THE THEORY OF ACTIVE PORTFOLIO MANAGEMENT

THE THEORY OF ACTIVE PORTFOLIO MANAGEMENT

LOS 55a: Justify active portfolio management when security markets are
nearly efficient. Vol 6, pg 457-463
Market efficiency is based on the notion that investors are willing to depart from a passive
investment strategy to trade on any perceived mispricing (i.e., instances where the market price
of a security deviates from its intrinsic value).
There are economic and empirical arguments that suggest that it is possible for active portfolio
management strategies to beat passive strategies.
Economic logic: If it were impossible to beat a passive investment strategy, investors would
move their funds from active management strategies to less expensive passive strategies. As less
money is actively managed, prices would no longer reflect intrinsic values, and the consequent
mispricing and profit opportunities would lure back active managers who would then be able
to outperform passive strategies again.
Empirical evidence:
Some portfolio managers have consistently been able to earn abnormal returns.
There is sufficient variability in returns realized by portfolio managers to statistically
preclude us from concluding that no money managers outperform passive investment
strategies.
Some anomalies have been persistent enough to suggest that managers who identified
them and traded on them would have been able to beat a passive investment strategy
over extended periods of time.
These arguments suggest that active portfolio managers can indeed enhance returns even if
markets are almost efficient.
Objectives of Active Portfolios
The mean-variance framework allows us to separate the product decision (how the optimal
risky asset portfolio is determined) and the consumption decision (how the investors funds are
allocated between the optimal risky asset portfolio and the risk-free asset). The separation theorem
tells us that all investors hold the same optimal risky asset portfolio regardless of their level of
risk aversion. They only differ with respect to the weights of the optimal risky asset portfolio
and the risk-free asset in their individual portfolios. These weights depend on the individual
investors risk-return preferences (utility function) that determine the shape of her indifference
curves. More (less) risk-averse investors hold a smaller (greater) proportion of their optimal
investor portfolios in the optimal risky asset portfolio and a greater (smaller) proportion in the
risk-free asset.
We have also learned that the optimal risky asset portfolio is the portfolio that maximizes the
slope of the capital allocation line (straight line drawn from the risk-free rate to a portfolio on
the efficient frontier of risky assets). Stated differently, the optimal risky asset portfolio is one
that maximizes the reward-to-variability ratio (Sharpe ratio).

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The aim of an active portfolio manager is to tilt the weights (of asset classes and/or individual
securities within those asset classes) of the optimal risky asset portfolio such that the realized
Sharpe ratio (slope of the ex-post CAL) is greater (steeper) than that of the passive strategy of
simply holding the market portfolio of risky assets.
For our purposes we
define a purely
passive strategy as
one that uses only
index funds and
applies fixed weights
that do not vary in
response to perceived
market conditions.

Further, the risk-free rate, expected returns on assets, variances of assets, covariances of assets,
and managers Sharpe ratios are all not constant over time. Therefore, we can make arguments
against a purely passive strategy (or in favor of active portfolio management) because active
portfolio theory is needed to:

Develop capital market forecasts (expected returns, variances and covariances) for all
major asset classes.
Assign weights to different asset classes such that the Sharpe ratio of the optimal risky
asset portfolio is maximized.
Assign weights to the optimal risky asset portfolio and the risk-free asset in line with
the individual investors utility function (risk aversion).
Rebalance the portfolio in light of changing market expectations and investor circumstances.

The Value of Perfect Market Timing

Consider the following investment strategies:
Strategy A: Invest $1,000 in 30-day commercial paper and keep rolling over the proceeds into
30-day paper for the 52-year period.
Strategy B: Invest $1,000 in the NYSE Index and reinvest all dividends for the 52-year period.
The average monthly return on this investment was 10.70% and the standard deviation of returns
was 22.14%.
Strategy C: Invest with perfect market timing. What this assumes is that the investor is able to
predict (with 100% accuracy) at the beginning of each month whether the return on the NYSE
Index for that particular month will be greater than that on 30-day paper. If the return on equities
is expected to be greater the investor shifts her funds into the NYSE index for that month;
otherwise, she leaves her funds invested in 30-day paper.
Over the period from January 1, 1927 to December 21, 1978:
The average annual return and standard deviation on Investment B was greater than that
of Investment A. This makes sense because equity investments entail greater risk, so
their expected return ought to be higher as well.
The average annual return and standard deviation on Investment C was greater than that
of Investment B (and A). However note that:

o The standard deviation of returns for Investment C is a misleading measure of

risk. This is because the return on Strategy C is at least as much as that of Strategy
B, if not greater (in months when the 30-day paper return exceeds the NYSE
index return). In other words, Strategy C only provides positive surprises, so no
matter how significant its standard deviation, you would always prefer Strategy
C to Strategy B.

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Even if the net return on Strategy C (after accounting for fair management
fees) were lower than that on Strategy B, Strategy C would still be preferred
(despite its higher standard deviation of returns). This is because (as mentioned
earlier) standard deviation is not an appropriate measure of risk for Strategy C.
The skewness of returns on Strategy B is very low as over a large sample size,
equity returns are approximately normally distributed. However, the skewness
of returns on Strategy C is quite high (the distribution is skewed to the right).
This is because this strategy effectively eliminates the negative tail of the
distribution (returns below the 30-day paper return).

The bottom line is that mean-variance analysis is not adequate for valuing market timing. Another
approach to valuing perfect market timing ability is to view it as a call option where the return
equals the greater of (1) the 30-day rate and (2) the return on the NYSE Index.
The Value of Imperfect Forecasting
The appropriate measure of market forecasting ability is not the overall proportion of perfect
forecasts. If the market rises for three days out of four and the manager always predicts a bullish
market, the 75% success ratio is not the correct measure of forecasting ability. The correct
approach would be to examine the proportion of bull markets correctly forecasted and the
proportion of bear markets correctly forecasted. Under this approach, the true measure of our
managers forecasting ability would be calculated as:
P1 + P2 1 = 1.0 + 0 1= 0
P1 = Proportion of bull markets correctly forecasted
P2 = Proportion of bear markets correctly forecasted
The value of imperfect market timing will be calculated by multiplying the call option value of
a perfect market timer (C) by P1 + P2 1.

LOS 55b: Describe the steps and the approach of the Treynor-Black Model
for security selection. Vol 6, pg 464-472
Overview of the Treynor-Black Model
Recall from Level I, that a mispriced security is one that offers a positive risk-adjusted return
or alpha. From time to time, an analyst may identify securities that appear to be underpriced and
offer positive anticipated alphas to the investor. However, increasing the weight of the particular
security in her portfolio would mean losing some of the benefits of full-diversification. Therefore,
active portfolio managers must strike a balance between (1) aggressively pursuing alpha by
taking positions on mispriced securities and (2) ensuring that their portfolios remain diversified
by not allowing a few stocks to dominate.
The Treynor-Black model is an optimization model for portfolio managers who use security
analysis. The model assumes that markets are nearly efficient. The bullets that follow provide
a basic overview of the model.

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Only a limited number of securities are analyzed in detail to determine whether they are
mispriced. The securities that are not analyzed are assumed to be fairly priced.
The model treats the market portfolio as the passive portfolio. The market portfolio is
the baseline portfolio that is efficiently diversified.
The investment manager knows the expected rate of return on the passive (market)
portfolio, E(rM), and the variance of the market portfolio, M2.
The aim here is to form an active portfolio that consists of a limited number of stocks
that are expected to generate alpha. The (1) amount of perceived mispricing and (2) the
specific risk of the security determine the weight of an individual security in the active
portfolio.
The next step is to create the active portfolio. This process is described in detail in the
next section.
The final step is to create the optimal combination of the active portfolio and the passive
(market) portfolio. This process is described in the section after the next one.

Creating the Active Portfolio

If all securities are fairly priced, the rate of return on security i is given by:
ri = rf i (rM rf) ei
ei represents firm-specific disturbance (also known as the nonsystematic component of return),
which (1) has an expected value of 0, and (2) is independent across securities. This expression
can be converted into the following form, which is known as the single index model:
ri rf = i i (rM rf) ei Ri = i i RM ei
Ri = ri rf : The excess return on security i
RM = rM rf : The excess return on the market
The single index model asserts that the excess return on security i is composed of:
The systematic (non-diversifiable) component of return, i RM. This component of excess
return is related to the return on the market.

o i represents the sensitivity of the excess return on security i to the excess return
on the market.
The nonsystematic (diversifiable) component of return, ei is also known as the residual
return. We have already described this component earlier.
The excess risk-adjusted return or alpha, i.
In order to determine the weight of each security in the active portfolio (using the formulas
provided below) we first need to determine i, i and 2ei (variance of the residual return). We
can run a regression of the excess returns of security i on the excess returns of the market to
come up with estimates of i, i and 2ei.
i is the intercept term of the regression.
i is the slope coefficient.
ei is the standard error of regression (presented in the regression statistics). In terms of
the single index model, it represents the standard deviation of the residual return.
2ei represents unsystematic risk.

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The weight of security k in the active portfolio (Portfolio A) is determined using the following
expression:
wk =

k / ek
n

i / ei

i=1

This expression should make sense to you:

k / 2ek represents anticipated alpha for the security per unit of unsystematic risk entailed
in the security.
The greater the anticipated alpha per unit of unsystematic risk for a security, the greater
the reward-to-risk ratio, and the greater the weight of the security in the active portfolio.
n

The expression ( i / ei ) represents the total anticipated alpha per unit of

i=1

unsystematic risk for the active portfolio as a whole. It equals the sum of the anticipated
alpha-unsystematic risk ratios for all the securities in the active portfolio. It is basically
a scale factor to ensure that the portfolio weights sum to one.
Example 1: Determining Weights of Individual Securities in the Active Portfolio
The macroeconomic forecasting unit of Drex Portfolio Inc. (DPF) issues the following forecasts:

Expected return on the market: E(rM) = 15%

Risk-free rate: rf = 7%
Excess return on the market: RM = E(rM) rf = 8%
Standard error of this forecast: M = 20%

Security analysts at the company come up with the following forecasts for three securities that
they believe are mispriced:
Stock
1
2
3

7%
5%
3%

1.6
1
0.5

e
45%
32%
26%

Determine the following:

1. The weight of each stock in the active portfolio.
2. The anticipated alpha of the active portfolio.
3. The beta of the active portfolio.
4. The unsystematic risk of the active portfolio.
Solution:
We first need to determine the anticipated alpha-unsystematic risk ratios (/2e) for each of
the three stocks. This is done by first computing unsystematic risk (2e) for each of the stocks
and then dividing the anticipated alpha () by unsystematic risk (2e).

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Stock
1
2
3

7%
5%
3%

1.6
1
0.5

e
45%
32%
26%

/2e
2e
0.452 = 0.2025 0.07/0.452 = 0.3457
0.322 = 0.1024 0.05/0.322 = 0.4883
0.262 = 0.0676 0.03/0.262 = 0.4438
0.3012
Total

We then determine the weight of each security in the active portfolio by dividing the anticipated
alpha-unsystematic risk ratio (/2e) for the security by the sum of the anticipated alphaunsystematic risk ratios for all three securities (0.3012).
Stock

1
7% 1.6
2
5%
1
3
3% 0.5

e
2 e
45% 0.2025
32% 0.1024
26% 0.0676
Total

/2e
(/2e) / 0.3012
0.3457
0.3457/0.3012 = 1.1477
0.4883 0.4883/0.3012 = 1.6212
0.4438
0.4438/0.3012 = 1.4735
0.3012
1.0000

1.

Therefore:
wStock 1 = 1.1477
wStock 2 = 1.6212
wStock 3 = 1.4735

2.

The anticipated alpha of a portfolio equals the weighted average of the

anticipated alphas of the individual securities comprising the portfolio.
A = 1.1477 0.07 + (6212) (0.05) + 1.4735 0.03 = 0.2056 = 20.56%

3.

The beta of a portfolio equals the weighted average of the betas of the individual
securities comprising the portfolio.
A = 1.14771.6 + (1.6212)1.0 + 1.4735 0.5 = 0.9519

4.

The unsystematic variance of the active portfolio is calculated using the formula for
the variance of a 3-asset portfolio. However, we only use the unsystematic variances
of the three stocks here. This is because the unsystematic risks of the stocks are not
correlated so all terms in the variance formula that include the covariance equal 0.
2eA = 1.14772 0.452 + (1.6212) 2 0.322 + 1.47352 0.262 = 0.6826

Creating the Optimal Risky Portfolio

Now that we have learned how to determine the weights of individual securities in the active
portfolio, we turn our attention to determining the weights of the active portfolio and the passive
(market) portfolio in the overall optimal risky portfolio.
Lets begin with an overview of what we are trying to do here. Go back to LOS 54b in Reading
54 where we came up with the minimum variance frontier between Stock A and Stock B (2 risky
assets). The minimum variance frontier was a function of:
The expected returns on Stock A and Stock B.
The standard deviation of returns for Stock A and Stock B.
The covariance of returns between Stock A and Stock B.

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Once we have determined the minimum variance frontier, it is easy to determine the efficient
frontier (portion of minimum variance frontier above and to the right of the global minimum
variance portfolio). Once the risk-free asset is added to the mix, we then determine the optimal
risky asset portfolio as the tangency portfolio where a line drawn from the risk-free rate is tangent
to the efficient frontier. This tangency portfolio offers the highest excess return per unit of risk.
We are going to try to accomplish the same thing here, except that instead of Stock A and Stock
B, we will be working with Portfolio M (the passive, market portfolio) and Portfolio A (the active
portfolio). The minimum variance frontier that considers only these two risky portfolios can be
drawn up based on the following parameters:
The expected return on the market: rM
The expected return on the active portfolio: E(rA) = A + A RM + rf where
RM = E(rM) rf
The variance of the market: 2M
The variance of the active portfolio: Systematic risk + Unsystematic risk = 2A 2M + 2eA
The covariance of the active portfolio with the market portfolio: CovA,M = A 2M
Once we have drawn up the minimum variance frontier (and the efficient frontier) the (new)
optimal risky portfolio (Portfolio P) is determined through an optimization process. Portfolio P
consists of only Portfolios M and A. It occurs at the point of tangency between a straight line
drawn from the risk-free rate and the (new) efficient frontier, EF1.

Note that these

formulas for variance
and covariance were
given in an earlier
reading under the
market model.

Figure 1: The Optimization Process with Active and Passive Portfolios

E(r)
The initial efficient frontier (EF0) consists of all
risky assets.

CAL(P)
CML

The point of tangency between EF0 and the CML

defines the market portfolio (Portfolio M).

EF1
E(rA) = A R f + i(RM)

rM

The active portfolio (Portfolio A) is expected to

generate positive alpha. Therefore it plots above
the CML.

A
P

EF0

The new efficient frontier (EF1) combines

Portfolios M and A with varying weights.

M
M

The (new) optimal risky portfolio (Portfolio P)

is the point of tangency between a straight line
drawn from RFR and EF1.The CAL with the
highest Sharpe ratio is now CAL(P).
The point of tangency between an investors
indifference curve and CAL(P), Point X
determines the weight of Portfolio P in the
optimal investor Portfolio.

RFR

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The expression for the optimal weight, w*, of the active portfolio (Portfolio A) in the optimal
risky portfolio (Portfolio P) is given as:
A

w* =

A(1A) + RM

2(eA)
2M

Assuming (for simplicity) that the beta of Portfolio A equals 1, the optimal weight, w0, of Portfolio
A in Portfolio P is calculated as:
A
w0 =

RM
2(eA)

A /2(eA)
RM /2M

2 M
According to this equation (see part between the = signs), if Portfolio A has average systematic
risk (A = 1), then the optimal weight of Portfolio A in Portfolio P equals the relative advantage
of Portfolio A (the ratio of Portfolio As alpha to market excess return) divided by the disadvantage
of Portfolio A (the ratio of nonsystematic risk of Portfolio A to market risk).
If the beta of Portfolio A does not equal 1, we can use the following equation to determine the
optimal weight, w*, of Portfolio A in Portfolio P.
w* =

w0
(1A)w0

Notice that w* increases with greater A (systematic risk). The greater the systematic risk of
Portfolio A, the smaller the benefit of diversifying it with the market, and the more beneficial
it is to take advantage of mispriced securities.
Example 2: Determining Weights of the Active and Passive Portfolios in the Optimal
Portfolio
Using the information provided in Example 1, determine the weights of the active and market
portfolios in the optimal risky portfolio (Portfolio P) for DPF. Also determine the final weights
of Stocks 1, 2 and 3 in the optimal risky portfolio.
Solution:
In Example 1, we obtained the following:

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RM = 8%
M = 20%
A = 20.56%
A = 0.9519
2eA = 0.6826

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Therefore:
w0 =

A /2(eA)
RM /

0.2056/0.6826
= 0.1506
0.08/(0.2)2

And:
w* =

w0

(1A)w0

0.1506
= 0.1495
1 + (10.9519)(0.1506)

Notice the following:

The alpha for Portfolio A is impressively high (20.56%) but its weight in the optimal
risky portfolio (before adjustment for beta) is quite low (15.06%). This can be attributed
to the fact that it has a high nonsystematic standard deviation (= 82.62%).
The beta for Portfolio A is close to 1.0 (0.9519) which is why the adjustment for beta
is small (from 15.06% to 14.95%).
Since the beta of Portfolio A is lower than 1.0, its adjusted weight (w* = 14.95%) is
lower than its original weight (w0 = 15.06%). This makes sense because the active
portfolio has lower-than-average risk that is correlated with the market (systematic
risk).In this case, more of the market portfolio must be added (and the weight of the
active portfolio reduced) to gain full diversification benefits.
The weights of the mispriced securities, the active portfolio and the market portfolio in the
optimal risky portfolio, Portfolio P, are calculated below:
Weight in Portfolio A Calculation of Final Weight Final Weight
Stock 1
Stock 2
Stock 3
Active Portfolio
Market Portfolio

wStock 1

1.1477
1.6212
1.4735

wStock 2
wStock 3
w*
1 w*

0.1495 1.1477
0.1495 (1.6212)
0.1495 1.4735

0.1716
0.2424
0.2203
0.1495
0.8505
1.0000

Evaluation of Performance
Sharpe Ratio
The square of the sharpe ratio of the optimal risky portfolio (Portfolio P) can be separated into
contributions from the square of the market sharpe ratio and the square of the active portfolios
infromation ratio:
2
2
SP = SM

2 A

2(eA)

RM
M

(eA)

Notice from this equation that Portfolio P improves upon the square of the sharpe ratio for the
market portfolio, S2M by the amount:

(eA)

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The ratio of the degree of mispricing to the non-systematic standard deviation (i/ei) measures
the performance of the active component of the optimal risky portfolio. It is referred to as the
information ratio. The information ratio for each individual security measures the contribution
of that security to the performance of the active portfolio. Further, the sum of the squared
information ratios of the individual securities equals the squared information ratio of the active
portfolio.
2

A
(eA)

i
(ei)

i=1

Example 3: Determining the Impact of the Active Portfolio on the Sharpe Ratio
Using the information in Example 1, determine the Sharpe ratio of (1) the market and (2) the
optimal risky portfolio.
Solution:
RM

SM =

2.

The table below computes the information ratios for each of the three mispriced stocks:

1.

20

= 0.40

Stock

/e

1
2
3

7%
-5%
3%

1.6
1
0.5

45%
32%
26%

0.1556
-0.1563
0.1154

2
R
A
2
2
SP = SM + 2 A = M +
M
(eA)
(eA)

SP2 = 0.42 + (0.15562 + (0.1563)2 + 0.11542) Sp = 0.4711

The Sharpe ratio of the optimal risky portfolio is higher than that of the market portfolio by
0.0711. This increase represents the improvement in the risk-return tradeoffs available to the
investor by adding the active portfolio to the market portfolio.
M 2 measures the difference in expected returns between:
1.
2.

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The market portfolio (that has a standard deviation of M).

A portfolio (Portfolio P*) that lies on the new CAL, CAL(P), and has the same standard
deviation as the market portfolio (M).

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Example 4: Calculating and Interpreting M 2

Continuing with the DPF example that we have been working with in this reading, calculate
the M 2.
Solution:
The risk premium on Portfolio P* can be calculated by multiplying the slope of CAL(P) i.e.
the Sharpe ratio of the optimal risky portfolio (which we have already calculated in Example
3) by the standard deviation of the market portfolio (given in Example 1 as 20%).
RP* = E(rP*) rf = SP M = 0.4711 0.20 = 0.0942 or 9.42%
The M 2 is then calculated as the difference between RP* and RM. RM was given as 8% in
Example 1.
M 2 = RP* RM = 9.42 8 = 1.42%
For the given level of risk (M) adding the optimal amount of the active portfolio (Portfolio
A) to the market portfolio (Portfolio M) improves the investors expected return by 1.42%.
To summarize, the TB model exploits any perceived security mispricing through active portfolio
management (Portfolio A), but at the same time maintains a well-diversified portfolio (Portfolio
M). Once the optimal risky asset portfolio (Portfolio P) has been identified, the optimal investor
portfolio occurs at the point of tangency between CAL (P) and the investors indifference curve.

Multifactor Models and Active Portfolio Management

So far, our entire analysis of active portfolio management has been based on the single (singlefactor) index model. The Treynor-Black model can also be applied to a multifactor framework.
With multifactor models:

TB analysis continues to focus on the residuals of the model.

The active portfolio would still be formed by calculating each securitys alpha relative
to its expected return given its beta (sensitivity) to all factors incorporated in the model.
However, the determination of variance and covariance estimates is a lot more complicated
than when applying the TB model to a single-factor framework.

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LOS 55c: Explain how an analyst's accuracy in forecasting alphas can be

measured and how estimates of forecasting can be incorporated into the
Treynor-Black approach. Vol 6, pg 472-473
Imperfect Forecasts of Alpha Values
An analysts past record in predicting alpha accurately should be considered by a portfolio
manager in determining the weight of the active portfolio (Portfolio A) in the overall risky
portfolio (Portfolio P) going forward. Based on the index model and stock betas, we can determine
actual realized alphas on the analysts previous recommendations using average excess realized
returns on the security (R) and the market (RM):
Actual (realized) alpha: RRM
To measure the forecasting accuracy of the analyst, we can regress alpha forecasts (f ) on realized
alpha ().
f aa
For simplicity, we assume that a and a equal 0 and 1 respectively. Given that forecast errors
() are uncorrelated with true alpha () i.e., Cov, equals 0, the variance of the forecast is given
as:

f +
We can evaluate the quality of the analysts forecasts by calculating the coefficient of determination
of the regression described above. The R2 can be calculated as the proportion of the total variation
in the analysts forecasts of alpha that is explained by variation in actual alpha:

This estimate of R2 is used as a shrinking factor to adjust the analysts forecasts of alpha. The
adjusted forecast equals R2 multiplied by forecasted alpha (f ).
If the analysts has a record of predicting alpha with 100% accuracy (i.e., R2 = 100%)
then we should take the forecast as it is to implement the Treynor-Black model.
If the analysts has a record of predicting alpha with 0% accuracy (i.e., R2 = 0%) then
we should ignore the analysts forecasts of alpha.

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Example 5: Adjusting Forecast of Alpha for Imperfect Forecasts

Continuing with the DPF portfolio example, now assume that historically, variation in actual
alphas has explained 20% of the variation in alphas forecasted by DPFs security analysis
team. Determine the weight of the active portfolio in the overall risky portfolio if the analysts
forecast of alpha for Stocks 1, 2 and 3 are adjusted for imperfect forecasts.
Solution:
We will once again use the formulas for w0 and then w* to determine the weight of the active
portfolio in the overall risky portfolio. However, instead of using an alpha of 20.56% as we
did in Example 2, we will now use an alpha of:
Adjusted Alpha = Shrinking factor Alpha forecast
= R 2 A
= 0.20 20.56
= 4.112%
w0 =
w* =

A /2(eA)
RM /2M

0.04112/0.6826
=

0.08/0.04

= 0.0312

0.0301
= 0.03008
1 + (10.9519)(0.0301)

Note that the purpose of this exercise is not to make up for deficiencies in the TB model. We
are just adjusting our expectations for the quality of forecasts.

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