CHAPTER NINE: INVESTMENT PORTFOLIO MANAGEMENT

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An investor is a party that makes an investment into one or more categories of assets --- equity, debt securities, real estate, currency, commodity, derivatives such as put and call options, etc. --- with the objective of making a profit.  Inviduals  Organizations: Financial entities including Brokerages, Banks, Funds…

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CHAPTER NINE: INVESTMENT PORTFOLIO MANAGEMENT 06/08/2011 1
INVESTOR An investor is a party that makes an investment into one or more categories of assets --- equity, debt securities, real estate, currency, commodity, derivatives such as put and call options, etc. --- with the objective of making a profit.  Inviduals  Organizations: Financial entities including Brokerages, Banks, Funds… 06/08/2011 2
INVESTMENT PROCESS - Analyze the market - Evaluate expected returns and risks - Design the optimized portfolio 06/08/2011 3
Risk aversion U =E(r) -0,5A. Б2 Б2 = 0 -> U = E(r) (Risk free portfolio) Risk of portfolio and Diversification Return and Risk of portfolio: [8-9] n ER p   ( wi  ERi ) i 1 06/08/2011 4
PORTFOLIO MANAGEMENT Active Management – The process of managing investment portfolios by attempting to time the market and/or select “undervalued” stocks to buy and “overvalued” stocks to sell based upon company research, investigation and analysis Passive Management – The process of managing investment portfolios by trying to match the performance of an index or asset class of securities as closely as possible by holding all or a representative sample of the securities in the index or asset class – Does not use market timing or stock selection strategies 06/08/2011 5
Investment Decision Matrix: Where Do You Fit In? Market Timers and Stock Selectors* 1. 2. Stock Selectors Where the common crowd hangs out Preference of stockbrokers and many financial Preference of active management, advisors* high-cost “gurus*” High cost, high turnover, high taxes Heavy on investment hype The Informed Investor 3. 4. Market Timers Based on academic research and data* Tactical analysis* (with no proven results) As much as 40% of institutional invested dollars Tax inefficient The prudent investors Short-term outlook Receive market returns Where YOU should be (and where we are) 06/08/2011 6
• Asset Class Investing – Stocks and Bonds – US and International – Large Cap and Small Cap – Growth and Value – Short-Term and Long-Term Maturity 06/08/2011 7
• Why Use Passive Asset Class Investing? – Lower portfolio turnover – Lower operating expenses – Lower transaction costs – Greater tax-efficiency – Long-term perspective – Broad diversification/risk reduction – Control of asset allocation – Passive asset class funds capture separate dimensions of worldwide returns 06/08/2011 8
Passive versus Active Portfolio Management • Review of Market Efficiency • Anomalies • Market Timing • A theoretical model of active portfolio management (Treynor-Black) • Quantitative Investment Management 06/08/2011 9
Passive Management • Buy and Hold • Indexation • Active management must beat these strategies on a net risk adjusted return basis! • What if markets are efficient? 06/08/2011 10
Treynor-Black Model • Suppose you can identify securities that you expect to outperform (or underperform) on a risk-adjusted basis • How do you exploit this model? 06/08/2011 11
Treynor-Black Model: Assumptions • Analysts can only produce quality analysis on a small number of securities • There is a passive market portfolio (M) • Forecasts of return (E(rM) and risk (s) exist • Determine abnormal return (a) for analyzed securities • Find optimal weights of analyzed securities to create active component (A) • Combine A, M and risk-free asset to achieve efficiency 06/08/2011 12
Treynor-Black: Construction (Step 1) • Assume: ri = rf + bi(rM - rf) + ei • For analyzed security k: rk = rf + bk(rM - rf) + ek + ak => estimate ak, bk, s2(ek) • To construct A: wk = (ak/s2(ek))/(S[ai/s2(ei)]) => determine aA, bA, s2(eA) 06/08/2011 13
Treynor-Black: Construction (Step 2) • w0 = (aA/s2(eA))/[(E(rM)-rf)/s2M] • w* = w0/(1+(1-bA)w0) • w0 is the proportion of A in the new, enhanced market portfolio (M‘) 06/08/2011 14