BM410: Investments
Portfolio Construction 1:
Basics and
Active versus Passive
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Objectives
 A. Understand the uses and types of
benchmarks
 B. Understand portfolio rebalancing
 C. Understand the importance of portfolio
management and performance evaluation
 D. Understand active versus passive investing
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A. Understand the Uses and
Types of Benchmarks
 What are benchmarks?
•
Benchmarks are measuring devices which give
the performance of a specific set of securities for
comparison purposes. Benchmarks may be built
on published indexes or may be customized to
suit a specific investment strategy
 Why are benchmarks important?
•
Benchmarks are the standard from which your
portfolio should be judged. You cannot know
how your are performing without a benchmark
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Uses of Benchmarks (continued)
 What are the uses of benchmarks?
• 1. Tracks average returns for a specific asset class
• 2. Used to compare performance of mutual fund
managers in similar asset classes and to check
broker’s recommendations
• 3. Use as a base to build portfolios
 Key Questions in choosing or using an Index:
• Is it representative of the performance of assets
desired?
• How broad is the benchmark, i.e. number securities?
• How is it constructed, i.e. price, total return index?
• How is it weighted, i.e.4 market cap, equal weighted?
Uses of Benchmarks (continued)
 How are benchmarks differentiated?
•
Type:
• Stocks:
• Large capitalization (cap), small cap, mid
cap, international, emerging markets, etc.
• Bonds:
• Long-term, short-term, corporate bonds,
government bonds, convertible bonds, etc.
• Other Asset Classes:
• Real estate, REITs, currencies,
commodities, derivatives, gold, hedge
funds, etc.
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Uses of Benchmarks (continued)
 Geography:
• Global:
• Follows performance of a set of assets from a
specific set of countries including the US, i.e.,
MSCI World, MSCI AC Free. International
includes only countries outside the US
• Regional:
• Follows performance of a set of assets from a
specific region of the world , i.e., MSCI EAFE,
DJ Asia, Latin America
• Country:
• Follows performance of a set of assets from a
specific country , i.e.,
MSCI Argentina,
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S&P/IFC Chile, Japan TOPIX, etc.
Uses of Benchmarks (continued)
 Asset Size:
•
•
Market Capitalization
 Follows the performance of a set of assets with
a specific market capitalization range, i.e.
large- cap, mid-cap, small-cap, micro-cap, etc.
Industry:
 Follows the performance of a set of assets
from a specific industry, whether global,
regional, or country, i.e. Telecomm, Financial,
Retail, Automotive, Consumer Durable, etc.
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Uses of Benchmarks (continued)
 Investment Style:
• Value
These follow stocks that are perceived to be
undervalued by the market, i.e. their PE and
P/BV ratios are lower than the market.
 Blend
These follow a portfolio of stocks that include
both value and growth in their portfolio.
• Growth
These follow stocks that are expected to achieve
accelerated growth, whether due to increased
earnings, dominant8market position, or other
Benchmarks Types
Types of Return Benchmarks:
 Price Return:
• Includes only price appreciation or capital gains
 Total Return with Gross Dividends (or gross
dividends reinvested):
• Includes both price appreciation and dividends.
It does not take into account the impact of
withholding taxes on dividends (international)
 Total Return with Net Dividends:
• Includes both price appreciation and dividends.
It also takes into account the impact of
withholding taxes on dividends, hence dividends
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received internationally will be less than paid
Benchmark Construction
 How are stocks weighted in various benchmarks?
• Market-value weighted (S&P 500, NASDAQ)
• Weight is based on market capitalization
• Stocks are weighted according to their
market capitalization. This assumes market
capitalization (price * shares) is a good
proxy for size
• Price weighted (DJIA, Nikkei, Japan)
• Weight is based on the price of the stock
• Stocks with a higher price are weighted
more in the index. This assumes a higher
priced stock is more valuable than a lower
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priced stock
Benchmark Construction (continued)
 Equally weighted (Value Line)
• All stocks are weighted the same
• Stocks are equally weighted. This assumes all

stocks are equal and hence gives a higher
weighting to smaller stocks
Float weighted (MSCI Emerging Markets Free)
• Weight is based on market cap and available float
outstanding, i.e. what investors can really purchase
• Stocks are weighted according to available
shares outstanding. This gives greater
preference to companies whose shares can be
purchased (i.e., are not held by a few
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individuals) and who
do not have foreign
Finding Data on Indexes
 Where do you find these benchmarks or
indexes?
 Internet: Any of the many financial sites
available: CNN Money, YahooFinance, etc.
Generally these free Benchmarks are without
dividends (make sure you check)
 Proprietary Data Providers: Bloomberg, Reuters,
etc. They will also produce special indexes for a
fee ( i.e. MSCI EM Free ex-Malaysia)
 Data Suppliers: Standard and Poors, Morgan
Stanley Capital International, NASDAQ,
Bloomberg, etc.
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Vanguard Sends Notice of Index Changes
 From a Vanguard e-mail: “We believe that the new indexes will
reflect the performance of the funds' targeted market segments
more accurately than any other available indexes. We believe
stock indexes should:
•
•

Be constructed according to objective rules, not subjective judgment.
Weight their holdings to reflect only "floating" shares, meaning those that
are available and freely traded in the open market.
• Feature overlapping buffer zones around the breakpoints between large-,
mid-, and small-capitalization segments.
• Assess a variety of factors to identify a stock as "growth" or "value."
• Rebalance their holdings to reflect market changes in a gradual and
orderly fashion.“
From Vanguard Website on 5/6/03:
http://flagship.vanguard.com/VGApp/hnw/web/corpcontent/vanguardviews/jsp/VanViewsNCArti
cle.jsp?chunk=/freshness/News_and_Views/ALL_benchchange_04032003.html
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Key Benchmarks
 Examples of benchmarks:
• Domestic equities:
• Large cap stocks
• Small-cap stocks
• Micro-cap stocks
• International equities:
• Global
S&P 500 (SPX)
Russell 5000 (RTY)
Wilshire Micro-cap
S&P Global 1200, MSCI
World, DJ World
• International
MSCI EAFE (Europe, Australia
and the Far East)
• Emerging Markets S&P/IFCI and MSCI Emerging
14Markets Free
Key Benchmarks (continued)
 Corporate Bonds
• Short-term
DJ Corporate Bond Index
• Intermediate
Lehman Brothers Intermediate
• High Yield
Salomon Smith Barney High Yield
• Mortgage backed Lehman Brothers MBS Index
• Yankee
Merrill Lynch Yankee Index
 Treasury Securities
• Intermediate
Lehman Intermediate Treasury
• Long-term
Lehman Long-term Treasury
 Real Estate
• REIT
Standard & Poors REIT
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Questions
 Do we understand the uses and types of
Benchmarks to an investor?
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B. Understand Portfolio Rebalancing
 What is portfolio rebalancing?
• The process of bringing portfolios back into given
target asset allocation ratios.
 What causes the need to rebalance portfolios?
• Changes occur due to:
• Changes in asset class performance
• Changes in investor objectives or risk
• Introduction of new capital
• Introduction of new asset classes
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Portfolio Rebalancing (continued)
 Why is this rebalancing so critical?
• You must balance competing principles of keeping
both transactions costs and tracking error low
 What is tracking error?
• That is the return that is lost from your portfolio
being different from your target weight
 What are the different ways of rebalancing?
•
•
•
•
Periodic-based (or calendar-based)
Percent-range-based (or volatility-based)
Equal-probability-based
Active risk-based
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Portfolio Rebalancing (continued)
 What is periodic-based rebalancing?
• Specify a time period, i.e. quarterly, annually, etc.
After each time period, rebalance the portfolio back
to your original asset allocation targets
 Advantages
• Most simple of the methods
• Longer periods have lower transactions costs (but
higher tracking error costs)
 Disadvantages
• Independent of market performance
• Performance will depend on relative timing of large
market moves and rebalancings
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Portfolio Rebalancing (continued)
 What is percent-range-based rebalancing?
• Rebalance the portfolio every time your actual
holdings are +/-5% (or 10%) from your target ratios.
Rebalance whenever any weight is outside this range
 Advantages
• Easy to implement
• Wider ranges will reduce transactions costs (at the
expense of higher tracking error)
• Asset performance will trigger rebalancing
 Disadvantages
• Setting an effective range is difficult
• Assets with higher target ranges and volatility will
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generate most rebalances
Portfolio Rebalancing (continued)
• Are there other methods?
• Equal probability rebalancing
• Allow a “no-trade” region around each assets
allocation target so each asset is equally likely to
trigger rebalancing. Rebalance to target ratios
whenever any asset is outside this region
• Active risk rebalancing
• Allow a “no-trade” region around each asset
based on transactions costs, risk aversion,
correlation, and volatility. Rebalance only when
active risk (defined as the standard deviation of
active return) is above a specified threshold.
When this happens, rebalance only back to target
threshold, not back21to target ratios
Portfolio Rebalancing (continued)
 Which are the best methods?
• Generally, for most investors with fewer investable
assets, the easiest is likely to be most useable
• Generally, a combination of periodic-based and
percent-range based is useful
• Remember, the goal is to minimize your
transactions costs, your taxes, and your
tracking error costs
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Portfolio Rebalancing (continued)
• My recommendations
• For most of you, since you will be paying yourself
monthly and since you are careful in your selection
of assets:
• Use new money to purchase the “underweight”
assets, so you do not have to sell and incur
transactions costs or taxable events
• Use appreciated assets for your charity
contributions (see Teaching Tool 8), and use the
money you would have spent for your charity
contributions to purchase the underweight assets
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Questions
• Any questions on portfolio rebalancing?
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C. Understand the Importance of
Portfolio Management and Evaluation
 What is portfolio management?
• The development, construction, and management of
a portfolio of financial assets to attain an investor’s
specific goals
 What is performance evaluation?
• The process of evaluating a portfolio’s performance
with the goal of understanding the key sources of
return
 Why are these two topics so important?
• Both are complicated subjects and both are critical
to investing
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Portfolio Management
and Evaluation (continued)
 What is Active Portfolio Management?
• The process of using publicly available data to
actively manage a portfolio in an effort to:
• Beat the benchmark after all transactions costs,
taxes, management, and other fees
• However, you must do this consistently
year-after-year, and not just from luck
• Why is Active Management such a hot topic?
• Management fees for mutual funds which can
consistently outperform their benchmarks are 5-25
times higher than those on passive management (19
basis points versus 250 basis points)
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Portfolio Management
and Evaluation (continued)
 What is passive management?
• The process of buying a diversified portfolio which
represents a broad market index (or benchmark)
without any attempt to outperform the market
 Why is passive management such a hot topic?
• Most active managers fail to outperform their
benchmarks, especially after costs and taxes
• Investors have realized that if you can’t beat
them, join them, so they buy low-cost passive
funds which meet their benchmarks consistently
and minimize taxes
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Portfolio Management
and Evaluation (continued)
 What factors lead to above-benchmark or
excess returns?
• 1. Superior asset allocation
• Shifting assets between a poor-performing asset
class and a better performing asset class
• 2. Superior stock selection
• Picking sectors, industries, or companies within
a specified benchmark which, as a whole,
outperform the return on the specified
benchmark
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Portfolio Management
and Evaluation (continued)
 What is superior asset allocation?
• The process where the investor gains a higher
return than the benchmark from adjusting the
investment portfolio for movements in the market
• The investor shifts among stocks, bonds and
other asset classes based on their expectations
for returns from each of the asset classes
 What are the results?
• Done well, superior asset allocation yields higher
returns with lower risk.
• Done poorly, it yields lower returns, higher
transactions costs, and29higher taxes
Portfolio Management
and Evaluation (continued)
 What is superior stock selection?
• The process where the investor builds an investment
portfolio which earns returns in excess of the
benchmark through buying or selling undervalued
stocks, sectors or industries
• The investor shifts among the various securities
of the index in an attempt to buy the securities
with the highest growth potential
 What are the results?
• Done well, superior selection yields higher returns
with lower risk.
• Done poorly, it yields lower returns, high
transactions costs, and30high taxes
Portfolio Management
and Evaluation (continued)
 What is portfolio evaluation?
• The process of monitoring financial asset
performance, comparing asset performance to the
relevant benchmarks, and determining how well the
fund is meeting its objectives.
• If the assets are underperforming benchmarks,
the investor may sell underperforming assets and
purchase other assets which would more closely
align asset performance with benchmarks
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Portfolio Management
and Evaluation (continued)
 Why monitor performance?
• Unless you monitor performance, you will not
know how you are doing in working toward
accomplishing your objectives
• You need to know how every asset you own is
performing, and performing versus its benchmark,
so you can determine how well you are moving
toward your goals
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Portfolio Management
and Evaluation (continued)
 How do you evaluate performance?
• Calculate:
• 1. The period return on each owned asset
• 2. The period index return for each benchmark
• 3. The difference between the asset return and
benchmark return
• 4. The weight of each asset or portfolio in the
overall portfolio
• 5. The overall portfolio return
• With this information, you can know how each of
your funds or assets is performing versus its
benchmark, and how well
the portfolio is moving
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Portfolio Management
and Evaluation (continued)
 What is portfolio reporting?
• The process of reviewing portfolio performance
with the necessary participants, i.e. your spouse
• If you are managing your portfolio, you should
report performance to your spouse at least
monthly or quarterly
• If others are helping you manage your portfolio,
they should report performance to you and your
spouse at least quarterly as well.
• Be careful not to do too much buying and selling, as
these incur transactions costs and taxes
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Questions
Any questions on the importance of
portfolio management and evaluation?
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D. Active versus Passive Investing
• What is Active Portfolio Management?
• Trading to earn more than a “market” return for
time and risk
• It is using publicly available data to actively
manage a portfolio in an effort to consistently
beat the benchmark after all costs, taxes,
management, and other fees (not just from luck)
 What is passive management?
• Not trading to earn a market return for time and
risk.
• The process of buying a diversified portfolio
which represents a broad market index (or
benchmark) without any attempt to outperform
the market
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Active versus Passive (continued)
 Where does active management come in?
• 1. Asset allocation
• Shifting assets between a poor-performing asset
class and a better performing asset class
• 2. Stock selection
• Picking sectors, industries, or companies within
a specified benchmark which, as a whole,
outperform the return on the specified
benchmark
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Active versus Passive (continued)
 Assumptions of Active Investing
• Active management is a skill-based activity
• Some investments are simply better than others
• For those with the time, money, and skill, they may
be able to add value to the portfolio
• The challenge is being able to do it consistently
• Certain strategies, i.e. tax-managed investing, may
be even more advantageous in specific investment
environments
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Active versus Passive (continued)
• Active Investing
• Efficient markets argument
• Traders with superior abilities in
information, cost, and analysis will surpass
those without those competitive advantages
• If you do have those competitive
advantages, actively manage
• Inefficient markets argument
• Investors can find “pockets” of inefficiencies
and can exploit those inefficiencies to make
excess returns
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Active versus Passive (continued)
 What does active management require?
• Active management requires a competitive
advantage in at least one of three categories:
• 1. Information. You should have information
not widely available and not already reflected in
stock prices
• 2. Trading costs. You should have a lower cost
to trade, possibly helped by being a dealer or
floor trader
• 3. Analysis. You should have the ability to
convert public data into private knowledge about
value that is not fully reflected in current prices.
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Active versus Passive (continued)
 Assumptions of Passive Investing
• Stock pricing is informationally efficient
• Costs and fees (brokerage costs, bid-ask spreads,
and taxes) make active trading too costly
• Overconfidence further distorts investors abilities
• More than half all actively managed mutual funds
underperform their indices
• Active management leads to sub-optimal
diversification
• Passive management is very time- and resourceefficient
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Active versus Passive (continued)
• Passive investing
• Efficient markets argument
• Markets are efficient
• You cannot gain any advantage by research
and analysis
• Inefficient markets argument
• Traders with superior abilities in
information, cost, and analysis will surpass
those without those competitive advantages
• If you do not have those competitive
advantages, you should index
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Active versus Passive (continued)
 Does it have to be one or the other?
• Why not use a combined approach
• Index when that is perceived to add value
• Actively manage when you can add value there
• What about in-between?
• What about enhanced-indexing?
• It is often called risk-controlled active funds
or hybrid active-passive strategies
• For example, you could have a bond and
equity index funds, and you could
dynamically market time by varying your
allocations in each fund (i.e. asset
allocation)
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Review of Objectives
 A. Do you understand the different types and
uses of indexes?
 B. Do you understand the Importance of
Portfolio Management and Performance
Evaluation?
 C. Do you understand portfolio rebalancing?
 D. Do you understand active versus passive
investing?
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