UMN - Charles P Jones - Lecture 12 (20110927)

FIN221: Lecture 12 Notes
Chapters 21 and 22
Portfolio Management
Chapter 21 Charles P. Jones, Investments: Analysis and Management, Eighth Edition, John Wiley & Sons Prepared by G.D. Koppenhaver, Iowa State University
Portfolio Management
Involves decisions that must be made by every investor whether an active or passive investment approach is followed Relationships between various investment alternatives must be considered if an investor is to hold an optimal portfolio
Portfolio Management as a Process

Definite structure everyone can follow Integrates a set of activities in a logical and orderly manner Continuous and systematic Encompasses all portfolio investments With a structured process, anyone can execute decisions for investor
Portfolio Management as a Process

Objectives, constraints, and preferences are identified
Leads to explicit investment policies
Individual vs. Institutional Investors

Institutional investors
Maintain relatively constant profile over time Legal and regulatory constraints Well-defined and effective policy is critical
Individual investors
Life stage matters Risk defined as losing money Characterized by personalities Goals important Tax management is important part of decisions
Strategies developed and implemented Market conditions, asset mix, and investor circumstances are monitored Portfolio adjustments are made as necessary
Institutional Investors
Primary reason for establishing a longterm investment policy for institutional investors:
Prevents arbitrary revisions of a soundly designed investment policy Helps portfolio manager to plan and execute on a long-term basis
Short-term pressures resisted
Formulate Investment Policy

Investment policy summarizes the objectives, constraints, and preferences for the investor Information needed
Objectives
Return requirements and risk tolerance
Constraints and Preferences

Liquidity, time horizon, laws and regulations, taxes, unique preferences, circumstances
Life Cycle Approach

Risk/return position at various life cycle stages
Return B C Risk AA: Accumulation phase early career B: Consolidation phase mid-to late career C: Spending phase spending and gifting

Investment policy should contain a statement about inflation adjusted returns
Clearly a problem for investors Common stocks are not always an inflation hedge
Unique needs and circumstances

May restrict certain asset classes

Constraints and Preferences
Time horizon
Objectives may require specific planning horizon
Legal and Regulatory Requirements

Prudent Man Rule
Followed in fiduciary responsibility Interpretation can change with time and circumstances Standard applied to individual investments rather than the portfolio as a whole
Liquidity needs
Investors should know future cash needs
Tax considerations
Ordinary income vs. capital gains Retirement programs offer tax sheltering
ERISA requires diversification and standards applied to entire portfolio
Capital Market Expectations

Macro factors
Expectations about the capital markets
Rate of Return Assumptions

How much influence should recent stock market returns have?
Mean reversion arguments Stock returns involve considerable risk
Probability of 10% return is 50% regardless of the holding period Probability of >10% return decreases over longer investment horizons
Micro factors
Estimates that influence the selection of a particular asset for a particular portfolio
Rate of return assumptions

Make them realistic Study historical returns carefully
Expected returns are not guaranteed
Constructing the Portfolio

Use investment policy and capital market expectations to choose portfolio of assets
Define securities eligible for inclusion in a particular portfolio Use an optimization procedure to select securities and determine the proper portfolio weights
Markowitz provides a formal model
Asset Allocation
Involves deciding on weights for cash, bonds, and stocks
Most important decision
Differences in allocation cause differences in portfolio performance
Factors to consider
Return requirements, risk tolerance, time horizon, age of investor
Asset Allocation
Strategic asset allocation
Simulation procedures used to determine likely range of outcomes associated with each asset mix
Establishes long-run strategic asset mix
Monitoring Conditions and Circumstances

Investor circumstances can change for several reasons
Wealth changes affect risk tolerance Investment horizon changes Liquidity requirement changes Tax circumstance changes Regulatory considerations Unique needs and circumstances
Tactical asset allocation

Changes is asset mix driven by changes in expected returns Market timing approach
Portfolio Adjustments
Portfolio not intended to stay fixed Key is to know when to rebalance Rebalancing cost involves
Brokerage commissions Possible impact of trade on market price Time involved in deciding to trade
Performance Measurement
Allows measurement of the success of portfolio management Key part of monitoring strategy and evaluating risks Important for:
Those who employ a manager Those who invest personal funds
Cost of not rebalancing involves holding unfavorable positions
Find reasons for success or failure
Copyright 2002 John Wiley & Sons, Inc. All rights reserved. Reproduction or translation of this work beyond that permitted in Section 117 of the 1976 United States Copyright Act without the express written permission of the copyright owner is unlawful. Request for further information should be addressed to the Permissions Department, John Wiley & Sons, Inc. The purchaser may make back-up copies for his/her own use only and not for distribution or resale. The Publisher assumes no responsibility for errors, omissions, or damages, caused by use of these programs or from the use of the information contained herein.
Evaluation of Investment Performance

Chapter 22 Charles P. Jones, Investments: Analysis and Management, Eighth Edition, John Wiley & Sons Prepared by G. D. Koppenhaver, Iowa State University
How Should Portfolio Performance Be Evaluated?

Bottom line issue in investing Is the return after all expenses adequate compensation for the risk? What changes should be made if the compensation is too small? Performance must be evaluated before answering these questions
Considerations
Without knowledge of risks taken, little can be said about performance
Intelligent decisions require an evaluation of risk and return Risk-adjusted performance best
Relative performance comparisons

Benchmark portfolio must be legitimate alternative that reflects objectives
Considerations
Evaluation of portfolio manager or the portfolio itself?
Portfolio objectives and investment policies matter
Constraints on managerial behavior affect performance
AIMRs Standards
Minimum standards for reporting investment performance Standard objectives:
Promote full disclosure in reporting Ensure uniform reporting to enhance comparability
How well-diversified during the evaluation period?

Adequate return for diversifiable risk?
Requires the use of total return to calculate performance
Return Measures
Change in investors total wealth over an evaluation period
(V E - V B)/V B V E =ending portfolio value V B =beginning portfolio value
Return Measures
Dollar-weighted returns
Captures cash flows during the evaluation period Equivalent to internal rate of return Equates initial value of portfolio (investment) with cash inflows or outflows and ending value of portfolio Cash flow effects make comparisons to benchmarks inappropriate
Assumes no funds added or withdrawn during evaluation period

If not, timing of flows important
Return Measures
Time-weighted returns
Captures cash flows during the evaluation period and permits comparisons with benchmarks Calculate a return relative for each time period defined by a cash inflow or outflow Use each return relative to calculate a compound rate of return for the entire period
Which Return Measure Should Be Used?

Dollar- and Time-weighted Returns can give different results
Dollar-weighted returns appropriate for portfolio owners Time-weighted returns appropriate for portfolio managers
No control over inflows, outflows Independent of actions of client
AIMR requires time-weighted returns
Risk Measures
Risk differences cause portfolios to respond differently to market changes Total risk measured by the standard deviation of portfolio returns Nondiversifiable risk measured by a securitys beta
Estimates may vary, be unstable, and change over time
Risk-Adjusted Performance
The Sharpe reward-to-variability ratio
Benchmark based on the ex post capital market line
RVAR = [TR p RF]/SDp
=Average excess return / total risk Risk premium per unit of risk The higher, the better the performance Provides a ranking measure for portfolios
Risk-Adjusted Performance
The Treynor reward-to-volatilty ratio
Distinguishes between total and systematic risk
RVAR or RVOL?
Depends on the definition of risk
If total (systematic) risk best, use RVAR (RVOL) If portfolios perfectly diversified, rankings based on either RVAR or RVOL are the same Differences in diversification cause ranking differences
RVAR captures portfolio diversification
RVOL = [TR p RF ]/ p
=Average excess return / market risk Risk premium per unit of market risk The higher, the better the performance Implies a diversified portfolio
Measuring Diversification
How correlated are portfolios returns to market portfolio?
R2 from estimation of Rpt - RFt = p + p [RMt - RFt ] +Ept R2 is the coefficient of determination Excess return form of characteristic line The lower the R2, the greater the diversifiable risk and the less diversified
Jensens Alpha
The estimated coefficient in
Rpt - RFt = p + p [RMt - RFt] +E pt is a means to identify superior or inferior portfolio performance CAPM implies is zero Measures contribution of portfolio manager beyond return attributable to risk
If >0 (<0,=0), performance superior (inferior, equals) to market, risk-adjusted
Measurement Problems
Performance measures based on CAPM and its assumptions
Riskless borrowing? What should market proxy be?
If not efficient, benchmark error Global investing increases problem
Other Evaluation Issues

Performance attribution seeks an explanation for success or failure
Analysis of investment policy and asset allocation decision Analysis of industry and security selection Benchmark (bogey) selected to measure passive investment results Differences due to asset allocation, market timing, security selection
How long an evaluation period?

AMIR stipulates a 10 year period

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FIN221: Lecture 12 Notes

Portfolio Management as a Process

Portfolio Management as a Process

Individual vs. Institutional Investors

Formulate Investment Policy

Constraints and Preferences

Life Cycle Approach

Formulate Investment Policy

Unique needs and circumstances

Formulate Investment Policy

Legal and Regulatory Requirements

ERISA requires diversification and standards applied to entire portfolio

Capital Market Expectations

Rate of Return Assumptions

Rate of return assumptions

Expected returns are not guaranteed

Constructing the Portfolio

Monitoring Conditions and Circumstances

Tactical asset allocation

Cost of not rebalancing involves holding unfavorable positions

Find reasons for success or failure

Evaluation of Investment Performance

How Should Portfolio Performance Be Evaluated?

Relative performance comparisons

How well-diversified during the evaluation period?

Requires the use of total return to calculate performance

Assumes no funds added or withdrawn during evaluation period

Which Return Measure Should Be Used?

AIMR requires time-weighted returns

RVAR = [TR p RF]/SDp

If >0 (<0,=0), performance superior (inferior, equals) to market, risk-adjusted

Other Evaluation Issues

How long an evaluation period?

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