Active Portfolio Management Flashcards
drawbacks of Markowitz Mean-variance analysis
covariance matrix requiring a huge number of estimates
introduction of index models benefits
simplifies estimation of covariance matrix, enhances analysis of security risk premiums
market equilibrium: CAPM
in equilibrium the market portfolio is well-diversified, the specific risks of securities should have a negligible impact compared to their systematic risks therefore following the CAPM, the expected return of any asset should be proportionally related to its beta
the CAPM is an equilibrium model which specifies risk - return trade-offs of (1)an individual stock relative to market portfolio and (2) the market portfolio return and risk, it is derived assuming:
- single period investment horizon
- individual investors are price takers
- investments are limited to traded financial assets
- no taxes and transaction costs
- information is costless and available to all investors
- investors are rational mean-variance optimisers
- homogenous expectations
3 test results from testing CAPM
expected return beta relationship, variance = systematic risk + firm specific risk, covariance = product of betas x market risk
6 CAPM lessons
- dont hold an individual asset, hold the factor
- each investor has her own optimal exposure of factor risk
- the average investor holds the market
- the fact risk premium has an economic story
- the factor risk exposure = beta
- assess paying off in bad times have low risk premiums
market efficiency
a market is called efficient when security prices incorporate all information about the fundamentals, if markets are fully efficient a passive strategy using widely diversified portfolios is recommended
markets are not inefficient, but not fully efficiency
if market is not efficient profit from trading by casually, if it is easy, everyone will follow and their trading will make stock prices informative
if market is fully efficient and stock prices are fully revealing, there is no incentive for professional investors to forecast. without forecasts stock prices are not fully informative
active management
to beat passive market portfolio, if markets are 100% efficient the answer is no, but if nearly efficient active portfolio management seeks to exploit perceived market inefficiencies
active managed portfolio in markets near efficiency
not fully diversified and tilted away from mispriced securities
security selection
aims to indemnity misplaces securities, concentrate funds in undervalued stocks or undervalued sectors
Treynor-Black Model (1973)
- assumes that the security markets are almost efficient
- active portfolio management is to select the misprices securities which are then added to the passive market portfolio
- to objective is to maximise a reward-risk measure, the sharpe measures of the combination of active and passive portfolios
advantages of TB model
- TB analysis can add value to portfolio management by selecting the mispriced assets
- TB model is easy to implement
- TB model is useful in decentralised organsiations
limitations of TB model
- The mean variance optimization used in standard asset allocation
models is extremely sensitive to expected return assumptions the
investor must provide…The optimal portfolio, given its sensitive to
expected return, often appears to bear little or no relation to the
views the investor wishes to express
Black Litterman Model:
- generalisation of the TB model
- use bayesian rule
- this model can therefore incorporate more complex views & confidence in views
