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Active Portfolio Management

Active Portfolio Management. Joel R. Barber Department of Finance, BA 205A Florida International University. Style. Set of exposures to common factors Determined by regressing portfolio return on common factors Regression coefficients called manager’s style

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Active Portfolio Management

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  1. Active Portfolio Management Joel R. Barber Department of Finance, BA 205A Florida International University

  2. Style • Set of exposures to common factors • Determined by regressing portfolio return on common factors • Regression coefficients called manager’s style • Standard deviation of residual called residual risk

  3. Benchmark • Return on index matched to investor’s style or • Return on passive portfolio matched to investor’s style

  4. Tracking Error • Standard deviation of difference between active and benchmark portfolio returns • var(RA – RB) = var(RA) + var(RB) - 2cov(RA, RB) • Sometimes used to measures active risk • An indexed portfolio has minimum tracking error with respect to index

  5. Performance Alpha • Historical – • difference between historical returns on active and passive portfolio with same style • Alpha = RA – RB • Positive average alpha indication of superior performance • Always possible to achieve zero alpha through passive strategy

  6. Alpha Continued • Predicted alpha • Jensen’s alpha • Determined by regressing excess return on excess market return • RA - RF = alpha + (beta)(RB – RF) + residual • Equals performance alpha with respect to market benchmark for a portfolio

  7. Passive Management • Simple strategy • Diversified • Does not rely on superior information • Examples • Indexing • Matching portfolio to investor’s style • Characteristics • Constant portfolio weights • Small residual variance

  8. BARRA Risk Decomposition • Total risk • Common Factor: common to all assets • Specific risk factor: uncorrelated with specific risk of other assets • Default decomposition

  9. Total Risk Common Factor Risk Specific* Risk Index Risk Industry Risk *Asset Selection Risk

  10. Systematic-Residual Risk • Systematic Risk (Market Timing) - risk associated with market portfolio • Residual Risk – risk of component uncorrelated with the market portfolio • Select (settings window) • Market: S&P500 • Benchmark: none

  11. Total Risk Residual Risk Systematic* Risk Residual Common Specific Risk *Market Timing Risk

  12. Active Risk Decomposition • Benchmark risk – risk associated with benchmark • Active risk – risk associated with deviations from benchmark • Select • market: none • benchmark: S&P500

  13. Total Risk Active Risk* Benchmark Risk Active Common Specific Risk *Tracking error. Variances do not add

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