 The McGraw-Hill Companies, Inc., 1999 INVESTMENTS Fourth Edition Bodie Kane Marcus Irwin/McGraw-Hill 28-1 The Theory of Active Portfolio Management Chapter 28

 The McGraw-Hill Companies, Inc., 1999 INVESTMENTS Fourth Edition Bodie Kane Marcus Irwin/McGraw-Hill 28-2 Are markets totally efficient? Some managers outperform the market for extended periods While the abnormal performance may not be too large, it is too large to be attributed solely to noise Evidence of anomalies such as the turn of the year exist The evidence suggests that there is some role for active management Lure of Active Management

 The McGraw-Hill Companies, Inc., 1999 INVESTMENTS Fourth Edition Bodie Kane Marcus Irwin/McGraw-Hill 28-3 Adjust the portfolio for movements in the market Shift between stocks and money market instruments or bonds Results: higher returns, lower risk (downside is eliminated) With perfect ability to forecast behaves like an option Market Timing

 The McGraw-Hill Companies, Inc., 1999 INVESTMENTS Fourth Edition Bodie Kane Marcus Irwin/McGraw-Hill 28-4 rfrf rfrf rMrM Rate of Return of a Perfect Market Timer

 The McGraw-Hill Companies, Inc., 1999 INVESTMENTS Fourth Edition Bodie Kane Marcus Irwin/McGraw-Hill 28-5 YearLg. Stock ReturnT-Bill Return Average Standard Dev Returns from

 The McGraw-Hill Companies, Inc., 1999 INVESTMENTS Fourth Edition Bodie Kane Marcus Irwin/McGraw-Hill 28-6 Switch to T-Bills in 87, 90 and 94 No negative returns or losses Average Ret. = 17.44% S.D. Ret. = 12.38% Results with perfect timing - Increase in mean return - Lower S.D. With Perfect Forecasting Ability

 The McGraw-Hill Companies, Inc., 1999 INVESTMENTS Fourth Edition Bodie Kane Marcus Irwin/McGraw-Hill 28-7 Long horizon to judge the ability Judge proportions of correct calls Bull markets and bear market calls With Imperfect Ability to Forecast

 The McGraw-Hill Companies, Inc., 1999 INVESTMENTS Fourth Edition Bodie Kane Marcus Irwin/McGraw-Hill 28-8 Concentrate funds in undervalued stocks or undervalued sectors or industries Balance funds in an active portfolio and in a passive portfolio Active selection will mean some unsystematic risk Superior Selection Ability

 The McGraw-Hill Companies, Inc., 1999 INVESTMENTS Fourth Edition Bodie Kane Marcus Irwin/McGraw-Hill 28-9 Model used to combine actively managed stocks with a passively managed portfolio Using a reward-to-risk measure that is similar to the the Sharpe Measure, the optimal combination of active and passive portfolios can be determined Treynor-Black Model

 The McGraw-Hill Companies, Inc., 1999 INVESTMENTS Fourth Edition Bodie Kane Marcus Irwin/McGraw-Hill Analysts will have a limited ability to find a select number of undervalued securities Portfolio managers can estimate the expected return and risk, and the abnormal performance for the actively-managed portfolio Portfolio managers can estimate the expected risk and return parameters for a broad market (passively managed) portfolio Treynor-Black Model: Assumptions

 The McGraw-Hill Companies, Inc., 1999 INVESTMENTS Fourth Edition Bodie Kane Marcus Irwin/McGraw-Hill Passive Portfolio : S 2 m = [ E(r m ) - r f mm ] 2 Reward to Variability Measures

 The McGraw-Hill Companies, Inc., 1999 INVESTMENTS Fourth Edition Bodie Kane Marcus Irwin/McGraw-Hill Appraisal Ratio: A A = Alpha for the active portfolio (eA) = Unsystematic standard deviation for active     Reward to Variability Measures

 The McGraw-Hill Companies, Inc., 1999 INVESTMENTS Fourth Edition Bodie Kane Marcus Irwin/McGraw-Hill Combined Portfolio : S 2 p = [ E(r m ) - r f mm ] 2 +  eA [ A ] 2 Reward to Variability Measures

 The McGraw-Hill Companies, Inc., 1999 INVESTMENTS Fourth Edition Bodie Kane Marcus Irwin/McGraw-Hill Treynor-Black Allocation M A P E(r)  CML CAL RfRf

 The McGraw-Hill Companies, Inc., 1999 INVESTMENTS Fourth Edition Bodie Kane Marcus Irwin/McGraw-Hill Sharpe Measure will increase with added ability to pick stocks Slope of CAL>CML (r p -r f )/  p > (r m -r f )/  p P is the portfolio that combines the passively managed portfolio with the actively managed portfolio The combined efficient frontier has a higher return for the same level of risk Summary Points: Treynor-Black Model