Portfolio Management
3-228-07
Albert Lee Chun
The Institutional
Environment
Lecture 1
09-02-2008
0
Portfolio Management

This course Portfolio Management complements the course
Investments (2-201-99) by exploring various issues underlying
asset management. This is the most fundamental attribute of any
professionally managed portfolio. Even if most of the concepts
presented in class are specific to portfolios consisting of shares
or stock market indices, the majority of these concepts apply to a
wide variety of financial asset categories. In this course, students
will become familiar with fundamental concepts of portfolio
management including efficient frontier portfolios, multifactor
models, financial asset pricing models, market efficiency and the
performance evaluation of professionally managed portfolios.
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Course Outline
Sessions 1 and 2 : The Institutional Environment
 Sessions 3, 4 and 5: Construction of Portfolios
 Sessions 6 and 7: Capital Asset Pricing Model
 Session 8: Market Efficiency
 Session 9: Active Portfolio Management
 Session 10: Management of Bond Portfolios
 Session 11: Performance Measurement of
Managed Portfolios

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Evaluation

You will be evaluated using the following criteria:
 Midterm Exam: (October 21st)
40%
 Final Exam: (December 14th)
40%
 Project:
20%
 The
midterm and final exams are 3 hours long.
 The exams will be closed book.
 For the exams, you are allowed to have a singlesided, 8.5 x 11 inch “cheat sheet”, where you can
write all the information you want.
 Old exams will not be made available.
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Professor Albert’s Contact Info
E-mail:
Phone:
Office:
Office hours:
albert-lee.chun@hec.ca
514-340-5661
4.257
By Appointment Only
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. 
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Course Information

Text Book: Bodie, Kane, Marcus, Perrakis, Ryan.
Investments
8th Canadian edition,
2008, McGraw-Hill Ryerson.
Course Reader:
“Textbook 3228A”
You will need to get a copy

of this as we will assign readings from it.
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Course Information

Zonecours.hec.ca: Slides from lectures, exercices,
solutions, announcements, etc., will be posted here.

Prerequisites: It is important that you have taken and
passed the course « Investments » and to a lesser extent
« Options and Futures ». If you do not have a strong
background in finance at the level of « Investments »,
you may not be prepared to take this course.
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Today’s Lecture
Objective: (Chapter 4) To give an overview of
institutional investing and institutions’ role in
portfolio selection and management
Investment companies
 Mutual funds
 Costs of investing in Mutual Funds
 Investment performance of mutual funds
 Index Funds

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Investment Companies
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Services of Investment Companies
Investment companies pool funds into large
portfolios.
Advantages include:
 Diversification & divisibility
 Administration & record keeping
 Professional management
 Reduced costs


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Commissions/Transaction costs
Information costs
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Net Asset Value

Net Asset Value Per Share: Used as a basis for
valuation of investment company shares
Selling new shares
 Redeeming existing shares

Market Value of Assets  Liabilitie s
NAV 
Shares Outs tan ding
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Open-end and Closed-end Funds

Managed funds


Closed-end/ Open-end
Load funds
Shares Outstanding
 Closed-end: Do not redeem or issues shares
 Open-end: Can sell or redeem shares
Pricing
 Open-end: Net Asset Value (NAV)
 Closed-end: Premium or discount to (NAV)
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Closed-end Funds
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Other Organizations


Commingled funds
Real estate funds
Real estate limited partnerships
 Mortgage funds

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Segregated funds
Hedge funds
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Mutual Funds
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Mutual Fund Listings
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Growth of Mutual Funds
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Investment Policies

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Money Market
Fixed Income
Balanced and Income
Asset Allocation
Equity
Indexed
Specialized Sector
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Investment Policies

Statement about their objective:

Aggressive growth equity funds

Emerging markets equity funds

Growth and income equity funds

High yield fixed income funds

Mortgage-backed bond funds
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Types of Mutual Funds
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Largest Fund Families
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Mutual Funds Returns

The one-period rate of return on an investment in a openended fund is
rate of
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$income  $capital gains  $NAVt - $NAVt -1 
returnt 
$NAVt -1
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Example

Invest $1000 in a mutual fund

After 90 days, liquidated at NAV of $1,010.
During the 90 days you received:
 A $5 income disbursement
 A $15 capital gain disbursement

rate of
returnt 
$income  $capital gains  $NAVt - $NAVt -1 
$NAVt
$5  $15  $1,010 - $1,000 
 3%
rt 
$1,000
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Costs of Investing in Mutual Funds
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Costs of Investing in Mutual Funds

Entry fees (Front-end loads)
Diminish investor’s initial NAV
 Many no-load funds exist
 Many load funds charging between 0 and 8.5%
exist


Exit fees (redemption or Back-end loads)
Declines toward zero the longer the fund is held
 Most funds charge no exit fees

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Costs of Mutual Funds


Operating expenses
Transaction fees


Distribution fees


Cover the costs of buying/selling securities
In the US: allowed to deduct up to 1% of their assets per year
to pay for sales commissions and promotional expenses
Management Expense Ratio (MER)
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Example

$1,000 in a fund with up-front load fee of 3%.

1% per year annual management fee

Redemption fee of 1.5%

After 90 days, liquidated at NAV of $1,010.

During the 90 days you received:
 a $5 cash dividend disbursement and
 a $15 capital gain disbursement.
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Costs of Mutual Funds

Return over the 90-day period

Management fees in dollars over 90 days :
0.01 x (90/365) x $970 = $2.4

Redemption fee in dollars
$1,010 x 1.5% = $15.15

90-day return :
$5  $15  $1,010 - $970 - $2.4 - $15.15 - $30
 1.25%
rt 
$970  $30
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Impact of Costs on Performance
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Trading Scandal with Mutual Funds


Late trading – allowing some investors to purchase or
sell later than other investors
Market timing – allowing investors to buy or sell on
stale net asset values


Example: Exploiting time-zone differences
Net effect is to transfer wealth from existing owners to
the new purchasers or sellers
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Investment Performance of Mutual Funds
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First Look at Mutual Fund Performance



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Benchmark portfolio: Wilshire 5000 Index.
Figure 4.4 shows that average mutual fund
performance is generally less than broad market
performance measured by the index.
Return on average mutual fund was below the
Whilshire 5000 index 21 out of 35 years from
1971 to 2005.
The average return on the index exceeded that
of the mutual fund by 1%
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Performance vs. the Index
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Is Performance Due to Skill?




The must be good mangers and bad managers.
So do good managers consistently outperform
the index?
To test this, we seek evidence of persistence in
returns.
If good performance is due to skill then those
who rank in the top performing half in one
period would be expected to do well in the
next period.
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Do winners stay winners?
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Persistence in Fund Performance

The Malkiel study suggests that some funds
show consistent strong performance but it
seems to only be true in the 70s.

Other studies using Canadian data are
suggestive of good managers outperforming
the market this is also inconclusive.

Other studies suggest that bad performance is
more likely to persist than good performance.
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Survivorship Bias




Yet worst performing funds go out of business.
So when looking at mutual fund rankings of 5 year
returns, we should remember there are many funds
that failed to survive 5 years.
Hence, the performance of the surviving firms will
be upward biased.
This is known as a survivorship bias.
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Sources of Information
on Mutual Funds



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

PALTrak (Morningstar)
Wiesenberger’s Investment Companies (US)
Morningstar (US)
Investment Company Institute (US)
Popular press (Globefund)
Investment services (SEI, Comstat, etc.)
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Index Funds
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Costs of Index vs. Mutual Funds

Index funds do not need as large a staff


Decisions about what stock to buy have already been made
based on index commitment.
Savings are passed along to investors

Average management fee for a managed common stock
mutual fund: 1.4%

Management fee for Vanguard Index Trust in the US :
0.18%
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Example

Investments’ performance over the long run


Initial investment of $100,000
Assume a 10% gross annual return for both funds:
 Vanguard Index Trust 500 Mutual Fund charges a 0.18%
management fee for a net annual return of 9.82%
 The Average Managed Mutual Fund charges a 1.4%
management fee for a net annual return of 8.6%
Vanguard Index Trust
500
Average Managed
Mutual Fund
After 10 years
$255,000
$228,000
After 20 years
$651,000
$521,000
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Index funds

Advantages of index funds




Management expenses are minimized
Higher returns
No load funds
Slow turnover



Underlying indexes experience slow turnover;
Leads to lower commissions
Tax efficiency


Slow turnover leads to unrealized and untaxed capital gains
Taxed when investment is sold
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Index funds

Disadvantages of index funds

May be poorly managed

There may be some tracking error:
Tracking Error = Return of index – Return on indexed
portfolio
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Index funds
Tracking errors can occur due to:
 Management fees
 Manager didn’t invest in all target index securities.
 Weighting scheme differed from that of the target
index.
 Delayed reaction to changes in targeted index
 Manager may try to ‘outsmart’ the market (enhanced
indexing)
 Use of derivatives of the securities rather than the
securities themselves ( lower commissions )
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Index funds

To reduce tracking error, portfolio may contain more
of the different securities contained within the target
index.

As the number of different securities held within the
portfolio increases, the commissions are likely to be
higher.

Portfolio managers may try to reduce trading costs but
this can increase the chance of tracking error.
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Exchange Traded Funds




ETFs allow investors to trade index portfolios
like shares of stocks.
Examples – iShares, SPDRs and Vipers
Indexed with same weights used in the target
index
Unlike mutual funds:
Order executed immediately—not at market-on-close
prices
 Management fees are below 0.18%

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ETF Products
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Advantages of ETFs

Advantages of exchange index traded funds

Trade continuously. Can be bought/sold throughout the day
rather than just market-on-close prices

Can sell short, and can do so on a down-tick

They usually cannot use derivatives so investors are not
subject to counterparty risks
i.e. won’t have tracking error from the misuse of derivatives
Lower costs

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Wealth Accumulation

1$ invested in the following from end of 1925 to end of 1999
would have increased to :
Asset Class
Even a
fairly small
annual return
can create
large longterm results
Annual
Return
Ending
Wealth
S&P 500
11.3%
$2,845.6
Small company stock index
12.6%
$6,640.7
Long-term corporate bond index
5.6%
$56.38
Long-term government bond index
5.1%
$40.22
Intermediate-term government bond
5.2%
$43.93
U.S. Treasury Bills
3.8%
$15.64
Inflation
3.1%
$9.39
Method of computation : (1 + return)n = Ending Wealth
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A Note of Inflation

Inflation : the purchasing power of $1 is not the same from yearto-year (it decreases)

$1 of purchases made in 1925 would cost $9.39 by 1999


$2,845.63 after adjusting for inflation is worth in real terms:


$1 x (1 + 0.030728)74 = $9.39
$2,845.63  $9.39 = $303.05
While the accumulated real wealth is much lower than the nominal
wealth, it is still an impressive number
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Things to Read
Readings for Today’s lecture.
Chapter 4
 Readings for Next Week:
Chapter 5, sections 5.4 to 5.6 and 5.8

Chapter 23, sections 23.1 and 23.2
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