The Portfolio Management Process
1. Policy statement
– specifies investment goals and acceptable risk levels
– should be reviewed periodically
– guides all investment decisions
2. Study current financial and economic conditions and forecast future
trends
– determine strategies to meet goals
– requires monitoring and updates
3. Construct the portfolio
– allocate available funds to meet goals and minimize investor’s risks
– Include constraints in the optimization process (e.g., Liquidity needs and
Time horizon)
4. Monitor and update
– revise policy statement as needed and modify investment strategy
accordingly
– evaluate portfolio performance
Which is about…
• Four decisions
– What asset classes to consider for investment
– What optimal weights to assign to each eligible
class
– The allowable allocation ranges based on policy
weights
– What specific securities to purchase for the portfolio
Most (85% to 95%) of the overall investment
return is due to the first two decisions, not the
selection of individual investments
• FACT: Over long time periods sizable allocation to
equity will improve results
Example 1: Allocation and Market Timing
“Adjusting portfolio for up and down movements in the market”
Shift between risky assets and risk-free instruments (CML) Evidence of the
importance of Market Timing: Returns from 1987 - 1996 Switch to T-Bills in
87, 90 and 94No negative returns or losses; Average Ret. = 17.44%; S.D.
Ret. = 12.38% higher returns, lower risk (downside is partially eliminated)
Year
Lg. Stock Return
87
5.34
88
16.86
89
31.34
90
-3.20
91
30.66
92
7.71
93
9.87
94
1.29
95
37.71
96
23.00
Average
16.06
Standard Dev.
14.05
T-Bill Return
5.50
6.44
8.32
7.86
5.65
3.54
2.97
3.91
5.58
5.20
In Practice:Imperfect Ability to Forecast
• Ability to catch an EXISTING trend=higher proportions
of correct calls:
– Bull markets and bear market calls allocation: DeEmphasize individual security selection and focus
on undervalued (promising) asset classes (Efficient
Frontier, CML)  top-bottom approach
– Undervalued and overvalued securitiesselection:
Emphasize on individual security selection and
focus on undervalued securities (SML, asset pricing
models) bottom-up approach
3 approaches to portfolio management
• 3 strategies or approaches based on how you will change the
weights of your portfolio and select securities:
– Passiveselection focus—FIXED PROPORTIONS:
Indexation SML, asset valuation models, fundamental
analysis
– Semi-passive some timing, allocation and selection
focus—PROPORTIONS CHANGED PERIODICALLY
typically, your portfolio is broken down into a passive portion
and an active speculative portion.
– Active continuous allocation and selection—
PROPORTIONS CHANGED CONTINUOUSLY: recalculate
efficient frontier often and/or position the portfolio Beta (look
at the CML) for movements in the market :
» Bearishlower ßeta by buying T-bills
» Bullishincrease ßeta by selling T-bills
What is Required of a Portfolio
Manager?
• Above-average returns within a given risk class.
• Portfolio diversification to eliminate all unsystematic
risk.
• “above-average” or significant abnormal return?
– Abnormal=Excess performance compared to a benchmark
portfolio with the same initial Reward to risk
– Above-average return is a Point estimate
– Significant Abnormal (or excess) return refers to statistical
inferences about this point estimate.
• Factors that lead to abnormal performance
– Market/asset/sector/industry Allocation
– Security Selection
– Protection
Composite Portfolio
Performance Measures
• Treynor Measure SML
Ri  RFR
T=
Bi
• Sharpe Measure CML
Si =
R i  RFR
SDi
• Jensen Measure SML
J=(Rp –Rf) – Bj (Rm – Rf)
Example 2: Differentiate between the three
measures
Treynor versus Sharpe Measures
• Beta vs. Standard Deviation
– Treynor –> uses SML, thus focus on Beta assumes
that portfolio is well diversified.
– Sharpe-> uses the CML, thus focus on standard
deviationassumes that portfolio is not well
diversified.
• Ranking differences from different diversification
levels. (SML vs. CML)R2 will tell you!
• Benchmark choice may affect the R2
Example 3: The Jensen Measure
• Requires use of different RFR, Rm, and Rj, for
each period.
• Assumes portfolio is well diversified and only
considers systematic risk.
• Provides inferences about abnormal gain/loss
• Regression of (Rj- RFR) and (Rm - RFR).
– R2 can be useful as a measure of diversification.
Example 4: Jensen, Sharpe and
Treynor
(Rp-Rf)=Jensen + beta x (Rm-Rf)+e
Portfoli
o
Jense beta
n
A
0.19
RP is the risk premium: Rp-Rf
Sigma
A
Mean
(RP)
1.02%
B
0.47%
0.76%
C
0.94%
0.79%
R-2
1.19%
1.05* 0.94
B
-0.05
0.66* 0.92
C
0.46*
0.59* 0.69
D
0.36
0.76* 0.64
D
0.96%
1.04%
E
0.30*
0.79* 0.95
E
0.89%
0.89%
Market
0.9%
1.1%
* Indicates significance at the 95%
level
ANALYSIS
Treynor T_rank Sharpe S_rank Jensen J_rank
A
0.0097
4
0.857
4
0.190
4
B
0.0071
6
0.618
6
-0.050
6
C
0.0159
1
1.190
1
0.460*
1
D
0.0126
2
0.923
3
0.360
2
E
0.0113
3
1.000
2
0.300*
3
Market
0.009
5
0.82
5
0
5
Performance Attribution Analysis
• Decomposing overall performance into
components
• Components are related to specific elements of
performance:
– Asset Allocation
– Industry/Sector Allocation
– Security Choice Selection
• Thus,
Contribution for asset and sector/industry allocation
+ Contribution for security selection
= Total Contribution from asset class
Example 5: Benchmark
Benchmark Component
Equity (S&P500)
Weight (benchmark) Indexes Return(monthly)
60.0%
5.81%
Basic material
Business services
Capital good
Consumer cyclical
Consumer noncyclical
Credit sensitive
Energy
Technology
8.3%
4.1%
7.8%
12.5%
20.4%
21.8%
14.2%
10.9%
6.40%
6.50%
3.70%
8.40%
9.40%
4.60%
2.10%
-0.10%
Bonds(LBI) 21% treasury;
65% corporate
Cash(Money Market)
30.0%
10.0%
1.45%
0.48%
Benchmark Return
3.97%
Example 5: Portfolio
Portfolio
Equity
Weight
(portfolio)
70.0%
Basic material
Business services
Capital good
Consumer cyclical
Consumer noncyclical
Credit sensitive
Energy
Technology
2.0%
7.8%
1.9%
8.5%
40.4%
24.0%
13.5%
2.0%
Bonds 100% corporate 7.0%
cash
23.0%
Portfolio Return
Actual return
(monthly)
7.28%
Indexes Return
(monthly)
6.40%
6.50%
3.70%
8.40%
9.40%
4.60%
2.10%
-0.10%
1.89%
0.48%
5.34%
Example 5: So far…
Partial
Total
Formula
Excess return Excess Return
Conclusion, Excess return due to:
Total (equity, bonds and cash)
5.34%-3.97%
1.3700%
Market allocation
0.310%
Equity sector allocation
70% x 1.253%
0.877%
Bond sector allocation
7% x 0.37%
0.026%
Equity selection
70% x (1.47%-1.253%) 0.152%
Bond selection
7% x (0.44%-0.37%)
0.005%
Example 6: Analysis: Weighted excess
return due to asset allocation (between
each class)
(Actual Weight-Benchmark Weight) x Index Return
Market allocation
Equity
Bond
Cash
Total excess Return
due to
market allocation
Actual Benchmark Indexes Return
weight weight
(monthly)
70%
60%
5.81%
7%
30%
1.45%
23%
10%
0.48%
Excess return
over the index
0.581%
-0.334%
0.062%
0.310%
Example 6: So far…
Partial
Total
Formula
Excess return Excess Return
Conclusion, Excess return due to:
Total (equity, bonds and cash)
5.34%-3.97%
1.3700%
Market allocation
0.310%
Equity sector allocation
70% x 1.253%
0.877%
Bond sector allocation
7% x 0.37%
0.026%
Equity selection
70% x (1.47%-1.253%) 0.152%
Bond selection
7% x (0.44%-0.37%)
0.005%
Example 6: Analysis: Weighted excess return due
to equity sector allocation (between each sector)
(Actual Weight-Benchmark Weight) x Index Return
Sector allocation (equity)
Basic material
Business services
Capital good
Consumer cyclical
Consumer noncyclical
Credit sensitive
Energy
Technology
Total excess Return
due to
equity sector allocation
Actual Benchmark
weight weight
2.0%
8.3%
7.8%
4.1%
1.9%
7.8%
8.5%
12.5%
40.4%
20.4%
24.0%
21.8%
13.5%
14.2%
2.0%
10.9%
Indexes Return
(monthly)
6.40%
6.50%
3.70%
8.40%
9.40%
4.60%
2.10%
-0.10%
Excess return
over the index
-0.406%
0.243%
-0.219%
-0.339%
1.877%
0.102%
-0.014%
0.009%
1.253%
Weighted excess return due to equity sector allocation=1.253% x 70%=0.877%
Example 6: So far…
Partial
Total
Formula
Excess return Excess Return
Conclusion, Excess return due to:
Total (equity, bonds and cash)
5.34%-3.97%
1.3700%
Market allocation
0.310%
Equity sector allocation
70% x 1.253%
0.877%
Bond sector allocation
7% x 0.37%
0.026%
Equity selection
70% x (1.47%-1.253%) 0.152%
Bond selection
7% x (0.44%-0.37%)
0.005%
Example 6: Analysis: Weighted excess return due to
bond family allocation (between each family)
(Actual Weight-Benchmark Weight) x Index Return
Actual
Sector allocation (Bond) weight
Treasury
0%
Corporate
100%
Others
0%
Total excess Return
due to
bond sector allocation
Benchmark
weight
21%
65%
14%
Indexes Return
(monthly)
0.48%
1.69%
0.86%
Excess return
over the index
-0.102%
0.592%
-0.120%
0.370%
Weighted excess return due to bond family allocation=0.37% x 7%=0.026%
Example 6: So far…
Partial
Total
Formula
Excess return Excess Return
Conclusion, Excess return due to:
Total (equity, bonds and cash)
5.34%-3.97%
1.3700%
Market allocation
0.310%
Equity sector allocation
70% x 1.253%
0.877%
Bond sector allocation
7% x 0.37%
0.026%
Equity selection
70% x (1.47%-1.253%) 0.152%
Bond selection
7% x (0.44%-0.37%)
0.005%
Example 6: Analysis: Unweighted
excess return due to sector allocation
and security selection (within each
class)
Excess return
Equity
Bond
Cash
Portfolio R
eturn
7.28%
1.89%
0.48%
Benchmark
Return
5.81%
1.45%
0.48%
Portfolio
Excess return
1.47%
0.44%
0.00%
Total excess return
from the equity
portion of the
portfolio
Example 6: Conclusion
Total excess return
from equity sector
allocation
Partial
Total
Formula
Excess return Excess Return
Conclusion, Excess return due to:
Total (equity, bonds and cash)
5.34%-3.97%
1.3700%
Market allocation
0.310%
Equity sector allocation
70% x 1.253%
0.877%
Bond sector allocation
7% x 0.37%
0.026%
Equity selection
70% x (1.47%-1.253%) 0.152%
Bond selection
7% x (0.44%-0.37%)
0.005%
Total excess return from
the bond portion of the
portfolio
Total excess return from
the bond family allocation
You can do it for your portfolio!!!
• Go to morningstar.com & do an “X-ray” on your
portfolio. Look at the proportion in Stock/Bond/Cash
• For the equity portion: Take note of the weights of your
portfolio and the SP500 in each of the 10 sectors. Get
the three-month return for the SP500 and each sector
at
– http://screen.morningstar.com/index/indexReturns.html?mse
ction=IdxReturns
– Http://news.morningstar.com/stockReturns/CapWtdSectorRe
turns.html?msection=SectorReturns
• For the bond portion: Take note of the weights of your
portfolio in bonds. Get the three-month return for a
bond index (LB) at :
– http://screen.morningstar.com/index/indexReturns.html?mse
Example 7: Another example of PAA
Benchmark
Manager A
Manager B
Weight
Return
Weight
Return
Weight
Return
Stock
0.6
-5%
0.5
-4%
0.3
-5%
Bonds
0.3
-3.5
0.2
-2.5
0.4
-3.5
Cash
0.1
0.3
0.3
0.3
0.3
0.3
• Calculate the overall return of each portfolio and comment on
whether these managers have under- or over-performed the benchmark
fund.
• Using attribution analysis, calculate (1) the asset allocation and (2)
the sector allocation/stock selection (combined) effects. Combine your
findings with those of (a.) and discuss each manager’s skills.
Example 7: Another example of PAA
1. Excess return
R(Benchmark)= weighted average return
=60% x (–5%) +30% x (–3.5%) + 10% x
0.3%
= - 4.02%
R(a)= -2.41%
R(b)= -2.81%
So
Excess return (a)= -2.41%-(-4.02%)= 1.61%
Excess return (b)= -2.81%-(-4.02%)= 1.21%
Example 7: Another example of PAA
• Allocation effect:
A
Stock
Bond
cash
Total
Wa
50
20
30
Wbench
60
30
10
R bench
-5%
-3.5%
0.3%
Effect
0.5%
0.35%
0.06%
0.91%
B
Stock
Bond
cash
Total
Wb
30
40
30
W bench
60
30
10
R bench
-5%
-3.5%
0.3%
Effect
1.5%
-0.35%
0.06%
1.21%
Example 7: Another example of PAA
• Selection Effect: Excess return –Allocation
effect
• A: 1.61%-0.91%=0.7%
• B: 1.21%-1.21% =0%
• A is good at allocating and selecting
• B is specialized in allocating among asset
classes