Passive Equity Portfolio Management CH2-3

7/12/2023
Active Passive Portfolio Management
Chapter 2
Passive Equity Portfolio Management
strategies
Prepared by: Dr. Lina Bassam
By: Dr. Lina Bassam 1
An Overview
• Equity portfolio construction:
o Managers analyse economy, industries and companies to estimate a stock’s
intrinsic value.
o Evaluate firms’ strategies and competitive advantage and recommend
individual stocks for purchase or sale.
o Computers analyse relationships between stocks and market sectors to
identify undervalued stocks.
o Managers of equity portfolios can increase investor’s wealth through their
sector and asset allocation decisions.
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An Overview
• Equity portfolio management strategies:
• 1. Passive management
• 2. Active management
• One way to distinguish these strategies is to decompose the total actual return
that the portfolio manager attempts to produce.
An Overview
• Equity portfolio management strategies:
• Total Actual Return = Expected Return + Alpha
• Passive:
o Total Actual Return = [Risk-free rate + Risk premium]
• Active:
o Total Actual Return = [Risk-free rate + Risk premium] + [Alpha]

To understand this we should have a closer look at the CAPM (The Capital Asset Pricing
Model)
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An Overview: the CAPM

• CAPM indicates what should be the expected or required rates of return on risky
assets
• This helps to value an asset by providing an appropriate discount rate to use in
dividend valuation models
• You can compare an estimated rate of return to the required rate of return
implied by CAPM - over/under valued ?

• The Security Market Line (SML)
o The relevant risk measure for an individual risky asset is its covariance with
the market portfolio (Covi,m)
o This is shown as the risk measure
o The return for the market portfolio should be consistent with its own risk,
which is the covariance of the market with itself - or its variance:  m2
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• The Expected Rate of Return for a Risky Asset
E(R i ) = RFR +  i (R M - RFR)
• The expected rate of return of a risk asset is determined by the RFR plus a risk
premium for the individual asset
• The risk premium is determined by the systematic risk of the asset (beta) and the
prevailing market risk premium (RM-RFR)
• Note: Unsystematic risk is a risk specific to a company or industry, while systematic risk is the risk
tied to the broader market.

Graph of SML with Normalized Systematic Risk
E(R i )
SML
Rm
Negative Beta
RFR
0 1.0 Beta(Cov im/  2 )

By: Dr. Lina Bassam M 8
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Determining the Expected Rate of Return for a Risky Asset
Stock Beta RFR = 6% (0.06)
Assume:
A 0.70 RM = 12% (0.12)
B 1.00
Implied market risk premium = 6% (0.06)
C 1.15
D 1.40
E -0.30 E(R i ) = RFR +  i (R M - RFR)
E(RA) = 0.06 + 0.70 (0.12-0.06) = 0.102 = 10.2%
E(RB) = 0.06 + 1.00 (0.12-0.06) = 0.120 = 12.0%
E(RC) = 0.06 + 1.15 (0.12-0.06) = 0.129 = 12.9%
E(RD) = 0.06 + 1.40 (0.12-0.06) = 0.144 = 14.4%
E(RE) = 0.06 + -0.30 (0.12-0.06) = 0.042 = 4.2%

• In equilibrium, all assets and all portfolios of assets should plot on the SML
• Any security with an estimated return that plots above the SML is
underpriced
• Any security with an estimated return that plots below the SML is
overpriced
• A superior investor must derive value estimates for assets that are
consistently superior to the consensus market evaluation to earn better
risk-adjusted rates of return than the average investor
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• Compare the required rate of return to the estimated rate of return for a
specific risky asset using the SML over a specific investment horizon to
determine if it is an appropriate investment
• Independent estimates of return for the securities provide price and
dividend outlooks

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• To summarizes the relationship between the required rate of return for
each stock based on its systematic risk as computed earlier, and its
estimated rate of return (based on the current and future prices, and its
dividend outlook.
• This difference between estimated return and expected (required) return is
sometimes referred to as a stock’s alpha or its excess return.
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• If the alpha is zero, the stock is on the SML and is properly valued in line
with its systematic risk. Plotting these estimated rates of return and stock
betas on the SML we specified earlier gives the graph shown in previous
slide.
• Stock A is almost exactly on the line, so it is considered properly valued
because its estimated rate of return is almost equal to its required rate of
return.

• Stocks B and D are considered overvalued because their estimated rates of
return during the coming period are below what an investor should expect
(require) for the risk involved. As a result, they plot below the SML.
• In contrast, Stocks C and E are expected to provide rates of return greater
than we would require based on their systematic risk. Therefore, both
stocks plot above the SML, indicating that they are undervalued stocks
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An Overview – Jenson’s Alpha

• Lets go back to Alpha mentioned on slid 4, which called Jensen‘s Alpha:
• It shows excess actual return over required return and excess of actual risk
premium over required risk premium.
• This measure of the portfolio manager’s performance is based on the CAPM.
• Jensen’s Alpha = (Rp– RFR) – βp (Rm –RFR)
= Rp – βp (Rm)
Passive Equity Portfolio Management

• Portfolio return will track those of a benchmark index over time.
o Benchmark is an index used for the analysis of the evaluation of a market and
that also serve to measure the result obtained by portfolios.
• No attempt to generate alpha
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Passive Equity Portfolio Management Strategy

• A passive portfolio strategy focuses on maximizing diversification with little
expectational input. A passive portfolio fund essentially mirrors a market index.
• Long-term buy and hold strategy: cash distributions are to be reinvested
• 1. Attempt to replicate the performance of an index: Passive equity portfolio

management attempts to design a set of stock holdings that replicates the
performance of a specific benchmark. If the manager tries to outperform the
benchmark, he or she clearly violates the passive premise of the portfolio.
Designed to matched market performance

• 2. Follows the efficient market hypothesis, which states that financial markets are
informationally efficient.
• 3. No attempt is made to distinguish attractive from unattractive securities,
forecast their prices, time markets or market sectors. Usually tracks an index over
time: Occasional rebalancing, if the composition of the underlying benchmark
changes
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• 4. Passive investment is cheaper, less complex, and often produces superior after-
tax results over medium to long time horizons than actively managed portfolio.
• 5. Managers are judged by how well she tracks the target “Minimizes the
deviation between stock portfolio and index returns”
• 6. May slightly underperform the target index due to fees and commissions
Index Portfolio Construction Techniques
• Full replication
• Sampling
• Quadratic optimization or programming
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• Full Replication
o All securities in the index are purchased in proportion to weights in the index
o This helps ensure close tracking
o Increases transaction costs, particularly with dividend reinvestment

• Sampling
o Buys a representative sample of stocks in the benchmark index according to their
weights in the index
o Fewer stocks means lower commissions
o Reinvestment of dividends is less difficult
o Will not track the index as closely, so there will be some tracking error
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• Quadratic Optimization (or programming techniques)
o Historical information on price changes and correlations between securities are
input into a computer program that determines the composition of a portfolio
that will minimize tracking error with the benchmark
o Relies on historical correlations, which may change over time, leading to failure to
track the index
Tracking Error and Index Portfolio Construction
• The goal of the passive manager should be to minimize

the portfolio’s return volatility relative to the index, i.e.,
to minimize tracking error
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Tracking Error and Index Portfolio Construction
• Tracking Error Measure
• Return differential in time period t
Δt =Rpt – Rbt
where Rpt= return to the managed portfolio in Period t
Rbt= return to the benchmark portfolio in Period t
• Tracking error is measured as the standard deviation of Δt,

normally annualized (TE)
Expected Tracking Error Between the S&P 500 Index and

Portfolio Samples of Less Than 500 Stocks
Expected Tracking
Error (Percent)
4.0
3.0
2.0
1.0
500 400 300 200 100 0

Number of Stocks
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Tracking error
• Wi = investment weight of asset i in the managed portfolio

• Rit = return to asset i in period t
• Rbt = return to the benchmark portfolio in period t
• N = number of assets in the managed portfolio
• With these definitions, we can define the Period t return to
managed portfolio as: 𝑁
𝑅𝑝𝑡 = ෍ 𝑤𝑖 𝑅𝑖𝑡
𝑖=1
Tracking error
• We can then specify the Period t return differential between the

managed portfolio and the benchmark as:
𝑁
𝛥𝑡 = ෍ 𝑤𝑖 𝑅𝑖𝑡 − 𝑅𝑏𝑡 = 𝑅𝑝𝑡 − 𝑅𝑏𝑡

𝑖=1
• Notice that, given the returns to the N assets in the managed portfolio
and the benchmark, ∆ is a function of the investment weights that the
manager selects and that not all of the assets in the benchmark need
be included in the managed portfolio (i.e., w = 0 for some assets)
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Tracking error
• For a sample of T return observations, the variance of ∆ can be

calculated as follows:
• Finally, the standard deviation of the return differential is
Tracking error
• so that annualized tracking error (TE) can be calculated as
• where P is the number of return periods in a year (e.g., P = 12 for

monthly returns, P = 252 for daily returns).
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Tracking error (Example)

• Suppose an investor has formed a portfolio designed to track a
particular benchmark. Over the last eight quarters, the returns to this
portfolio, as well as the index returns and the return difference
between the two, were:

• The periodic average and standard deviation of the manager’s return
differential (i.e., “delta”) relative to the benchmark are
DIFFERENCE
Period Manager Index (∆) (∆i) - (∆avg) [(∆i) - (∆avg)]2
1 2.30 2.70 -0.40 -0.60 0.36
2 -3.60 -4.60 1.00 0.80 0.64
3 11.20 10.10 1.10 0.90 0.81
4 1.20 2.20 -1.00 -1.20 1.44
5 1.50 0.40 1.10 0.90 0.81
6 3.20 2.80 0.40 0.20 0.04
7 8.90 8.10 0.80 0.60 0.36
8 -0.80 0.60 -1.40 -1.60 2.56
Sum 1.60 7.02
Average 0.20
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• Average ∆ = 1.60/8 = %0.20
7.02
• ∆= = 1.002 = %1
8−1
• Thus, the manager’s annualized tracking error for this two-year period is
2 percent (= 1 percent × √4).
Methods of Index Portfolio Investing

• Although investors can construct their own passive investment
portfolios that mimic a particular equity index, there are at least two
“pre-packaged” ways of accomplishing this goal that are typically more
convenient and less expensive for the small investor. These are
• (1) buying shares in an index mutual fund or
• (2) buying shares in an exchange-traded fund (ETF)
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• Index Funds
• In an indexed portfolio, the fund manager will typically attempt to
replicate the composition of the particular index exactly
• The fund manager will buy the exact securities comprising the index
in their exact weights

• Index Funds
• Change those positions anytime the composition of the index itself
is changed
• Low trading and management expense ratios
• Advantage: provide an inexpensive way for investors to acquire a

diversified portfolio
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• ETFs
• Depository receipts that give investors a pro rata claim on the
capital gains and cash flows of the securities that are held in
deposit by a financial institution that issued the certificates
• Advantage of ETFs over index mutual funds is that they can be

bought and sold (and short sold) like common stock
Exercises
1. You have a portfolio with a market value of $50 million and a
beta (measured against the S&P 500) of 1.2. If the market rises
10 percent, what value would you expect your portfolio to have?
Solution:
$50 million x 1.2 x 1.1 = 66 million
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Exercises
2. Given the monthly returns that follow, how well did the passive portfolio track the
S&P 500 benchmark? Find the R2 , alpha, and beta of the portfolio. Compute the
average return differential and annual tracking error.
Exercises
S&P 500 benchmark? Find the R2 , alpha, and beta of the portfolio.
Portfolio S&P 500
Returns % Return % (Rm - Ri - E(Ri) * Rm
Month Ri (Rm) Ri - E(Ri) (Ri - E(Ri))2 Rm - E(Rm) E(Rm))2 - E(Rm)
Jan 5.00 5.20 4.76 22.66 5.03 25.30 23.94
Feb -2.30 -3.00 -2.54 6.45 -3.17 10.05 8.05
Mar -1.80 -1.60 -2.04 4.16 -1.77 3.13 3.61
Apr 2.20 1.90 1.96 3.84 1.73 2.99 3.39
May 0.40 0.10 0.16 0.03 -0.07 0.00 -0.01
Jun -0.80 -0.50 -1.04 1.08 -0.67 0.45 0.70
Jul 0.00 0.20 -0.24 0.06 0.03 0.00 -0.01
Aug 1.50 1.60 1.26 1.59 1.43 2.04 1.80
Sep -0.30 -0.10 -0.54 0.29 -0.27 0.07 0.15
Oct -3.70 -4.00 -3.94 15.52 -4.17 17.39 16.43
Nov 2.40 2.00 2.16 4.67 1.83 3.35 3.95
Dec 0.30 0.20 0.06 0.00 0.03 0.00 0.00
Sum 2.90 2.00 0.02
By: Dr. Lina Bassam 60.35 -0.04 64.79 62.01 42
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Exercises
S&P 500 benchmark? Find the R2 , alpha, and beta of the portfolio.
Computation Answer
E(Ri) 2.9/12 0.24
E(Rm) 2/12 0.17
Vari (Ri - E(Ri))2 / 11 = 60.35 / 11 5.49
Varm (Rm - E(Rm))2 / 11 = 64.79 / 11 5.89
σi √5.49 2.34
σm √5.89 2.43
COVi,m Ri - E(Ri) * Rm - E(Rm) / 11 = 62.01/12 5.64
Ri,m 5.64 / 2.34*2.43 0.99
R2 0.99*0.99 0.98
bi 5.64 / 5.89 0.96
 E(Ri) - E(Rm) * bi = 0.24 – (0.17 * 0.96) 0.08
Exercises
2. Compute the average return differential and annual tracking error.
Portfolio S&P 500 DIFFERENCE
Month Returns % Ri Return % (Rm) (∆) (∆i) - (∆avg) [(∆i) - (∆avg)]2
Jan 5.00 5.20 -0.20 -0.28 0.0784
Feb -2.30 -3.00 0.70 0.62 0.3844
Mar -1.80 -1.60 -0.20 -0.28 0.0784
Apr 2.20 1.90 0.30 0.22 0.0484
May 0.40 0.10 0.30 0.22 0.0484
Jun -0.80 -0.50 -0.30 -0.38 0.1444
Jul 0.00 0.20 -0.20 -0.28 0.0784
Aug 1.50 1.60 -0.10 -0.18 0.0324
Sep -0.30 -0.10 -0.20 -0.28 0.0784
Oct -3.70 -4.00 0.30 0.22 0.0484
Nov 2.40 2.00 0.40 0.32 0.1024
Dec 0.30 0.20 0.10 0.02 0.0004
Sum 2.90 2.00 0.90 -0.06 1.12
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Exercises
2. Compute the average return differential and annual tracking error.
• Average ∆ =0.9/12 = 0.075  0.08
1.12
• ∆= = 0.1 = 0.32
12−1
• Thus, the manager’s annualized tracking error for this period is 1.11 percent (= 0.32 percent ×
√12).
23

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7/12/2023

Active Passive Portfolio Management

Prepared by: Dr. Lina Bassam

By: Dr. Lina Bassam 1

By: Dr. Lina Bassam 2

By: Dr. Lina Bassam 3

• Total Actual Return = Expected Return + Alpha

o Total Actual Return = [Risk-free rate + Risk premium]

o Total Actual Return = [Risk-free rate + Risk premium] + [Alpha]

By: Dr. Lina Bassam 4

An Overview: the CAPM

By: Dr. Lina Bassam 5

An Overview: the CAPM

By: Dr. Lina Bassam 6

An Overview: the CAPM

By: Dr. Lina Bassam 7

An Overview: the CAPM

0 1.0 Beta(Cov im/  2 )

An Overview: the CAPM

By: Dr. Lina Bassam 9

An Overview: the CAPM

By: Dr. Lina Bassam 10

An Overview: the CAPM

By: Dr. Lina Bassam 11

An Overview: the CAPM

By: Dr. Lina Bassam 12

An Overview: the CAPM

By: Dr. Lina Bassam 13

An Overview: the CAPM

• To summarizes the relationship between the required rate of return for

• This difference between estimated return and expected (required) return is

sometimes referred to as a stock’s alpha or its excess return.

By: Dr. Lina Bassam 14

An Overview: the CAPM

• Stock A is almost exactly on the line, so it is considered properly valued

By: Dr. Lina Bassam 15

An Overview: the CAPM

• Stocks B and D are considered overvalued because their estimated rates of

• In contrast, Stocks C and E are expected to provide rates of return greater

than we would require based on their systematic risk. Therefore, both

By: Dr. Lina Bassam 16

An Overview – Jenson’s Alpha

By: Dr. Lina Bassam 17

Passive Equity Portfolio Management

By: Dr. Lina Bassam 18

Passive Equity Portfolio Management Strategy

• 1. Attempt to replicate the performance of an index: Passive equity portfolio

Passive Equity Portfolio Management Strategy

By: Dr. Lina Bassam 20

Passive Equity Portfolio Management Strategy

By: Dr. Lina Bassam 21

Index Portfolio Construction Techniques

By: Dr. Lina Bassam 22

Index Portfolio Construction Techniques

By: Dr. Lina Bassam 23

Index Portfolio Construction Techniques

By: Dr. Lina Bassam 24

Index Portfolio Construction Techniques

By: Dr. Lina Bassam 25

Tracking Error and Index Portfolio Construction

• The goal of the passive manager should be to minimize

By: Dr. Lina Bassam 26

Tracking Error and Index Portfolio Construction