1. The Portfolio Management Process 1. Policy statement –specifies investment goals and acceptable risk levels –should be reviewed periodically –guides all investment decisions 2. Study current financial and economic conditions and forecast future trends –determine strategies to meet goals –requires monitoring and updates 3. Construct the portfolio –allocate available funds to meet goals and minimize investor’s risks –Include constraints in the optimization process (e.g., Liquidity needs and Time horizon) 4. Monitor and update –revise policy statement as needed and modify investment strategy accordingly –evaluate portfolio performance

2. Which is about… Four decisions –What asset classes to consider for investment –What optimal weights to assign to each eligible class –The allowable allocation ranges based on policy weights –What specific securities to purchase for the portfolio Most (85% to 95%) of the overall investment return is due to the first two decisions, not the selection of individual investments FACT: Over long time periods sizable allocation to equity will improve results

3. “Adjusting portfolio for up and down movements in the market” Shift between risky assets and risk-free instruments (CML) Evidence of the importance of Market Timing: Returns from 1987 - 1996  Switch to T-Bills in 87, 90 and 94  No negative returns or losses; Average Ret. = 17.44%; S.D. Ret. = 12.38%  higher returns, lower risk (downside is partially eliminated) Example 1: Allocation and Market Timing YearLg. Stock ReturnT-Bill Return 87 5.345.50 88 16.866.44 89 31.348.32 90 -3.207.86 91 30.665.65 92 7.713.54 93 9.872.97 94 1.293.91 95 37.715.58 96 23.005.20 Average 16.06 Standard Dev. 14.05

4. Ability to catch an EXISTING trend=higher proportions of correct calls: –Bull markets and bear market calls  allocation: De- Emphasize individual security selection and focus on undervalued (promising) asset classes (Efficient Frontier, CML)  top-bottom approach –Undervalued and overvalued securities  selection: Emphasize on individual security selection and focus on undervalued securities (SML, asset pricing models)  bottom-up approach In Practice:Imperfect Ability to Forecast

5. 3 approaches to portfolio management 3 strategies or approaches based on how you will change the weights of your portfolio and select securities: –Passive  selection focus—FIXED PROPORTIONS : Indexation  SML, asset valuation models, fundamental analysis –Semi-passive  some timing, allocation and selection focus—PROPORTIONS CHANGED PERIODICALLY  typically, your portfolio is broken down into a passive portion and an active speculative portion. –Active  continuous allocation and selection— PROPORTIONS CHANGED CONTINUOUSLY: recalculate efficient frontier often and/or position the portfolio Beta (look at the CML) for movements in the market : »Bearish  lower ßeta by buying T-bills »Bullish  increase ßeta by selling T-bills

6. What is Required of a Portfolio Manager? Above-average returns within a given risk class. Portfolio diversification to eliminate all unsystematic risk. “above-average” or significant abnormal return? –Abnormal=Excess performance compared to a benchmark portfolio with the same initial Reward to risk –Above-average return is a Point estimate –Significant Abnormal (or excess) return refers to statistical inferences about this point estimate. Factors that lead to abnormal performance –Market/asset/sector/industry Allocation –Security Selection –Protection

7. Composite Portfolio Performance Measures Treynor Measure  SML Sharpe Measure  CML Jensen Measure  SML J=(R p –Rf) – B j (R m – Rf)

8. Example 2: Differentiate between the three measures Treynor versus Sharpe Measures Beta vs. Standard Deviation –Treynor –> uses SML, thus focus on Beta  assumes that portfolio is well diversified. –Sharpe-> uses the CML, thus focus on standard deviation  assumes that portfolio is not well diversified. Ranking differences from different diversification levels. (SML vs. CML)  R 2 will tell you! Benchmark choice may affect the R 2

9. Example 3: The Jensen Measure Requires use of different RFR, R m, and R j, for each period. Assumes portfolio is well diversified and only considers systematic risk. Provides inferences about abnormal gain/loss Regression of (R j - RFR) and (R m - RFR). –R 2 can be useful as a measure of diversification.

10. Example 4: Jensen, Sharpe and Treynor Portfoli o Jense n betaR-2 A0.191.05*0.94 B-0.050.66*0.92 C0.46*0.59*0.69 D0.360.76*0.64 E0.30*0.79*0.95 Mean (RP) Sigma A1.02%1.19% B0.47%0.76% C0.94%0.79% D0.96%1.04% E0.89% Market0.9%1.1% (Rp-Rf)=Jensen + beta x (Rm-Rf)+e * Indicates significance at the 95% level RP is the risk premium: Rp-Rf

11. ANALYSIS TreynorT_rankSharpeS_rankJensenJ_rank A0.009740.85740.1904 B0.007160.6186-0.0506 C0.015911.19010.460*1 D0.012620.92330.3602 E0.011331.00020.300*3 Market0.00950.82505

12. Decomposing overall performance into components Components are related to specific elements of performance: –Asset  Allocation –Industry/Sector  Allocation –Security Choice  Selection Thus, Contribution for asset and sector/industry allocation + Contribution for security selection = Total Contribution from asset class Performance Attribution Analysis

13. Example 5: Benchmark 21% treasury; 65% corporate

14. Example 5: Portfolio 100% corporate

15. Example 5: So far…

16. Example 6: Analysis: Weighted excess return due to asset allocation (between each class) (Actual Weight-Benchmark Weight) x Index Return

17. Example 6: So far…

18. Example 6: Analysis: Weighted excess return due to equity sector allocation (between each sector) (Actual Weight-Benchmark Weight) x Index Return Weighted excess return due to equity sector allocation=1.253% x 70%=0.877%

19. Example 6: So far…

20. Example 6: Analysis: Weighted excess return due to bond family allocation (between each family) (Actual Weight-Benchmark Weight) x Index Return Weighted excess return due to bond family allocation=0.37% x 7%=0.026%

21. Example 6: So far…

22. Example 6: Analysis: Unweighted excess return due to sector allocation and security selection (within each class)

23. Example 6: Conclusion Total excess return from the equity portion of the portfolio Total excess return from equity sector allocation Total excess return from the bond portion of the portfolio Total excess return from the bond family allocation

24. You can do it for your portfolio!!! Go to morningstar.com & do an “X-ray” on your portfolio. Look at the proportion in Stock/Bond/Cash For the equity portion: Take note of the weights of your portfolio and the SP500 in each of the 10 sectors. Get the three-month return for the SP500 and each sector at –http://screen.morningstar.com/index/indexReturns.html?mse ction=IdxReturnshttp://screen.morningstar.com/index/indexReturns.html?mse ction=IdxReturns –Http://news.morningstar.com/stockReturns/CapWtdSectorRe turns.html?msection=SectorReturnsHttp://news.morningstar.com/stockReturns/CapWtdSectorRe turns.html?msection=SectorReturns For the bond portion: Take note of the weights of your portfolio in bonds. Get the three-month return for a bond index (LB) at : –http://screen.morningstar.com/index/indexReturns.html?mse ction=IdxReturnshttp://screen.morningstar.com/index/indexReturns.html?mse ction=IdxReturns

25. Example 7: Another example of PAA BenchmarkManager AManager B WeightReturnWeightReturnWeightReturn Stock0.6-5%0.5-4%0.3-5% Bonds0.3-3.50.2-2.50.4-3.5 Cash0.10.3 Calculate the overall return of each portfolio and comment on whether these managers have under- or over-performed the benchmark fund. Using attribution analysis, calculate (1) the asset allocation and (2) the sector allocation/stock selection (combined) effects. Combine your findings with those of (a.) and discuss each manager’s skills.

26. Example 7: Another example of PAA 1. Excess return R(Benchmark)= weighted average return =60% x (–5%) +30% x (–3.5%) + 10% x 0.3% = - 4.02% R(a)= -2.41% R(b)= -2.81% So Excess return (a)= -2.41%-(-4.02%)= 1.61% Excess return (b)= -2.81%-(-4.02%)= 1.21%

27. Example 7: Another example of PAA Allocation effect: AW aWbenchR benchEffect Stock5060-5%0.5% Bond2030-3.5%0.35% cash30100.3%0.06% Total0.91% BW bW bench R benchEffect Stock3060-5%1.5% Bond4030-3.5%-0.35% cash30100.3%0.06% Total1.21%

28. Example 7: Another example of PAA Selection Effect: Excess return –Allocation effect A: 1.61%-0.91%=0.7% B: 1.21%-1.21% =0% A is good at allocating and selecting B is specialized in allocating among asset classes