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Active or Passive? Issues and Strategies

This document discusses strategies for active and passive equity portfolio management. It covers indexing strategies that replicate an index, tracking error as a measure of accuracy, and reasons for rebalancing a portfolio. Active strategies involve trying to beat the market return through stock picking, industry picking, or other forecasting approaches. The Treynor-Black model provides a framework for constructing an optimal active portfolio based on estimated abnormal returns and risks of analyzed securities.

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Ashish Gupta
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45 views23 pages

Active or Passive? Issues and Strategies

This document discusses strategies for active and passive equity portfolio management. It covers indexing strategies that replicate an index, tracking error as a measure of accuracy, and reasons for rebalancing a portfolio. Active strategies involve trying to beat the market return through stock picking, industry picking, or other forecasting approaches. The Treynor-Black model provides a framework for constructing an optimal active portfolio based on estimated abnormal returns and risks of analyzed securities.

Uploaded by

Ashish Gupta
Copyright
© Attribution Non-Commercial (BY-NC)
We take content rights seriously. If you suspect this is your content, claim it here.
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Download as PPT, PDF, TXT or read online on Scribd
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Active or Passive?

Issues and
Strategies
• Market Efficiency
• Anomalies
• Market Timing
• A theoretical model of active portfolio
management (Treynor-Black)
• Quantitative Investment Management
Equity Portfolio Management:
Active or Passive?
Equity Portfolio Management:
Active or Passive?
• Passive:
– LT buy and hold
– Indexation
• Replication of an index (broad or specialized
• Sampling and Tracking Error
 = 0
– Rebalancing
Indexation
• Identify a Benchmark Index
– replicate benchmark index performance
– a true passive strategy will not attempt to
outperform index
– Tracking Error = measure of accuracy
Tracking Error: Measure 1
• n

TE1 =  ( R
t 1
pt  R bt ) 2

where Rpt and Rbt are portfolio and benchmark returns


respectively
Tracking Error: Measure 1
•
TE2 = σe

This represents the standard deviation of the error terms of


a regression equation explaining returns from the portfolio
with returns from the benchmark.
• We will revisit σe later
Rebalancing an Equity Portfolio
• Why?
– to manage tracking error (if indexing or not)
– to maintain a desired set of weights or risk level
– client needs change
– Market risk level changes
– bankruptcies, mergers, IPOs
• Why not?
– it’s costly!
Rebalancing: Example 1
Jan. 1 Price per Number $ Value % of Beta
Share of Shares Total
Value
X 20 167 $3340 0.333 1.2

Y 15 222 $3330 0.333 1.6

Z 35 95 $3325 0.333 0.8

Total $9995 1.20


Rebalancing: Example 1
June 1 Price per Number $ Value % of Beta
Share of Shares Total
Value
down X 16 167 $2672 0.256 1.3
20%
up Y 20 222 $4440 0.425 1.7
33%
unch. Z 35 95 $3325 0.319 0.8

Total 10445 1.31


Rebalancing: Example 1
• Portfolio is no longer equally weighted
• To rebalance:
– Sell Y, buy X and Z
– Positions must be reset to $10445/3 = $3482
– Sell 4440 - 3482 = $958 of Y (48 shares)
– Buy 3482 - 2672 = $810 of X (51 shares)
– Buy 3482 - 3325 = $157 of Z (4 shares)
Rebalancing: Example 1
June 1 Price per Number $ Value % of Beta
Rebal- Share of Shares Total
anced Value
X 16 167 $3488 0.334 1.3

Y 20 222 $3480 0.334 1.7

Z 35 95 $3465 0.332 0.8

Total 10433 1.27


Rebalancing: Example 1
• LT effects of this strategy?

• Alternatives?

• Example 2: Rebalancing to reestablish a


specific level of systematic risk (Target
Beta = 1.2)
Rebalancing: Example 2
• Reestablishing a beta of 1.2:
– No unique solution for more than 2 securities
– Need to sell high  stocks and buy low  stocks
– For example, sell Y, buy Z, hold X constant
 p = (.256)(1.3)+(WY)(1.7)+(1-.256-WY)(.8)
– Find Y such that p = 1.2
• WY = .302 => WZ = 1-.256-.302 = .442
• $3488 in X, $3151 in Y, $4611 in Z
Active Equity Strategies
• Beat the market on a risk adjusted basis!
• Need a benchmark
• More expensive: turnover, research
• Must outperform on a fee-adjusted basis
Active Management is Forecasting!
• The Fundamental Law of Active Management:
(Grinold and Kahn)
IR = IC x (BR)0.5
• IR = information ratio
– “reward-to-risk” or /σe
• IC = information coefficient
– correlation between forecast and actual (CORR(E(), 
• BR = breadth
– # of stocks evaluated per period
IR = IC x (BR)0.5
• Example:
– a stockpicker has an IC of .035 and makes 200
“bets” per quarter (800 per year)
– IR = (.035)(800)0.5 = .99 (is this good??)
– BARRA research indicates that an IR of +1.0 is
in the 90th percentile (-1.0 is in 10th, 0 is in
50th)
– What if I’m an industry picker?
Using the Fundamental law to forecast alpha

• Suppose that there is some indicator or signal that


we use to forecast performance. Call it S. S can
be a single factor (price-to-book) or the result of a
multifactor analysis. Standardize S. (e.g., S=+1.0
is 1 s.d. above the mean of 0)
• Adapting the fundamental law:
 = IC x σe x S
 = Skill x Volatility x Signal
Using the Fundamental law to forecast alpha

• Example:
– Your analysis produces a binary “buy” or “sell”
recommendation. Your IC = .05 (really good!)

Stock Sigma Buy or Sell Score Alpha


A .15 Buy +1.0 .0075
B .20 Buy +1.0 .01
C .15 Sell -1.0 -.0075
D .30 Sell -1.0 -.015
E .25 Sell -1.0 -.0125
Treynor-Black Model
• Suppose you can identify securities that you
expect to outperform (or underperform) on
a risk-adjusted basis

• How do you exploit this model?


Treynor-Black Model: Assumptions
• Analysts can only produce quality analysis on a small
number of securities
• There is a passive market portfolio (M)
• Forecasts of return (E(rM) and risk () exist
• Determine abnormal return () for analyzed securities
• Find optimal weights of analyzed securities to create active
component (A)
• Combine A, M and risk-free asset to achieve efficiency
Treynor-Black: Construction
(Step 1)
• Assume: ri = rf + i(rM - rf) + ei
• For analyzed security k:
rk = rf + k(rM - rf) + ek + k
=> estimate k, k, 2(ek)
• To construct A:
wk = (k/2(ek))/(i/2(ei)])
=> determine A, A, 2(eA)
Treynor-Black: Construction
(Step 2)
• w0 = (A/2(eA))/[(E(rM)-rf)/2M]

• w* = w0/(1+(1-A)w0)

• w0* is the proportion of A in the new,


enhanced market portfolio (M‘)
Active Equity Strategies
• Styles:
– Sector Rotation: move in/out of sectors as
economy improves/declines
– Earnings Momentum: overweight stocks
displaying above average earnings growth
– Enhanced Index Fund - majority of funds track
index, some funds are actively managed
– Quantitative Investment Management

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