Central Issues in Asset Management

Bernt Arne Ødegaard

12 January 2016

Contents1 Introduction to asset management 2

2 Asset Classes 42.1 Facts: Returns on broad asset classes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 42.2 Real Estate . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6

3 The Market Portfolio 8

4 Efficient Markets 104.1 Example . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 104.2 Markets can not be fully efficient . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12

5 Trading Strategies 13

6 Portfolio Performance Evaluation 146.1 Benchmark . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 146.2 Evaluating Performance – implementing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14

6.2.1 Sharpe ratio . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 146.2.2 Alpha . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15

7 Delegated Portfolio Management 15

8 Corporate Governance 18

9 Trading Costs 189.1 High Frequency Trading . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 19

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1 Introduction to asset management

What is the goal?

• Maintain, and preferably increase, current wealth.

• Think about: utility of future cashflows when withdrawing from wealth.

• Unstructured problem

Structuring problem: Simplify, Simplify, Simplify

• Collect investment possibilities in broad groups.

Asset Classes

– Tools for storing value.

– Examples: Typical asset classes.

– Facts: Returns on some asset classes.

• Asset Value mainly determined by two components:

– Expectation of increase in value (return).

– Uncertainty (risk).

• Portfolio problem:

– optimize expected return

– at an acceptable level of risk

Solving the portfolio problem:

– Simplify portfolio decision: Choose constant weights (fraction invested) in asset classes.

– Mathematically, this is formulated as a tradeoff between higher returns (means) and increaseduncertainty (variability/variance) of the higher return. (the “Mean-Variance” problem)

– The best (optimal) portfolio is the one with the highest expected return per unit of risk.

– All investors have the same choice problem, end up with the same composition of the risky partof the portfolio.

– In equilibrium, since all assets must be owned, the risky portfolio is the market portfolio of allassets.

Why is the market portfolio so important?

• Market Portfolio: Ownership of productive capacity of an economy.

• Example: Composition of (US) stock market portfolios, 1900, 2015.

Market Efficiency – how do markets work?

• Financial markets: Summarizes opinions of all traders.

• Example: How are stock prices (not) affected by news? Star Wars.

• But markets can not be completely efficient. (Grossmann-Stiglitz-intuition)

Ways of generating extra returns - concepts

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• Alpha strategies – e.g. stock picking.

• Beta strategies – e.g. factor loading.

• Market Timing – rebalancing.

• Market imperfections – e.g. liquidity.

• Being paid for services – e.g. stock lending.

• Active/Passive strategies

Does an asset manager generate extra returns?

• The problem of measuring performance. How to measure the unobservable?

– What is a benchmark?

– Performance measures

∗ Sharpe Ratio – risk return tradeoff.∗ Jensen’s Alpha – return from mispricing

Delegated portfolio management.

• Original portfolio allocator: Choose desired portfolio

• To implement portfolio choice: Hire asset manager(s), told to match (beat) index

• The asset manager should relate to the tracking error (difference target index and actual returns).

Corporate Governance.

• To what extent can one use being a small minority owner to anything else than generating wealth?

• Governance costs

Trading Costs.

• Analogy: The effect of biofouling on speed of ships.

• Unanswered question: How has the recent development of electronic trading in asset markets affecttrading costs?

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2 Asset Classes

An asset class is a investment vehicle.Example of wide classification

• Equities

• Bonds

• Mutual Funds/Hedge Funds

• Private Equity/Venture Capital

• Real Assets

– Real Estate

– Infrastructure

But classification can be more finely specified

• Equities

– Industry-Grouped

– Country–Grouped

• Bonds

– Country Grouping, e.g.

∗ Industrialized countries∗ Emerging Economies∗ . . .

– Type of Issuer Grouping, e.g.

∗ Treasury securities (Sovereign debt)∗ Company debt∗ . . .

– Creditworthiness grouping, e.g.

∗ Sovereign debt∗ Investment grade company debt∗ High yield company debt (Junk Bonds)

2.1 Facts: Returns on broad asset classes

Let us now show some facts about the world portfolio. Figure 1 describes an estimate of the world’s return(wealth increase) for the period 1900–2015. The cumulative returns in panel A should be interpreted as theamount an investment of $1 would have increased to. As we see the best choice would have been to haveheld equities over the period.But a word of warning. Equities may have long periods of low returns. See the average returns for the2000-2015 period. (The lost decade.)

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Figure 1 Historical performance of the world portfolioPanel A: World cumulative returns

Panel B: World average returns

Real (inflation-adjusted) returns. Source Credit Suisse Global Investment Returns Yearbook 2015

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The country that has done best over this period is the US. (It should not be a surprise, they have had nowars on their own soil since the civil war ended in 1865.) Let us therefore also show similar numbers for theUS market (figure 2).

Figure 2 Historical performance of the US portfolioPanel A: US cumulative returns

Panel B: US average returns

Real (inflation-adjusted) returns. Source Credit Suisse Global Investment Returns Yearbook 2015

2.2 Real Estate

December of 2015 there was a presentation of an expert group on investments in real estate and infrastructure.This is part of the process of investigating changes in the mandate of NBIM.From that we show their estimates of returns on real estate investments, in figure 3.These are the types of numbers used to evaluate how to treat real estate as an investment class in the periodahead.

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Figure 3 Historical performance of real estate investments

Source: (van Nieuwerburgh, Stanton, and de Bever, 2015, pg 39).

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3 The Market Portfolio

The main components of a country’s market portfolio:

• Government Bonds – debt to the country.

• Corporate Bonds – debt to largest companies in country.

• Listed equities – equity of largest companies in country.

By holding the market portfolio of a country, own a “fraction” of country’s productive capacity.Example: The composition of the US stock market portfolio in 1900. (If Morgan Kane was investing.) Shownin Panel A of figure 4. Over half of the investments were railroads, which was the infrastructure investmentof its day. Compare that with today’s market composition, in panel B.

Figure 4 Industry Composition US stock market portfolio. 1900 vs 2015Industry composition US 1900

Panel B: Industry composition US 2015

Source Credit Suisse Global Investment Returns Yearbook 2015

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What countries enter the index? Again, compare 1900 with 2015, in figure 5.

Figure 5 Country Composition World Stock market portfolio. 1900 vs 2015Panel A: 1900.

Panel B: 2015.

Source Credit Suisse Global Investment Returns Yearbook 2015

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4 Efficient Markets

The best way to think about assets traded in financial markets:The current market price is hard to beat.

• The market price is an average of the valuations of all traders in the economy.

• Aggregates the information of all these traders.

• The markets best estimate of the value.

4.1 Example

Star Wars and the Disney Stock Price

On Dec 18, 2015, Disney released the 7th installment in the continuing Star Wars film saga.

The film opened to record crowds, selling tickets of $119.1 million in North America alone, and becamee thefastest film ever to generate $1 billion in global ticket sales (12 days).This should be good news for the Disney stock owners, right? This increased cash flow should mean increasedstock prices?Well, if the markets are reasonably efficient, these ticket sales are already part of the expectations of futurecash flows. What affect stock prices should actually only be the unexpected part of the news about thesuccess of the film at release.Let us therefore look at the movement of the stock of Disney around the release dateThe stock price actually fell...This is not due to a general market decline around then, as shown in the evolution of the index for the sameperiodSo, Disney is falling relative to the market just as one of their major revenue drivers shows strong perfor-mance...Now, Disney is a large corporation, with many different business areas, and 1.65 billion shares outstanding,so the film revenues are not that large per share, but, unless other news are happening at Disney (thereare no press releases from Disney in the period), the relative fall in stock prices is interesting. If we justattribute it to the Star Wars release, does it mean that Disney paid too much for Lucasfilm, which theyaquired for about $4 billion in 2012?What about the time when Disney bought Lucasfilm, what happened to the stock price?

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Figure 6 Disney and the S&P 500, Dec 2015Panel A: Disney (DIS)

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Data Source: Yahoo Finance.

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The transaction happened in 2012, with a press release oct 30, 2012, announcing the aquisition of Lucasfilmby Disney. Figure 7 shows the evolution of the stock of Disney, and the stock market, at the time. Therewas little sign of a large jump in Disney stock around the aquisition.

Figure 7 Disney and the S&P 500, Oct-Nov 2012Disney (DIS)

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Evolution of Disney (DIS) Adjusted Share price and the S&P 500 stock price in october and november 2012. Data Source: Yahoo

Finance

4.2 Markets can not be fully efficient

However, there is a limit to how efficent market can be.Generating opinions about asset value requires information, and time and energy in processing the informa-tion.1 These are costly activities. For anybody to engage in such activities, need a potential reward, whichone get if there is a mispricing to correct. But the activity of trading to use a mispricing will move prices...Prices will adjust towards their correct prices.

1When Disney buys Star Wars, how much is this worth, and will it change the price of Disney?

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This is the insight of Grossman and Stiglitz (1980), which is much used (and abused) in justifying activepositions.

5 Trading Strategies

Default: Passive Asset Management.

• Replicate a market-weighted stock market index, i.e. buy the stocks in the index in the index propor-tions.

Participate in the world economy like everybody else.

Can be implemented at low cost (algorithmic trading).

Low overhead (manpower)

Favourite of academics, particularly those with strong views on market efficiency.

However... Are we sure that the market portfolio is optimal for GPFG?

• With the long term perspective of this fund, without short term withdrawals, is the market portfoliooptimal?

Or should the fact that the objective of the fund is different from most move one away from a puremarket portfolio?

• Are we losing valuable opportunities for extra return?

This is the case for active investing, that one can generate extra returns by being smart.

The Grossman-Stiglitz argument says that yes, there is scope for some investors to earn an extrareturn.2

But is the GPFG the right vehicle for chasing those opportunities? ...

Open question. But to answer it one needs to answer whether there are ways in which GPFG canidentify those opportunities. So what are some of the strategies employed to do so?

Ways of generating extra returns - concepts (giving some of the jargon, as well)

• Alpha strategies

Can we identify stocks/assets where the current market price is wrong (mispricing)

Example (the Warren Buffett way) – fundamental valuation of a company (predicting cash flows, etc)3Difference between estimated value and current stock price – mispricing. Buy low (underpriced) andsell high (overpriced).

• Beta strategies

Can we deviate from the market portfolio in ways that pays off?

– Increase the risk – should get higher return.– Digging deeper into what risk mean.

Current financial theory: several source of risk (factors).If one correctly identifies the factors, “tilting portfolio” away from market portfolio may be optimal,if one takes on factor risk one want.However – empirical challenge to identify factors.

2See also Berk and Green (2004).3Star Wars example: Predict which films will pay off.

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• Market Timing

– Can we move money between asset classes when expected returns change?With fixed asset class weights, rebalancing is an attempt at market timing. (selling stocks whenthey have increased, buy when they have fallen)

• Market imperfections

Are there market features that induce mispricing that the GPFG can exploit better than others.

Much toted example: Liquidity. Illiquid assets demand a higher return. A long term investor canweather illiquidity better than other investor, harvest liquidity premia.

Still, not all illiquid assets automatically deliver liquidity premia...

• Being paid for services

Example: Stock lending.

6 Portfolio Performance Evaluation

Need a way to ask: Does a portfolio manager do a good job?Concrete notion of “good job” by:Ability to generate a higher return than one could get by some simple, comparable, alternative strategy.

6.1 Benchmark

This notion of “simple, comparable, alternative strategy” implemented by constructing a benchmark, an indexrepresenting some possible alternative strategy.Common choice of benchmark: A market portfolio, a portfolio with weights proportional to the marketcapitalization of the assets (bonds/stocks) in the market in question.This benchmark is implementable, buy all the stocks in the index in the same proportions.

6.2 Evaluating Performance – implementing

Portfolio Performance Evaluation: Ways of comparing actual portfolio returns with benchmark returns.There is no single way of doing this.Instead, many different ways of doing so, most of which are informative.Therefore: typically calculate and report several such measures.Show some basic examples

6.2.1 Sharpe ratio

The Sharpe Ratio is the return in excess of a risk free rate, divided by the standard deviation of the return.In symbols, let rp be the portfolio return and rf the risk free rate, then the Sharpe ratio is

SR =E[rp]− rfσ(rp − rf )

In a picture

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The Sharpe Index6

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The Sharpe Ratio

The picture also shows the Sharpe calculation for the market portfolio m.

6.2.2 Alpha

Alpha is the difference between the actual returns of a portfolio and the return of a benchmark portfolio,where the benchmark should be the return of a “comparable” portfolio.

αp = rp − rbenchmark

The best known alpha is due to Michael Jensen, where the benchmark is the market portfolio adjusted forhow the riskiness of the portfolio differs from the market. (This is called the Capital Asset Pricing Model(CAPM).In symbols

αp = rp − (rf + βi(E[rm]− rf ))

In a picture

Jensens Alpha6

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7 Delegated Portfolio Management

General

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• Original portfolio allocator

– the big decision.

– choose an asset class composition (weights)

• To implement portfolio choice: Hire asset manager(s)

Way of operationalizing a chosen asset class composition:

– Specify a target index

– Tell the asset manager to match, and preferably beat, index.

The optimal contract for such a delegated portfolio assignment: Sharing of profits from beating theindex between asset manager and principal.

• Portfolio Performance for delegated portfolio management

– (In principle) only care about difference between target index and actual portfolio. (trackingerror)

∗ Important measure: Information Ratio. Similar measure to Sharpe Ratio, but dividing returnsin excess of benchmark with variability, instead of returns/variability.

∗ Understanding what causes (more/less) returns than index. Attribution/Contribution.

Specifics – The Norwegian Pension Funds

• Mapping roles.

– Original portfolio allocator: People of Norway.

Drawing by Arild Midthun

Mission: Store the Wealth from Oil Revenues

Drawing by Arild Midthun

– Representative for people: Storting→ Ministry of Finance (Finansdepartementet) – Principal.

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→

– hires two agents:

∗ Norges Bank (NBIM): Global (ex Norway)

∗ Folketrygdfondet: Local (Norway + Nordics)

Big Decision: Asset Weights (SPU)

NBIM Mission: Match this index, attempt to add extra returns.

• Reporting for NBIM.

– The important issue

∗ How do we fulfull the contractual obligation of delivering asset returns matching (improvingon) the index?

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→ Performance metrics on tracking error.

– But should not loose sight of original portfolio problem (mean-variance tradeoff)

∗ Inform Ministry of Finance (Finansdepartementet): Have they made the right choice of assetweight in target index?

∗ Communicate to original owners (people of Norway): Is NBIM doing a good job in lookingafter my money?

→ Performance metrics on portfolio itself.

8 Corporate Governance

• To what extent can one use being a small minority owner to anything else than generating wealth?

– Very little.

– A small minority owner has no say in management, can at best influence (voice).

– The sum of owners decide (annual meeting), but must be coordinated.

– Exit: possible, but what does it accomplish? Replacing a disgruntled owner with a gruntled?

– Concentrate on the wealth contribution.

• Governance costs

– Need to deal with corporate events (e.g. mergers, yes, no?).

– Voting in annual meetings.

– Watch operations to check exclusion restrictions (weapons, tobacco,...)

9 Trading Costs

Trading financial assets, while cheap, is not costless.Taking the effect of trading costs into account is a central part of asset management.Let us take an analogy from a business know to most Norwegians, shipping.Biofouling or biological fouling is the accumulation of microorganisms, plants, algae, or animals on wettedsurfaces. (Wikipedia)Illustration (magnified) of ships hull that’s been in the water a while:

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Bifouling is a major problem for ships.

• Slowing down speed.

In the day of sailing ships with wooden hulls, biofouling could reduce the speed of the ship with athird.

Even today, in powered ships, biofouling can reduce a ship’s speed with 10%.

• Unprotected wooden hulls are gradually destroyed.

Trading costs have some of the same characteristics as biofouling

• It sounds trivial and boring.

• But it is actually extremely important to keep costs low.

9.1 High Frequency Trading

The most visible aspect of current financial markets: Computerization.Trading is moving towards fully electronic, competing, exchanges.Lowered transaction costs for small, individual traders by a factor of 10.However, still an unsolved problem: How has this new environment impacted trading costs for large institu-tional investors (like NBIM). Are they being front run? (Flash Boys).

ReferencesJonathan B Berk and Richard C Green. Mutual fund flows and performance in rational markets. Journal of Political Economy,

112(6):1269–1295, 2004.

Sanford Grossman and Joseph Stiglitz. On the impossibility of informationally efficient markets. American Economic Review,1980.

Stijn van Nieuwerburgh, Richard Stanton, and Leo de Bever. A review of real estate and infrastructure investments by theNorwegian Government Pension Fund Global (GPFG). Report submitted to the Norwegian Ministry of Finance, December2015.

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