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Finance 450
Active vs. Passive Portfolio
Management
What is “alpha”?
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Alpha = the amount by which the market is
beaten, after adjusting for risk
What is alpha for the market as a whole?
Alpha for market as a whole is zero
• So, on average, portfolios are ON the SML
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Provides conceptual value of CAPM
• Regardless of whether market is efficient, it is still a
zero-sum game
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Burden of active manager
• In order to win (i.e., beat the market), someone else
has to lose
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Key question = what is special about you (and
about your knowledge) that will allow you to be
the one that wins?
Generating alpha
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Are there ways to consistently
generate alpha?
See portfolio manager performance
example:
Portfolio Manager’s Performance:
Past Three Years
S&P 500
Fund
Manager
Compound Annual Return
-4.98%
-22.01%
Total Return
-14.20%
-52.56%
Previous Three Years:
Portfolio Manager’s Performance:
Past Four Years
S&P 500
Fund
Manager
Compound Annual Return
0.50%
-14.19%
Total Return
2.02%
-45.77%
Previous Four Years:
Portfolio Manager’s Performance:
Past Five Years
S&P 500
Fund
Manager
Compound Annual Return
3.17%
-0.54%
Total Return
16.91%
-2.67%
Previous Five Years:
Portfolio Manager’s Performance:
Past Six Years
S&P 500
Fund
Manager
No. of Down Years
2 of 6
4 of 6
Compound Annual Return
3.29%
-1.66%
Total Return
21.47%
-9.58%
Previous Six Years:
Generating alpha
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Would you have invested with this
manager?
Who is this manager with this horrible
record?
Warren Buffett, of course!!!
Portfolio = investment in BerkshireHathaway, over the period of 1970 – 1975
Note: while stock price lagged market
substantially, book value per share grew
faster than market each year except
1975; this is a metric with which Buffett is
more concerned
Generating alpha
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As we have seen previously in discussing the
EMH, value stocks tend to outperform growth
stocks
Concomitantly, Warren Buffett has the best
investment record in history, becoming the 2nd
richest man in the world in the process
However, as we have just now seen, although
value wins on average, over the long run, it does
not win perfectly consistently!
Instead, the markets tend to cycle, with different
styles of investment performing well at different
times
Book to Market as a Predictor of Return:
Annualized Rate of Return
Value (positive a) tends to outperform Growth (negative a)
25
%
20%
15%
10%
Value
5%
0%
1
2
High Book/Market
3
4
5
6
7
8
9
10
Low Book/Market
Rolling Annualized Average 5-year Difference
Between the Returns to Value and Growth Composites:
The Market cycles between Value and Growth,
But Value Wins on Average
50%
30%
20%
-10%
-20%
Year
1997
1996
1995
1994
1993
1992
1991
1990
1989
1988
1987
1986
1985
1984
1983
1982
1981
1980
1979
1978
1977
1976
1975
0%
1974
10%
1973
Relative Difference
40%
Empirical Regularities:
Sources of alpha

Three categories that tend to outperform over the
long run:
• Value stocks vs. Growth stocks
• Size: Small caps tend to outperform large caps
• Momentum: stocks with momentum (earnings or price)
tend to beat stocks without momentum

However, the payoffs to all of these tend to cycle!
• A typical portfolio manager, being judged on a quarter-byquarter basis, would have been fired long before if he had
the same record as Buffett for 1970 – 1975!
• (In fact, he fired himself during this period!)
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None of these beats the market perfectly
consistently
• A typical portfolio manager would need to try to cycle along
with the market, in order to keep from ever lagging too far
behind it
Empirical Regularities:
Sources of alpha
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Beating the market consistently would require
some sort of rotation strategy in order to profit
from the type of securities that are performing
well in the given type of market
But - combination of “fat tails” and “volatility
clustering” (discussed previously) can cause
problems!
• Best performance for a given style is likely to follow
closely on the heels of its worst performance, and much
of the movement for the style is likely to come in a
relatively short burst (thus, if you miss it, it’s gone)
• E.g.: 40% of the stock market gains for the entire
decade of the 1980’s occurred during a mere 10 trading
days !
• So efforts to cycle with the market and keep from falling
too far behind it also make it much more difficult to beat
the market!
Sources of alpha:
Advantage of Individual Investors
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“Individual investors enjoy a key advantage over professionals
in one critical respect. You can pick and choose stocks and bide
your time unflustered by the fierce and often corrosive
quarterly performance sweepstakes, especially in hostile
market climates. Value investing … demands sober reflection.
Scarce to begin with, sober reflection gets even scarcer as bull
markets progress.”
• John Neff, “John Neff on investing”
Nonetheless, if one wants to try to cycle or rotate with the
market and still stay ahead (or at least not get too far behind),
• Maturity diversification could be beneficial
 picking a variety of stocks that are expected to pay off
over different time horizons
• Two good authors are Peter Lynch and John Neff
• William O’Neill could also be useful
Passive versus Active
Equity Portfolio Management
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Goal of Active Management
• Generate alpha with some consistency
• Very difficult to do
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Goal of Passive Management
• Recognizes difficulty of generating alpha
• Instead focuses on minimizing “omega” ( =
“tracking error”) and trying to match the
underlying index
Passive versus Active Management
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Passive equity portfolio management
• Designed to match market performance
• Usually tracks an index over time
• Managers are judged on how well they track
the target index
• Typically entails a long-term buy-and-hold
strategy
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Active equity portfolio management
• Attempts to outperform some passive
benchmark portfolio on a risk-adjusted basis
Passive Equity Portfolio
Management Techniques
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Full replication
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Sampling
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Quadratic optimization or programming
Full Replication
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All securities in the index are purchased in
proportion to weights in the index
This helps ensure close tracking
But, increases transaction costs,
particularly with dividend reinvestment
Sampling
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Buys a representative sample of stocks in
the benchmark index according to their
weights in the index
Fewer stocks means lower commissions
Reinvestment of dividends is less difficult
But, will not track the index as closely, so
there will be some tracking error
Frequently used in conjunction with
quadratic optimization (see below)
Expected Tracking Error Between the S&P 500
Index and Portfolio Samples of Less Than 500
Stocks
Expected Tracking
Error (Percent)
Figure 22.1
4.0
3.0
2.0
1.0
500
400
300
200
100
0
Number of Stocks
Quadratic Optimization
(or programming techniques)
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Variation of Markowitz portfolio optimization
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But rather than maximize E(R) while minimizing ,
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Instead maximize a (= expected excess return)
while minimizing  (= expected tracking error)
Efficient Frontier for
Enhanced/Optimized Index Funds
a
Efficient
Frontier
ap
0
p
Tracking Error ()
An Overview of Active Equity
Portfolio Management Strategies
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Goal is to earn a portfolio return that
exceeds the return of a passive benchmark
portfolio, net of transaction costs, on a
risk-adjusted basis
Practical difficulties of active manager
• Transactions costs must be offset
• Risk can exceed passive benchmark
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“Tilting” portfolio away from benchmark tends to
increase total risk of portfolio compared to total risk of
benchmark
Technical Strategies
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Somewhat less commonly used
Contrarian investment strategy
Price momentum strategy
Earnings momentum strategy
Fundamental Strategies
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Much more commonly used
Top-down versus bottom-up approaches
Asset and sector rotation strategies
Selection Process
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Two general approaches:
1. Top-down, three-step approach
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Tries to beat the market quarter by quarter
Over the short term, performance of a company is
dominated by business cycle and performance of
industry
Similarly, performance of stock price over the short
term is dominated by movements in overall market
and industry segments
Selection Process
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Two general approaches:
2. Bottom-up, stock valuation, stock picking
(stock screening) approach
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Willing to drift further away from market with hope
of greater profits over the long run
Over the long run, stock price will be driven by
performance of underlying company
What Buffett’s approach entails, since he plans to
hold stock much longer than length of typical
business cycle
Top-Down, Three-Step Approach
1. General economic influences
• Decide how to allocate investment funds among countries,
and within countries to bonds, stocks, and cash
• Two components – geographic allocation and asset class
allocation
2. Industry influences
• Determine which industries will prosper and which
industries will suffer on a global basis and within countries
• Must understand cyclical vs. structural effects
3. Company analysis
• Determine which companies in the selected industries will
prosper and which stocks are undervalued
Three General Categories of Active
Management Strategies
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Correspond with three stages of top-down
approach:
• Market timing - shifting funds into and out of stocks,
bonds, and T-bills depending on broad market forecasts
and estimated risk premiums
• Shifting funds among different equity sectors and
industries (sector rotation) or among investment styles
(e.g., theme investing) to catch hot concepts before the
market does
• Stockpicking - individual issues
Sector Rotation
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Position a portfolio to take advantage of
the market’s next move
Screening can be based on various stock
characteristics:
•
•
•
•
•
Value
Growth
P/E
Capitalization
Sensitivity to economic variables
Value versus Growth
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Growth stocks will outperform value
stocks for a time and then the opposite
occurs
Over time value stocks have offered
somewhat higher returns than growth
stocks
Value versus Growth
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Growth-oriented investor will:
• focus on EPS and its economic determinants
• look for companies expected to have rapid EPS
growth
• assumes constant P/E ratio,
• so, as earnings grow, price will grow
concomitantly
Value versus Growth
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Value-oriented investor will:
• focus on the price component
• not care as much about current earnings
• assume the P/E ratio is below its natural level
• note: P/Book is probably a better measure of
value than is P/E
Approaches to Valuation of
Common Stock
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How do you determine whether a stock is a
good value?
Two general approaches have been developed:
1. Discounted cash-flow valuation
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Present value of some measure of cash flow, such
as dividends, operating cash flow, and free cash
flow
2. Relative valuation technique
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Value estimated based on its price relative to
significant variables or metrics of value, such as
earnings, cash flow, book value, or sales
Valuation Approaches
and Specific Techniques
Approaches to Equity Valuation
Discounted Cash Flow
Techniques
Relative Valuation
Techniques
• Present Value of Dividends (DDM)
• Price/Earnings Ratio (PE)
•Present Value of Operating Cash Flow
•Price/Cash flow ratio (P/CF)
•Present Value of Free Cash Flow
•Price/Book Value Ratio (P/BV)
•Price/Sales Ratio (P/S)
Approaches to the
Valuation of Common Stock
These two approaches have some factors in
common
 Both are affected by:
• Investors’ required rate of return
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kV
How to estimate – CAPM, APT, Haugen’s model?
• Estimated growth rate of the variable used
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gV
Will vary depending on stage in industry life cycle
Using the Discounted Cash Flow
Valuation Approach
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Requires some measure of cash flow that will be discounted
• Dividends
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Discount at cost of equity
• Free cash flow to equity
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Discount at cost of equity
• Operating cash flow
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Discount at Weighted Average Cost of Capital (WACC)
Provides estimate of value for company as a whole
(aggregate value of stock plus aggregate value of bonds)
Estimated future cash flows are discounted back to the
present to provide some measure of the absolute value of the
company or its stock
With constant expected future growth, form of model is
simple, though application can still be problematic
Why and When to Use the
Relative Valuation Techniques
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Provides information about how the
market is currently valuing stocks –
compare stock to:
• aggregate market
• alternative industries
• individual stocks within industries
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But no guidance as to whether valuations
are appropriate – best used when:
• have comparable entities
• aggregate market is not at a valuation extreme
Final Comments on Valuation
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In the end, as with much in finance,
valuation is at least as much of an art as a
science
Ben Graham’s analogy: you don’t have to
know someone’s exact weight to be able
to say whether they are “fat” or “skinny”
New Enterprise example
• Wide range of values from valuation
• But even at lowest end, book value still way
undervalued
Final Comments on Valuation
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Valuation entails / requires some vision of the future
• In a real sense, investing means betting on some vision of
the future
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But, interaction of business cycle effects vs. industry
life cycle effects can confound vision of future
• Internet stocks = beginning of industry life cycle + upswing
in business cycle
• New England Wire & Cable = downturn in business cycle +
ending of industry life cycle
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Note – industry life cycle is not always the same
thing as the company’s life cycle:
• Studebaker example – transitioned from Conestoga wagons
(early 1800’s) to farm wagons (later 1800’s) to farm trucks
(early 1900’s) to automobiles (through early 1960’s)
Final Comments on Valuation
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New England Wire and Cable example
Jorgie’s vision
• Problems are temporary, driven by downturn in
business cycle
• When economy (and gov’t infrastructure spending)
turn back up, company will turn around
• W&C division is a positive NPV project
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Larry the Liquidator’s vision
• Problems are permanent, caused by obsolescence and
foreign competition
• Company has moved past the peak of the industry life
cycle
• W&C division is a negative NPV project