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Dr Cesario MATEUS

cesario.mateus.1@city.ac.uk

www.cesariomateus.com

MSc Investment Management

Portfolio Management

mailto:cesario.mateus.1@city.ac.ukhttp://www.cesariomateus.com/http://www.cesariomateus.com/mailto:cesario.mateus.1@city.ac.uk

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Lecture 1

Introduction to Passive vs. Active Portfolio ManagementStrategies

Strategic Asset Allocation (SAA)

January, 25, 2012

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Three forms of market efficiency

A market that is strong form efficient is also semi-strong and

weak form efficient

Strong form (SF): Today price

includes todaysprivate information

Semi strong form (SSF): Today price

includes todayspublicinformation

Weak form (WF): Today priceincludespastinformation

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Two conflicting views

Efficient market type:

Rational economists

The market knows best

Competition and incentive forfinancial gains ensure fairpricing and market efficiency

Replicate, do not attempt tobeat the market

Inefficient market type:

Behavioural economists

Behaviouralists know best

The irrationality of the herdpushes prices away fromfundamentals and allowsmispricings to survive

Attempt to beat the market byexploiting these mispricings

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Strong Form of EfficiencySince all information is reflected in prices fully and instantaneously it will

be useless in predicting future prices (and returns).

The type of information analysts use depends on their belief regarding

what information is reflected in market prices

Technical analysts

Fundamental analysts

Technical analysts (chartists) believe weak form inefficiency

Its possible to beat the market trading on past price movements

and trends

Fundamental analysts believe in weak form efficiency Earning abnormal returns/profits requires gathering and analyzing

information

Forecasting future earnings, dividends and other fundamentals better

than other investors increases the chance of earning abnormal

returns/profits

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Fundamental versus Technical Analysis

Fundamental Analysis: involves analysing its income statements,financial statements, its management and competitive advantages and its

competitors and markets

The analysis is performed on historical and present data, but with

the goal to make financial projections

Technical analysis: the study of market action, primarily through the use

of charts, for the purpose of forecasting future price trends

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Assume that markets are efficient basing decisions on results of portfolio theory and CAPM

Manage portfolios that are surrogates for the market portfolioor those tailored for particular (not average) clients - index

funds indexation strategy

The aim: to achieve average performance through returnswhich are equal to the market as a whole

success judged by how small is the difference between fundsreturn and index return - trackingerror

Morningstar survey found an average of 38 basis pointsacross all index funds.

Investment policies: Passive

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Origins from 1970s: Wells Fargos index portfolio

CAPM: concept of the Market portfolio

Performance of passive funds:

not very competitive in the 70s and 80s

shift towards passive management in the 1990s

increasingly good performance over longer time horizon

Important to choose the right benchmark portfolio

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Investment policies: Active

Assume that there are mispriced securities or groups of securities:do not believe in market efficiency and have different forecasts

than consensus

Active portfolio: differences between proportions in the actual and

benchmark portfoliobets are placed on certain securities

The aim: to outperform the benchmark indexsuccess judged by how large is the difference between fund return

and index return

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Turnover and transaction costs of passive fund are smaller aswell as management fees

Active management must generate at least 1.25% of gross

additional return to break even with passive

Greater diversification in the passive management

Frequent revising of portfolios by active managers in search

for the winners

The aim of the passive is to achieve returns close to the

market returns, while active is trying to outperform

Passive v s. active management

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Passive vs. active management, cont.

Passive management would be favored by a rational investor

if skills are not there, active management would produce high

costs and no compensation

active portfolio is more risky than passive due to

unsystematic risk

Market is said to be zero-sum game: winners & losers

Combination of the two investment policies is possible

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Do active portfolio managers beat passive portfolio

managers?

Source: B. Malkiel (2003)

52%

63%

71%

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

1 Year 5 Years 10 Years

Time period ending 31 December 2001

Percentage of active general equity funds that were beaten

by Vanguard (S&P) Index Fund after expenses

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Security (sector) selection or stock screening

Based on various active quant techniques such as:

Momentum investing, earnings surprise, style investing, use ofrelative valuation techniques, optimisation etc.

Asset allocation (AA) Allocating the funds within one asset class or between assetclasses

Strategic AA: based on long-term forecasts and used fordetermining longer term position in an asset class

Tactical AA: based on short-term forecasts and used fordetermining switching between or within asset classes

Market Timing

Determining when to switch from one asset (class) to another

Can be done at individual security level and market level

General Approaches to Active Strategies

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Asset Allocation

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What is Asset Allocation (AA)?

AA traditionally involves allocation of funds between thefollowing asset classes: equities, bonds, property, cash, etc

Within each of these asset classes, separate allocationdecisions need to be made: value vs. growth stocks;

domestic vs. international stocks; government vs.corporate bonds etc.

Practitioners dilemma: traditional vs. alternative assetclasses (commodities, private equity, FX, hedge funds)

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Asset Allocation in practice

In 1980s and 1990s institutional investors allocated most fundsto equity Barclays Capital: 100 invested in 1899 in UK stock market (with

income reinvested) would be worth around 25,022 in real termstoday; while the same investment in gilts and cash will be worth323 and 286 respectively.

Asset mix has changed in the last 10 years, particularly since2008: bonds represent greater proportion of the holdings

Reasons: high equity market returns from 1990s may not be

repeated in the future; when markets are in downturn, investors turnto less risky investments

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AA in practice: change in the UK asset mix

1997: AUM by Asset Type

52.8%

5.7%

2.9%

32.8%

4.1%1.2%0.4%

UK Equity &

BondBond

Global Equity

Managed

Money Market

Other

2009: AUM by Asset Type

31.4%

29.6%

19.9%

8.1%

1.8%6.2%

1.0%

UK Equity

Balanced

Bond

Global Equity

Absolute return

Money Market

Other

Source: IMA survey, 2009

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CFA guidelines on investment process

Define objectives: desired investment outcomes (return and riskobjectives)

Define constraints: regulatory, legal

Formulate investment policy statement to include:

Client description, investment horizon, statement of investment

goals and objectives/constraints, schedule for review ofperformance, asset allocation considerations that are accounted forwhen developing strategic asset allocation and rebalancingguidelines among others

Investment policy is the basis for strategic asset allocation

Monitor and rebalance portfolio (if and when needed)

Portfolio manager given a mandate: set of instructionsdetailing his task and how the performance will be evaluated,including the specification of the managers benchmark.

Fact: there is no correct way to formulate an investment

process

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To define objectives, start from the client!!

Type of investor

Drivers of returnrequirement

Risk tolerance

Individual Life cycle, education,

retirement

Variable

Life insurance Actuarial and business

Low risk

Mutual Fund Variable Variable

Endowment funds Depends on when

income is needed

Usually low risk

Non-life insurance Policy risks (short

term)

Very low risk

Pension Fund Pension liabilities (long

term)

Very low risk

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Top-Down Analysis

Capital Allocation Decision: Choice of proportion of the overall portfolio to

place in safe but low-return versus risky but higher-return securities

Asset Allocation Decision: Distribution of risky investments across broad

asset classes: Stocks, Bonds, etc

Selection Decision: Choice of which particular securities to hold within

each asset class.

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The next step: Strategic Asset Allocation (SAA)

The efficient optimisation of investment allocation to major assetclasses of investment in order:

to meet the overall investment objectives of the institution and

to achieve an acceptable balance between risk and return

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Investment process has been agreed upon The next step is to design the SAA, this is the allocation to asset

classes that in the long-term would meet client's needs

Involves periodically rebalancing the portfolio in order to maintain along-term goal for asset allocation.

SAA is also known as policy AA (Asset Allocation)

Four main approaches to SAA:

Capitalisation-based: i.e., using assets in proportion as in theworld portfolioas in CAPM.

Follow the median manager, especially among pensionmanagers. No loss of mandate. Maximise managers utility?

Mean Variance Optimisation (MVO): how to generate keyinputs?

Liability driven investment (LDI): asset/liability issues.

Strategic Asset Allocation (SAA)

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SAA Following the median manager

Choose SAA to reflect allocation of a median portfoliomanager

Popular when performance measured with peer-group

benchmark There is incentive NOT to underperform median manager

Managers protected from being fired for taking higher-than-average risks

Herding bias

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SAA Mean Variance Optimization (MVO) approach

Best long-term asset mix to achieve investors objectives (5years)

Objective of SAA: identify return requirement of the fund andcombine asset classes in such a way that the expected return

is achieved with the lowest volatility; i.e. identify efficientfrontier for any given group of asset classes

Based on long-term view of asset performance and oninvestors risk profile / investment horizon; so need to know:

1. Long-term expected returns of asset classes2. Volatility of those asset classes

3. Correlations between those asset classes

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SAA (MVO): Determining long-term expected returns

(building block approach)

To form a view about long-term expected returns, one needs toconsider:

Expected real return

Expected inflation

Expected risk premium

Expected real return: even if there is economy with no inflation,investors will require real return on investment (as there isopportunity cost: we invest and forego consumption today for

future consumption)

Expected real return is closely related to the growth rate ofthe economy, which is quite stable over time (in the UK andmajor economies, ranging 2-3% over the last 30 years).

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SAA (MVO): Determining long-term expected returns

(building block approach)

Expected inflation: investors require compensation for expectedinflation over time, in addition to the long term growth rate of theeconomy

Target inflation: in UK Bank of England (BoE) target is2%1%; ECB target is below 2%, similar to USA, Australia,

Canada etc.

Expected real return + Expected inflation = required return on cashdeposit over time

Also known as neutral policy rate (interest rates over timeaverage around this rate) or riskless rate, used as a basis forreturn expected on risky investments

Add the risk premium: credit risk, liquidity risk, equity risk premium

etc.

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SAA (MVO): Determining long-term volatility and

correlationsEstimates of future volatility are based on historical valuesBUT

both volatility and correlations are time varying

Correlations have risen over time due to globalisation (many

companies operating in foreign markets) - is there any benefit in

international diversification and global asset allocation then?YES!

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SAA: choosing the strategic portfolio

Asset allocator produces mean-variance frontier which canenable them to select a strategic investment portfolio:

Standard deviation, risk: established using

historic estimates of volatilities and correlations

Individual asset

classes

Efficient frontier

Expected

return:established

via

'building

blockapp

roach'

A

B

C

D

E

F

Standard deviation, risk: established using

historic estimates of volatilities and correlations

Individual asset

classes

Efficient frontier

Expected

return:established

via

'building

blockapp

roach'

A

B

C

D

E

F

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MVO based SAA portfolio weights

Stable weights over time (Fixed weight asset allocation)

However, weights do not really have to remain fixed all the time -

optimal strategic asset mix changes if there is:

Revision of estimates for expected returns, risks andcorrelations

Change in the clients risk profile

Accept current market valuations; i.e., consistent with passive

portfolio management and market efficiency

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MVO based SAA what are the problems?Michaud (1989) The Markowitz Optimisation Enigma: Is

OptimizedOptimal?, Financial Analysts Journal, Jan/Feb 1989: Assumes normal distributionand requires long history of data

Meaningless optimal portfolio (only a few assets in very highweightings)

Based on risk and return which are both subject to estimation error

Liquidity of assets is often ignored introducing liquidity as aconstraint results in less return maximisation and less riskreduction, moving efficient frontier to the lower right corner on themean/standard deviation graph

Existence of optimally equivalent portfolios: portfolios that havestatistically identical risk return profile but very different composition

Small changes in inputs in MVO result in large changes to optimalportfolio

Despite these problems, optimisation is used in solving asset allocationproblems and index tracking

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SAA and optimisation problems potential solution

Version of Global optimisation combining CAPM, investorexpectations and traditional MVO analysis is given by Black

and Litterman model from Goldman Sachs.

Model provides the flexibility of combining the market equilibriumwith additional market views of the investor

For detailed discussion referto Black F. and Litterman, R. (1992)

Global Portfolio Optimisation, Financial Analysts Journal,

September/October 1992.

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Liability Driven Investment (LDI) based SAA

Popular with pension funds

Objective of LDI: return on the assets should at least match thepayout on liabilities

Objective until mid 1990s: beat the peer-group benchmark

Example of LDI objective: match the change in liabilities

plus outperformance of x % p.a (focuses on the liabilitiesfirst and then addresses the desired level ofoutperformance over the liabilities, subject to various riskconstraints).

LDI objective should be viewed as a refinement of existing

investment objectives rather than a completely new approach Before LDI approach was introduced, the focus was purelyon assets. Whereas in LDI exposures to various assetclasses, can be translated to an expectation ofperformance relative to liabilities

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LDI: 4 Step Process Step 1- Creating Liability Matching Portfolio:

Liability matching portfolio: lowest risk portfolio which is a

combination of assets having similar sensitivity to inflation,

interest rates and other variables as the liabilities

Forecasts of cash-flows and their sensitivity to inflation, interest

rates etc..

Typical liability matching portfolio would include:

Index linked gilts, Corporate index linked bonds, Corporate

bonds (to match liabilities with shorter duration) and swaps

(interest rate, inflation and credit default - to syntheticallymatch longer duration liabilities).

Considered as the reference portfolio in the LDI strategy

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LDI: 4 Step Process

Step 2 Risk Budget and Benchmark

Determine the overall risk constraints of the portfolio, the aggregate

target outperformance and how much of this will come from market

exposure (passive management) and how much from active

management. For example a target of 0.5% or 1% outperformance

over liabilities which is coming from market exposure (beta) can be

shown below:

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Step 3 Active manager outperformance A target of 2% outperformance over liabilities might be adopted with

1% coming from market exposure (beta) and 1% from active

management (alpha). Active portfolio composition example: 55%

government and corporate bonds (liability matching portfolio) and

45% other risky assets (e.g. 25% active domestic and internationalequity, 10% property, 5% hedge funds and 5% commodities)

LDI: 4 Step Process

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Step 4 - Implementation Be pragmatic, there is more than one way to apply

Recall the structuring of fixed income portfolios to meet knownliabilitiesclassical immunisation, cashflow matching, etc.

What if liabilities are uncertain (i.e. stochastic)? You can choosefrom a wide range of assets, e.g. equities, hedge funds - these arealso stochastic.

Asset risk: asset allocation will produce different returns,volatilities, correlations, etc: should it be static or dynamic assetmix?

Around half of the UK pension funds have adopted LDI approach

LDI: 4 Step Process

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Source: IMA survey 2009

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Reading list (Lectures 1&2)

Baca, S., Garbe B and R. Weiss, The rise of sector effects in major equitymarkets, Financial Analysts Journal, Sep / Oct 2000, 34-40

Bodie, Kane and Marcus, Essentials of Investments, pp 593-598 onPerformance Attribution

Black F. and Litterman, R. (1992) Global Portfolio Optimisation, FinancialAnalysts Journal, September/October 1992

Brinson, G., Hood R. and G. Beebower (1986), Determinants of Portfolio

Performance, Financial Analysts Journal, July/August 1986. Brinson, G. Singer B and G. Beebower (1991), Determinants of Portfolio

Performance II: An Update, Financial Analysts Journal, May/June 1991.

Dahlquist, M. and C. R. Harvey (2001), Global Tactical Asset Allocation, TheJournal of Global Capital Markets, Spring 2001.

Elton, E, Gruber, M, Brown, S and W. Goetzmann, Chapter 10 on InternationalDiversification in 8th edition Modern Portfolio Theory and InvestmentAnalysis,Wiley

Hood, R. (2005), Determinants of Portfolio Performance 20 years later,Financial Analysts Journal, September/October 2005.

Idzorek, T(2010), Asset Allocation is King, Morningstar Advisor, April/May

2010