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Chapter 21

Chapter 21. Portfolio Management Techniques. Chapter Summary. Objective: To discuss specific techniques used in active portfolio management Indexing and Asset allocation The Treynor-Black Model Hedging Performance attribution procedures. Indexing. Passive vs Active investing

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Chapter 21

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  1. Chapter 21 Portfolio Management Techniques

  2. Chapter Summary • Objective: To discuss specific techniques used in active portfolio management • Indexing and Asset allocation • The Treynor-Black Model • Hedging • Performance attribution procedures

  3. Indexing • Passive vs Active investing • Equity indexing - ETFs • Bond indexing – cellular portfolio • Money-market funds • Mixed strategies – timing, sector funds

  4. Asset Allocation • Baseline allocation (e.g. 60-30-10) • Modified weightings for timing • Tactical asset allocation (relative predicted returns by asset class)

  5. Summary Reminder • Objective: To discuss specific techniques used in active portfolio management • Indexing and Asset allocation • The Treynor-Black Model • Hedging • Performance attribution procedures

  6. 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

  7. 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

  8. Reward to Variability Measures Passive Portfolio:

  9. Reward to Variability Measures Appraisal Ratio: aA= Alpha for the active portfolio s(e)A= Unsystematic standard deviation for active portfolio

  10. Reward to Variability Measures Combined Portfolio:

  11. CAL E(r) CML P A M Rf  Treynor-Black Allocation

  12. 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

  13. Summary Reminder • Objective: To discuss specific techniques used in active portfolio management • Indexing and Asset allocation • The Treynor-Black Model • Hedging • Performance attribution procedures

  14. Hedging Systematic Risk • To protect against a decline in level stock prices, short the appropriate number of futures index contracts • Less costly and quicker to use the index contracts • Use the beta for the portfolio to determine the hedge ratio

  15. Hedging Systematic Risk: Text Example Portfolio Beta = .8 S&P 60 = 400 Decrease = 2.5% S&P 60 falls to 390 Portfolio Value = $30 million Project loss if market declines by 2.5% = (.8) (2.5) = 2% 2% of $30 million = $600,000 Each S&P 60 index contract will change $2,000 for a 2.5% change in the index

  16. Hedge Ratio: Text Example

  17. Uses of Interest Rate Hedges • Owners of fixed-income portfolios protecting against a rise in rates • Corporations planning to issue debt securities protecting against a rise in rates • Investor hedging against a decline in rates for a planned future investment • Exposure for a fixed-income portfolio is proportional to modified duration

  18. Hedging Interest Rate Risk: Text Example Portfolio value = $10 million Modified duration = 9 years If rates rise by 10 basis points (.1%) Change in value = ( 9 ) ( .1%) = .9% or $90,000 Present value of a basis point (PVBP) = $90,000 / 10 = $9,000

  19. Hedge Ratio: Text Example

  20. Summary Reminder • Objective: To discuss specific techniques used in active portfolio management • Indexing and Asset allocation • The Treynor-Black Model • Hedging • Performance attribution procedures

  21. Performance Attribution • Decomposing overall performance into components • Components are related to specific elements of performance • Example components • Broad Allocation • Industry • Security Choice • Up and Down Markets

  22. Process of Attributing Performance to Components Set up a ‘Benchmark’ or ‘Bogey’ portfolio • Use indexes for each component • Use target weight structure

  23. Process of Attributing Performance to Components • Calculate the return on the ‘Bogey’ and on the managed portfolio • Explain the difference in return based on component weights or selection • Summarize the performance differences into appropriate categories

  24. Formula for Attribution Where B is the bogey portfolio and p is the managed portfolio

  25. Contribution for asset allocation (wpi - wBi) rBi + Contribution for security selection wpi (rpi - rBi) = Total Contribution from asset class wpirpi -wBirBi Contributions for Performance

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