Lecture11 Active Portfolio Management

Lecture11 Active Portfolio Management - Active Portfolio...

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Active Portfolio Management Tyler R. Henry 1 FINA 4310 Outline Contents 1 Market Timing 1 2 Security Selection 3 1 Market Timing Market Timing One approach to attempt to generate risk-adjusted excess returns is to adjust portfolio risk according to expectations of market returns. This strategy is known as market timing . In its purest sense , a manager would market time by shifting all of the portfolio wealth into a risk-free asset (T-bills) when the expectation of market returns is low, and shifting all wealth into the market portfolio (or optimal risky portfolio) when the expectation of market returns is high. In practice , managers that implement market timing strategies adjust portfolio beta up and down based on their forecasts: Low market return -→ Low portfolio β High market return -→ High portfolio β Q: What will be the outcome of a market timer with good forecasting ability, and how does this relate to the portfolio beta? Market Timing: Portfolio Characteristic Line 1
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Market Timing: Portfolio Characteristic Line r P - r f Slope = β α r M - r f No Market Timing: Constant Beta 11/07/07 FINA 4310 29 Market Timing: Portfolio Characteristic Line Market Timing: Portfolio Characteristic Line r P - r f α Slope = β r M - r f Market Timing: Beta changes with expected market premium 11/07/07 FINA 4310 30 Market Timing: Portfolio Characteristic Line Market Timing: Portfolio Characteristic Line r P - r f Successful Market Timing r M - r f No Market Timing What would an unsuccessful attempt at market timing look like? 11/07/07 FINA 4310 31 What would an unsuccessful attempt at market timing look like? What would an unsuccessful attempt at market timing look like? 2
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Market Timing Strategy Market Timing Strategy Market Timing 0 7 r M - r f β 0.5 0.6 0.7 < -5% 0.2 -5% - 0% 0.4 0% - 4% 0.6 4% - 7% 0.8 0.2 0.3 0.4 Rp - Rf 7% - 10% 1.0 10% - 13% 1.2 13% - 16% 1.4 16% 19% 1 6 -0.1 0 0.1 -0.15 -0.1 -0.05 0 0.05 0.1 0.15 0.2 0.25 0.3 0.35 R Rf 16% - 19% 1.6 19% - 22% 1.8 22% - 25% 2.0 > 25% 2.2 Rm - Rf What is the empirical evidence on manager’s ability to market time? 11/07/07 FINA 4310 32 What is the empirical evidence on managers ability to market time? 2 Security Selection Security Selection Another approach to generate superior risk-adjusted performance is to select un- derpriced securities and include them in an active portfolio. What would the portfolio characteristic line (PCL) look like for a manager that has superior stock-picking ability, but does not attempt to market time? What would the PCL look like for a manager that has both superior stock picking ability and market timing ability? What would the PCL look like for a manager that has superior stock picking ability, and poor market timing ability? Treynor-Black Model The Treynor-Black (TB) model provides a model of active portfolio management in security markets that are nearly efficient.
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