7. Active Risk & Return Flashcards
Active investing
Investing to beat the benchmark
CAPM assumes…
expected returns are proportional to beta and expected residual returns are zero
Probability of active investing based on CAPM =
0 –> no residual return (alpha)
If everyone has the same information, then everyones return will be
equal
Job of an active fund manager is to
outperform the benchmark portfolio (in NZ = NZX50, small sized portfolio = Russel 2000)R
Russel 2000
smallest 2000 stocks in russel 3000 portfolio (russel3000 = largest 3000 companies in US)
Objective of an active fund is to
beat the benchmark
Objective of a passive fund is to
replicate the fund
Fundamental Funds focus on (2)
long position in undervalued stocks
Quantitative Funds focus on (2)
long and short positions in both over and undervalued stocks
______ funds underperformed _____ funds during COVID-19
Quantitative, fundamentals
What is value investing?
Based on the fundamentals, suggests choosing stocks that appear to be undervalued
Who is the father of value investing?
Benjamin Graham
Grinlod-Kahn quantitative approach
ranks stocks on continuum
Exceptional Return
residual return (alpha) + benchmark timing
buy ___ alpha stocks
positive
sell ___ alpha stocks
negative
Active investment can be dividend into two components:
stock selection and benchmark timing
What is benchmark timing?
Using skilled forecast of returns to the benchmark to time aggressive and defensive investing moves (aggressive = > + 1 beta, defensive = < + 1 beta)
What is stock selection?
Using skilled forecast of individual stock returns to outperform the benchmark
Information ratio =
alpha/omega = active return/active risk
Sharpe Ratio
Mean (Return - Rf)/Std Dev (return - rf)
How to annualise sharpe ratio?
x by square root of trading days
Skilled forecasts are possible if the market
is not fully efficient
Active investing involves ____ frontier
ex-ante - maximising utility type function based on investors risk aversion rather than minimising risk (markowitz)
How to generate skilled forecast? (3)
- Identify characteristics of stocks that are associated with beating benchmark
- Collect measures of those characteristics and standardise them
- Run a back test to see whether these characteristics outperformed the benchmark or not
When should you overinvest in DY?
high
When should you overinvest in P/E?
low
Tactical asset allocation could be the…
short-term choice of alpha exposure in which active managers shift the holdings of stock in a portfolio to take advantage of certain market events
strategic asset allocation could be the
long-term choice of beta risk made by high-level decision makers = active investing
Investors prefer…
higher returns and less risk
utility is a
positive function of expected return and negative function of risk
risk aversion
lamda
variance squared
standard deviation
risk premium
Rp - Rf
K
skilled forecast
μ
naive/consensus forecast
KP =
Eskilled (RP)-RF
μP =
Econcensus(RP)-RF
Concensus forecast
cannot outperform benchmark (CAPM + benchmark)
Investors care more about _____ than _______
active risk than benchmark risks
Risk aversion to _____ is much higher than to ______
active risk, benchmark risk
