BM410: Investments

1. BM410: Investments Portfolio Construction 1: Basics and Active versus Passive

2. Objectives • A. Understand the uses and types of benchmarks • B. Understand portfolio rebalancing • C. Understand the importance of portfolio management and performance evaluation • D. Understand active versus passive investing

3. A. Understand the Uses and Types of Benchmarks • What are benchmarks? • Benchmarks are measuring devices which give the performance of a specific set of securities for comparison purposes. Benchmarks may be built on published indexes or may be customized to suit a specific investment strategy • Why are benchmarks important? • Benchmarks are the standard from which your portfolio should be judged. You cannot know how your are performing without a benchmark

4. Uses of Benchmarks (continued) • What are the uses of benchmarks? • 1. Tracks average returns for a specific asset class • 2. Used to compare performance of mutual fund managers in similar asset classes and to check broker’s recommendations • 3. Use as a base to build portfolios • Key Questions in choosing or using an Index: • Is it representative of the performance of assets desired? • How broad is the benchmark, i.e. number securities? • How is it constructed, i.e. price, total return index? • How is it weighted, i.e. market cap, equal weighted?

5. Uses of Benchmarks (continued) • How are benchmarks differentiated? • Type: • Stocks: • Large capitalization (cap), small cap, mid cap, international, emerging markets, etc. • Bonds: • Long-term, short-term, corporate bonds, government bonds, convertible bonds, etc. • Other Asset Classes: • Real estate, REITs, currencies, commodities, derivatives, gold, hedge funds, etc.

6. Uses of Benchmarks (continued) • Geography: • Global: • Follows performance of a set ofassets from a specific set of countries including the US, i.e., MSCI World, MSCI AC Free. International includes only countries outside the US • Regional: • Follows performance of a set of assets from a specific region of the world , i.e., MSCI EAFE, DJ Asia, Latin America • Country: • Follows performance of a set of assets from a specific country , i.e., MSCI Argentina, S&P/IFC Chile, Japan TOPIX, etc.

7. Uses of Benchmarks(continued) • Asset Size: • Market Capitalization • Follows the performance of a set of assets with a specific market capitalization range, i.e. large- cap, mid-cap, small-cap, micro-cap, etc. • Industry: • Follows the performance of a set of assets from a specific industry, whether global, regional, or country, i.e. Telecomm, Financial, Retail, Automotive, Consumer Durable, etc.

8. Uses of Benchmarks (continued) • Investment Style: • Value • These follow stocks that are perceived to be undervalued by the market, i.e. their PE and P/BV ratios are lower than the market. • Blend • These follow a portfolio of stocks that include both value and growth in their portfolio. • Growth • These follow stocks that are expected to achieve accelerated growth, whether due to increased earnings, dominant market position, or other factors

9. Benchmarks Types Types of Return Benchmarks: • Price Return: • Includes only price appreciation or capital gains • Total Return with Gross Dividends (or gross dividends reinvested): • Includes both price appreciation and dividends. It does not take into account the impact of withholding taxes on dividends (international) • Total Return with Net Dividends: • Includes both price appreciation and dividends. It also takes into account the impact of withholding taxes on dividends, hence dividends received internationally will be less than paid

10. Benchmark Construction • How are stocks weighted in various benchmarks? • Market-value weighted (S&P 500, NASDAQ) • Weight is based on market capitalization • Stocks are weighted according to their market capitalization. This assumes market capitalization (price * shares) is a good proxy for size • Price weighted (DJIA, Nikkei, Japan) • Weight is based on the price of the stock • Stocks with a higher price are weighted more in the index. This assumes a higher priced stock is more valuable than a lower priced stock

11. Benchmark Construction (continued) • Equally weighted (Value Line) • All stocks are weighted the same • Stocks are equally weighted. This assumes all stocks are equal and hence gives a higher weighting to smaller stocks • Float weighted (MSCI Emerging Markets Free) • Weight is based on market cap and available float outstanding, i.e. what investors can really purchase • Stocks are weighted according to available shares outstanding. This gives greater preference to companies whose shares can be purchased (i.e., are not held by a few individuals) and who do not have foreign ownership limits

12. Finding Data on Indexes • Where do you find these benchmarks or indexes? • Internet: Any of the many financial sites available: CNN Money, YahooFinance, etc. Generally these free Benchmarks are without dividends (make sure you check) • Proprietary Data Providers: Bloomberg, Reuters, etc. They will also produce special indexes for a fee ( i.e. MSCI EM Free ex-Malaysia) • Data Suppliers: Standard and Poors, Morgan Stanley Capital International, NASDAQ, Bloomberg, etc.

13. Vanguard Sends Notice of Index Changes • From a Vanguard e-mail: “We believe that the new indexes will reflect the performance of the funds' targeted market segments more accurately than any other available indexes. We believe stock indexes should: • Be constructed according to objective rules, not subjective judgment. • Weight their holdings to reflect only "floating" shares, meaning those that are available and freely traded in the open market. • Feature overlapping buffer zones around the breakpoints between large-, mid-, and small-capitalization segments. • Assess a variety of factors to identify a stock as "growth" or "value." • Rebalance their holdings to reflect market changes in a gradual and orderly fashion.“ • From Vanguard Website on 5/6/03: http://flagship.vanguard.com/VGApp/hnw/web/corpcontent/vanguardviews/jsp/VanViewsNCArticle.jsp?chunk=/freshness/News_and_Views/ALL_benchchange_04032003.html

14. Key Benchmarks • Examples of benchmarks: • Domestic equities: • Large cap stocks S&P 500 (SPX) • Small-cap stocks Russell 5000 (RTY) • Micro-cap stocks Wilshire Micro-cap • International equities: • Global S&P Global 1200, MSCI World, DJ World • International MSCI EAFE (Europe, Australia and the Far East) • Emerging Markets S&P/IFCI and MSCI Emerging Markets Free

15. Key Benchmarks(continued) • Corporate Bonds • Short-term DJ Corporate Bond Index • Intermediate Lehman Brothers Intermediate • High Yield Salomon Smith Barney High Yield • Mortgage backed Lehman Brothers MBS Index • Yankee Merrill Lynch Yankee Index • Treasury Securities • Intermediate Lehman Intermediate Treasury • Long-term Lehman Long-term Treasury • Real Estate • REIT Standard & Poors REIT

16. Questions • Do we understand the uses and types of Benchmarks to an investor?

17. B. Understand Portfolio Rebalancing • What is portfolio rebalancing? • The process of bringing portfolios back into given target asset allocation ratios. • What causes the need to rebalance portfolios? • Changes occur due to: • Changes in asset class performance • Changes in investor objectives or risk • Introduction of new capital • Introduction of new asset classes

18. Portfolio Rebalancing (continued) • Why is this rebalancing so critical? • You must balance competing principles of keeping both transactions costs and tracking error low • What is tracking error? • That is the return that is lost from your portfolio being different from your target weight • What are the different ways of rebalancing? • Periodic-based (or calendar-based) • Percent-range-based (or volatility-based) • Equal-probability-based • Active risk-based

19. Portfolio Rebalancing (continued) • What is periodic-based rebalancing? • Specify a time period, i.e. quarterly, annually, etc. After each time period, rebalance the portfolio back to your original asset allocation targets • Advantages • Most simple of the methods • Longer periods have lower transactions costs (but higher tracking error costs) • Disadvantages • Independent of market performance • Performance will depend on relative timing of large market moves and rebalancings

20. Portfolio Rebalancing (continued) • What is percent-range-based rebalancing? • Rebalance the portfolio every time your actual holdings are +/-5% (or 10%) from your target ratios. Rebalance whenever any weight is outside this range • Advantages • Easy to implement • Wider ranges will reduce transactions costs (at the expense of higher tracking error) • Asset performance will trigger rebalancing • Disadvantages • Setting an effective range is difficult • Assets with higher target ranges and volatility will generate most rebalances

21. Portfolio Rebalancing (continued) • Are there other methods? • Equal probability rebalancing • Allow a “no-trade” region around each assets allocation target so each asset is equally likely to trigger rebalancing. Rebalance to target ratios whenever any asset is outside this region • Active risk rebalancing • Allow a “no-trade” region around each asset based on transactions costs, risk aversion, correlation, and volatility. Rebalance only when active risk (defined as the standard deviation of active return) is above a specified threshold. When this happens, rebalance only back to target threshold, not back to target ratios

22. Portfolio Rebalancing (continued) • Which are the best methods? • Generally, for most investors with fewer investable assets, the easiest is likely to be most useable • Generally, a combination of periodic-based and percent-range based is useful • Remember, the goal is to minimize your transactions costs, your taxes, and your tracking error costs

23. Portfolio Rebalancing (continued) • My recommendations • For most of you, since you will be paying yourself monthly and since you are careful in your selection of assets: • Use new money to purchase the “underweight” assets, so you do not have to sell and incur transactions costs or taxable events • Use appreciated assets for your charity contributions (see Teaching Tool 8), and use the money you would have spent for your charity contributions to purchase the underweight assets

24. Questions • Any questions on portfolio rebalancing?

25. C. Understand the Importance of Portfolio Management and Evaluation • What is portfolio management? • The development, construction, and management of a portfolio of financial assets to attain an investor’s specific goals • What is performance evaluation? • The process of evaluating a portfolio’s performance with the goal of understanding the key sources of return • Why are these two topics so important? • Both are complicated subjects and both are critical to investing

26. Portfolio Management and Evaluation (continued) • What is Active Portfolio Management? • The process of using publicly available data to actively manage a portfolio in an effort to: • Beat the benchmark after all transactions costs, taxes, management, and other fees • However, you must do this consistently year-after-year, and not just from luck • Why is Active Management such a hot topic? • Management fees for mutual funds which can consistently outperform their benchmarks are 5-25 times higher than those on passive management (19 basis points versus 250 basis points)

27. Portfolio Management and Evaluation (continued) • What is passive management? • The process of buying a diversified portfolio which represents a broad market index (or benchmark) without any attempt to outperform the market • Why is passive management such a hot topic? • Most active managers fail to outperform their benchmarks, especially after costs and taxes • Investors have realized that if you can’t beat them, join them, so they buy low-cost passive funds which meet their benchmarks consistently and minimize taxes

28. Portfolio Management and Evaluation (continued) • What factors lead to above-benchmark or excess returns? • 1. Superior asset allocation • Shifting assets between a poor-performing asset class and a better performing asset class • 2. Superior stock selection • Picking sectors, industries, or companies within a specified benchmark which, as a whole, outperform the return on the specified benchmark

29. Portfolio Management and Evaluation (continued) • What is superior asset allocation? • The process where the investor gains a higher return than the benchmark from adjusting the investment portfolio for movements in the market • The investor shifts among stocks, bonds and other asset classes based on their expectations for returns from each of the asset classes • What are the results? • Done well, superior asset allocation yields higher returns with lower risk. • Done poorly, it yields lower returns, higher transactions costs, and higher taxes

30. Portfolio Management and Evaluation (continued) • What is superior stock selection? • The process where the investor builds an investment portfolio which earns returns in excess of the benchmark through buying or selling undervalued stocks, sectors or industries • The investor shifts among the various securities of the index in an attempt to buy the securities with the highest growth potential • What are the results? • Done well, superior selection yields higher returns with lower risk. • Done poorly, it yields lower returns, high transactions costs, and high taxes

31. Portfolio Management and Evaluation (continued) • What is portfolio evaluation? • The process of monitoring financial asset performance, comparing asset performance to the relevant benchmarks, and determining how well the fund is meeting its objectives. • If the assets are underperforming benchmarks, the investor may sell underperforming assets and purchase other assets which would more closely align asset performance with benchmarks

32. Portfolio Management and Evaluation (continued) • Why monitor performance? • Unless you monitor performance, you will not know how you are doing in working toward accomplishing your objectives • You need to know how every asset you own is performing, and performing versus its benchmark, so you can determine how well you are moving toward your goals

33. Portfolio Management and Evaluation (continued) • How do you evaluate performance? • Calculate: • 1. The period return on each owned asset • 2. The period index return for each benchmark • 3. The difference between the asset return and benchmark return • 4. The weight of each asset or portfolio in the overall portfolio • 5. The overall portfolio return • With this information, you can know how each of your funds or assets is performing versus its benchmark, and how well the portfolio is moving toward its objectives

34. Portfolio Management and Evaluation (continued) • What is portfolio reporting? • The process of reviewing portfolio performance with the necessary participants, i.e. your spouse • If you are managing your portfolio, you should report performance to your spouse at least monthly or quarterly • If others are helping you manage your portfolio, they should report performance to you and your spouse at least quarterly as well. • Be careful not to do too much buying and selling, as these incur transactions costs and taxes

35. Questions • Any questions on the importance of portfolio management and evaluation?

36. D. Active versus Passive Investing • What is Active Portfolio Management? • Trading to earn more than a “market” return for time and risk • It is using publicly available data to actively manage a portfolio in an effort to consistently beat the benchmark after all costs, taxes, management, and other fees (not just from luck) • What is passive management? • Not trading to earn a market return for time and risk. • The process of buying a diversified portfolio which represents a broad market index (or benchmark) without any attempt to outperform the market

37. Active versus Passive (continued) • Where does active management come in? • 1. Asset allocation • Shifting assets between a poor-performing asset class and a better performing asset class • 2. Stock selection • Picking sectors, industries, or companies within a specified benchmark which, as a whole, outperform the return on the specified benchmark

38. Active versus Passive (continued) • Assumptions of Active Investing • Active management is a skill-based activity • Some investments are simply better than others • For those with the time, money, and skill, they may be able to add value to the portfolio • The challenge is being able to do it consistently • Certain strategies, i.e. tax-managed investing, may be even more advantageous in specific investment environments

39. Active versus Passive (continued) • Active Investing • Efficient markets argument • Traders with superior abilities in information, cost, and analysis will surpass those without those competitive advantages • If you do have those competitive advantages, actively manage • Inefficient markets argument • Investors can find “pockets” of inefficiencies and can exploit those inefficiencies to make excess returns

40. Active versus Passive (continued) • What does active management require? • Active management requires a competitive advantage in at least one of three categories: • 1. Information. You should have information not widely available and not already reflected in stock prices • 2. Trading costs. You should have a lower cost to trade, possibly helped by being a dealer or floor trader • 3. Analysis. You should have the ability to convert public data into private knowledge about value that is not fully reflected in current prices.

41. Active versus Passive (continued) • Assumptions of Passive Investing • Stock pricing is informationally efficient • Costs and fees (brokerage costs, bid-ask spreads, and taxes) make active trading too costly • Overconfidence further distorts investors abilities • More than half all actively managed mutual funds underperform their indices • Active management leads to sub-optimal diversification • Passive management is very time- and resource-efficient

42. Active versus Passive (continued) • Passive investing • Efficient markets argument • Markets are efficient • You cannot gain any advantage by research and analysis • Inefficient markets argument • Traders with superior abilities in information, cost, and analysis will surpass those without those competitive advantages • If you do not have those competitive advantages, you should index

43. Active versus Passive (continued) • Does it have to be one or the other? • Why not use a combined approach • Index when that is perceived to add value • Actively manage when you can add value there • What about in-between? • What about enhanced-indexing? • It is often called risk-controlled active funds or hybrid active-passive strategies • For example, you could have a bond and equity index funds, and you could dynamically market time by varying your allocations in each fund (i.e. asset allocation)

44. Review of Objectives • A. Do you understand the different types and uses of indexes? • B. Do you understand the Importance of Portfolio Management and Performance Evaluation? • C. Do you understand portfolio rebalancing? • D. Do you understand active versus passive investing?