Portfolio Management

Portfolio Concepts:
Mean Variance Analysis -> expected returns, variances, covariances, of individual investments
to analyze risk-return trade off combinations
-

All investors are risk averse

Expected returns, variances, covariances, known for all assets
No taxes or transaction costs
Investors create optimal portfolios relying on expected return, variances, covariances

Expected return -> w1 x E(r1) + w2 x E(r2)

Variance 2p = w2121 + w2222 + 2w1w2Cov1,2

Correlation 1,2, = Cov1,2 / 12

Covariance = 1,2 x 12

3 assets
Minimum Variance Frontier -> Least Risk for given return
Efficient Frontier -> lie along upper portion of minimum variance frontier E(rp) Vs 2p

Equally weighted portfolio ->

i2 = avg variance all assets

;
;

Or

Cov-bar = avg cov of all pairings

*-> as # of assets gets large, 1st part gets close to Zero; Cov gets close to Avg Cov (n-1/n) close
to 1; equally weighted portfolio approaches avg covariance as n gets large
Max Risk Reduction -> # of stocks very large;
lower the correlation, greater potential benefits; But, great the # reqd to reap those benefits
Including rfr in portfolio changes efficient frontier from curve to linear: E(rc) = wf(rf) + wp(rp)
Variance = 2p same but w2f 2f = 0

2wfwp Cov Fp = 0 (third term in 2 asset equation)

Capital Allocation Line (CAL): Lies tangent to efficient frontier; intercept to tangency = lending;
beyond tangency = borrowing;
line can become kinked; Tangency portfolio optimal

Sharpe Ratio = E(Rt) Rf / T

CAL: Intercept = rfr;

Slope = Reward to risk ratio; Y = a + bX

Y = dependent variable [E(Rc)] expected return;

X = independent variable (c std. deviation of investment combination)
a -> intercept (rfr);

b = slope

E(Rc) = RFR + (E(Rt) Rf/T) x c

c = investor risk

Choosing weight between rfr and RT? c = wtt; Each investor CAL depends on expectations
CML -> Captial Market Line (returns and total risk); [all investors agree on expected return, std
dev, and correlations of all assets.]
There are many different CALs but only one CML; Intercept RFR; slope = sharpe ratio;
tangency portfolio = market portfolio (mkt value weights)
-

Assumes all assets in market place included@ proportional size.

Identical expectations;
- Returns, deviations, correlations

Security Market Line (graph of CAPM) -> shows relationship between Assets return and
systematic risk (measured by eta).
E(Ri) = Rf + [E (Rm Rf)];

= Cov i,m / 2m

= correlation (i,m) x std dev i/std dev mkt

*****

Sharpe:

B>1 = cyclical;

(Rm Rf) / i

B<1 = defensive

* watch out for variance 2 vs standard deviation ; watch for risk premium vs mkt risk wording
Risk & Return for individual asset can lie on SML but Not CML; will lie below CML
SML includes unsystematic Risk;

CML uses total risk;

Inputs to Mean Variance Model:

Historical Estimates: Too many #; large error
Market Model: 2 sources of risk -> systematic and unsystematic
Market Model Ri = i + i Rm + Ei
i = intercept (value of Ri when Rm equals zero);

Rm = return on mkt portfolio

i = slope (estimate of systematic risk for Asset i)

Ei = regression error (expected value equal to zero); (error uncorrelated with market return)
Firm specific surprises are uncorrelated across assets;
Expected return for asset i: E(Ri) = i + i E(Rm)
Systematic unsystematic
Variance Asset i: 2i = i22m + 2e

Cov = ij2m

Expected Return on Asset i depends on expected Return on Mkt Porfolio E(Rm), sensitivity on
returns to Asset i to movements in the mkt & avg return to i when mkt return = 0;
Covariance between any 2 stocks is product of betas and variance of Mkt portfolio
Adjusted eta: All this theory above uses historical data to compute estimates; We must adjust
Beta to forecast the future: past future -> beta instability
i,t = a + 1 i,t-1 + vi,t ;

vi,t = random error, expected value is Zero

*Beta instability -> historically may be wrong; tends to gravitate towards 1 over time;
Historical Beta > 1 -> Adjusted beta will be less than historical Beta and more than 1
Historical Beta < 1 -> Adjusted beta will be more than historical Beta and less than 1

Multifactor Model
1 Macroeconomic Factor Models Unexpected surprises (GDP growth; Credit Quality, etc);
sensitivities are regression slope estimates
Intercept = stock expected return; surprise unexpected; error term is unsystematic risk
2 Fundamental Factor Models Firm specific factors (P/E, Mkt Cap, Leverage, Growth)
Standardized sensitivities; not estimates! Intercept term not expected return
3 Statistical Factor Models Arbitrage Pricing Theory (APT)

APT: assumes no mkt imperfections; Arbitrage not possible; unsystematic risk can be
completely diversified away;
Cross sectional pricing model (explains variation across assets during single time period);
intercept is RFR;
Active Return: Rp Rb (Difference between managed portfolio & Benchmark)
Active Risk: tracking error =
(std dev of active return)
Active Factor Risk: risk from deviations between Portfolio factor sensitivities & benchmark
sensitivities;
[over/underweight an industry compared to benchmark]
Active Specific Risk: Risk from deviations between Portfolio individual asset weightings &
benchmarks.
[over/underweight specific firm within an industry ]
Information Ratio: Demonstrate Fund Managers consistency in generating return;
Active Return
Active Risk

is better; active return per unit of active risk

Just like Sharpe Ratio

Active Risk squared: Active Factor Risk + Active Specific Risk

Factor Portfolio: hedged against all but one risk;

higher active factor risk

One factor beta = 1 all other factor beta =0;

Tracking Portfolio: set of factor exposures; same as benchmark; tries to select superior
securities and beat the benchmark without taking inc risk;
factor betas = benchmark
Residual Risk and Return: Information Ratio
Alpha (residual return) : Return of Portfolio in excess of benchmark (adjusted for risk difference
between Rp & Rb);
expost -> realized;
ex-ante -> forecast
Rpt = p + p Rbt + Et ;

Rpt = excess (Rp Rfr); (regression slope)

p = ex-post (actual or realized) alpha (intercept); Bp = portfolio Beta; Rbt = excess return on
benchmark ( Rbt RfR) ; Et = random component
alpha -> weighted avg of alphas in portfolio;
Information Ratio:

ex-ante -> fwd looking; expost -> bkwds

annualized residual return / annualized residual risk

Ex-post information ratio:

t/n;

t = t-stat of ;

IR =

/w

n = # years of data

Budget Constraint: = IR x w [intercept term]

Can increase return only by inc risk
Information Ratio inc w time horizon: numerator inc w time, denominator inc w time
IR = slope of residual frontier;

Level of aggressiveness does NOT affect IR****

Value Added:

Active Return Vs

Active Risk

-> trade off

( x w2)
= risk aversion parameter
(higher -> greater risk aversion & more conservative)
VA = higher -> higher or with lower risk aversion or lower residual risk w
and w -> not decimal! Use % =

= IR x w -> budget constraint; VA = ( x w2) - sub into ->

VA = IR x w - ( x w2)

*VA initially increases with risk, but eventually penalty for risk outweighs gains from taking
additional risk.
Optimal level of risk:
VA = IR x w ( x w2)
w* = IR
2

w* = IR
2
New subbed in formula
VA = IR2
4

= IR
2w*
Or = w* x IR
2

Manager level of aggressiveness does not affect their IR;

aversion -> the higher the optimal level of residual risk.

The higher the IR & lower the risk

Active Management
Information Coefficient (IC): Measure of Managers forecasting accuracy;
Breadth (BR): # of independent forecasts of exceptional return per year that manager makes
BR = 2 forecasts per month x 12 months per year = 24 forecasts per year
Information Ratio (IR):

= IC x BR ;

*pay attention -> differences of IR and IC

Additivity Principal: IRF2 (firm) = IR2FI + IR2EQ ; F: Firm; FI: Fixed Income; EQ: Equity
Do each IR independently, then 2, then add them
and

IRF2 (firm) = IC2FI x BRFI + IC2EQ x BREQ

*dont forget IC not IR; dont forget to 2 and in right order
Optimal Level of residual risk: w*= IR / 2;
VA* = IR2 / 4

w*=IC X BR / 2

= IC2 x BR / 4

Market Timing -> bet on direction of the market

IC = 2 (Nc/N) -1;

Nc = correct bets on direction of mkt; N = # bets on direction of mkt

*if correct half the time -> IC and IR will be Zero!

Lets say original investment strategy results in IC; If new information is correlated to old one, IC
will change by proportion of correlations
ICcombined = IC x (2/1+r)

r = correlation between two information sources

Assumptions of Fundamental Law of Active Mgmt

1 - Manager has accurate knowledge of his/her skills and exploits this optimally
2 Sources of information are independent; 3 information coefficient is same of each bet;

Portfolio Mgmt Process & IPS

Evaluating Investor & Mkt characteristics: objectives/constraints; environment,
Develp IPS: Formalizes objectives & constraints, guides decisions, strategy;

Planning

Asset Allocation Strategy;

Measure & Evaluate Performance: Rebalancing may be needed
Monitor dynamic investor objectives & capital market conditions: ongoing process
View Risk Vs Return on whole portfolio
3 steps: Planning ; Execution ; Feedback
Objectives:

risk tolerance / aversion; reqd vs desired return;

income vs total return

Constraints:

liquidity, time, legal/regulatory, tax, unique (ethical practices -> tobacco, guns)