0 Portfolio Management 3-228-07 Albert Lee Chun The Institutional Environment Lecture 1 09-02-2008.

1

Portfolio Portfolio ManagementManagement

3-228-073-228-07 Albert Lee ChunAlbert Lee Chun

The Institutional The Institutional EnvironmentEnvironment

Lecture 1Lecture 1 09-02-2008

Albert Lee Chun Portfolio Management 2

Portfolio ManagementPortfolio Management This course Portfolio Management complements the This course Portfolio Management complements the

course Investments (2-201-99) by exploring various course Investments (2-201-99) by exploring various issues underlying asset management. This is the issues underlying asset management. This is the most fundamental attribute of any professionally most fundamental attribute of any professionally managed portfolio. Even if most of the concepts managed portfolio. Even if most of the concepts presented in class are specific to portfolios presented in class are specific to portfolios consisting of shares or stock market indices, the consisting of shares or stock market indices, the majority of these concepts apply to a wide variety of majority of these concepts apply to a wide variety of financial asset categories. In this course, students financial asset categories. In this course, students will become familiar with fundamental concepts of will become familiar with fundamental concepts of portfolio management including efficient frontier portfolio management including efficient frontier portfolios, multifactor models, financial asset pricing portfolios, multifactor models, financial asset pricing models, market efficiency and the performance models, market efficiency and the performance evaluation of professionally managed portfolios.evaluation of professionally managed portfolios.

3

Course Outline Course Outline

Sessions 1 and 2 : The Institutional Sessions 1 and 2 : The Institutional Environment Environment Sessions 3, 4 and 5: Construction of Sessions 3, 4 and 5: Construction of PortfoliosPortfolios Sessions 6 and 7: Capital Asset Sessions 6 and 7: Capital Asset Pricing ModelPricing Model Session 8: Market EfficiencySession 8: Market Efficiency Session 9: Active Portfolio Session 9: Active Portfolio ManagementManagement Session 10: Management of Bond Session 10: Management of Bond PortfoliosPortfolios Session 11: Performance Session 11: Performance Measurement of Managed PortfoliosMeasurement of Managed Portfolios


EvaluationEvaluation You will be evaluated using the following You will be evaluated using the following

criteria:criteria: Midterm Exam: (Midterm Exam: (October 21stOctober 21st)) 40% 40% Final Exam: (Final Exam: (December December 14th14th)) 40%40% Project:Project: 20%20%

The midterm and final exams are 3 hours The midterm and final exams are 3 hours long. long.

The exams will be closed book.The exams will be closed book. For the exams, you are allowed to have a For the exams, you are allowed to have a

single-sided, 8.5 x 11 inch “cheat sheet”, single-sided, 8.5 x 11 inch “cheat sheet”, where you can write all the information where you can write all the information you want.you want.

Old exams will not be made available.Old exams will not be made available.


E-mail: [email protected]: 514-340-5661Office: 4.257Office hours: By Appointment Only

Professor Albert’s Contact InfoProfessor Albert’s Contact Info

Please do not be shy about contacting me if you have questions about the material!

I will hold individual office hours as needed.

I’m happy to chat with you about the course or about your future plans.


Course InformationCourse Information Text BookText Book: : Bodie, Kane, Marcus, Perrakis, Bodie, Kane, Marcus, Perrakis,

Ryan. Ryan.

InvestmentsInvestments

8th Canadian edition, 8th Canadian edition,

2008, McGraw-Hill Ryerson.2008, McGraw-Hill Ryerson.

Course ReaderCourse Reader::

““Textbook 3228A”Textbook 3228A”

You will need to get a copyYou will need to get a copy

of this as we will assign readings from it.of this as we will assign readings from it.


Course InformationCourse Information

Zonecours.hec.caZonecours.hec.ca: : Slides from lectures, Slides from lectures, exercices, solutions, announcements, etc., exercices, solutions, announcements, etc., will be posted here.will be posted here.

Prerequisites:Prerequisites: It is important that you It is important that you have taken and passed the course have taken and passed the course « « Investments »Investments » and to a lesser extent and to a lesser extent « « Options and Futures »Options and Futures ». . If you do not If you do not have a strong background in finance at the have a strong background in finance at the level of « Ilevel of « Investmentsnvestments », you may not be », you may not be prepared to take this courseprepared to take this course. .


Today’s LectureToday’s Lecture

Objective: (Chapter 4) To give an overview Objective: (Chapter 4) To give an overview of institutional investing and institutions’ of institutional investing and institutions’ role in portfolio selection and managementrole in portfolio selection and management Investment companies Investment companies Mutual fundsMutual funds Costs of investing in Mutual FundsCosts of investing in Mutual Funds Investment performance of mutual fundsInvestment performance of mutual funds Index FundsIndex Funds

4-84-8


Investment CompaniesInvestment Companies

4-94-9


Investment companies pool funds into large portfolios.

Advantages include: Diversification & divisibilityDiversification & divisibility Administration & record keepingAdministration & record keeping Professional managementProfessional management Reduced costsReduced costs

Commissions/Transaction costs Information costs

Services of Investment CompaniesServices of Investment Companies

4-104-10


Net Asset Value Per Share: Used as Net Asset Value Per Share: Used as a basis for valuation of investment a basis for valuation of investment company sharescompany shares Selling new sharesSelling new shares Redeeming existing sharesRedeeming existing shares

Net Asset ValueNet Asset Value

dingOutsShares

sLiabilitieAssetsofValueMarketNAV

tan

4-114-11


Open-end and Closed-end FundsOpen-end and Closed-end Funds Managed fundsManaged funds

Closed-end/ Open-endClosed-end/ Open-end Load fundsLoad funds

Shares OutstandingShares Outstanding Closed-end: Do not redeem or issues sharesClosed-end: Do not redeem or issues shares Open-end: Can sell or redeem sharesOpen-end: Can sell or redeem shares

PricingPricing Open-end: Net Asset Value (NAV)Open-end: Net Asset Value (NAV) Closed-end: Premium or discount to (NAV)Closed-end: Premium or discount to (NAV)

4-124-12


Closed-end FundsClosed-end Funds


Commingled fundsCommingled funds Real estate fundsReal estate funds

Real estate limited partnerships Real estate limited partnerships Mortgage fundsMortgage funds

Segregated fundsSegregated funds Hedge fundsHedge funds

Other OrganizationsOther Organizations

4-144-14


Mutual FundsMutual Funds

4-154-15


Mutual Fund ListingsMutual Fund Listings

4-164-16


Growth of Mutual FundsGrowth of Mutual Funds

4-174-17


Money Market Money Market Fixed IncomeFixed Income Balanced and Income Balanced and Income Asset AllocationAsset Allocation EquityEquity IndexedIndexed Specialized SectorSpecialized Sector

Investment PoliciesInvestment Policies

4-184-18


Investment PoliciesInvestment Policies

Statement about their objective:Statement about their objective: Aggressive growth equity fundsAggressive growth equity funds

Emerging markets equity fundsEmerging markets equity funds

Growth and income equity fundsGrowth and income equity funds

High yield fixed income fundsHigh yield fixed income funds

Mortgage-backed bond fundsMortgage-backed bond funds


Types of Mutual FundsTypes of Mutual Funds

4-204-20


Largest Fund FamiliesLargest Fund Families


Mutual Funds ReturnsMutual Funds Returns

The one-period rate of return on an The one-period rate of return on an investment in a open-ended fund is investment in a open-ended fund is

$NAV

$NAV - $NAV gains $capital $income

1-t

1-tttreturn of rate


ExampleExample

Invest $1000 in a mutual fund Invest $1000 in a mutual fund

After 90 days, liquidated at NAV of $1,010. After 90 days, liquidated at NAV of $1,010. During the 90 days you received:During the 90 days you received:

A $5 income disbursement A $5 income disbursement A $15 capital gain disbursementA $15 capital gain disbursement

3%

$1,000$1,000 - $1,010 $15 $5

r t

$NAV

$NAV - $NAV gains $capital $income

t

1-tttreturn of rate


Costs of Investing in Mutual FundsCosts of Investing in Mutual Funds

4-244-24


Entry fees (Entry fees (Front-end loadsFront-end loads)) Diminish investor’s initial NAVDiminish investor’s initial NAV Many no-load funds existMany no-load funds exist Many load funds charging between 0 and 8.5% existMany load funds charging between 0 and 8.5% exist

Exit fees (redemption or Exit fees (redemption or Back-end loadsBack-end loads)) Declines toward zero the longer the fund is heldDeclines toward zero the longer the fund is held Most funds charge no exit feesMost funds charge no exit fees

Costs of Investing in Mutual FundsCosts of Investing in Mutual Funds

4-254-25


Costs of Mutual FundsCosts of Mutual Funds

Operating expensesOperating expenses Transaction feesTransaction fees

Cover the costs of buying/selling securitiesCover the costs of buying/selling securities

Distribution fees Distribution fees In the US: allowed to deduct up to 1% of their In the US: allowed to deduct up to 1% of their

assets per year to pay for sales commissions assets per year to pay for sales commissions and promotional expensesand promotional expenses

Management Expense Ratio (MER)Management Expense Ratio (MER)


ExampleExample

$1,000 in a fund with up-front load fee of $1,000 in a fund with up-front load fee of 3%.3%.

1% per year annual management fee 1% per year annual management fee

Redemption fee of 1.5%Redemption fee of 1.5%

After 90 days, liquidated at NAV of After 90 days, liquidated at NAV of $1,010$1,010. .

During the 90 days you received: During the 90 days you received: a $5 cash dividend disbursement and a $5 cash dividend disbursement and a $15 capital gain disbursement.a $15 capital gain disbursement.


Costs of Mutual FundsCosts of Mutual Funds

Return over the 90-day period Return over the 90-day period

Management fees in dollars over 90 days :Management fees in dollars over 90 days :

0.01 x (90/365) x $970 = $2.40.01 x (90/365) x $970 = $2.4

Redemption fee in dollarsRedemption fee in dollars

$1,010 x 1.5% = $15.15$1,010 x 1.5% = $15.15

90-day return :90-day return :

1.25%

$30 $970$30 - $15.15 - $2.4 - $970 - $1,010 $15 $5

r t


Impact of Costs on PerformanceImpact of Costs on Performance


Trading Scandal with Mutual FundsTrading Scandal with Mutual Funds

Late trading – allowing some investors to Late trading – allowing some investors to purchase or sell later than other investorspurchase or sell later than other investors

Market timing – allowing investors to buy Market timing – allowing investors to buy or sell on stale net asset valuesor sell on stale net asset values Example: Exploiting time-zone differencesExample: Exploiting time-zone differences

Net effect is to transfer wealth from Net effect is to transfer wealth from existing owners to the new purchasers or existing owners to the new purchasers or sellerssellers

4-304-30


Investment Performance of Mutual FundsInvestment Performance of Mutual Funds

4-314-31


First Look at Mutual Fund PerformanceFirst Look at Mutual Fund Performance Benchmark portfolio: Wilshire 5000 Benchmark portfolio: Wilshire 5000

Index.Index. Figure 4.4 shows that average mutual Figure 4.4 shows that average mutual

fund performance is generally less than fund performance is generally less than broad market performance measured by broad market performance measured by the index.the index.

Return on average mutual fund was Return on average mutual fund was below the Whilshire 5000 index 21 out of below the Whilshire 5000 index 21 out of 35 years from 1971 to 2005.35 years from 1971 to 2005.

The average return on the index The average return on the index exceeded that of the mutual fund by 1%exceeded that of the mutual fund by 1%

4-324-32


Performance vs. the IndexPerformance vs. the Index

4-334-33


Is Performance Due to Skill?Is Performance Due to Skill?

The must be good mangers and bad The must be good mangers and bad managers.managers.

So do good managers consistently So do good managers consistently outperform the index?outperform the index?

To test this, we seek evidence of To test this, we seek evidence of persistence in returns. persistence in returns.

If good performance is due to skill If good performance is due to skill then those who rank in the top then those who rank in the top performing half in one period would be performing half in one period would be expected to do well in the next period.expected to do well in the next period.


Do winners stay winners?Do winners stay winners?

4-354-35


Persistence in Fund PerformancePersistence in Fund Performance

The Malkiel study suggests that some The Malkiel study suggests that some funds show consistent strong performance funds show consistent strong performance but it seems to only be true in the 70s.but it seems to only be true in the 70s.

Other studies using Canadian data are Other studies using Canadian data are suggestive of good managers suggestive of good managers outperforming the market this is also outperforming the market this is also inconclusive.inconclusive.

Other studies suggest that bad Other studies suggest that bad performance is more likely to persist than performance is more likely to persist than good performance. good performance.


Survivorship BiasSurvivorship Bias

Yet worst performing funds go out of Yet worst performing funds go out of business.business.

So when looking at mutual fund So when looking at mutual fund rankings of 5 year returns, we should rankings of 5 year returns, we should remember there are many funds that remember there are many funds that failed to survive 5 years. failed to survive 5 years.

Hence, the performance of the Hence, the performance of the surviving firms will be upward biased.surviving firms will be upward biased.

This is known as a This is known as a survivorship biassurvivorship bias..


PALTrak (Morningstar)PALTrak (Morningstar) Wiesenberger’s Investment Companies Wiesenberger’s Investment Companies

(US)(US) Morningstar (US)Morningstar (US) Investment Company Institute (US)Investment Company Institute (US) Popular press (Globefund)Popular press (Globefund) Investment services (SEI, Comstat, etc.)Investment services (SEI, Comstat, etc.)

Sources of Information Sources of Information on Mutual Fundson Mutual Funds

4-384-38


Index FundsIndex Funds

4-394-39


Costs of Index vs. Mutual FundsCosts of Index vs. Mutual Funds

Index funds do not need as large a Index funds do not need as large a staff staff Decisions about what stock to buy have Decisions about what stock to buy have

already been made based on index already been made based on index commitment.commitment.

Savings are passed along to investors Savings are passed along to investors Average management fee for aAverage management fee for a managed managed

common stock mutual fund: 1.4%common stock mutual fund: 1.4%

Management fee for Vanguard Index Trust in Management fee for Vanguard Index Trust in the US : 0.18%the US : 0.18%


ExampleExample Investments’ performance over the Investments’ performance over the

long runlong run Initial investment of $100,000Initial investment of $100,000 Assume a 10% gross annual return for both Assume a 10% gross annual return for both

funds:funds: Vanguard Index Trust 500 Mutual Fund Vanguard Index Trust 500 Mutual Fund

charges a 0.18% management fee for a net charges a 0.18% management fee for a net annual return of 9.82%annual return of 9.82%

The Average Managed Mutual Fund The Average Managed Mutual Fund charges a 1.4% management fee for a net charges a 1.4% management fee for a net annual return of 8.6%annual return of 8.6%

Vanguard Index Vanguard Index Trust 500Trust 500

Average Average Managed Managed

Mutual FundMutual Fund

After 10 yearsAfter 10 years $255,000$255,000 $228,000$228,000

After 20 yearsAfter 20 years $651,000$651,000 $521,000$521,000


Index fundsIndex funds

Advantages of index fundsAdvantages of index funds

Management expenses are minimizedManagement expenses are minimized Higher returnsHigher returns No load fundsNo load funds Slow turnoverSlow turnover

Underlying indexes experience slow turnover; Underlying indexes experience slow turnover; Leads to lower commissionsLeads to lower commissions

Tax efficiencyTax efficiency Slow turnover leads to unrealized and untaxed Slow turnover leads to unrealized and untaxed

capital gainscapital gains Taxed when investment is soldTaxed when investment is sold



Disadvantages of index fundsDisadvantages of index funds May be poorly managedMay be poorly managed

There may be some tracking error:There may be some tracking error:

Tracking ErrorTracking Error = = Return of indexReturn of index – – Return Return on indexed on indexed

portfolioportfolio



Tracking errors can occur due to:Tracking errors can occur due to: Management feesManagement fees Manager didn’t invest in all target index Manager didn’t invest in all target index

securities.securities. Weighting scheme differed from that of the target Weighting scheme differed from that of the target

index.index. Delayed reaction to changes in targeted indexDelayed reaction to changes in targeted index Manager may try to ‘outsmart’ the market Manager may try to ‘outsmart’ the market

(enhanced indexing)(enhanced indexing) Use of derivatives of the securities rather than Use of derivatives of the securities rather than

the securities themselves ( lower commissions )the securities themselves ( lower commissions )



To reduce tracking error, portfolio may To reduce tracking error, portfolio may contain more of the different securities contain more of the different securities contained within the target index. contained within the target index.

As the number of different securities held As the number of different securities held within the portfolio increases, the within the portfolio increases, the commissions are likely to be higher.commissions are likely to be higher.

Portfolio managers may try to reduce trading Portfolio managers may try to reduce trading costs but this can increase the chance of costs but this can increase the chance of tracking error.tracking error.


Exchange Traded FundsExchange Traded Funds

ETFs allow investors to trade index ETFs allow investors to trade index portfolios like shares of stocks.portfolios like shares of stocks.

Examples – iShares, SPDRs and Examples – iShares, SPDRs and VipersVipers

Indexed with same weights used in Indexed with same weights used in the target indexthe target index

Unlike mutual funds:Unlike mutual funds: Order executed immediately—not at Order executed immediately—not at

market-on-close pricesmarket-on-close prices Management fees are below 0.18%Management fees are below 0.18%

4-464-46


ETF ProductsETF Products

4-474-47


Advantages of exchange index traded Advantages of exchange index traded fundsfunds

Trade continuously. Can be bought/sold throughout Trade continuously. Can be bought/sold throughout the day rather than just market-on-close pricesthe day rather than just market-on-close prices

Can sell short, and can do so on a down-tickCan sell short, and can do so on a down-tick

They usually cannot use derivatives so investors are They usually cannot use derivatives so investors are not subject to counterparty risksnot subject to counterparty risks

i.e. won’t have tracking error from the misuse of i.e. won’t have tracking error from the misuse of derivativesderivatives

Lower costsLower costs

Advantages of ETFsAdvantages of ETFs


Wealth AccumulationWealth Accumulation

1$ invested in the following from end of 1925 to 1$ invested in the following from end of 1925 to end of 1999 would have increased to :end of 1999 would have increased to :

Asset ClassAsset ClassAnnual Annual ReturnReturn

Ending Ending WealthWealth

S&P 500S&P 500 11.3%11.3% $2,845.$2,845.66

Small company stock indexSmall company stock index 12.6%12.6% $6,640.$6,640.77

Long-term corporate bond indexLong-term corporate bond index 5.6%5.6% $56.38$56.38

Long-term government bond indexLong-term government bond index 5.1%5.1% $40.22$40.22

Intermediate-term government Intermediate-term government bond bond

5.2%5.2% $43.93$43.93

U.S. Treasury BillsU.S. Treasury Bills 3.8%3.8% $15.64$15.64

InflationInflation 3.1%3.1% $9.39$9.39

Even afairly small

annual return can create large long-term results

Method of computation : (1 + return)n = Ending Wealth


A Note of InflationA Note of Inflation

Inflation : the purchasing power of $1 is not the Inflation : the purchasing power of $1 is not the same from year-to-year (it decreases)same from year-to-year (it decreases) $1 of purchases made in 1925 would cost $9.39 by 1999$1 of purchases made in 1925 would cost $9.39 by 1999

$1 x (1 + 0.030728)$1 x (1 + 0.030728)7474 = $9.39 = $9.39

$2,845.63 after adjusting for inflation is worth in $2,845.63 after adjusting for inflation is worth in real terms:real terms: $2,845.63 $2,845.63 $9.39 = $303.05 $9.39 = $303.05

While the accumulated real wealth is much lower While the accumulated real wealth is much lower than the nominal wealth, it is still an impressive than the nominal wealth, it is still an impressive numbernumber


Things to ReadThings to Read

Readings for Today’s lecture. Readings for Today’s lecture.

Chapter 4Chapter 4 Readings for Next Week:Readings for Next Week:

Chapter 5Chapter 5, sections 5.4 to 5.6 and , sections 5.4 to 5.6 and 5.85.8

Chapter 23, sections 23.1 and 23.2 Chapter 23, sections 23.1 and 23.2

0 Portfolio Management 3-228-07 Albert Lee Chun The Institutional Environment Lecture 1 09-02-2008.

Documents

Transcript of 0 Portfolio Management 3-228-07 Albert Lee Chun The Institutional Environment Lecture 1 09-02-2008.