficient
• Presence of transaction costs force greater precision
on estimates of alpha
• Revision whenever new information induced
expected active return is higher than the transaction
cost 25
 Portfolio Construction contd…
• A few generic types among many:
- Screens: rank stocks by α - choose from
the top – equal/value weight – very
popular
- Stratification: categorizing stocks into
industry/size/other attributes and then
apply screens

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Portfolio Construction contd…
- Linear Programming: sophisticated
stratification – builds a portfolio that is
close to benchmark in all the risk
dimensions
- Quadratic Programming: can
accommodate all constraints and
limitations – requires a lot more inputs
– volatility and correlation estimates
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