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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?.

Samuel
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Active or Passive? Issues and Strategies

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  1. Active or Passive? Issues and Strategies • Market Efficiency • Anomalies • Market Timing • A theoretical model of active portfolio management (Treynor-Black) • Quantitative Investment Management

  2. Equity Portfolio Management: Active or Passive?

  3. 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

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

  5. Tracking Error: Measure 1 • TE1 =where Rpt and Rbt are portfolio and benchmark returns respectively

  6. Tracking Error: Measure 1 • TE2 = σeThis 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 σe later

  7. 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? • it’s costly!

  8. Rebalancing: Example 1

  9. Rebalancing: Example 1

  10. 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)

  11. Rebalancing: Example 1

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

  13. 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

  14. 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

  15. 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 a/σe • IC = information coefficient • correlation between forecast and actual (CORR(E(a), a) • BR = breadth • # of stocks evaluated per period

  16. 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 I’m an industry picker?

  17. 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:a = IC x σe x Sa = Skill x Volatility x Signal

  18. Using the Fundamental law to forecast alpha • Example: • Your analysis produces a binary “buy” or “sell” recommendation. Your IC = .05 (really good!)

  19. 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?

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

  21. 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)

  22. Treynor-Black: Construction (Step 2) • w0 = (aA/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‘)

  23. 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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