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Brian J. Jacobsen
Brian J. Jacobsen
is the chief portfolio strategist at Wells Fargo Funds
Management, LLC, in
Menomonee Falls, WI.
brian.jacobsen@wellsfargo.com
Fall 2011
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sources of investor value. I also provide an approximation for measuring this value.
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Passive portfolios are typically attempts at replicating the performance of a benchmark. Active management is an attempt at outperforming a benchmark by
adjusting the weights of the securities that compose the
benchmark in accord with the managers forecast of the
relative desirability of the securities.
An index and a benchmark are not the same thing.
An index is an indicator of how a particular subset of
the market is performing. A benchmark for a portfolio
manager may be an index, but is not necessarily an
index. A benchmark should take into consideration the
various constraints imposed on a manager and ref lect the
opportunity set from which the manager may select
investments. A benchmark may be a blend of indices
where the blend may change over time.
An index may not be an appropriate benchmark,
especially for an active manager. Active managers not
only adjust portfolio exposure to broad asset classes, such
as sectors, but also by substituting securities from outside
the index.
Index construction methodologies vary, but there are
some general characteristics of all indices that leave room
for portfolio managers to outperform the index itself. These
rules of weighting provide plenty of opportunities for an
active manager to add value to an otherwise passive portfolio by trading intraday or by taking preemptive action
between index reconstitution dates. Of course, this also creates a lot of room for an active manager to destroy value!
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1 + rSD U
1 1 + rSU
= 1 + r + r 1 + r + r
1
f
p
f
p
D
(1a)
(r f + rp rSD )
U
1
=
(1b)
U
U
D
D (1 + r f + rp )(rS rS ) (rS r f rp )
1 = (1 e ) (1 + rMU )(1 + rMD ) U
D
(1c)
(1 + r f + rp )(rSU rSD )
(1 + rMU )(r f + rp rSD ) + (1 + rMD )(rSU r f rp )
(1d)
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1 + r f + rp +
(1e)
e=
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(1f )
( 1.021)
( 2.000 )
0.448 TY
( 2.626 )
( 1.183 )
+ 0.553 TY
( 1.540 )
( 0.184 )
(1g)
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Exhibit 1
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Note: The exhibit charts the average upside return and downside return for any given month. Actual anticipations would be distributions around these lines.
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Exhibit 2
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Note: These are the fees that would completely consume the investors surplus. Investors need to pay less than these to get an investor surplus.
Exhibit 3
Maximum Expense Ratio and Asymmetric Beta When Varying Uncertainty Exists around the Ability
to Deliver Asymmetric Beta
Fall 2011
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Conclusion
Endnotes
The views expressed are as of May 7, 2011, and are those
of the author and not those of Wells Fargo Funds Management, LLC. The views are subject to change at any time in
response to changing circumstances in the market and are not
intended to predict or guarantee the future performance of any
individual security, market sector, or the markets generally.
Wells Fargo Funds Management, LLC, is a registered
investment advisor and a wholly owned subsidiary of Wells
Fargo & Company.
NOT FDIC INSURED NO BANK
GUARANTEE MAY LOSE VALUE
Merton [1981] showed how, in a capital asset pricing
model and rational expectations framework, to value a manager
as a protective put on a portfolio. There have been numerous
papers outlining how to value multi-asset options or options
with variable maturity dates and f lexible characteristics; see
Johnson [1987], Rodriguez [2002], and Ronn and Bliss [1994].
In this article, I build on those insights to show how portfolio
management is valuable, at least in a subjective sense.
2
This, of course, assumes the investor is not investing
through an investment company, which has a fiduciary duty
to vote on corporate governance issues in the best interests
of the shareholders.
3
The Peltzman Effect refers to a situation in which a
safety device alters the behavior of the user such that the
efficacy of the device is undermined. A simple example is
when driving with an airbag makes people drive more recklessly, causing more accidents. In investing, the safety device
(diversification) alters investor behavior by causing indifference toward any given corporate issue. That indifference can
lead to more systematic risk.
1
References
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Clarke, R., H. de Silva, and S. Thorley. Portfolio Constraints and the Fundamental Law of Active Management.
Financial Analysts Journal, Vol. 58, No. 5 (2002), pp. 48-66.
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The Journal of Portfolio Management 2011.38.1:131-139. Downloaded from www.iijournals.com by Hassan Saleem on 12/07/11.
It is illegal to make unauthorized copies of this article, forward to an unauthorized user or to post electronically without Publisher permission.
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Ronn, E., and R. Bliss. A Nonstationary Trinomial Model
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Managed Portfolios. Financial Markets, Institutions & Instruments, Vol. 1, No. 4 (1992), pp. 1-58.
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Extreme Value Market-Timing Approach. Journal of Financial Planning, Vol. 3, No. 1 (1990), pp. 28-35.
To order reprints of this article, please contact Dewey Palmieri
at dpalmieri@ iijournals.com or 212-224-3675.
Fall 2011
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