Bodie Kane Marcus Perrakis RyanINVESTMENTS, Fourth Canadian Edition Copyright © McGraw-Hill Ryerson Limited, 2003 Slide 21-1 Chapter 21

Bodie Kane Marcus Perrakis RyanINVESTMENTS, Fourth Canadian Edition Copyright © McGraw-Hill Ryerson Limited, 2003 Slide 21-2 Chapter Summary  Objective: To discuss specific techniques used in active portfolio management Indexing and Asset allocation The Treynor-Black Model Hedging Performance attribution procedures

Bodie Kane Marcus Perrakis RyanINVESTMENTS, Fourth Canadian Edition Copyright © McGraw-Hill Ryerson Limited, 2003 Slide 21-3 Indexing  Passive vs Active investing  Equity indexing - ETFs  Bond indexing – cellular portfolio  Money-market funds  Mixed strategies – timing, sector funds

Bodie Kane Marcus Perrakis RyanINVESTMENTS, Fourth Canadian Edition Copyright © McGraw-Hill Ryerson Limited, 2003 Slide 21-4 Asset Allocation  Baseline allocation (e.g )  Modified weightings for timing  Tactical asset allocation (relative predicted returns by asset class)

Bodie Kane Marcus Perrakis RyanINVESTMENTS, Fourth Canadian Edition Copyright © McGraw-Hill Ryerson Limited, 2003 Slide 21-5 Summary Reminder  Objective: To discuss specific techniques used in active portfolio management Indexing and Asset allocation The Treynor-Black Model Hedging Performance attribution procedures

Bodie Kane Marcus Perrakis RyanINVESTMENTS, Fourth Canadian Edition Copyright © McGraw-Hill Ryerson Limited, 2003 Slide 21-6  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

Bodie Kane Marcus Perrakis RyanINVESTMENTS, Fourth Canadian Edition Copyright © McGraw-Hill Ryerson Limited, 2003 Slide 21-7  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

Bodie Kane Marcus Perrakis RyanINVESTMENTS, Fourth Canadian Edition Copyright © McGraw-Hill Ryerson Limited, 2003 Slide 21-8 Reward to Variability Measures Passive Portfolio:

Bodie Kane Marcus Perrakis RyanINVESTMENTS, Fourth Canadian Edition Copyright © McGraw-Hill Ryerson Limited, 2003 Slide 21-9 Appraisal Ratio:  A = Alpha for the active portfolio  (e) A = Unsystematic standard deviation for active portfolio Reward to Variability Measures

Bodie Kane Marcus Perrakis RyanINVESTMENTS, Fourth Canadian Edition Copyright © McGraw-Hill Ryerson Limited, 2003 Slide Combined Portfolio: Reward to Variability Measures

Bodie Kane Marcus Perrakis RyanINVESTMENTS, Fourth Canadian Edition Copyright © McGraw-Hill Ryerson Limited, 2003 Slide Treynor-Black Allocation M A P E(r)  CML CAL RfRf

Bodie Kane Marcus Perrakis RyanINVESTMENTS, Fourth Canadian Edition Copyright © McGraw-Hill Ryerson Limited, 2003 Slide  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

Bodie Kane Marcus Perrakis RyanINVESTMENTS, Fourth Canadian Edition Copyright © McGraw-Hill Ryerson Limited, 2003 Slide Summary Reminder  Objective: To discuss specific techniques used in active portfolio management Indexing and Asset allocation The Treynor-Black Model Hedging Performance attribution procedures

Bodie Kane Marcus Perrakis RyanINVESTMENTS, Fourth Canadian Edition Copyright © McGraw-Hill Ryerson Limited, 2003 Slide Hedging Systematic Risk  To protect against a decline in level stock prices, short the appropriate number of futures index contracts  Less costly and quicker to use the index contracts  Use the beta for the portfolio to determine the hedge ratio

Bodie Kane Marcus Perrakis RyanINVESTMENTS, Fourth Canadian Edition Copyright © McGraw-Hill Ryerson Limited, 2003 Slide Hedging Systematic Risk: Text Example Portfolio Beta =.8S&P 60 = 400 Decrease = 2.5%S&P 60 falls to 390 Portfolio Value = $30 million Project loss if market declines by 2.5% = (.8) (2.5) = 2% 2% of $30 million = $600,000 Each S&P 60 index contract will change $2,000 for a 2.5% change in the index

Bodie Kane Marcus Perrakis RyanINVESTMENTS, Fourth Canadian Edition Copyright © McGraw-Hill Ryerson Limited, 2003 Slide Hedge Ratio: Text Example

Bodie Kane Marcus Perrakis RyanINVESTMENTS, Fourth Canadian Edition Copyright © McGraw-Hill Ryerson Limited, 2003 Slide Uses of Interest Rate Hedges  Owners of fixed-income portfolios protecting against a rise in rates  Corporations planning to issue debt securities protecting against a rise in rates  Investor hedging against a decline in rates for a planned future investment  Exposure for a fixed-income portfolio is proportional to modified duration

Bodie Kane Marcus Perrakis RyanINVESTMENTS, Fourth Canadian Edition Copyright © McGraw-Hill Ryerson Limited, 2003 Slide Hedging Interest Rate Risk: Text Example Portfolio value = $10 million Modified duration = 9 years If rates rise by 10 basis points (.1%) Change in value = ( 9 ) (.1%) =.9% or $90,000 Present value of a basis point (PVBP) = $90,000 / 10 = $9,000

Bodie Kane Marcus Perrakis RyanINVESTMENTS, Fourth Canadian Edition Copyright © McGraw-Hill Ryerson Limited, 2003 Slide Hedge Ratio: Text Example

Bodie Kane Marcus Perrakis RyanINVESTMENTS, Fourth Canadian Edition Copyright © McGraw-Hill Ryerson Limited, 2003 Slide Summary Reminder  Objective: To discuss specific techniques used in active portfolio management Indexing and Asset allocation The Treynor-Black Model Hedging Performance attribution procedures

Bodie Kane Marcus Perrakis RyanINVESTMENTS, Fourth Canadian Edition Copyright © McGraw-Hill Ryerson Limited, 2003 Slide  Decomposing overall performance into components  Components are related to specific elements of performance  Example components Broad Allocation Industry Security Choice Up and Down Markets Performance Attribution

Bodie Kane Marcus Perrakis RyanINVESTMENTS, Fourth Canadian Edition Copyright © McGraw-Hill Ryerson Limited, 2003 Slide Set up a ‘Benchmark’ or ‘Bogey’ portfolio  Use indexes for each component  Use target weight structure Process of Attributing Performance to Components

Bodie Kane Marcus Perrakis RyanINVESTMENTS, Fourth Canadian Edition Copyright © McGraw-Hill Ryerson Limited, 2003 Slide  Calculate the return on the ‘Bogey’ and on the managed portfolio  Explain the difference in return based on component weights or selection  Summarize the performance differences into appropriate categories Process of Attributing Performance to Components

Bodie Kane Marcus Perrakis RyanINVESTMENTS, Fourth Canadian Edition Copyright © McGraw-Hill Ryerson Limited, 2003 Slide Where B is the bogey portfolio and p is the managed portfolio Formula for Attribution

Bodie Kane Marcus Perrakis RyanINVESTMENTS, Fourth Canadian Edition Copyright © McGraw-Hill Ryerson Limited, 2003 Slide Contributions for Performance Contribution for asset allocation (w pi - w Bi ) r Bi +Contribution for security selection w pi (r pi - r Bi ) = Total Contribution from asset class w pi r pi -w Bi r Bi