Active or Passive? Issues and Strategies

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 later e
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
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
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)
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
LT effects of this strategy? Alternatives? Example 2: Rebalancing to reestablish a specific level of systematic risk (Target Beta = 1.2)
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 (BR)0.5
Example:
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 () 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, 2(ek) To construct A: wk = (k/2(ek))/([i/2(ei)]) => determine A, A, 2(eA)
Treynor-Black: Construction (Step 2)

w0 = (A/2(eA))/[(E(rM)-rf)/2M] 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

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Active or Passive? Issues and Strategies

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Active or Passive?

Issues and Strategies

Equity Portfolio Management: Active or Passive?

Equity Portfolio Management: Active or Passive?

Tracking Error: Measure 1

Tracking Error: Measure 1

Rebalancing an Equity Portfolio

down X 20% up Y 33% unch. Z

Active Equity Strategies

Active Management is Forecasting!

Using the Fundamental law to forecast alpha

Using the Fundamental law to forecast alpha Example:

Treynor-Black Model: Assumptions

Treynor-Black: Construction (Step 1)

Treynor-Black: Construction (Step 2)

Active Equity Strategies

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