PortfolioManagementNotes

Reading53
Systematicrisk:anassetsnondiversifiablerisk.
Arbitragepricingtheoryhasthreeassumptions:
Afactormodeldescribesasitreturns.
Therearemanyassets,soinvestorscanformawelldiversifiedportfoliothateliminateassetspecificrisk.
Noarbitrageopportunitiesexistamongwelldiversifiedportfolios.
Ifalltheabovehold,thefollowingequationholds:

=factorriskpremium,whichistheexpectedrewardforbearingtheriskofaportfoliowithasensitivity

of1tofactorjandasensitivityof0toallotherfactors.
Iftheaboveholdstrue,thisiscalledapurefactorportfolio.

RMRF=thereturnonavalueweightedindexinexcessoftheonemonthTbillrate.
SMB=smallminusbig.A(+)valuemeanssmallcap,anda()meanslargecap.
HML=highminuslow.A(+)meansvalue,anda()meanslargecap.
WML=winnersminuslosers,amomentumfactor.
Inamacroeconomicfactormodel,thefactorsaresurprisesinmacroeconomicvariablesthatsignificantlyexplain
returns.
Theinterceptistheexpectedreturnonassetai.
Theslopecoefficientsarethefactorsensitivitiesoftheasset.Thefactorsensitivityisameasureofthe
responseofreturntoeachunitofincreaseinafactor.Question2pg.409.
Surprise=actualexpected
Wedevelopthefactor(surprises)firstandthenestimatethefactorsensitivitiesthroughregressions.
Inafundamentalfactormodel,thefactorsareattributesofstocksorcompaniesthatareimportantinexplaining
crosssectionaldifferencesinstockprices.
Thefactorsarestatedasreturnsratherthanreturnsurprisesinrelationtoproductivevalues,sotheydonot
generallyhaveexpectedvaluesof0.
Theinterceptisnolongerinterpretedastheexpectedreturn.
Isapplicabletodeterminethestyle(valuevs.growth)ofamanager.
Anassetssensitivitytoafactorisexpressedusingastandardizedbeta,thevalueoftheattributeforthe
assetminustheaveragevalueoftheattributeacrossallstocksdividedbythestandarddeviationofthe
attributesvalueacrossallstocks.

Industryfactorsensitivitiesaretypicallymodeledby01dummyvariables.thesensitivityisoneifthisdog
belongstotheindustryand0ifitdoesnot.
Wegenerallyspecifythefactorsensitivities(attributes)firstandthenestimatethefactorreturnsthrough
regressions.
Companyfundamentalfactorsarerelatedtothecompany'sinternalperformance.
Companysharerelatedfactorsincludevaluationmeasuresandotherfactorsrelatedtosharepriceorthe
tradingcharacteristicsoftheshares.Thesefactorsincorporateinvestorsexpectationsconcerningthe
company.
Macroeconomicfactors:sectororindustrymembershipfactorsfallunderthisheading.
Inastatisticalfactormodel,statisticalmethodsareappliedtohistoricalreturnsofagroupofsecuritiestoextract
factorsthatcanexplaintheobservedreturnsofsecuritiesinthegroup.
Analystsfavorfundamentalmultifactormodelsindecomposingthesourcesofreturns.
Activereturn=RpRB
Activereturn=
Activereturnhastwocomponents:factortilts(overweightorunderweight)andsecurityselection.
Activeriskisthestandarddeviationofactivereturns.Itsalsocalledtrackingerror(TE),ortrackingrisk.
TE=
Informationratioisatoolforevaluatingmeanactivereturnsperunitofactiverisk
HistoricalIR=
1

Anindexfundthateffectivelymeetsitsinvestmentobjectiveisexpectedtohaveaninformationratioof
zero,becauseitsactivereturnshouldbezero.
Inanalyzingrisk,itiseasiertousevariancebecausethevariancesofuncorrelatedvariablesareadditive.
Activerisksquared=
Wecanseparateaportfoliosactiverisksquaredintotwocomponents:
Activefactorriskisthecontributiontoactiverisksquaredresultingfromtheportfoliosdifferent
frombenchmarkexposuresrelativetofactorsspecifiedintheriskmodel.
Activespecificriskorsecurityselectionriskmeasurestheactivenonfactororresidualrisk
assumedbythemanager.Portfoliomanagersattempttoprovideapositiveaveragereturnfrom
securityselectionascompensationforassumingactivespecificrisk.
Activespecificrisk=;=assetsweightintheportfolioand=theresidualriskoftheith
asset.

Reading54
Floatadjustedmarketcapitalizationweightedindicesonlyincludesharesthatareavailabletothegeneralpublic.
Totalsharesoutstandingmayincludesharesthatareprivatelyheldandnotopentotradeinthemarket.
RA=RPRB
Ariskadjustedcalculationofvalueaddedincorporatessomeestimateofthemanagedportfoliosriskrelativeto
thebenchmark,oftencapturedbytheportfoliosbeta, p=Rp pRB.Thisistheportfolioactiveweight.

Thefirsttermisthevalueaddedfromassetallocationandsecondtermisthevalueaddedfromthesecurity
selection.

Sharperatio:
TheSharperatioisunaffectedbytheadditionofcashorleverageinaportfolio.
Theinformationratiocanbethoughtofasawaytomeasuretheconsistencyofactivereturn,asmostinvestors
wouldpreferamoreconsistentlygeneratedvalueadded(lowactiverisk)ratherthanalumpyactivereturn
pattern.
IR=
Expostinformationratioswillbenegativeiftheactivereturnisnegative.
UnliketheSharperatio,theIRisaffectedbyleverageandcash.
Theinformationratioforanunconstrainedportfolioisunaffectedbytheaggressivenessoftheactive
weights.

Aninvestorshouldchoosethemanagerwiththehighestexpectedskillasmeasuredbytheinformationratio,
becauseinvestingwiththehighestinformationratiomanagerwillproducethehighestSharperatioforthe
investorsportfolio.

Theinformationratioisthesinglebestcriterionforconstructinganactivelymanagedportfolio,andtheexpost
informationratioisthebestcriterionforevaluatingthepastperformanceofvariousactivelymanagedfunds.
;thisistheactivereturnofsecurities.Thesecuritysexpectedactivereturnisnotatedas i

Signalqualityismeasuredbythecorrelationbetweentheforecastedactivereturns( i)andtherealizedactive
returns(RAi).Thisiscommonlycalledtheinformationcoefficient(IC).InvestorswithhigherICwilladdmore
valueovertime,butonlytotheextentthatthoseforecastsareexploitedintheconstructionofthemanaged
portfolio.Theinformationcoefficientisessentiallytheextenttowhichtheportfoliomanagersexpectationsare
realized.
Thecorrelationbetweentheactiveweights( wi)andforecastedreturns( i)measuresthedegreetowhichthe
investorsriskadjustedforecastsforreturnscorrelatewiththeriskadjustedactiveweights.Thisiscalledthe
transfercoefficient(TC).
Asacorrelationcoefficient,TCcanrangefrom1to+1.AlowTCresultsfromtheformalorinformal
constraintsimposedonthestructureoftheportfolio.IfTC=0,thenthereisnoexpectationofvalueadded
fromactivemanagement.Theinvestorshouldjustinvestinthebenchmarkportfolio.
Sirepresentsasetofstandardizedforecastsofexpectedreturnsacrosssecurities,sometimescalledscores.
Themeanvarianceoptimalactiveweightsare:;BR=breadth
2

ICistheexantecrosssectionalcorrelationbetweentheNforecastedactivereturns( i)andtheNrealized
activereturns(RAi).Tobemoreaccurate,ICistheexanteriskweightedcorrelation:
IC=COR
BR,breadth,isconceptuallyequaltothenumberofindependentdecisionsmadeperyearbytheinvestorin
constructingtheportfolio.BRoftenequalsthenumberofsecurities.
;the*indicatedthattheactivelymanagedportfolioisconstructedfromoptimalactivesecurityweights().
;thisisknownasthefundamentallaw.
IR*=
STD(RA)=
Expostperformancemeasurement:
Knowinghowactualreturnsmatchupwithrealizedreturns(therealizedinformationcoefficient,ICR)
allowstheinvestortoexaminewhatrealizedreturntoexpectgiventhetransfercoefficient.

TheIRforaconstrainedportfoliogenerallydecreaseswiththeaggressivenessofthestrategy.
; RMisthebenchmarktrackingriskpredictedbytheriskmodel,and ICistheadditionalriskinducedbythe
uncertaintyoftheinformationcoefficient.
Apracticalmeasureofbreadthis:BR=; isthecorrelationcoefficient.
Ifacompany'sdecisionsarenotindependent,thenthecompanymaybeoverstatingitsbreadth.
IR=TCxICx
Althoughrelaxingaportfoliosconstraintswillincreasethetransfercoefficient(andexpectedactivereturns),the
lowerinformationcoefficientreducestheinformationratioandtheexpectedactivereturn.
Akeycomponentofthediscountrateistheexpectedreturnonaninflationlinkedbondissuedbythegovernment
ofadevelopedcountry.
Thedifferencebetweenaninflationlinkednoteandanominalnotereflectsbothinvestorexpectations
abouttheleveloffutureinflationaswellasapremiumfortheuncertaintyoffutureinflation.

Reading55
Themarginalutilityofconsumptionistheadditionalsatisfactionorutilitythatconsumerderivesfroman
additionalunitofconsumption
Innertemporalrateofsubstitution=
Ingoodeconomictimes,individualsmayhaverelativelyhighlevelsofcurrentincomesothatthecurrent
consumptionishigh.Inthiscase,theutilityderivedfromanadditionalunitofconsumptiontodaywillbe
relativelylow.Conversely,inbadeconomictimescurrentincomeandconsumptionwilltendtobe
relativelylow,whichmeansthattheutilityderivedfromanadditionalunitofconsumptiontodaywillbe
relativelyhigh.
Inessence,itshigherinabadeconomyandlowerinagoodeconomy.
Themarginalutilityofconsumptionofinvestorsdiminishesastheirwealthincreasesbecausetheyhave
alreadysatisfiedfundamentalneeds,Thus,investorswouldreceivealargerbenefit(utility)fromanasset
thatpaysoffmoreinbadtimesrelativetoonethatpaysoffingoodeconomictimes.
Ifinnertemporalrateofsubstitution>bondprice,theinvestorwouldprefertobuymoreofthebondtoday.

Aninvestorsmarginalutilityassociatedwithagivenexpectedpayoffisdecreasedbyanyincreaseinuncertainty
ofthepayoff;thus,theinvestormustbecompensatedwithahigherexpectedreturn.Thisresultfollowsfrom
decreasingmarginalutilityofwealthorincomebecausethelossofutilityfromlowerwealthislargerthanthegain
fromanequivalentincreaseinwealth.
Onesmarginalutilityisalwayslowerasoneswealthorincomeincreases.
Theriskpremiumforagivenriskislowerforwealthierindividualsbecausetheaveragelossofmarginal
utilityfromanyrisktakingissmaller,whichmeansthatrelativetopoorerindividuals,wealthier
individualsaremorewillingtotakeonagivenrisk.
Anindividualwithdecreasingabsoluteriskaversionwouldlowerthepriceofsafeassets.

Allinvestorsinthefinancialmarketwouldincreasetheirsavingswhenuncertaintyabouttheirfutureincome
increases.Thishighersavingsmeansthattheexpectedmarginalutilityinthefutureislowerbecausetheinvestors
futureresourcesarehigher.
Ingeneralwithriskaverseinvestors,thecovariancetermformostriskyassetsisexpectedtobenegative.Thatis,
whentheexpectedfuturepriceoftheinvestmentishigh,themarginalutilityoffutureconsumptionrelativetothat
ofcurrentconsumptionislow.
Mostriskyassetshavereturnsthattendtobehighduringgoodtimes,whenthemarginalvalueofconsumptionis
low,andlowduringbadtimes,whenthemarginalvalueofconsumptionishigh,andsobearapositiverisk
premium.
IfthereisaknownindependentchangeintherealGDPgrowth,orachangethatcanbeforecastedperfectly,then
anincreaseinrealGDPgrowthshouldleadtoanincreaseintherealdefaultfreerateofinterestbecausemore
goodsandserviceswillbeavailableinthefuturerelativetoday.
Aneconomywithhighertrendrealeconomicgrowthshouldhavehigherrealdefaultfreeinterestratesthanan
economywithlowertrendgrowth.Weshouldthusexpecttofindthatrealdefaultfreeinterestratesinfast
growingdevelopingeconomies,suchasIndiaandChina,arehigherthaninslowergrowing,developingeconomies.
TherealinterestratesarehigherinaneconomyinwhichGDPgrowthismorevolatilecomparedwithrealinterest
ratesinaneconomyinwhichgrowthismorestable.
Thewillingnessofinvestorstosubstitutefuturewealthforcurrentconsumptionwillbeinverselyrelatedtothe
changeinrealGDPgrowth.
Thenominalrateofinterestwillequaltherealinterestratethatisrequiredtobalancetherequirementsofsavers
andinvestorsplusinvestorsexpectationsofinflationovertherelevantborrowing/lendingperiod.
Whentheeconomyisproducingmorethantheoptimalamount,thisiscalledapositiveoutputgap.Itsassociated
withhighinflation,whereasanegativegapisassociatedwithhighlevelsofunemployment.
Ifacountryishavingapositiveoutputgap,theappropriatepolicyrateshouldbeabovetheneutralrate.
Settingratestoolowfortoolongcancreateacreditbubble,andsettingthemtoohighfortoolongcanleadtoa
recessionaryorevendepressionlikeeconomicconditions.
Premiumsdemandedonbondsriseduringtimesofeconomicweakness,whentheprobabilityofdefaultishigher.
Recoveryratestendtobehigherduringwhentheeconomyisexpandingandlowerwhenitiscontracting.
Thisisbecauseassetsthatcanbesoldinordertorecovervalueforbondholdersarelikelytofetchahigher
priceinabuoyantratherthanastagnanteconomicenvironment.
Whenspreadswiden,thespreadsonbondsissuedbycorporationswithalowcreditratingand/orthatarepartof
acyclicalsectorwilltendtowidenthemost.
P/Estendtoriseduringperiodsofeconomicexpansion,ArelativelyhighP/Evaluationlevelshouldbeassociated
withalowerreturnpremiumtobearingequityriskgoingforward.
AlowerP/Ecouldbearesultofdecreasingearningsgrowthexpectations,risingrealinterestrates,
increasingvolatilityinrealGDPgrowth,risinginflationexpectationsoruncertaintyaboutfutureinflation,
andanincreasingequityriskpremium.
Valuestocksandsmallcapstocksaremorethanlikelytooutperformgrowthandlargecapstocks,immediately
afterarecession.
Equitiestendtonotbeeffectivehedgesagainstbadconsumptionoutcomesandtendtobebadhedgesagainst
recessions.
Thetheprocyclicalnatureofcommercialpropertypricesmeansthatinvestorswillgenerallydemandarelatively
highriskpremiuminreturnforinvestinginthisassetclass.Thereasonisbecausecommercialpropertydoesnot
appeartobeaverygoodhedgeagainstbadeconomicoutcomes.
Thecovariancebetweenariskaverseinvestorsinnertemporalrateofsubstitutionandtheexpectedfutureprice
ofariskassetistypicallynegative.
Oneinterpretationofanupwardslopingyieldcurveisthatreturnstoshortdatedbondsaremorenegatively
correlatedwithbadtimesthanarereturnstolongdatedbonds.
Thesensitivityofacorporatebondsspreadtochangesinthebusinesscycleandthelevelofcyclicalitytendtobe
positivelycorrelated.
Commercialrealestateriskpremiumsareclosertoequityriskpremiumsthanfixedincomeriskpremiums.
Commercialrealestateissensitivetochangesintheeconomiccycle,andthustheriskpremiumishighlycorrelated
withequitiesandcorporatebonds.

Reading56
4

Youmustevaluatetheportfolioasawhole.Ifyouevaluatetheprospectsofeachassetinisolationandignoretheir
interrelationships,wewilllikelymisunderstandtheriskandreturnprospectsoftheinvestorstotalinvestment
position.
TheIPSshouldidentifypertinentinvestmentobjectivesandconstraintsforaparticularinvestor.
IncorporatingshorttermeconomictrendsintotheIPSisinappropriate.
Usinganotherclientsassetallocationasatemplateforaclientisinappropriate.
ThePlanningStep
Youmustfirstidentifyandspecifytheinvestorsobjectivesandconstraints.Investmentobjectivesare
desiredinvestmentoutcomes.Constraintsarelimitationsandareeitherinternal(suchasaclients
liquidityneeds,timehorizon,etc.)orexternal(taxissues,legalrequirements)
Theplanningstepinvolvestheconcreteelaborationofaninvestmentstrategythatis,themanagers
approachtoinvestmentanalysisandsecurityselection.
Youcanactivelymanage,index,orsemiactivelymanage.Thisiswhenthemanagerseekspositive
alphawhilekeepingtightcontroloverriskrelativetotheportfoliosbenchmark.
TheExecutionStep
Themanagerintegratesinvestmentstrategieswiththecapitalmarketexpectationstoselectthespecific
assetsfortheportfolio.Portfoliomanagersinitiateportfoliodecisionsbasedonanalystsinputs,and
tradingdesksthenimplementthesedecisions.Subsequently,theportfolioisrevisedasinvestor
circumstancesorcapitalmarketsexpectationschange;thus,theexecutionstepinteractsconstantlywith
thefeedbackstep.
Ifachangedcircumstancebecomespermanent,theIPSmustbeupdated.
TheFeedbackStep
Twotypesoffactorsaremonitored:investorrelatedfactorssuchastheinvestorscircumstances,and
economicandmarketinputfactors.
Performanceattributionexamineswhytheportfolioperformedasitdidandinvolvesdeterminingthe
sourcesofaportfoliosperformance.Performanceappraisalistheevaluationofwhetherornotthe
managerisdoingagoodbasedonhowtheportfoliodidrelativetoabenchmark.
Wecanexamineaportfoliosperformancethroughthreesources:decisionsregardingthestrategicasset
allocation,markettiming,andsecurityselection.
Thefirstelementoftheriskreturnobjectiveistheriskobjectivebecauseitwilllargelydeterminethereturn
objective.
Valueatrisk(VAR)istheaprobabilitybasedmeasureofthelossthatoneanticipateswillbeexceeded
onlyaspecifiedsmallfractionofthetimeoveragivenhorizon
Investorsoftenfindthatquantitativeriskobjectivesareeasiertospecifyinrelativethaninabsoluteterms.
Risktoleranceisnotafunctionofaneedforhigherreturns.
Variance,ortotalrisk,istherelevantriskmeasurefortheCML;theSMLusesbeta.
IfasecuritylivesbelowtheSML,itisovervaluedandshouldnotbeconsidered.