CFA二级培训项目

P tf li M
Portfolio Managementt

洪波 CFAFRMRFP
金程教育资深培训师
地点： ■ 上海□北京 □深圳
Topic Weightings in CFA Level II

Session NO. Content Weightings

Study Session 1
1‐2
2 Ethics & Professional Standards 10

Study Session 3 Quantitative Methods 5‐10

Study Session 4 E
Economic
i AAnalysis
l i 5 10
5‐10

Study Session 5‐7 Financial Statement Analysis 15‐25

Study Session 8‐9 Corporate Finance 5‐15
Study Session 10‐13 Equity Analysis 20‐30
Study Session 14‐15 Fixed Income Analysis 5‐15
Study Session 16‐17 Derivative Investments 5‐15
Study Session 18 Portfolio Management 5‐15
Studyy Session 13 Alternative Investments 515

2-102
 Portfolio Management
SS18
R53 Portfolio
P f li Concepts
C
R54 Residual Risk and Return: The Information Ratio
R55 The Fundamental Law of Active Management
R56 The portfolio Management Process and the Investment
Policy Statement

3-102
 Portfolio Concepts
(1)
(1)mean variance
i analysis
l i
(2) practical issues in mean‐variance
mean variance analysis
(3)Multifactor models

4-102
 Mean‐variance Analysis

LOS 53.a: Explain mean‐variance analysis and its assumptions, and calculate the expected
return and the standard deviation of return for a portfolio of two or three assets.
 Definition: it refers to the use of expected returns, variances, and covariances
of individual investments to analyze the risk‐return tradeoff of combinations
(i.e., portfolios) of these assets.
 Main assumptions
 All investors are risk averse; theyy prefer
p less risk to more for the same level
of expected return;
 Expected returns for all assets are known;
 The variances and covariances of all asset returns are known;
 Investors need only know the expected returns, variances, and covariance
of returns to determine optimal portfolios.
portfolios They can ignore skewness,
skewness
kurtosis and other attributes of a distribution;
 There are no taxes or transaction costs.

5-102
Mean‐variance Analysis

Formula
n n n
E (rp )   wi E ( Ri )  2
p   wi w j cov(Ri , R j )
i 1 i 1 j 1

 For a two
two‐asset
asset portfolio

E ( rp )  w1 E ( R1 )  w2 E ( R2 )
 2 p  w12 12  w2 2 2 2  2 w1 w2 1, 2 1 2
 For a three‐asset
three asset portfolio

E (rp )  w1 E ( R1 )  w2 E ( R2 )  w3 E ( R3 )

2 p  w12 12  w 2 2  2 2  w 32 23  2w1w 21,2 12  2w1w 31,313  2w 2 w 32,32 3

6-102
 Minimum Variance and Efficient Frontiers
LOS 53. b: Describe the minimum‐variance and efficient frontiers, and explain the steps to
solve for the minimum‐variance frontier.
 Minimum
Mi i variance
i and
d the
h efficient
ffi i frontiers
f i
Efficient portfolio: one offering the highest expected return for a given
level of risk as measured by variance or standard deviation
Minimum‐variance portfolios: portfolios that have minimum variance for
each ggiven level of expected
p return

7-102
 Minimum Variance and Efficient Frontiers

The minimum‐variance frontier is a graph of the expected

return/variance combinations for all minimum‐variance portfolios.
 Steps to solve
l ffor the
h minimum‐variance frontier
f
 Estimation step: Estimate the expected return and variance for
each individual asset and the correlation of each pair of assets
assets.
 Optimization step: Solve for the weights that minimize the
portfolio variance subject to the following constraints:
 The portfolio expected return equals a pre‐specified target
return
 The portfolio weights sum to 100%
 Repeat Optimization Step for many different values of pre‐
p
specified target
g return
 Calculation step: Calculate the expected returns and variances
for all the minimum‐variance portfolios determined in
Optimization Step
Step.
8-102
 Minimum Variance and Efficient Frontiers

LOS 53. c: Explain the benefits of diversification and how the correlation in a two‐asset
portfolio and the number of assets in a multi‐asset portfolio affect the diversification benefits.
 Characteristics about minimum‐variance frontiers and diversification
The endpoints for all of the frontiers are the same
Correlation in the two‐asset portfolio
 Correla on = +1 → the minimum‐variance frontier is an upward‐sloping straight
line diversification has no potential benefits
line，diversification benefits.
 Correla on from +1 to 0.5 → the minimum‐variance frontier bows out to the
left,
e t, in the
t e direction
d ect o ofo ssmaller
a e sta
standard
da d de
deviation
at o
 Correlation of 0.5, 0 and ‐1 → we can get more expected return with less risk.
As we lower correlation, holding all other values constant, there are
increasingly larger potential benefits to diversification.
 Correlation = ‐1 → the minimum‐variance frontier has two linear segments.
P f li risk
Portfolio i k can be
b reduced
d d to zero, if desired.
d i d
9-102
 Minimum Variance and Efficient Frontiers

 Between the two extreme correlations of +1 and ‐1, the minimum‐

variance frontier has a bullet‐like shape.

 The efficient frontier is the positively sloped part of the minimum‐

variance frontier.

10-102
Equally‐weighted Portfolio of n Stocks
LOS 53. d: Calculate the variance of an equally weighted portfolio of n stocks, explain the capital
allocation and capital market lines (CAL and CML) and the relation between them, and calculate the value
of one of the variables given values of the remaining variables.
 Equally‐weighted portfolio of n stocks
1
wi  w j  , i=1,2,…,n, j=1,2,…,n
n
n n n n
1
 2
p   wi w j cov(Ri , R j )  2  cov(R , R )
i j
i 1 j 1 n i 1 j 1
2
 Simplified equation (with average variance of return across all stocks  and the
average covariance between all pairs of two stocks cov ):

n趋向于无穷 2 1 2 n 1 1 1 n(n  1)
 2
 cov  p    cov
2
2 p  n( ) 2   2 2 * cov
p
n n n n 2
 More g
general expression
p ((assumingg stocks have the same standard deviation of returns):
)

n趋向于无穷 1  1 2 n 1
 2
 i 
2  2
p  （
2
 ） 2p    

p
n n n
11-102
 CAL and CML
Capital Allocation Line (CAL)
 Definition: describes the expected results of the investor’s
decision on how to optimally allocate her capital among risky and
risk‐free assets.
 General principles concerning the risk risk‐return
return trade
trade‐off
off in a
portfolio
containing a risk
risk‐free
free asset:
 If we can invest in a risk‐free asset, then the CAL represents
the best risk‐return trade‐off achievable;
 The CAL has a y‐intercept equal to the risk‐free rate;
 The CAL is tangent to the efficient frontier of risky assets.
 Exact formula
E ( RT )  RF
E ( RP )  RF  P
R T

12-102
 CAL and CML
 Capital Market Line (CML)
 When investors share identical expectations about the mean
returns, variance off returns, and d correlations
l off risky
k assets, the
h
CAL for all investors is the same and is known as the capital
market line ((CML):
)
E ( RM )  R F
E ( RP )  RF  P
M
 Notes: in the discussion on CML, it is different with CAL in that we
have assumed that investors may have different views about risky
assets’ mean returns,
assets returns variances of returns
returns, and correlations
correlations.
 Thus each investor may perceive a different efficient
frontier of risky assets
 and have a different tangency portfolio, the optimal
portfolio of risky assets which the investor may combine
with risk‐free
risk free borrowing or lending
lending.

13-102
 CAPM
LOS 53. e: Explain the capital asset pricing model (CAPM), including its underlying
assumptions and the resulting conclusions.

 Implication
 CAPM implies that the expected excess rate of return on an
asset is directly proportional to its covariance with the
market
k t return
t
 Exact formula

E ( Ri )  RF   i [ E ( RM )  RF ]

14-102
 CAPM

 Assumptions
 Investors need onlyy know the expectedp returns, the variances,
and the covariances of returns to determine which portfolios are
optimal for them.
 Investors have identical views about risky assets’ mean returns,
variances of returns, and correlations.
 Investors
I t can buy b and d sellll assets
t iin any quantity
tit without
ith t affecting
ff ti
price, and all assets are marketable (can be traded).
 Investors can borrow and lend at the risk‐free
risk free rate without limit
limit,
and they can sell short any asset in any quantity.
 Investors p
payy no taxes on returns and pay p y no transaction costs on
trades.

15-102
 CAPM
LOS 53. f: Explain the security market line (SML), the beta coefficient, the market risk
premium, and the Sharpe ratio, and calculate the value of one of these variables given the
values of the remaining variables.
 beta coefficient
measure of the asset sensitivity to movements in the market
Exact formula

C i , mkt
Cov  i , mkt i mkt  i , mkt i
 i   
 mkt 2  mkt 2
 mkt

 market risk premium  [ E ( RM )  RF ]

rp  r f
 Sharpe ratio 
p

16-102
 SML

 SML: the graph of CAPM

 Main differences between the SML and the CM L

SML CML
Measure of risk Uses systematic risk (non‐ Uses standard deviation
diversifiable risk) (total risk, systematic risk)
Application Tool used to determine the Tool used to determine the
appropriate expected returns appropriate asset allocation
for securities (percentages allocated to the risk‐
f
free assett and
d to
t the
th market
k t
portfolio) for the investor
Definition p of the CAPM
Graph Graph
p of the efficient frontier
Slope Market risk premium Market portfolio Sharpe ratio

17-102
Mean‐Variance Portfolio Choice Rules: An Introduction

 One of the most basic portfolio choice decisions is the selection of

p
an optimal asset allocation startingg from a set of p
permissible asset
classes.
 A second kind of decision involves modifying an existing portfolio.

18-102
Decisions Related to Existing Portfolios 1

 1. Comparisons of Portfolios as Stand‐Alone Investments

 This investor prefers A to B if either
 the mean return on A is equal to or larger than that on B, but
A has a smaller standard deviation of return than B,, or
 the mean return on A is strictly larger than that on B, but A
and B have the same standard deviation of return.

19-102
Decisions Related to Existing Portfolios 2

 2. The Decision to Add an Investment to an Existing Portfolio

 Three inputs needed:
 the Sharpe ratio of the new investment;
 the
th Sharpe
Sh ratio
ti off the
th existing
i ti portfolio;
tf li and
d
 the correlation between the new investment's return and portfolio p's
return,
t C
Corr(R
(Rnew, Rp).
)
 Adding the new asset to your portfolio is optimal if the following condition is
met.
met
E ( Rnew )  RF  E ( RP )  RF 
  Corr ( Rnew , RP )
 new   P 

20-102
Comparison

 we considered investments as stand‐alone and needed to

consider onlyy Sharpe
p ratios (from
( a mean–variance p
perspective)
p )
in choosing among them.
 in the case in which we can combine two investments, we must
also consider their correlation.

21-102
 Portfolio Concepts
(1)
(1)mean variance
i analysis
l i
(2) practical issues in mean‐variance
mean variance analysis
(3)Multifactor models

22-102
Limitation of historical estimates 1

 The historical method requires estimating a very large number of

parameters when we are optimizing
p p g for even a moderatelyy large
g
number of assets.
 If a portfolio manager has n stocks in a portfolio and wants to use
mean‐variance analysis, she must estimate
 n parameters for the expected returns to the stocks;
 n parameters for the variances of the stock returns; and
 n(n ‐1)/2 parameters for the covariances of all the stock
returns with each other.
 Together, the parameters total n2/2 + 3n/2.

23-102
Limitation of historical estimates 2

 The second limitation is that historical estimates of return

parameters typically
p yp y have substantial estimation error.
 The problem is least severe for estimates of variances.
 The p problem is acute with historical estimates of mean returns.
 Estimation error is also serious with historical estimates of
covariances.
 In current industry practice:
 the historical sample
p covariance matrix is not used without
adjustment in mean‐variance optimization. Adjusted values of
variance and covariance may be weighted averages of the raw
samplel values
l and
d the
h average variance
i or covariance,
i
respectively.

24-102
 Market Model
LOS 53.g: Explain the market model, and state and interpret the market model’s predictions
with respect to asset returns, variances, and covariances.
 Definition: the regression model often used to estimate betas for common
stocks
Ri   i   i RM   i
 Two sources of risk
 Unanticipated macroeconomic events (systematic risk)
 Firm‐specific events (unsystematic risk)
 Assumptions
 The expected value of the error term is zero
 The errors are uncorrelated with the market return
 The error terms, are uncorrelated among different assets. (The firm‐
specific surprises are uncorrelated across assets)

25-102
Assumptions of market model compared to single‐variable linear regression

 Note that some of these assumptions are very similar to those we

g
made about the single‐variable linear regression
g model in the
reading on correlation and regression.
 The market model, however, does not assume that the error term
is normally distributed or that the variance of the error term is
identical across assets.

26-102
 Market Model

 three predictions
 expected return for asset i E ( Ri )   i   i E ( RM )
 the expected return on asset i depends only on the
expected return on the market portfolio E ((R
RM )
 the sensitivity of the returns on asset i to movements in the
market
 the average return to asset i when the market return is
zero
eo
 variance of asset i  2
i   2
i  2
M   2


 the variance of the returns on asset i consist of two components:

 a systematic component related to the asset’s beta
 an unsystematic component related to firm
firm‐specific
specific events

27-102
 Market Model

covariance between assets i and j covi , j   i  j 2 M

 the covariance between any two stocks is calculated as the
product of their betas and the variance of the market portfolio

 We can use the market model to greatly reduce the computational task
off providing
idi ththe iinputs
t tto a mean‐variance
i optimization.
ti i ti
 For each of the n assets, we need to know  i ,  i ,  
2
as well as the
expected‐return
d andd variance ffor the
h market.
k Because we need d to estimate
only 3n + 2 parameters with the market model, we need far fewer
parameters to construct the
h minimum‐variance
i i i frontier
f i than
h we would ld if
we estimated the historical means, variances, and covariances of asset
returns.
t
28-102
 Market Model

LOS 53.h: Calculate an adjusted beta, and explain the use of adjusted and historical
betas as predicators of future betas.
betas

 beta instability problem

 The
h beta
b d
derived
i d from
f the
h market
k model
d l is
i a goodd estimate
i off
historical relationships but not necessarily a good predictor of
f t
future relationships
l ti hi
 Reason: if the historical beta inaccurately predicts the future beta
→ inaccurate forecasts will be used when a emp ng to derive
the efficient frontier and to make optimal portfolio decisions

29-102
Market Model

 Exact formula  i ,t   0   1  i ,t 1   i ,t
Where:  i,t is the beta forecast
 i ,t 1 is the historical beta derived from the market model

 adjusted beta formula forecast i ,t   0   1  i ,t 1

Where: the sum of  0 and 1 is set equal to 1

1/3 2/3

30-102
 Instability in the minimum‐variance frontier (efficient frontier)
LOS 53.i: Explain reasons for and problems related to instability in the minimum‐variance
frontier.
reasons
 the statistical inputs (means,
(means variances
variances, covariances) are unknown,
unknown and must be
forecast →greater uncertainty in the inputs leads to less reliability in the efficient
frontier
 Instabilityy definition: small changes
g in the statistical inputs
p can cause large g
changes in the efficient frontier
 time instability: statistical input forecasts derived from historical sample
estimates often change over time, causing the estimated efficient frontier to
change over time
 “overfitting” problem: does too much with the differences which are actually not
meaningful. For two reasons:
 Use statisticallyy and economicallyy insignificant
g difference in means
 Use too much negative weights for some asset, but actually investors will
seldomly sell short due to unlimited loss
To address the instability problem:
 the
th analyst
l t might
i ht consider
id constraining
t i i th the portfolio
tf li weights
i ht ((e.g., prohibiting
hibiti
short sales so that all portfolio weights are positive)
 employing forecasting models that provide better forecasts than historical
estimates
 avoiding rebalancing until significant changes occur in the efficient frontier.
31-102
Historical minimum‐variance frontier comparison

 researchers have developed various methods to address portfolio

g
managers' concerns about the issue of instability.
y

32-102
 Portfolio Concepts
(1)
(1)mean variance
i analysis
l i
(2) practical issues in mean‐variance
mean variance analysis
(3)Multifactor models

33-102
 Multifactor model
LOS 53.j: Describe and compare macroeconomic factor models, fundamental factor models,
and statistical factor models.
LOS 53.k: Calculate the expected return on a portfolio of two stocks, given the estimated
macroeconomic factor model for each stock.
 Multifactor models have gained importance for the practical business of portfolio
management for two main reasons.
1. multifactor models explain asset returns better than the market model does.
2. multifactor models provide a more detailed analysis of risk than does a single
factor model
model.
 Passive management. Analysts can use multifactor models to match an index fund's
factor exposures to the factor exposures of the index tracked.
 Active management.
management Many quantitative investment managers rely on multifactor
models in predicting alpha (excess risk‐adjusted returns) or relative return (the return
on one asset or asset class relative to that of another) as part of a variety of active
investment strategies.
strategies
 In evaluating portfolios, analysts use multi‐factor models to understand the
sources of active managers' returns and assess the risks assumed relative to the
manager'ss benchmark (comparison portfolio)
manager portfolio).

34-102
Macroeconomic Factor, Fundamental Factor, and Statistical Factor
models

 Macroeconomic Factor

 Fundamental factor models

 Statistical factor models

Mixed factor models

 Some practical factor models have the characteristics of

more
o e tthan
a one
o e of the
t e abo
abovee categories.
catego es Wee can
ca call
ca suc
such
models mixed factor models.

35-102
Macroeconomic Factor model

 Macroeconomic Factor Surprise = actual value – predicted (expected) value

 assumption:
p the factors are surprises
p in macroeconomic variables
that significantly explain equity returns Regression (time series)

 exactly formula for return of asset i Return FGDP FQS

bi1, bi2
Ri  E ( Ri )  bi1 FGDP  bi 2 FQS   i … … …

Where: Ri = return for asset i … … …

E(Ri ) = expected return for asset i … … …

FGDP = surprise in the GDP rate … … …

FQS = surprise in the credit quality spread … … …

bi1 = GDP surprise

p sensitivityy of asset i
bi2 = credit quality spread surprise sensitivity of asset i
εi = firm‐specific
p surprise
p which not be explained
p byy the model.

36-102
Macroeconomic Factor model ‐ What does surprise mean?

 Suppose our forecast at the beginning of the month is that

inflation will be 0.4 p
percent duringg the month. At the end of the
month, we find that inflation was actually 0.5 percent during the
month. During any month,
 Actual inflation = Predicted inflation + Surprise inflation
 In this case, actual inflation was 0.5 percent and predicted
inflation was 0.4 percent. Therefore, the surprise in inflation was
0.5 ‐ 0.4 = 0.1 percent.

37-102
Macroeconomic Factor model – factor sensitivity, error term

 Slope coefficients are naturally interpreted as the factor

sensitivities of the asset. A factor sensitivityy is a measure of the
response of return to each unit of increase in a factor, holding all
other factors constant.
 The term εi is the part of return that is unexplained by expected
return or the factor surprises. If we have adequately represented
th sources off common risk
the i k (the
(th ffactors),
t ) th then εi mustt representt
an asset‐specific risk. For a stock, it might represent the return
from an unanticipated company‐specific
company specific event.

38-102
Factor Sensitivities for a Two‐Stock Portfolio (example)

 Suppose that stock returns are affected by two common factors: surprises in
inflation and surprises in GDP growth. A portfolio manager is analyzing the
returns on a portfolio
f li off two stocks,
k Manumatic
M i (MANM) and d Nextech
N h (NXT),
(NXT)
The following equations describe the returns for those stocks, where the
factors FINFL. and FGDP, represent the surprise in inflation and GDP growth,
respectively:
RMANM  0.09  1FINFL  1FGDP   MANM
RNXT  0.12  2 FINFL  4 FGDP   NXT
 One‐third of the portfolio is invested in Manumatic stock, and two‐thirds is
invested in Nextech stock. Formulate an expression for the return on the
portfolio.
 State the expected return on the portfolio.
 Calculate the return on the portfolio given that the surprises in inflation and
GDP growth are 1 percent and 0 percent, respectively, assuming that the error
t
terms for
f MANM and d NXT both
b th equall 0.5
0 5 percent.
t

39-102
Factor Sensitivities for a Two‐Stock Portfolio (answer)

Solution to 1:
 The portfolio's
portfolio s return is the following weighted average of the
returns to the two stocks: Rp = (1/3)(0.09) + (2/3)(0 .12) + [(1/3)(‐ I)
+ (2/3)(2)] FINFL+ [(1/3)(1) + (2/3)(4)]FGDP + (1/3) εMANM + (2/3) εNXT
= 0.11 + 1 FINFL+ 3FGDP + (1/3) εMANM + (2/3) εNXT
Solution to 2:
 The expected return on the portfolio is 11 percent, the value of
the intercept in the expression obtained in Part 1.
Solution to 3:
 Rp = 0.11 + 1 FINFL+ 3FGDP + (1/3) εMANM + (2/3) εNXT = 0.11 + 1(0.01)
+ 3(0) + (1/3)(0
(1/3)(0.005)
005) + (2/3)(0
(2/3)(0.005)
005) = 0
0.125
125 or 12
12.55 percent

40-102
Arbitrage Pricing Theory (APT)

LOS 53.l: Describe the arbitrage pricing theory (APT), including its underlying
assumptions and its relation to the multifactor models, calculate the expected
return on an asset’s
asset s factor sensitivities and the factor risk premiums,
premiums and determine
whether an arbitrage opportunity exists, including how to exploit the opportunity.
 APT
 asset pricing model developed by the arbitrage pricing theory
 Assumptions
p
 A factor model describes asset returns
 There are manyy assets,, so investors can form well‐diversified p
portfolios
that eliminate asset‐specific risk
 No arbitrage
g opportunities
pp exist amongg well‐diversified p
portfolios
 Exactly formula

E ( R P )  R F   P ,1 ( 1 )   P , 2 (  2 )  ...   P , k (  k )
41-102
Arbitrage Pricing Theory (APT)

The factor risk premium (or factor price, λ j ) represents the expected
return in
i excess off the
h risk
i k ffree rate ffor a portfolio
f li with
i h a sensitivity
i i i off 1 to
factor j and a sensitivity of 0 to all other factors. Such a portfolio is called a
pure factor portfolio for factor j.
The p
parameters of the APT equation
q are the risk‐free rate and the factor
risk‐premiums (the factor sensitivities are specific to individual
investments).
investments)

42-102
Arbitrage Pricing Theory (APT)

 Arbitrage Opportunities
 The APT assumes there are no market imperfections preventing
investors from exploiting arbitrage opportunities
→ extreme
t llong and
d short
h t positions
iti are permitted
itt d and
d mispricing
i i i willill
disappear immediately
→ all arbitrage opportunities would be exploited and eliminated
immediately

43-102
Arbitrage Pricing Theory (APT) ‐ Example

Example: suppose that two factors, surprise in inflation (factor 1) and surprise in GDP
growth (factor 2), explain returns. According to the APT, an arbitrage opportunity exists
unless
E (RP )  RF  βp,1 (λ 1 )+βp,2 (λ 2 )
Well‐diversified portfolios, J, K, and L, given in table.

Portfolio Expected
p return Sensitivityy to Sensitivityy to GDP
inflation factor factor
J 0.14 1.0 1.5
K 0.12 0.5 1.0
L 0.11 1.3 1.1

E (RJ )  0.14  RF  1.0λ 1 +1.5λ 2

E (RK )  0.12  RF  0.5λ1 +1.0λ 2 E (RP )  0.07  0.02βp,1 +0.06βp,2
E (RL )  0.11  RF  1.3λ1 +1.1λ 2
44-102
Fundamental Factor

 Fundamental factor models

 p
the factors are attributes of stocks or companies that are
important in explaining cross‐sectional differences in stock prices
 exactly formula 求出FP/E, Fsize 不同公司的R和对应的bi1，bi2
e.g. the
th return
t diff
difference
R i  a i  bi1FP/E  bi2 FSIZE  i between low and high
Regression (cross
P/E stocks sectional data)

Return bi1 bi2

No economic interpretation
… … …

 asset return can be explained by the price‐earnings … … …

ratio, market capitalization。 … … …
Asset i's attribut value - average attribute value
bij  … … …
 (attribute
( tt ib t value)
l )
(P/E)1 - P/E … … …
e.g. bi1 
 P/E

45-102
Standardized beta

 Dividend yield example:

 after standardization a stock with an average g dividend yield
y
will have a factor sensitivity of 0,
 a stock with a dividend yield one standard deviation above the
average will
ill have
h a factor
f t sensitivity
iti it off 1
1,
 and a stock with a dividend yield one standard deviation
below the average will have a factor sensitivity of ‐1 1.
 Suppose, for example, that an investment has a dividend yield of
3.5 percent and that the average dividend yield across all stocks
being considered is 2.5 percent. Further, suppose that the
standard deviation of dividend yields across all stocks is 2
percent.
percent
 The investment's sensitivity to dividend yield is (3.5% ‐
2.5%)/2% = 0.50, or one‐half standard deviation above
average.
46-102
Standardized beta

 The scaling permits all factor sensitivities to be interpreted

y, despite
similarly, p differences in units of measure and scale in the
variables.
 The exception to this interpretation is factors for binary variables
such as industry membership. A company either participates in an
industry or it does not.
 The industry factor sensitivities would be 0 ‐ 1 dummy
variables;
 in
i models
d l that
th t recognize
i that
th t companiesi ffrequently
tl operate
t iin
multiple industries, the value of the sensitivity would be 1 for
each industry in which a company operated.
operated

47-102
Macroeconomic Factor, Fundamental Factor, and Statistical Factor
models

 Statistical factor models

 uses multivariate statistics (factor analysis or principal
components) to identify multiple statistical factors that explain
the covariance among asset returns
 major weakness: the statistical factors do not lend themselves
well to economic interpretation

48-102
Arbitrage Pricing Theory (APT)

 The relation between APT and multifactor models

APT Multifactor models
Characteristics cross‐sectional equilibrium time‐series regression that explains
pricing model that explains the the variation over time in returns
variation t ’ expected
i ti across assets’ t d for
f one assett
returns
Assumptions equilibrium‐pricing
equilibrium pricing model that ad hoc (i.e., rather than being
assumes no arbitrage derived directly from an
opportunities equilibrium theory, the factors are
id tifi d empirically
identified i i ll by
b looking
l ki for
f
macroeconomic variables that best
fit the data)
Interception risk‐free rate expected return derived from the
APT equation in macroeconomic
factor model

49-102
 Arbitrage Pricing Theory (APT)

 Comparison CAPM and APT

CAPM APT
Assumptions All investors should hold some APT gives no special role to the
combination of the market market portfolio, and is far more
portfolio and the risk‐free asset. To flexible than CAPM. Asset returns
control risk, less risk averse follow a multifactor process,
investors simply hold more of the allowing investors to manage
market portfolio and less of the several risk factors, rather than
risk‐free asst. just one.
conclusions The risk of the investor’s portfolio Investor’s unique circumstances
is determined solely by the may drive the investor to hold
resulting portfolio beta. portfolios titled away from the
market portfolio in order to hedge
or speculate on multiple risk
f t
factors.

50-102
Multifactor models in current practice

 Burmeister, Roll, and Ross (1994) presented a macroeconomic factor model to

explain the returns on U.S. equities. The model is known as the BIRR model for
short. The BIRR model includes five factors:
1. Confidence risk: the unanticipated change in the return difference between
risky corporate bonds and government bonds, both with maturities of 20
years. when their confidence is high, investors are willing to accept a smaller
reward d for
f bearing
b i this hi risk.
ik
2. Time horizon risk: the unanticipated change in the return difference between
20‐year government bonds and 30‐day Treasury bills. This factor reflects
investors' willingness to invest for the long term.
investors term
3. Inflation risk: the unexpected change in the inflation rate. Nearly all stocks
have negative exposure to this factor, as their returns decline with positive
surprises in inflation.
inflation
4. Business cycle risk: the unexpected change in the level of real business activity,
A positive surprise or unanticipated change indicates that the expected growth
rate of the economy, y, measured in constant dollars,, has increased.
5. Market timing risk: the portion of the S&P 500's total return that remains
unexplained by the first four risk factors. Almost all stocks have positive
sensitivity to this factor.

51-102
Explaining the Annual Expected Excess Return for the S&P 500
Effect of Factor on
Risk Factor Factor Sensitivity Risk Premium (%) Expected Return (%)
Confidence risk 0.27 2.59 0.70
Time horizon risk 0.56 -0.66 -0.37
Inflation risk -0.37 -4.32 1.6
Business cycle risk 1.71 1.49 2.55
Market timing risk 1.00 3.61 3.61
Expected excess return 8.09
 The estimated APT model is E(R) = T‐bill rate + 2.59(Confidence risk) ‐
0 66(Ti
0.66(Time h
horizon
i risk)
i k) ‐ 4.32(lnflation
4 32(l fl i risk)
i k) + 1
1.49(Business
49(B i cycle
l risk)
i k) +
3.61(Market timing risk).
 The table shows that the S&P 500 had positive exposure to every risk factor
except inflation risk
risk.
 The two largest contributions to excess return came from market timing risk
and business cycle risk.
 According to the table,
table this model predicts that the S&P 500 will have an
expected excess return of 8.09 percent above the T‐bill rate, Therefore, if the
30‐day Treasury bill rate were 4 percent, for example, the forecasted return
for the S&P 500 would be 4 + 8.09 = 12.09 p percent a year.
y

52-102
Exposures to Economy‐Wide Risks

 William Hughes is the portfolio manager of a U.S. core equity portfolio that is
being evaluated relative to its benchmark, the S&P 500. Because Hughes's
performance
f will
ill be
b evaluated
l d relative
l i to this
hi benchmark,
b h k it
i is
i useful
f l to
understand the active factor bets that Hughes took relative to the S&P 500.
Core Portfolio's
Portfolio s
Core Portfolio's Factor S&P 500 Factor
Risk Factor Excess Factor
Sensitivity Sensitivity
Sensitivity
Confidence risk 0.27 0.27 0,00
Time horizon risk 0.56 0.56 0.00
Inflation risk -0.12 -0.37 0.25
Business cycle risk 2.25 1.71 0.54
Market timing risk 1.10 1.00 0.10

 We see that the p portfolio manager

g tracks the S&P 500 exactlyy on confidence
and time horizon risk but tilts toward greater business cycle risk. The portfolio
also has a small positive excess exposure to the market timing factor.

53-102
Exposures to Economy‐Wide Risks

 Ignoring nonsystematic risk and holding the values of the other factors
constant, if there is a +1 percent surprise in the business cycle factor, we
expect the
h return on the h portfolio
f li to b
be 0.01
0 01 x 0.54
0 54 = 0.0054
0 0054 or 0.54
0 54 percent
higher than the return on the S&P 500. Conversely, we expect the return on
the portfolio to be lower than the S&P 500's return by an equal amount for a –
1 percent surprise in business cycle risk.
 Because of the excess exposure of 0.54, the portfolio manager appears to be
placing a bet on economic expansion,
expansion relative to the benchmark.
benchmark
 the portfolio manager's excess sensitivity of 0.25 to the inflation factor. The
S&P 500 has a negative inflation factor exposure. The value of 0.25 represents
a smaller
ll negative
i exposure to inflation
i fl i forf theh core portfolio,
f li that
h iis, lless
rather than more exposure to inflation risk.
 The market timingg factor has an interpretation
p somewhat similar to that of the
CAPM beta about how a stock tends to respond to changes in the broad
market, with a higher value indicating higher sensitivity to market returns, all
else equal.

54-102
Expected Return in the Salomon RAM

 The Salomon RAM model explains returns to U.S. stocks in terms of nine factors: six
macroeconomic factors, a residual market factor, a residual size factor, and a residual
sector factor:
1. Economic growth: the monthly change in industrial production.
2. Credit quality: the monthly change in the yield of the Salomon Smith Barney High‐Yield
Market 10 + yyear index,, after removingg the component
p of the change
g that is correlated
with the monthly changes in the yields of 30‐year Treasury bonds.
3. Long rates: the monthly change in the yield of the 30‐year Treasury bond.
4. Short rates: the monthlyy changeg in the yyield of the 3‐month Treasuryy bill.
5. Inflation shock: the unexpected component of monthly change in CPI.
6. Dollar: the monthly change in the trade‐weighted dollar.
7 Residual market: the monthly return on the S&P 500 after removing the effects of the
7.
six factors above.
8. Small‐cap premium: the monthly difference between the return on the Russell 2000
Index and the S&P 500, after removingg the effect of the seven factors above.
9. Residual sector: the monthly return on a sector membership index after removing the
effect of the eight factors above.

55-102
Factor Portfolios(example)
 Analyst Wanda Smithfield has constructed six portfolios for possible use by
portfolio managers in her firm. The portfolios are labeled A, B, C, D, E, and F.
Risk Factor A B C D E F

Confidence risk 0.50 0.00 1.00 0.00 0.00 0.80

Time horizon risk 1.92 0.00 1.00 1.00 1.00 1.00

Inflation risk 0.00 0.00 1.00 0.00 0.00 -1.05

Business cycle risk 1.00 1.00 0.00 0.00 1.00 0.30

M k t timing
Market ti i risk
i k 0 90
0.90 0 00
0.00 1 00 0.00
1.00 0 00 0 00
0.00 0 75
0.75

1. A portfolio manager wants to place a bet that real business activity will increase.
A Determine and justify the portfolio among the six given that would be most
useful to the manager.
B What type
yp of position
p would the manager
g take in the portfolio
p chosen in
Part A?
56-102
Factor Portfolios(example)

2. A portfolio manager wants to hedge an existing positive exposure to time

horizon risk.
A Determine and justify the portfolio among the six given that would be most
useful to the manager.
B What type
yp of position
p would the manager
g take in the portfolio
p chosen in
Part A?

 Solution to 1A:
Portfolio B is the most appropriate choice. Portfolio B is the factor portfolio for
business cycle risk because it has a sensitivity of 1 to business cycle risk and a
sensitivity of 0 to all other risk factors.
factors Portfolio B is thus efficient for placing a pure
bet on an increase in real business activity.
 Solution to 1B:
Th manager would
The ld ttake
k a long
l position
iti ini Portfolio
P tf li B to t place
l a bet
b t on an
increase in real business activity.

57-102
Factor Portfolios(example)

 Solution to 2A:
Portfolio D is the appropriate choice. Portfolio D is the factor portfolio for time
h i
horizon risk
i kbbecause iit h
has a sensitivity
i i i off 1 to time
i h
horizon
i risk
i k and
d a sensitivity
i i i off
0 to all other risk factors. Portfolio D is thus efficient for hedging an existing
positive exposure to time horizon risk.

 Solution to 2B:
The manager
g would take a short p
position in Portfolio D to hedge
g the positive
p
exposure to time horizon risk.

58-102
 Active Risk and Information Risk
LOS 53.m: Explain sources of active risk, interpret tracking error, tracking risk, and
the information ratio, and explain factor portfolio and tracking portfolio.
 Active risk
 Activity return (track error)
 Definition: the differences in returns between a managed
portfolio and its benchmark
 Exactly formula active return  RP  RB
 Activity risk
 Definition: the standard deviation of active returns
 Exactly
E tl fformula
l

active risk  s( RP  RB ) 
 (R
Pt  RBt ) 2
n 1

59-102
 Active Risk and Information Risk

 Information Risk
 Definition: the ratio of mean active return to active risk
 Purpose: a tool for evaluating mean active returns per unit of
active
ti risk
ik
 Exactly formula

RP  RB
IR 
s (R P  R B )

60-102
Active risk squared

 We can separate a portfolio's active risk squared into two

p
components:
Active risk squared = s 2 (R P  R B )

 Active factor risk is the contribution to active risk squared

resulting from the portfolio's different‐than‐benchmark
exposures relative to factors specified in the risk model.
 Active specific risk or asset selection risk is the contribution to
active risk squared resulting from the portfolio's active weights on
individual assets as those weights interact with assets' residual
risk "
risk.
 Active risk squared = Active factor risk + Active specific risk

61-102
 Factor portfolio

 Factor Portfolio

 A portfolio manager can use multifactor models to establish a

specific desired risk profile for his portfolio.

 Factor portfolio: a portfolio that has been constructed to have

sensitivity equal to 1 to only one risk factor (e.g.
(e g GDP growth
rate), and sensitivities of 0 to the remaining factors.

 As a pure bet on a source of risk, factor portfolios are of

interest to a portfolio manager who wants to hedge that risk
(offset it) or speculate on it.

62-102
Example: factor portfolios

 Analyst Wanda Smithfield has constructed six portfolios for

possible use byy p
p portfolio managers
g in her firm. The p
portfolios are
labeled A, B, C, D, E, and F.
Portfolios
Risk Factor A B C D E F
Confidence risk 0.50 0.00 1.00 0.00 0.00 0.80
Time horizon risk 1.92 0.00 1.00 1.00 1.00 1.00
Inflation risk 0.00 0.00 1.00 0.00 0.00 -1.05
Business cycle risk 1.00 1.00 0.00 0.00 1.00 0.30
Market timing risk 0.90 0.00 1.00 0.00 0.00 0.75
Note: Entries are factor sensitivities.

63-102
 Tracking portfolio

Tracking Portfolio

 Tracking portfolio: a portfolio with factor sensitivities

that match those of benchmark
benchmark‐portfolio
portfolio or other
portfolio

64-102
Creating a tracking portfolio

 The plan sponsor has specified an equity benchmark for a portfolio manager,
who has decided to create a tracking portfolio for the benchmark. The
portfolio manager determines that the benchmark has a sensitivity of 1 1.3
3 to
the surprise in inflation and a sensitivity of 1.975 to the surprise in GDP.
 There are three constraints.
 portfolio weights sum to 1 1,
 the weighted sum of sensitivities to the inflation factor equals 1.3 (to
match the benchmark),
 the
th weighted
i ht d sum off sensitivities
iti iti tto the
th GDP factor
f t equals l 1.975
1 975 (to
(t match
t h
the benchmark).
 Thus we need three investments, to form the portfolio, which we take to be
Portfolios J,
J K,
K and L.
L We repeat Table 14 below.
below
Sensitivitiy to Sensitivity to GDP
Portfolio Expected Return
Inflation Factor Factor
J 0.14 1.0 1.5
K 0.12 0.5 1.0
L 0.11 1.3 1.1

65-102
Creating a tracking portfolio

 As mentioned, we need three equations to determine the

portfolio weights
p g wJ, wK, and wL in the trackingg portfolio.
p
 Equation 1. This equation states that portfolio weights must sum
to 1. wJ + wK + wL = 1
 Equation 2. The second equation states that the weighted
average of the sensitivities of J, K, and L to the surprise in inflation
must equal the benchmark's sensitivity to the surprise in inflation,
1.3. 1.0wJ + 0.5wK + 1.3wL = 1.3
 Equation
E ti 3.3 The
Th third
thi d equation
ti states
t t that
th t th
the weighted
i ht d average
of the sensitivities of J, K, and L to the surprise in GDP must equal
the benchmark's
benchmark s sensitivity to the surprise in GDPGDP, 1.975.
1 975 1.5w
1 5wJ +
1.0wK + 1.1wL = 1.975
 wJ = 2;; wK = ‐0.75;; wL = ‐0.25

66-102
Creating a tracking portfolio

 The tracking has an expected return of 0.14wJ + 0.12wK + 0.11wL =

( ) +(0.12)
0.14(2) ( ) ((‐0.75)) + 0.11(‐0.25)
( ) = 0.28 ‐ 0.09 ‐ 0.0275 =
0.1625.
 In previous Example using the same inputs, we calculated the APT
model as E (RP )  0.07  0.02βp,1 +0.06βp,2

 For the tracking portfolio, βp,1 =1.3 and βp,2  1.975 . As E(RP)=
0.07 ‐ 0.02(1.3) + 0.06(1.975) = 0.1625, we have confirmed the
expected
t d return
t calculation.
l l ti

67-102
 Residual Risk and Return: The
Information Ratio

68-102
Information ratio

LOS 54.a: define the terms “alpha” and “information ratio” in both their ex post and
ex ante senses;
LOS 54
54.b:compare
b:compare the information ratio and the alpha’s
alpha s TT‐statistic;
statistic;
 Alpha (residual return)：the return of a portfolio in excess of its benchmark.
(adjusted for risk difference between the portfolio and benchmark).
benchmark)

 Ex‐ante alpha is a forward‐looking forecast of residual return

 Ex‐post alpha is a back‐ward‐looking average of realized residual returns,

which can be computed using a regression model
R pt = a p + b p RBt + e t

 It can be p
positive or negative.
g

 Alpha of a portfolio: the weighted average of the alphas of the individual

securities in the portfolio

69-102
Information ratio

 Information ratio: the annualized residual return of the portfolio dividend by the
annualized residual risk.
annualized residual return α
information ratio = =
annualized residual risk ω
 Ex‐post information ratio
tα
ex-post information ratio =
n
 t α= t‐statistic of α in the regression model
 n = number of years of the data in the regression model.
 Information ratio can be computed over any horizon
 It would increase with the time horizon
 The quarterly information ratio would be half of the annual information ratio
 Example: a manager can achieve an expected residual return of 2% with a residual risk
of 5%, compute the expected residual return given a risk tolerance of 8% for residual
risk
 Information ratio=2%/5%=0.4 expected residual return = 0.4(8%)=3.2%
70-102
Example: residual return of a portfolio
 Consider five stocks that have non‐zero alpha, and a benchmark portfolio that
constrains an equal weighting in each of these stocks

Stock Alpha Benchmark Portfolio Portfolio X Portfolio X Portfolio Y

weight X weight active weight weight active weight

A ‐1.0% 20% 15% ‐5% 10% ‐10%

B ‐1.5% 20% 15% ‐5% 10% ‐10%
C 2 0%
2.0% 20% 25% 5% 30% 10%
D 0.5% 20% 25% 5% 30% 10%
E 0.0% 20% 20% 0% 20% 0%

71-102
Answer

 Portfolio alpha can be calculated as the weighted average of individual security alphas:
 Benchmark α = (0.20)(‐1.0%)+ (0.20)(‐1.5%) +(0.20)(2.0%)+ (0.20)(0.5%)+
(0.20)(0.0%)=0%
 Portfolio X α= (0.15)(‐1.0%)+ (0.20)(‐1.5%) +(0.25)(2.0%)+ (0.25)(0.5%)+
(0 20)(0 0%) 0 25%
(0.20)(0.0%)=0.25%
 Portfolio Y α= (0.10)(‐1.0%)+ (0.10)(‐1.5%) +(0.30)(2.0%)+ (0.30)(0.5%)+
(
(0.20)(0.0%)=0.5%
)( )
 Portfolio alphas can also be computed using the active weights:
 Portfolio X α= (‐0.05)(‐1.0%)+ (‐0.05)(‐1.5%) +(0.05)(2.0%)+ (0.05)(0.5%)+
(0.00)(0.0%)=0.25%
 Active weights of portfolio Y are twice as large as portfolio, which means portfolio is
more aggressive.
aggressive Due to the same information set,set the information ratio is unchanged.
unchanged
 In conclusion:
p
Information ratio is independent of manager’s
g level of aggressiveness
gg

72-102
Residual frontier

 Residual frontier is the plot of residual return vs. residual risk for a given
information ratio.
14 Residual return(%)
12
10 T
8 S
6 R
4
2 Q
0 P
0
B 5 10 15 20 25 30 Residual risk(%)

 Portfolio B is the benchmark portfolio with zero alpha and zero residual risk.
 The slop of the residual frontier is the information ratio
 For an active manager,
g , the information ratio can be viewed as a budget
g constraint
 The manager can increase the active return only by increasing residual risk

73-102
Value added

LOS 54.c: explain the objective of active management in terms of value added;;
 Value added is a metric that attempts to capture the tradeoff between return
and active risk. VA = α- (λ×ω2 )
Wh
Where: λ = risk
i k aversion
i parameter
t ((a hi
higher
h λ indicates
i di t higher
hi h risk
i k aversion
i )

 The objective of active management is to maximize value added.

 Value added is higher for a manager with higher alpha, lower risk aversion,
lower residual risk. Constant value added parabolas

 Value added can be thought of as

risk adjusted excess return: alpha is

a discounted for higher residual risk

or higher risk aversion

74-102
Optimization
LOS 54.d:calculate the optimal level of residual risk to assume for given levels of
manager ability and investor risk aversion;;
 An investor would p
prefer the highest
g value for VA (highest
( g parabola)
p )
but it limited to the opportunities presented by their residual frontier.

 When the residual frontier is tangent to the highest achievable value

added parabolas, the tangency point is the optimal portfolio.

75-102
Example: Value added

 Jackie Schroff is a value manager with First Partners, LLP. Schroff estimates
that he can generate residual return of 3% annually. Schroff’s residual risk is
6 5%
6.5%.
 Compute the value added for:
 a.
a an aggressive investor ( λλ=0
0.05).
05)
 b. a moderately risk‐averse investor (λ=0.10 ).
 c. a conservative investor (λ=0.15).

 Answer:
 a. VA  3% -（0.05  6.52）=0.89%
 b. VA  3%-（0.10  6.52）= -1.23%
 c. VA  3%- 0 15  6.5
3% （0.15 6 52）= -3.34%
3 34%

 Value added decreases as the investor’s risk aversion increases

76-102
Optimization

 Calculate the optimal level of residual risk

 Value added initiallyy increases with risk,, but the penalty

p y for risk eventuallyy
outweighs the gains from taking additional risk.
 the optimal
p level of residual risk ggiven IR and λ : Optimal portfolio

 Higher(lower) the IR and lower(higher) the

risk aversion, the higher (lower) the optimal
level of residual risk
 The implied level of risk aversion:

77-102
Choice of active strategy
LOS 54.e: justify why the choice for a particular active strategy does not depend on
investor risk aversion.;
 Investor will choose the manager with the highest information ratio,
independent of the investor’s level of risk aversion.

 Risk
Ri k aversion
i off th
the iinvestor
t will
ill only
l ddetermine
t i h how aggressively
i l ((or
conservatively )the investor will implement that manager’s strategy.
 Proof:
P f

78-102
Example

 Using the following information, the manager who has the highest optimal
level of residual risk most likely:
Manager Residual return Residual risk Level of risk
aversion
A 5 0%
5.0% 5 5%
5.5% 0 12
0.12
B 4.0% 5.0% 0.10
C 5.0% 7.5% 0.08
 Solution: C

Manager Residual Residual IR Level of risk Optimal level of

return risk aversion residual risk
A 5.0% 5.5% 0.909 0.12 3.79
B 4.0% 5.0% 0.800 0.10 4.00
C 5.0% 7.5% 0.667 0.08 4.17

79-102
 The Fundamental Law of
Active Portfolio Management

80-102
 The Fundamental Law of Active Portfolio Management

 define the terms “information coefficient” and “breadth” and

describe how they combine to determine the information ratio;
 describe how the optimal level of residual risk of an investment
strategy changes with information coefficient and breadth, and how
the value added of an investment strategy changes with information
coefficient and breadth;
 contrast market timing and security selection in terms of breadth and
required investment skill;
 describe how the information ratio changes when the original
investment strategy is augmented with other strategies or
information sources;
 describe the assumptions on which the fundamental law of active
management is based.

81-102
Fundamental law of active management
LOS 55.a: define the terms “information coefficient” and “breadth” and describe
how they combine to determine the information ratio;

 Information coefficient (IC): a measure of a manager’s forecasting accuracy,

which can be viewed as the correlation of a manager’s forecast and actual
outcomes.

 Breath(BR): the number of independent forecasts of exceptional return per

year that the manager makes.

 If multiple analysts pick different stocks in the same industry,

industry the same
information may be used by the analysts, which is not independent.

 Quantify BR: If an analyst follows two stocks and makes monthly bets:

BR = 2 forecasts/month * 12months/year=24 forecasts/year

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Fundamental law of active management

 Fundamental law of active management relates breath and skill to the

information ratio:

 The information ratio can be increased by improving the forecasting

accuracy or the number of bets

 Additivity principle: assume the firm with two analysts: a fixed income analyst
and an equity analyst:

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Example

 Dharmesh Thakur, equity analyst with Gupta Asset Management, currently

follows 100 stocks and makes quarterly forecasts.
forecasts Thakur’s information
coefficient is 0.05.

1. Compute Thakur’s information ratio.

2. If Thakur chooses to follow an additional 100 stocks (with quarterly

forecasts) but with an information coefficient of 0.04, what will be
Thakur’s new information ratio?

 Answer:

1
1. Th k ’ currentt breadth
Thakur’s b dth = 400.
400 Current
C t information
i f ti ratio
ti = 0 05  400
0.05 400=1.00
1 00

2. New information ratio = 1

[1.002  (0.04) 2 (400)] 2  1.28

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Fundamental law of active management
LOS 55.b: describe how the optimal level of residual risk of an investment strategy
changes with information coefficient and breadth, and how the value added of an
investment strategy changes with information coefficient and breadth;
 Given the optimal level of residual risk

 The optimal level of residual risk increases with information

coefficient
ffi i t and
dbbreadth
dth and
d decreases
d with
ith risk
i k aversion.
i

 The value added for an optimal level of residual risk by the active
manager can be quantified as:

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Fundamental law of active management

LOS 55.c: contrast market timing and security selection in terms of breadth and
required investment skill;

 Market timing is simply a bet on the direction of the market.

 The information coefficient of the manager is the covariance between the

forecast and the actual direction of the market:

Nc
IC = 2( ) -1
N

Where N is the total number of bets on marketNdirection

C /N=0.5
made by the analyst
and
d NC is
i the
th number
b off b
bets
t th
thatt were correct.
t

 If the manager is correct half the time (i.e. ), IC=0

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Example

 Darsh Bhansali is a manager with Optimus Capital. Bhansali, a market timer,

makes bets every quarter about the direction of the market.
market Bhansali’s
forecasts are right 55% of the time. Mike Neal is an equity analyst focusing on
Asian stocks.
k Neal,l a security selector,
l selects
l undervalued
d l d securities and
d
typically makes 50 bets per year. Neal has an information coefficient of 0.04.
Compute the information ratios of Bhansali and Neal.

 Answer:

 Bhansali’s IC = 2(0.55) – 1 = 0.01, Bhansali’s IR = (0.01) 4 = 0.20

 Neal’s IR = (0.04
0 04)( 50 ) = 0.28
0 28

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Fundamental law of active management

LOS 55.d: describe how the information ratio changes when the original investment
strategy is augmented with other strategies or information sources;
 When
Wh a manager obtains
b i an additional
ddi i l source off iinformation
f i that
h iis correlated
l d
(correlation=r) with the manager’s original information, the information
coefficient does not increase proportionately with the amount of the new
information.

 The combined IC using the two sources information is:

 If the information is independent (r=0):

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Fundamental law of active management

LOS 55.e: describe the assumptions on which the fundamental law of active
management is based;
 Assumption of the fundamental law of active management:

 The manager
g has accurate knowledge
g of his skills and acts on
information optimally.

 Sources off information

f are independent
d d

 Information coefficient(i.e. the skill involved in forecasting) is

constant across bets

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 The Portfolio Management Process
and the Investment Policy Statement

90-102
The Portfolio Management Process and the Investment
Policy Statement
Portfolio Perspective
Portfolio Management
Investment Objectives and Investment Constrains
M
Management i
investment portfolios
f li

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Portfolio Perspective

LOS 56.a: Explain the importance of the portfolio perspective.

 Portfolio
f Perspective:
p focus on the aggregate
gg g of all the investor’s
holdings the portfolio
 Harry Markowitz → Modern Por olio Theory (MPT)
 Some pricing models
 h as CAPM,
such CAPM APT
APT, ICAPM
ICAPM, etc
t
→ these pricing models are all based on the principle that systematic
risk is priced
→ should analyze the risk‐return tradeoff of the portfolio

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 Portfolio Management
LOS 56.b: Describe the steps of the portfolio management process and the
components of those steps.
 Steps
S
the planning step
 Identifying and Specifying the Investor’s Objective and Constraints
 Creating the Investment Policy Statement
 Forming Capital Markets Expectations
 Creating the Strategic Asset Allocation
the execution step
the feedback step
 Monitoring and Rebalance
 Performance Evaluation

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 Investment Objectives and Investment Constrains

LOS 56.e: Define investment objectives and constraints, and explain and distinguish among
the types of investment objectives and constraints.
LOS 56.f: Contrast the types of investment time horizons, determine the time horizon for a
particular investor, and evaluate the effects of this time horizon on portfolio choice.
 Investment objectives
 Investment objectives
b relate
l to what
h the
h investor wants to accomplish
l h with
h the
h
portfolio
 Objectives are mainly concerned with risk and return considerations
Risk objective

Risk measurement
meas rement ‐ Value
Val e at risk (VAR)

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 Investment Objectives and Investment Constrains

 Some specific factors that affect the ability to accept risk

 Required spending needs：How much variation in portfolio value
can the investor tolerance before she is inconvenienced in the
short term?
 Long‐term wealth target: How much variation in portfolio value
can the investor tolerance before it jeopardizes meeting long‐term
wealth goals?
 Financial strengths: Can the investor increase savings if the
portfolio is insufficient to meet his spending needs?
 Liabilities: Is the investor legally obligated to make future
payments to beneficiaries, or does the investor have certain
spending requirement?

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Investment Objectives and Investment Constrains

Return objective
 Return measurement
 such as: total Return; absolute Return; return relative to the
benchmark’s; return nominal returns; real returns inflation‐
adjusted
d d returns; pretax returns; post‐tax returns
 Return desire and requirement
 desired
d i d return is i that
h llevell off return stated
dbby the
h client,
li
including how much the investor wishes to receive from the
portfolio
 required return represents some level of return that must
be achieved by the portfolio, at least on an average basis to
meet the target financial obligations

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Investment Objectives and Investment Constrains

 Investment constrains
 Investment constrains are those factors restrictingg or limitingg
the universe of available investment choices
 Types
 Liquidity requirement: a need for cash of new contributions or
savings at a specified point in time
 Time horizon: the time period associated with an investment
objective (short term
term, long term
term, or a combination of the two).
two)
 Tax concerns: tax payments reduce the amount of the total return

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 Investment Objectives and Investment Constrains

Legal and regulatory factors:

 external factors imposed by governmental,
governmental regulatory,
regulatory or oversight
authorities to constrain investment decision‐making.
Unique circumstances:
 internal factors, an individual investor’s portfolio choices may be
constrained
t i db by circumstances
i t focusing
f i on h health
lth needs,
d supportt off
dependents, and other circumstances unique to the particular
individual.
individual

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 IPS

 Definition
 a written planning document that governs all investment
decisions for the client
 Main roles
 Be readily implemented by current or future investment advisers.
 Promote long‐term discipline for portfolio decisions.
 Help protect against short‐term shifts in strategy when either
market environments or portfolio performance cause panic or
overconfidence.

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 IPS
 Elements
 A client description that provides enough background so any
competent investment adviser
d can give a common
understanding of the client’s situation.
 The purpose of the IPS with respect to policies,
policies objectives
objectives,
goals, restrictions, and portfolio limitations.
 Identification of duties and responsibilities of parties
involved.
 The formal statement of objectives and constrains.
 A calendar schedule for both portfolio performance and IPS
review.
 Asset allocation rangesg and statements regarding
g g flexibilityy
and rigidity when formulating or modifying the strategic
asset allocation.
 Guidelines for portfolio adjustments and rebalancing
rebalancing.
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 IPS

 Three approaches
 Passive investment strategy approach: portfolio composition does
not react to changes in expectations, an example in indexing
 Active approach: involves holding a portfolio different from a
benchmark or comparison portfolio for the purpose of producing
positive excess risk‐adjusted
risk adjusted returns
 Semiactive approach: an indexing approach with controlled use of
weights different from benchmark
 Asset allocation
 the final step in the planning stage, combines the IPS and capital
market expectations to formulate weightings on acceptable asset
classes
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 Management investment portfolios

LOS 56.g: Justify ethical conduct as a requirement for managing investment

portfolios.
 Justify ethical conduct as a requirement for managing investment
portfolios
 the investment professional who manages client portfolio well
meets both standards of competence
p and standards of conduct
 the appropriate standard of conduct is embodied by the CFA
Institute Code and Standards

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