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The aim of an active portfolio manager is to tilt the weights (of asset classes and/or individual
securities within those asset classes) of the optimal risky asset portfolio such that the realized
Sharpe ratio (slope of the ex-post CAL) is greater (steeper) than that of the passive strategy of
simply holding the market portfolio of risky assets.
For our purposes we
define a purely
passive strategy as
one that uses only
index funds and
applies fixed weights
that do not vary in
response to perceived
market conditions.
Further, the risk-free rate, expected returns on assets, variances of assets, covariances of assets,
and managers Sharpe ratios are all not constant over time. Therefore, we can make arguments
against a purely passive strategy (or in favor of active portfolio management) because active
portfolio theory is needed to:
Develop capital market forecasts (expected returns, variances and covariances) for all
major asset classes.
Assign weights to different asset classes such that the Sharpe ratio of the optimal risky
asset portfolio is maximized.
Assign weights to the optimal risky asset portfolio and the risk-free asset in line with
the individual investors utility function (risk aversion).
Rebalance the portfolio in light of changing market expectations and investor circumstances.
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Even if the net return on Strategy C (after accounting for fair management
fees) were lower than that on Strategy B, Strategy C would still be preferred
(despite its higher standard deviation of returns). This is because (as mentioned
earlier) standard deviation is not an appropriate measure of risk for Strategy C.
The skewness of returns on Strategy B is very low as over a large sample size,
equity returns are approximately normally distributed. However, the skewness
of returns on Strategy C is quite high (the distribution is skewed to the right).
This is because this strategy effectively eliminates the negative tail of the
distribution (returns below the 30-day paper return).
The bottom line is that mean-variance analysis is not adequate for valuing market timing. Another
approach to valuing perfect market timing ability is to view it as a call option where the return
equals the greater of (1) the 30-day rate and (2) the return on the NYSE Index.
The Value of Imperfect Forecasting
The appropriate measure of market forecasting ability is not the overall proportion of perfect
forecasts. If the market rises for three days out of four and the manager always predicts a bullish
market, the 75% success ratio is not the correct measure of forecasting ability. The correct
approach would be to examine the proportion of bull markets correctly forecasted and the
proportion of bear markets correctly forecasted. Under this approach, the true measure of our
managers forecasting ability would be calculated as:
P1 + P2 1 = 1.0 + 0 1= 0
P1 = Proportion of bull markets correctly forecasted
P2 = Proportion of bear markets correctly forecasted
The value of imperfect market timing will be calculated by multiplying the call option value of
a perfect market timer (C) by P1 + P2 1.
LOS 55b: Describe the steps and the approach of the Treynor-Black Model
for security selection. Vol 6, pg 464-472
Overview of the Treynor-Black Model
Recall from Level I, that a mispriced security is one that offers a positive risk-adjusted return
or alpha. From time to time, an analyst may identify securities that appear to be underpriced and
offer positive anticipated alphas to the investor. However, increasing the weight of the particular
security in her portfolio would mean losing some of the benefits of full-diversification. Therefore,
active portfolio managers must strike a balance between (1) aggressively pursuing alpha by
taking positions on mispriced securities and (2) ensuring that their portfolios remain diversified
by not allowing a few stocks to dominate.
The Treynor-Black model is an optimization model for portfolio managers who use security
analysis. The model assumes that markets are nearly efficient. The bullets that follow provide
a basic overview of the model.
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Only a limited number of securities are analyzed in detail to determine whether they are
mispriced. The securities that are not analyzed are assumed to be fairly priced.
The model treats the market portfolio as the passive portfolio. The market portfolio is
the baseline portfolio that is efficiently diversified.
The investment manager knows the expected rate of return on the passive (market)
portfolio, E(rM), and the variance of the market portfolio, M2.
The aim here is to form an active portfolio that consists of a limited number of stocks
that are expected to generate alpha. The (1) amount of perceived mispricing and (2) the
specific risk of the security determine the weight of an individual security in the active
portfolio.
The next step is to create the active portfolio. This process is described in detail in the
next section.
The final step is to create the optimal combination of the active portfolio and the passive
(market) portfolio. This process is described in the section after the next one.
o i represents the sensitivity of the excess return on security i to the excess return
on the market.
The nonsystematic (diversifiable) component of return, ei is also known as the residual
return. We have already described this component earlier.
The excess risk-adjusted return or alpha, i.
In order to determine the weight of each security in the active portfolio (using the formulas
provided below) we first need to determine i, i and 2ei (variance of the residual return). We
can run a regression of the excess returns of security i on the excess returns of the market to
come up with estimates of i, i and 2ei.
i is the intercept term of the regression.
i is the slope coefficient.
ei is the standard error of regression (presented in the regression statistics). In terms of
the single index model, it represents the standard deviation of the residual return.
2ei represents unsystematic risk.
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The weight of security k in the active portfolio (Portfolio A) is determined using the following
expression:
wk =
k / ek
n
i / ei
i=1
unsystematic risk for the active portfolio as a whole. It equals the sum of the anticipated
alpha-unsystematic risk ratios for all the securities in the active portfolio. It is basically
a scale factor to ensure that the portfolio weights sum to one.
Example 1: Determining Weights of Individual Securities in the Active Portfolio
The macroeconomic forecasting unit of Drex Portfolio Inc. (DPF) issues the following forecasts:
Security analysts at the company come up with the following forecasts for three securities that
they believe are mispriced:
Stock
1
2
3
7%
5%
3%
1.6
1
0.5
e
45%
32%
26%
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Stock
1
2
3
7%
5%
3%
1.6
1
0.5
e
45%
32%
26%
/2e
2e
0.452 = 0.2025 0.07/0.452 = 0.3457
0.322 = 0.1024 0.05/0.322 = 0.4883
0.262 = 0.0676 0.03/0.262 = 0.4438
0.3012
Total
We then determine the weight of each security in the active portfolio by dividing the anticipated
alpha-unsystematic risk ratio (/2e) for the security by the sum of the anticipated alphaunsystematic risk ratios for all three securities (0.3012).
Stock
1
7% 1.6
2
5%
1
3
3% 0.5
e
2 e
45% 0.2025
32% 0.1024
26% 0.0676
Total
/2e
(/2e) / 0.3012
0.3457
0.3457/0.3012 = 1.1477
0.4883 0.4883/0.3012 = 1.6212
0.4438
0.4438/0.3012 = 1.4735
0.3012
1.0000
1.
Therefore:
wStock 1 = 1.1477
wStock 2 = 1.6212
wStock 3 = 1.4735
2.
3.
The beta of a portfolio equals the weighted average of the betas of the individual
securities comprising the portfolio.
A = 1.14771.6 + (1.6212)1.0 + 1.4735 0.5 = 0.9519
4.
The unsystematic variance of the active portfolio is calculated using the formula for
the variance of a 3-asset portfolio. However, we only use the unsystematic variances
of the three stocks here. This is because the unsystematic risks of the stocks are not
correlated so all terms in the variance formula that include the covariance equal 0.
2eA = 1.14772 0.452 + (1.6212) 2 0.322 + 1.47352 0.262 = 0.6826
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Once we have determined the minimum variance frontier, it is easy to determine the efficient
frontier (portion of minimum variance frontier above and to the right of the global minimum
variance portfolio). Once the risk-free asset is added to the mix, we then determine the optimal
risky asset portfolio as the tangency portfolio where a line drawn from the risk-free rate is tangent
to the efficient frontier. This tangency portfolio offers the highest excess return per unit of risk.
We are going to try to accomplish the same thing here, except that instead of Stock A and Stock
B, we will be working with Portfolio M (the passive, market portfolio) and Portfolio A (the active
portfolio). The minimum variance frontier that considers only these two risky portfolios can be
drawn up based on the following parameters:
The expected return on the market: rM
The expected return on the active portfolio: E(rA) = A + A RM + rf where
RM = E(rM) rf
The variance of the market: 2M
The variance of the active portfolio: Systematic risk + Unsystematic risk = 2A 2M + 2eA
The covariance of the active portfolio with the market portfolio: CovA,M = A 2M
Once we have drawn up the minimum variance frontier (and the efficient frontier) the (new)
optimal risky portfolio (Portfolio P) is determined through an optimization process. Portfolio P
consists of only Portfolios M and A. It occurs at the point of tangency between a straight line
drawn from the risk-free rate and the (new) efficient frontier, EF1.
CAL(P)
CML
EF1
E(rA) = A R f + i(RM)
rM
A
P
EF0
M
M
RFR
A = eA
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The expression for the optimal weight, w*, of the active portfolio (Portfolio A) in the optimal
risky portfolio (Portfolio P) is given as:
A
w* =
A(1A) + RM
2(eA)
2M
Assuming (for simplicity) that the beta of Portfolio A equals 1, the optimal weight, w0, of Portfolio
A in Portfolio P is calculated as:
A
w0 =
RM
2(eA)
A /2(eA)
RM /2M
2 M
According to this equation (see part between the = signs), if Portfolio A has average systematic
risk (A = 1), then the optimal weight of Portfolio A in Portfolio P equals the relative advantage
of Portfolio A (the ratio of Portfolio As alpha to market excess return) divided by the disadvantage
of Portfolio A (the ratio of nonsystematic risk of Portfolio A to market risk).
If the beta of Portfolio A does not equal 1, we can use the following equation to determine the
optimal weight, w*, of Portfolio A in Portfolio P.
w* =
w0
(1A)w0
Notice that w* increases with greater A (systematic risk). The greater the systematic risk of
Portfolio A, the smaller the benefit of diversifying it with the market, and the more beneficial
it is to take advantage of mispriced securities.
Example 2: Determining Weights of the Active and Passive Portfolios in the Optimal
Portfolio
Using the information provided in Example 1, determine the weights of the active and market
portfolios in the optimal risky portfolio (Portfolio P) for DPF. Also determine the final weights
of Stocks 1, 2 and 3 in the optimal risky portfolio.
Solution:
In Example 1, we obtained the following:
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RM = 8%
M = 20%
A = 20.56%
A = 0.9519
2eA = 0.6826
Therefore:
w0 =
A /2(eA)
RM /
0.2056/0.6826
= 0.1506
0.08/(0.2)2
And:
w* =
w0
(1A)w0
0.1506
= 0.1495
1 + (10.9519)(0.1506)
wStock 1
1.1477
1.6212
1.4735
wStock 2
wStock 3
w*
1 w*
0.1495 1.1477
0.1495 (1.6212)
0.1495 1.4735
0.1716
0.2424
0.2203
0.1495
0.8505
1.0000
Evaluation of Performance
Sharpe Ratio
The square of the sharpe ratio of the optimal risky portfolio (Portfolio P) can be separated into
contributions from the square of the market sharpe ratio and the square of the active portfolios
infromation ratio:
2
2
SP = SM
2 A
2(eA)
RM
M
(eA)
Notice from this equation that Portfolio P improves upon the square of the sharpe ratio for the
market portfolio, S2M by the amount:
(eA)
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The ratio of the degree of mispricing to the non-systematic standard deviation (i/ei) measures
the performance of the active component of the optimal risky portfolio. It is referred to as the
information ratio. The information ratio for each individual security measures the contribution
of that security to the performance of the active portfolio. Further, the sum of the squared
information ratios of the individual securities equals the squared information ratio of the active
portfolio.
2
A
(eA)
i
(ei)
i=1
Example 3: Determining the Impact of the Active Portfolio on the Sharpe Ratio
Using the information in Example 1, determine the Sharpe ratio of (1) the market and (2) the
optimal risky portfolio.
Solution:
RM
SM =
2.
The table below computes the information ratios for each of the three mispriced stocks:
1.
20
= 0.40
Stock
/e
1
2
3
7%
-5%
3%
1.6
1
0.5
45%
32%
26%
0.1556
-0.1563
0.1154
2
R
A
2
2
SP = SM + 2 A = M +
M
(eA)
(eA)
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f +
We can evaluate the quality of the analysts forecasts by calculating the coefficient of determination
of the regression described above. The R2 can be calculated as the proportion of the total variation
in the analysts forecasts of alpha that is explained by variation in actual alpha:
This estimate of R2 is used as a shrinking factor to adjust the analysts forecasts of alpha. The
adjusted forecast equals R2 multiplied by forecasted alpha (f ).
If the analysts has a record of predicting alpha with 100% accuracy (i.e., R2 = 100%)
then we should take the forecast as it is to implement the Treynor-Black model.
If the analysts has a record of predicting alpha with 0% accuracy (i.e., R2 = 0%) then
we should ignore the analysts forecasts of alpha.
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A /2(eA)
RM /2M
0.04112/0.6826
=
0.08/0.04
= 0.0312
0.0301
= 0.03008
1 + (10.9519)(0.0301)
Note that the purpose of this exercise is not to make up for deficiencies in the TB model. We
are just adjusting our expectations for the quality of forecasts.
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