Active or Passive?

Issues and Strategies

Market Efficiency Anomalies Market Timing A theoretical model of active portfolio management (Treynor-Black) Quantitative Investment Management

Equity Portfolio Management: Active or Passive?

Equity Portfolio Management: Active or Passive?

Passive:
LT buy and hold Indexation
Replication of an index (broad or specialized Sampling and Tracking Error =0

Rebalancing

Indexation
Identify a Benchmark Index
replicate benchmark index performance a true passive strategy will not attempt to outperform index Tracking Error = measure of accuracy

Tracking Error: Measure 1

TE1 =
( Rpt Rbt ) 2
t 1 n

n
where Rpt and Rbt are portfolio and benchmark returns respectively

Tracking Error: Measure 1

TE2 =

This represents the standard deviation of the error terms of a regression equation explaining returns from the portfolio with returns from the benchmark. We will revisit e later

Rebalancing an Equity Portfolio

Why?
to manage tracking error (if indexing or not) to maintain a desired set of weights or risk level client needs change Market risk level changes bankruptcies, mergers, IPOs

Why not?
its costly!

Rebalancing: Example 1
Jan. 1 Price per Number $ Value Share of Shares % of Total Value Beta

X Y Z Total

20 15 35

167 222 95

$3340 0.333 1.2 $3330 0.333 1.6 $3325 0.333 0.8 $9995 1.20

Rebalancing: Example 1
June 1 Price per Number $ Value Share of Shares % of Total Value Beta

down X 20% up Y 33% unch. Z

16 20 35

167 222 95

$2672 0.256 1.3 $4440 0.425 1.7 $3325 0.319 0.8 10445 1.31

Total

Rebalancing: Example 1
Portfolio is no longer equally weighted To rebalance:
Sell Y, buy X and Z Positions must be reset to $10445/3 = $3482 Sell 4440 - 3482 = $958 of Y (48 shares) Buy 3482 - 2672 = $810 of X (51 shares) Buy 3482 - 3325 = $157 of Z (4 shares)

Rebalancing: Example 1
June 1 Rebalanced Price per Number $ Value Share of Shares % of Total Value Beta

X Y Z Total

16 20 35

167 222 95

$3488 0.334 1.3 $3480 0.334 1.7 $3465 0.332 0.8 10433 1.27

Rebalancing: Example 1
LT effects of this strategy?
Alternatives? Example 2: Rebalancing to reestablish a specific level of systematic risk (Target Beta = 1.2)

Rebalancing: Example 2
Reestablishing a beta of 1.2:
No unique solution for more than 2 securities Need to sell high stocks and buy low stocks For example, sell Y, buy Z, hold X constant p = (.256)(1.3)+(WY)(1.7)+(1-.256-WY)(.8) Find Y such that p = 1.2
WY = .302 => WZ = 1-.256-.302 = .442 $3488 in X, $3151 in Y, $4611 in Z

Active Equity Strategies

Beat the market on a risk adjusted basis! Need a benchmark More expensive: turnover, research Must outperform on a fee-adjusted basis

Active Management is Forecasting!

The Fundamental Law of Active Management: (Grinold and Kahn)

IR = IC x (BR)0.5
IR = information ratio
reward-to-risk or /e

IC = information coefficient
correlation between forecast and actual (CORR(E(), )

BR = breadth
# of stocks evaluated per period

IR = IC x
Example:

0.5 (BR)

a stockpicker has an IC of .035 and makes 200 bets per quarter (800 per year) IR = (.035)(800)0.5 = .99 (is this good??) BARRA research indicates that an IR of +1.0 is in the 90th percentile (-1.0 is in 10th, 0 is in 50th) What if Im an industry picker?

Using the Fundamental law to forecast alpha

Suppose that there is some indicator or signal that we use to forecast performance. Call it S. S can be a single factor (price-to-book) or the result of a multifactor analysis. Standardize S. (e.g., S=+1.0 is 1 s.d. above the mean of 0) Adapting the fundamental law: = IC x e x S = Skill x Volatility x Signal

Using the Fundamental law to forecast alpha

Example:
Your analysis produces a binary buy or sell recommendation. Your IC = .05 (really good!)
Stock A B C D E Sigma .15 .20 .15 .30 .25 Buy or Sell Buy Buy Sell Sell Sell Score +1.0 +1.0 -1.0 -1.0 -1.0 Alpha .0075 .01 -.0075 -.015 -.0125

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?

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 () for analyzed securities Find optimal weights of analyzed securities to create active component (A) Combine A, M and risk-free asset to achieve efficiency

Treynor-Black: Construction (Step 1)

Assume: ri = rf + i(rM - rf) + ei For analyzed security k: rk = rf + k(rM - rf) + ek + k => estimate k, k, s2(ek) To construct A: wk = (k/s2(ek))/(S[i/s2(ei)]) => determine A, A, s2(eA)

Treynor-Black: Construction (Step 2)

w0 = (A/s2(eA))/[(E(rM)-rf)/s2M]
w* = w0/(1+(1-A)w0) w0* is the proportion of A in the new, enhanced market portfolio (M)

Active Equity Strategies

Styles:
Sector Rotation: move in/out of sectors as economy improves/declines Earnings Momentum: overweight stocks displaying above average earnings growth Enhanced Index Fund - majority of funds track index, some funds are actively managed Quantitative Investment Management