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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