TOPIC 11 - ACTIVE PORTFOLIO MANAGEMENT Flashcards
what’s a practical issue with portfolio management?
security analysts don’t usually have modest alpha estimates –> if you take them at face value can lead to misrepresentation
The Treynor-Black model is a portfolio optimization model that seeks to maximize a portfolio’s Sharpe ratio by
combining an actively managed portfolio built with a few mispriced securities and a passively managed market index fund. The Sharpe ratio evaluates the relative risk-adjusted performance of a portfolio or a single investment against the risk-free rate of return, such as the yield on U.S. Treasury securities.
Most investment managers are judged
on performance relative to a benchmark portfolio
what reveals the importance of tracking error?
the fact that most managers are judged on performance relative to a benchmark portfolio
what’s tracking error
dif btw the excess return on the optimal risky portfolio and excess return on the market index
in terms of tracking returns, if we subtract out excess returns on the market we get an expression using index model parametrisation that defines
and look at the extent to which performance diverges period to period against excess returns on the market
what does the black litterman model allow portfolio managers to do?
quantify complex forecasts (i.e., views) and apply these views to portfolio construction
5 steps in black litterman model
1) Estimate the covariance matrix from recent historical data
2) Determine a baseline forecast
3) Integrate the manager’s private views
4) Develop revised (posterior) expectations
5) Apply portfolio optimisation
The Black-Litterman Model is a portfolio allocation model that begins with
modern portfolio theory (MPT) and adds in investor views of expected returns.
the MPT model is seen to be limited in that it only
incorporates historical market data and then assumes those same returns going forward.
The BL model lets the investor
apply their own views and then optimizes the recommended asset allocation.
are the BL and TB models complements or substitutes
complements! but once you reach the optimsiation stage, both models are identical
the BL model can be viewed as a generalisation of the TB bc the BL model allows you to adjust expected return from views about alpha values as in the TB model, but it also allows you to
express views about relative performance that cannot be incorporated in the TB model
under the BL model are optimal portfolio weights and performance sensitive or not to the degree of confidence in thew views expressed?
highly sensitive!
The validity of hte BL model rests largely upon the way in which teh confidence about the views is developed
why isn’t the treynor black model applied in teh field?
bc it results in “wild” portfolio weights, which these extreme weights being a consequence of failing to adjust alpha values to reflect forecast precision
when should you use the BL mdoel vs the TB model?
BL model: use for asset allocation
TB model: for management of security analysis with property adjustment of alpha forecast
Kane, Marcus, and Trippi show that active management fees depend on what 3 things?
- the coefficient of risk aversion
- The distribution of the squared information ratio in the universe of securities
- The precision of the security analysts
Treynor-Black portfolio weights are sensitive to
large alpha values, which can result in practically infeasible long/short portfolio positions.
The full-blown Markowitz optimal risky portfolio is ….. to assumptions for expected return
extremely sensitive to assumptions for expected return.
constraining tracking risk (ie the variance of the return dif btw the managed and benchmark portfolio) acts to keep
the Treynor-Black portfolio within reasonable weights
Alpha forecasts must be …. to account for ….
shrunk (adjusted towards 0) to account for less-than-perfect forecasting quality.
Compiling past analyst forecasts and subsequent realisations allows one to
estimate the correlation between realisations and forecasts.
Regression analysis can be used to measure the
forecast quality and guide the proper adjustment of future forecasts.
When alpha forecasts are scaled back to account fo forecast imprecision, the resulting portfolio positions become
far more moderate.
The Black-Litterman model allows the private views of the portfolio manager to be
incorporated with market data in the optimisation procedure.
5) The Treynor-Black and Black-Litterman models are complementary tools. Both should be used. The TB model is more geared
toward security analysis, while the BL model more naturally fits asset allocation problems
Even low-quality forecasts are valuable. Almost imperceptible R-squares of only .001 regressions of realisations on analysts’ forecasts can be used to
substantially improve portfolio performance.
Views about the relative performance of bonds compared to stocks can have a
significant impact on how security analysis is conducted
For example, as a result of a predicted decrease in interest rates, bonds are now expected to perform better than previously expected. This performance forecast may also reflect forecasts about the quality (credit) spreads for bonds. In addition to the implications of macro forecasts, the play on yields can have important implications for corporations in financial distress with high leverage. The hierarchy of use of the model suggests
a top-down analysis, starting with the BL model inputs. This does not rule out feedback in the opposite direction if, for example, the preponderance of security analysis suggests an unexpectedly good (or bad) economy (or economic sector).
