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The Process of Portfolio Management Chapter 26, 27 McGraw-Hill/Irwin Copyright © 2005 by The McGraw-Hill Companies, Inc. All rights reserved. Determinants of Portfolio Policies Objectives Constraints Return Requirements Liquidity Risk ToleranceHorizon Policies Asset Allocation Diversification Regulations Risk Positioning Taxes Tax Positioning Unique Needs Income Generation 26-2 Matrix of Objectives Type of Investor Return Requirement Risk Tolerance Individual and Personal Trusts Life Cycle Life Cycle Mutual Funds Variable Variable Pension Funds Assumed actuarial rate Depends on payouts Endowment Funds Determined by income needs and asset growth to maintain real value Generally conservative 26-3 Matrix of Objectives (cont’d) Type of Investor Return Requirement Risk Tolerance Life Insurance Spread over cost of funds and actuarial rates Conservative Nonlife Ins. Co. No minimum Conservative Banks Interest Spread Variable 26-4 Constraints on Investment Policies Liquidity Ease (speed) with which an asset can be sold and created into cash Investment horizon - planned liquidation date of the investment Regulations Prudent man law Tax considerations Unique needs 26-5 Managing Portfolios of Individual Investors Overriding consideration is life cycle. Needs for current income Appropriate level of risk Appropriate level & type of life insurance Taxes and tax planning Tax-deferral option - controlling the timing of gains on investments. Tax-deferred retirement plans IRAs, Keogh plans Deferred annuities Fixed Variable 26-6 Future Trends in Portfolio Management Increased use of inflation-indexed bonds. More direct management of funds by individuals. More companies offering structured financial products Basic types of pension plans Defined contribution plans Defined benefit plans Pension investment strategies Defined contribution versus defined benefit Contingent immunization Investing in equities 26-7 The Theory of Active Portfolio Management Chapter 27 McGraw-Hill/Irwin Copyright © 2005 by The McGraw-Hill Companies, Inc. All rights reserved. Lure of Active Management Are markets totally efficient? Some managers outperform the market for extended periods. While the abnormal performance may not be too large, it is too large to be attributed solely to noise. Evidence of anomalies such as the turn of the year exist. The evidence suggests that there is some role for active management. 26-9 Market Timing Adjust the portfolio for movements in the market. Shift between stocks and money market instruments or bonds. Results: higher returns, lower risk (downside is eliminated). With perfect ability to forecast behaves like an option. 26-10 Return of a Perfect Market Timer rf rf rM 26-11 Returns from 1990 - 1999 Year Lg Stocks T-Bills 1990 1991 1992 1993 1994 1995 1996 1998 1999 -3.20 30.66 7.71 9.87 1.29 37.71 23.07 28.58 21.04 7.86 5.65 3.54 2.97 3.91 5.58 5.58 5.11 4.80 26-12 With Perfect Forecasting Ability Switch to bills in 1990 and 1994 Mean =18.94% Standard Deviation = 12.04% Invested in large stocks for the entire period Mean =17.41% Standard Deviation =14.11% The results are clearly related to the period 26-13 With Imperfect Ability to Forecast Long horizon to judge the ability Judge proportions of correct calls Bull markets and bear market calls 26-14 Superior Selection Ability Concentrate funds in undervalued stocks or undervalued sectors or industries. Balance funds in an active portfolio and in a passive portfolio. Active selection will mean some unsystematic risk. 26-15 Treynor-Black Model Model used to combine actively managed stocks with a passively managed portfolio. Using a reward-to-risk measure that is similar to the the Sharpe Measure, the optimal combination of active and passive portfolios can be determined. 26-16 Treynor-Black Model: Assumptions Analysts will have a limited ability to find a select number of undervalued securities. Portfolio managers can estimate the expected return and risk, and the abnormal performance for the actively-managed portfolio. Portfolio managers can estimate the expected risk and return parameters for a broad market (passively managed) portfolio. 26-17 Reward to Variability Measures Passive Portfolio : S 2 M r m r f 2 M 2 R M 2 M 2 26-18 Reward to Variability Measures Appraisal Ratio: A ( e) A 2 26-19 Reward to Variability Measures Combined Portfolio : R M S 2 M 2 P 2 A (e) A 2 26-20 Treynor-Black Allocation CAL CML E(r) P A M Rf 26-21 Summary Points: Treynor-Black Model Sharpe Measure will increase with added ability to pick stocks. Slope of CAL>CML (rp-rf)/p > (rm-rf)/p P is the portfolio that combines the passively managed portfolio with the actively managed portfolio. The combined efficient frontier has a higher return for the same level of risk. 26-22