Investment Strategy

Session 4

Chengcheng QU
APM

Office Hour J326 (Green Commons)

Monday/Thursday Period 4 [email protected]
Book in advance here 0977-88-6107
Agenda
• Recap: Mean and variance
• Estimation of return
• Estimation of risk
• Sharpe ratio
• Portfolio diversification
• Mutual funds and ETFs

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Mean and variance
For a random variable (e.g. asset return r), if the mean is 𝜇 and standard
deviation is 𝜎 (variance 𝜎 2 ):
𝑇
1 1
𝜇 = ෍ 𝑟𝑡 = (𝑟1 + 𝑟2 + ⋯ + 𝑟𝑇 )
𝑇 𝑇
𝑡=1
𝑇
1
𝜎2 = ෍(𝑟𝑡 −𝜇)2
𝑇
𝑡=1
1
or 𝑠 2 = σ𝑇𝑡=1(𝑟𝑡 −𝜇)2 for sample variance.
𝑇−1

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Given outcomes at probability 𝑝𝑡
𝑝1
𝑟1 𝑇
𝑝2 𝑟2 𝜇 = ෍ 𝑝𝑡 𝑟𝑡
𝑝3 𝑡=1
𝑟3 = (𝑝1 𝑟1 + 𝑝2 𝑟2 + ⋯ + 𝑝𝑇 𝑟𝑇 )
…
𝑇
…
𝜎 2 = ෍ 𝑝𝑡 (𝑟𝑡 − 𝜇)2
𝑝𝑇 𝑟𝑇 𝑡=1

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Estimation of return
Return for a single period: holding-period return (HPR)
E.g. if buy, hold, and sell a stock
𝐸𝑛𝑑 𝑃𝑟𝑖𝑐𝑒 − 𝐵𝑒𝑔𝑖𝑛 𝑃𝑟𝑖𝑐𝑒 + 𝐶𝑎𝑠ℎ 𝑑𝑖𝑣𝑖𝑑𝑒𝑛𝑑
𝐻𝑃𝑅 =
𝐵𝑒𝑔𝑖𝑛 𝑃𝑟𝑖𝑐𝑒
𝐸𝑛𝑑 𝑃𝑟𝑖𝑐𝑒 − 𝐵𝑒𝑔𝑖𝑛 𝑃𝑟𝑖𝑐𝑒 𝐶𝑎𝑠ℎ 𝑑𝑖𝑣𝑖𝑑𝑒𝑛𝑑
= +
𝐵𝑒𝑔𝑖𝑛 𝑃𝑟𝑖𝑐𝑒 𝐵𝑒𝑔𝑖𝑛 𝑃𝑟𝑖𝑐𝑒
= 𝐶𝑎𝑝𝑖𝑡𝑎𝑙 𝑔𝑎𝑖𝑛𝑠 𝑦𝑖𝑒𝑙𝑑 + 𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑 𝑦𝑖𝑒𝑙𝑑

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Estimation of return
Returns over Multiple Periods
• Arithmetic average, or the simple average, is a common measure of investment
performance.
• Geometric average equals the single per-period rate that compound to the same
final value.
E.g. (1 + .10) × (1 + .25) × (1 − .20) × (1 + .20) = (1 + 𝑟𝐺 ) 2
1
𝑟𝐺 = (1 + .10) × (1 + .25) × (1 − .20) × (1 + .20) 4

𝑟𝐺 =0.0719
• Dollar-weighted return, or internal rate of return (IRR), sets the present value of
the cash flows equal to the initial cost of establishing.

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Estimation of risk
• Standard deviation 𝜎 measures the volatility of the return, calculated as the
average absolute deviation from the mean.
• Value at risk (VaR) measures of downside risk, the worst loss that will be
suffered with a given probability, often 1% or 5%.
E.g. The 5% VaR is the fifth-percentile rate of return.
Return (%) Probability mean 5.00 %
-15.25 0.05 var 113.69 %^2
-10.25 0.1 sd 10.66 %
-5.25 0.1 VaR -15.25 %
-0.25 0.15
4.75 0.15
9.75 0.2
14.75 0.1
19.75 0.1
24.75 0.05
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Sharpe ratio
Evaluating portfolios according to their expected returns and standard deviations
(or variances) is called mean-variance analysis.
A statistic commonly used to rank portfolios in terms of this risk-return trade-off is
the Sharpe ratio, defined as
Portfolio risk premium 𝐸 𝑟𝑝 − 𝑟𝑓
𝑆𝑅 = =
Standard deviation of portfolio excess return 𝜎𝑝
While standard deviation is a useful risk measure for diversified portfolios but less
useful for individual securities.
Therefore, the Sharpe ratio is a valid statistic only for ranking portfolios; not for
individual assets.

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Historical return and risk

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Distribution of historical return
• The tails are fatter than the
normal distribution.
• Downside risk were
substantially greater than
upside potential.
• Negative skewness.

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Historical risks

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Portfolio expected return and risk 1
A portfolio of a risky portfolio and risk-free asset
𝐶𝑜𝑚𝑝𝑙𝑒𝑡𝑒 𝑝𝑜𝑟𝑡𝑓𝑜𝑙𝑖𝑜 = 𝑤 𝑅𝑖𝑠𝑘𝑦 𝑝𝑜𝑟𝑡𝑓𝑜𝑙𝑖𝑜 + 1 − 𝑤 𝑅𝑖𝑠𝑘 − 𝑓𝑟𝑒𝑒 𝑎𝑠𝑠𝑒𝑡
where 𝑤 and 1 − 𝑤 are the weight of risky and risk-free asset in the portfolio.
Then the portfolio return is:
𝑟𝐶 = 𝑤𝑟𝑃 + 1 − 𝑤 𝑟𝑓
with expectation: 𝐸(𝑟𝐶 ) = 𝑤𝐸(𝑟𝑃 ) + 1 − 𝑤 𝑟𝑓 , assume that 𝑟𝑓 is constant;
variance: 𝑉𝑎𝑟(𝑟𝐶 ) = 𝑉𝑎𝑟(𝑤𝑟𝑃 + 1 − 𝑤 𝑟𝑓 ) = 𝑉𝑎𝑟(𝑤𝑟𝑃 ) = 𝑤 2 𝜎𝑃2 ;
standard deviation: 𝜎𝐶 = 𝑤𝜎𝑃 .

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CAL of one risky portfolio and risk-free asset
• CAL (Capital allocation line)
depicts the risk-return
combinations available by
varying capital allocation 𝑤.

𝑤
• The Sharpe ratio is the
𝑤 same on this CAL.
• More risk-averse investors
will choose portfolios near
point F (risk-free asset).

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Portfolio expected return and risk 2
A portfolio of two risky asset
𝑃𝑜𝑟𝑡𝑓𝑜𝑙𝑖𝑜 = 𝑤𝐴 𝑅𝑖𝑠𝑘𝑦 𝑎𝑠𝑠𝑒𝑡 𝐴 + 𝑤𝐵 𝑅𝑖𝑠𝑘𝑦 𝑎𝑠𝑠𝑒𝑡 𝐵
Where 𝑤𝐴 and 𝑤𝐵 are the weight of risky assets in the portfolio.
Then the portfolio return is:
𝑟𝑃 = 𝑤𝐴 𝑟𝐴 + 𝑤𝐵 𝑟𝐵
with expectation: 𝐸(𝑟𝑃 ) = 𝑤𝐴 𝐸(𝑟𝐴 ) + 𝑤𝐵 𝐸(𝑟𝐵 )
variance: 𝑉𝑎𝑟(𝑟𝑃 ) = 𝜎𝑃2 = 𝑉𝑎𝑟(𝑤𝐴 𝑟𝐴 + 𝑤𝐵 𝑟𝐵 )
= 𝑤𝐴 2 𝜎𝐴2 + 𝑤𝐵 2 𝜎𝐵2 + 2𝑤𝐴 𝑤𝐵 𝜌𝐴,𝐵 𝜎𝐴 𝜎𝐵 ;
standard deviation: 𝜎𝑃 = 𝜎𝑃2 .

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CAL of two risky assets
• When 𝜌𝐴,𝐵 = 1
• CAL is a straight line
• Portfolios depends only on risk
aversion
• When 𝜌𝐴,𝐵 < 1
• CAL is on the left of the straight line
• Portfolio return equals to the weighted
average of assets’ return
• Portfolio return’s standard deviation is
less than the weighted average of
assets’ standard deviation

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Optimal portfolio of two risky assets
Given the portfolio expected return and standard deviation
𝐸(𝑟𝑃 ) = 𝑤𝐴 𝐸(𝑟𝐴 ) + 𝑤𝐵 𝐸(𝑟𝐵 )

𝜎𝑃 = 𝑤𝐴 2 𝜎𝐴2 + 𝑤𝐵 2 𝜎𝐵2 + 2𝑤𝐴 𝑤𝐵 𝜌𝐴,𝐵 𝜎𝐴 𝜎𝐵

Portfolio’s Sharpe ratio is

𝑤𝐴 𝐸(𝑟𝐴 ) + 𝑤𝐵 𝐸(𝑟𝐵 ) − 𝑟𝑓

𝑤𝐴 2 𝜎𝐴2 + 𝑤𝐵 2 𝜎𝐵2 + 2𝑤𝐴 𝑤𝐵 𝜌𝐴,𝐵 𝜎𝐴 𝜎𝐵

For two-assets portfolio 𝑤𝐴 + 𝑤𝐵 = 1, 𝑤𝐵 = 1 − 𝑤𝐴

We find the optimal 𝑤𝐴 to maximize portfolio’s Sharpe ratio
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Optimal portfolio of two risky assets
For 𝜌𝐴,𝐵 ≠ 1, the curve is continuous and calculate the derivative to get the
optimal allocation:
2
𝜎𝐵 𝐸(𝑟𝐴 )−𝑟𝑓 −𝜌𝜎𝐴 𝜎𝐵 𝐸(𝑟𝐵 )−𝑟𝑓
𝑤𝐴∗ = 2 𝜎 2 −(𝜌𝜎 𝜎 )2
𝜎𝐴 𝐵 𝐴 𝐵

2
𝜎𝐴 𝐸(𝑟𝐵 )−𝑟𝑓 −𝜌𝜎𝐴 𝜎𝐵 𝐸(𝑟𝐴 )−𝑟𝑓
𝑤𝐵∗ = 1 − 𝑤𝐴∗ = 2 𝜎 2 −(𝜌𝜎 𝜎 )2 .
𝜎𝐴 𝐵 𝐴 𝐵

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Investment companies
Investment companies are financial intermediaries that
• collect funds from individual investors
• and invest those funds in a potentially wide range of securities or other
assets.

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Mutual funds
• Open-end funds
When investors in open-end funds wish to “cash out” their shares, they sell
them back to the fund at NAV.
• Close-end funds
Investors in closed-end funds who wish to cash out sell their shares to other
investors.
Shares of closed-end funds are traded on organized exchanges and can be
purchased through brokers just like other common stock; their prices
therefore can differ from NAV.
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ETFs
• Most ETFs are classified and regulated as investment companies.
• Like mutual funds, ETFs offer investors a pro-rated ownership share of a
portfolio of stocks, bonds, or other assets and must report net asset value
each day.
• Investors buy and sell ETF shares through a broker just as they would
shares of stock.

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Assets under management (AUM)

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Active vs. passive funds
Question: Do actively managed funds always provide higher returns to
investors compared to passive funds?
• Do investors pay for fund management?
• Which are more likely to charge higher fees, active or passive fund?
• How do the fees affect net return investors receive?

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What does investment research say
Where Can Active Funds Beat
Passive Strategies? (Transcript)
https://youtu.be/jwdj59xX2CE?featur
e=shared

Betting Big on Stocks Rarely Beats

Boring Investing (Transcript)

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About Morningstar Inc.
Morningstar is an investment research company offering mutual fund, ETF,
and stock analysis, ratings, and data, and portfolio tools for investors.
Morningstar tracks trillions of assets in long-term mutual funds and ETFs
worldwide.
Home page: https://www.morningstar.com/
Morningstar Financial Research Library:
https://www.morningstar.com/business/insights/research-library

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