Two active portfolio

strategies in a world of
efficient market :
Market Timing.
Security selection .

Market efficiency
prevails
When many investors are willing to depart
from a passive strategy of efficient
diversification by identifying undervalued
Securities to earn abnormal return .
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Why do exceptional
managers appear to
earn
1. Luck .abnormal returns ;
2. Abnormal returns are so small . It is not
possible to determine whether or not there is
abnormal returns .
3. Some managers take advantage of anomalies
such as the end of year effect , that are
persistent enough to make abnormal returns .
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Objectives of active
portfolio
An optimal portfolio is one that maximizes the
return to volatility ratio, or expected excess
returns divided by the standard deviation of the
portfolio . Clients evaluate managers by this
criterion , which is the sharpe measure .
Sp = E(Rp) Rf divided by SD of P
The most able manager is the one with the
highest sharpe measure .

Sharpe measure
Used to evaluate mutual fund performance ,
and is widely used to evaluate the professional
portfolio managers . It measures the excess
returns of the portfolio over the risk free rate
per unit of risk as measured by the SD of the
portfolio .
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 Then it is compared to the results of the

indexed portfolio . If the excess return per unit
of risk for the managed portfolio is greater
than that of the indexed portfolio , The
manager has added value to the portfolio .
A higher Sharpe measure than a passive
strategy indicates the benefits of active
management .
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Market Timing ( MT )
Market Timing is asset allocation , in which
the investment will increase if one forecasts
that the market will outperform the T-Bills .
The return on the perfect timing strategy can
never be less than the risk free return . Thus,
SD is not an appropriate measure of risk .
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Valuing market timing as

an option
To analyze the pattern of returns to the perfect
timer is to compare the returns of the foresight
investor with another investor's returns who
holds a call option on the equity portfolio .
Investing 100% in T-Bills plus a call option on
the equity portfolio will yield returns identical
to those of the perfect timer .
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 Such as portfolio pays risk free rate

when the market is Bearish (market
return is less than risk free rate) . And
pays the market return when the market
is Bullish (paying more than risk free
rate) . Thus, this portfolio return is
equivalent to that of perfect timing .
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 The value of imperfect forecasting managers are

not perfect forecasters . They can correctly
predicts 60% of all Bull Markets . and 70% of all
Bear Markets .
Therefore
P1+P0-1 is the correct measure for the timing
ability.
i.e. 60% + 70% -1 = 30%
For a perfect forecaster P1 = P0 = 1 ( 100% )

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 A forecaster who always predicts a Bear

Market, Mispredicts all Bull Markets P1 =0 .
And correctly predicts Bear markets P0 = 1 has
a forecasting ability of 1+0-1=0
If call option ( C ) denotes the value of the
perfect timer .
( P1 - P2 1 )c measures the value of perfect
market ability .
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Security Selection : The

Treynor Black Model

This is an optimizing model for portfolio

managers who use security analysis in a
nearly efficient market . the basic points of
the model are :
1. Security analysts can analyze in depth
relatively FEW securities , securities not
analyzed are assumed to be fairly priced .

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2. For the purpose of efficient diversification ,

the market index portfolio is the passive
portfolio .
3. The objective of security analysis to form an
active portfolio of a limited number of
securities . The perceived mispriced of the
securities is what guides the composition of
the active portfolio .
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4. Steps analysts take to construct an active

portfolio and to forecast performance .

Estimate Beta and residual risk to each

analyzed security . From the Beta and the
macro forecast , E( rm-rf ) determine the
required rate of return of the security .
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 Given the degree of mispricing of each

security , determine the expected return and
the abnormal return ( Alpha ) .
Use the estimates of alpha , beta and residual
risk to determine the optimal weights of the
securities of the portfolio .
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Estimate alpha , beta and residual variance

for the active portfolio based on the weights
of the securities in the portfolio .

5. To determine the optimal risky portfolio ,

which will be a combination of passive and
active portfolio , the macro forecasts for the
passive index portfolio and the composite
forecasts for the active portfolio are used .
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 Alpha of an active portfolio is 2% . expected

return on the market index is 16% . variance of
the return on the market portfolio is 4% , and
nonsystematic variance of the active portfolio
is 1% . and its Beta is 1 risk free rate is 8% .
the optimal proportion to invest in the active
portfolio is :
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 Alpha / nonsystematic variance) / (Er-rf) /

variance of the return .
(2/1) / (16-8) / 4 = 1 = 100% to be invested
in the active portfolio .

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Steps to implement the Treynor

Black Model
Portfolio construction :
Assuming securities are fairly priced , the rate
of return on the security X is
Rx = B(rm-rf) + ex
Ex is the zero mean , firm specific
(nonsystematic risk ) component assumed to
be independent across securities .

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 An active portfolio , is the portfolio

formed by mixing analyzed stocks of
perceived nonzero alpha values .This
portfolio ultimately is combined with the
passive market index portfolio .
The optimal portfolio will lie on the CAL
which is above the CML .
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CAL
CML

E(r)
P

Rf

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 For the superior analyst , the index

portfolio is inefficient ,
The passive and active portfolio are not
correlated, Thus, combining the two will
be beneficial .

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 Adjusted Alpha (alpha / nonsystematic risk)

is :
- The determinant variable for the value of
active portfolio .
- Measures the contribution of the individual
security to the active portfolio. i.e.
determines the weight of the security in the
portfolio .
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