CHAPTER NINE: INVESTMENT PORTFOLIO MANAGEMENT potx

CHAPTER NINE: INVESTMENT PORTFOLIO MANAGEMENT... An investor is a party that makes an investment into one or more categories of assets --- equity, debt derivatives such as put and call o

CHAPTER NINE: INVESTMENT PORTFOLIO MANAGEMENT

An investor is a party that makes an investment into

one or more categories of assets - equity, debt

derivatives such as put and call options, etc - with the objective of making a profit

 Inviduals

 Organizations: Financial entities including Brokerages, Banks, Funds…

INVESTMENT PROCESS

- Analyze the market

- Evaluate expected returns and risks

- Design the optimized portfolio

Risk aversion

Risk of portfolio and Diversification

Return and Risk of portfolio:

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Active Management

– The process of managing investment portfolios by

attempting to time the market and/or select

“undervalued” stocks to buy and “overvalued” stocks to sell based upon company research, investigation and

analysis

Passive Management

– The process of managing investment portfolios by trying

to match the performance of an index or asset class of

securities as closely as possible by holding all or a

representative sample of the securities in the index or

asset class

– Does not use market timing or stock selection strategies

PORTFOLIO MANAGEMENT

Investment Decision Matrix:

Where Do You Fit In?

Market Timers and Stock Selectors *

Where the common crowd hangs out Preference of active management, high-cost “gurus * ”

Heavy on investment hype

Stock Selectors Preference of stockbrokers and many financial advisors *

High cost, high turnover, high taxes

Market Timers

Tactical analysis * (with no proven results)

Tax inefficient

Short-term outlook

The Informed Investor

Based on academic research and data *

As much as 40% of institutional invested dollars The prudent investors

Receive market returns Where YOU should be (and where we are)

• Asset Class Investing

– Stocks and Bonds

– US and International

– Large Cap and Small Cap

– Growth and Value

– Short-Term and Long-Term Maturity

• Why Use Passive Asset Class Investing?

– Lower portfolio turnover

– Lower operating expenses

– Lower transaction costs

– Greater tax-efficiency

– Long-term perspective

– Broad diversification/risk reduction

– Control of asset allocation

– Passive asset class funds capture separate dimensions

of worldwide returns

Passive versus Active Portfolio

Management

• Review of Market Efficiency

• Anomalies

• Market Timing

• A theoretical model of active portfolio

management (Treynor-Black)

• Quantitative Investment Management

Passive Management

• Buy and Hold

• Indexation

• Active management must beat these

strategies on a net risk adjusted return basis!

• What if markets are efficient?

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)

securities

• Find optimal weights of analyzed securities to create active component (A)

• Combine A, M and risk-free asset to achieve

Treynor-Black: Construction (Step 1)

• Assume: ri = rf + bi(rM - rf) + ei

• For analyzed security k:

rk = rf + bk(rM - rf) + ek + ak

=> estimate ak, bk, s2(ek)

• To construct A:

wk = ( ak/ s2(ek))/( S[ai/ s2(ei)])

=> determine aA, bA, s2(eA)

Treynor-Black: Construction (Step 2)

• w0 = ( aA/ s2(eA))/[(E(rM)-rf)/ s2

M]

• w* = w0/(1+(1- bA)w0)

• w0 is the proportion of A in the new, enhanced market portfolio (M‘)