Complicated subject Theoretically correct measures are
difficult to construct Different statistics or measures are
appropriate for different types of investment decisions or
portfolios Many industry and academic measures are different The
nature of active management leads to measurement problems
INTRODUCTION BAHATTIN BUYUKSAHIN, JHU INVESTMENT 2
Slide 3
Dollar-weighted returns Internal rate of return considering the
cash flow from or to investment Returns are weighted by the amount
invested in each stock Time-weighted returns Not weighted by
investment amount Equal weighting DOLLAR- AND TIME-WEIGHTED RETURNS
BAHATTIN BUYUKSAHIN, JHU INVESTMENT 3
Slide 4
TEXT EXAMPLE OF MULTIPERIOD RETURNS PeriodAction 0Purchase 1
share at $50 1Purchase 1 share at $53 Stock pays a dividend of $2
per share 2Stock pays a dividend of $2 per share Stock is sold at
$108 per share BAHATTIN BUYUKSAHIN, JHU INVESTMENT 4
TIME-WEIGHTED RETURN Text Example Average:r G = [ (1.1)
(1.0566) ] 1/2 - 1 = 7.81% BAHATTIN BUYUKSAHIN, JHU INVESTMENT
6
Slide 7
Benchmark portfolio Comparison with other managers of similar
investment style May be misleading ADJUSTING RETURNS FOR RISK
BAHATTIN BUYUKSAHIN, JHU INVESTMENT 7
1) Sharpe Index RISK ADJUSTED PERFORMANCE: SHARPE r p = Average
return on the portfolio r f = Average risk free rate p = Standard
deviation of portfolio return BAHATTIN BUYUKSAHIN, JHU INVESTMENT
9
Slide 10
2) Treynor Measure RISK ADJUSTED PERFORMANCE: TREYNOR r p =
Average return on the portfolio r f = Average risk free rate p =
Weighted average for portfolio BAHATTIN BUYUKSAHIN, JHU INVESTMENT
10
Slide 11
RISK ADJUSTED PERFORMANCE: JENSEN 3) Jensens Measure p = Alpha
for the portfolio r p = Average return on the portfolio p =
Weighted average Beta r f = Average risk free rate r m = Average
return on market index portfolio BAHATTIN BUYUKSAHIN, JHU
INVESTMENT 11
Slide 12
INFORMATION RATIO Information Ratio = p / (e p ) Information
Ratio divides the alpha of the portfolio by the nonsystematic risk
Nonsystematic risk could, in theory, be eliminated by
diversification BAHATTIN BUYUKSAHIN, JHU INVESTMENT 12
Slide 13
M 2 MEASURE Developed by Modigliani and Modigliani Equates the
volatility of the managed portfolio with the market by creating a
hypothetical portfolio made up of T-bills and the managed portfolio
If the risk is lower than the market, leverage is used and the
hypothetical portfolio is compared to the market BAHATTIN
BUYUKSAHIN, JHU INVESTMENT 13
Slide 14
M 2 MEASURE: EXAMPLE Managed Portfolio: return = 35%standard
deviation = 42% Market Portfolio: return = 28%standard deviation =
30% T-bill return = 6% Hypothetical Portfolio: 30/42 =.714 in P
(1-.714) or.286 in T-bills (.714) (.35) + (.286) (.06) = 26.7%
Since this return is less than the market, the managed portfolio
underperformed BAHATTIN BUYUKSAHIN, JHU INVESTMENT 14
Slide 15
FIGURE 24.2 M 2 OF PORTFOLIO P BAHATTIN BUYUKSAHIN, JHU
INVESTMENT 15
Slide 16
It depends on investment assumptions 1) If the portfolio
represents the entire investment for an individual, Sharpe Index
compared to the Sharpe Index for the market 2) If many alternatives
are possible, use the Jensen or the Treynor measure The Treynor
measure is more complete because it adjusts for risk WHICH MEASURE
IS APPROPRIATE? BAHATTIN BUYUKSAHIN, JHU INVESTMENT 16
PERFORMANCE MEASUREMENT FOR HEDGE FUNDS When the hedge fund is
optimally combined with the baseline portfolio, the improvement in
the Sharpe measure will be determined by its information ratio:
BAHATTIN BUYUKSAHIN, JHU INVESTMENT 21
Slide 22
PERFORMANCE MEASUREMENT WITH CHANGING PORTFOLIO COMPOSITION For
actively managed portfolios, it is helpful to keep track of
portfolio composition and changes in portfolio mean and risk
BAHATTIN BUYUKSAHIN, JHU INVESTMENT 22
MARKET TIMING In its pure form, market timing involves shifting
funds between a market- index portfolio and a safe asset Treynor
and Mazuy: Henriksson and Merton: BAHATTIN BUYUKSAHIN, JHU
INVESTMENT 24
Slide 25
FIGURE 24.5 CHARACTERISTIC LINES: PANEL A: NO MARKET TIMING.
PANEL B: BETA INCREASES WITH EXPECTED MARKET EXCESS. RETURN PANEL
C: MARKET TIMING WITH ONLY TWO VALUES OF BETA. BAHATTIN BUYUKSAHIN,
JHU INVESTMENT 25
Slide 26
TABLE 24.4 PERFORMANCE OF BILLS, EQUITIES AND (ANNUAL) TIMERS
PERFECT AND IMPERFECT BAHATTIN BUYUKSAHIN, JHU INVESTMENT 26
Slide 27
FIGURE 24.6 RATE OF RETURN OF A PERFECT MARKET TIMER AS A
FUNCTION OF THE RATE OF RETURN ON THE MARKET INDEX BAHATTIN
BUYUKSAHIN, JHU INVESTMENT 27
STYLE ANALYSIS Introduced by William Sharpe 1992 study of
mutual fund performance 91.5% of variation in return could be
explained by the funds allocations to bills, bonds and stocks Later
studies show that 97% of the variation in return could be explained
by the funds allocation to a broader range of asset classes
BAHATTIN BUYUKSAHIN, JHU INVESTMENT 29
Slide 30
TABLE 24.5 STYLE ANALYSIS FOR FIDELITYS MAGELLAN FUND BAHATTIN
BUYUKSAHIN, JHU INVESTMENT 30
Slide 31
FIGURE 24.8 FIDELITY MAGELLAN FUND CUMULATIVE RETURN
DIFFERENCE: FUND VERSUS STYLE BENCHMARK AND FUND VERSUS SML
BENCHMARK BAHATTIN BUYUKSAHIN, JHU INVESTMENT 31
Slide 32
FIGURE 24.9 AVERAGE TRACKING ERROR FOR 636 MUTUAL FUNDS,
1985-1989 BAHATTIN BUYUKSAHIN, JHU INVESTMENT 32
Slide 33
MORNINGSTAR Morningstar computes fund returns as well as a risk
measure based primarily on fund performance in its worst years The
risk-adjusted performance is ranked across funds in a style group
and stars are awarded BAHATTIN BUYUKSAHIN, JHU INVESTMENT 33
Slide 34
EVALUATING PERFORMANCE EVALUATION Performance Evaluation has
two problems Many observations are needed for significant results
Shifting parameters when portfolios are actively managed makes
accurate performance evaluation all the more elusive BAHATTIN
BUYUKSAHIN, JHU INVESTMENT 34
Slide 35
FIGURE 24.10 RANKINGS BASED ON MORNINGSTARS CATEGORY RARS AND
EXCESS RETURN SHARPE RATIOS BAHATTIN BUYUKSAHIN, JHU INVESTMENT
35
Slide 36
Decomposing overall performance into components Components are
related to specific elements of performance Example components
Broad Allocation Industry Security Choice Up and Down Markets
PERFORMANCE ATTRIBUTION BAHATTIN BUYUKSAHIN, JHU INVESTMENT 36
Slide 37
Set up a Benchmark or Bogey portfolio Use indexes for each
component Use target weight structure ATTRIBUTING PERFORMANCE TO
COMPONENTS BAHATTIN BUYUKSAHIN, JHU INVESTMENT 37
Slide 38
Calculate the return on the Bogey and on the managed portfolio
Explain the difference in return based on component weights or
selection Summarize the performance differences into appropriate
categories ATTRIBUTING PERFORMANCE TO COMPONENTS CONTINUED BAHATTIN
BUYUKSAHIN, JHU INVESTMENT 38
Slide 39
Where B is the bogey portfolio and p is the managed portfolio
FORMULA FOR ATTRIBUTION BAHATTIN BUYUKSAHIN, JHU INVESTMENT 39
Slide 40
FIGURE 24.11 PERFORMANCE ATTRIBUTION OF ITH ASSET CLASS
BAHATTIN BUYUKSAHIN, JHU INVESTMENT 40
Slide 41
TABLE 24.6 PERFORMANCE OF THE MANAGED PORTFOLIO BAHATTIN
BUYUKSAHIN, JHU INVESTMENT 41
Global market US market is 39.2% of all markets in 2005 US
market share is down from 47% in 2000 Improved access &
technology New instruments Emphasis for our investigation Risk
assessment Diversification BACKGROUND BAHATTIN BUYUKSAHIN, JHU
INVESTMENT 46
Slide 47
TABLE 25.1 MARKET CAPITALIZATION OF STOCK EXCHANGES IN
DEVELOPED COUNTRIES BAHATTIN BUYUKSAHIN, JHU INVESTMENT 47
Slide 48
TABLE 25.2 MARKET CAPITALIZATION OF STOCK EXCHANGES IN EMERGING
MARKETS BAHATTIN BUYUKSAHIN, JHU INVESTMENT 48
Slide 49
FIGURE 25.1 PER CAPITA GDP AND MARKET CAPITALIZATION AS
PERCENTAGE OF GDP (LOG SCALE) BAHATTIN BUYUKSAHIN, JHU INVESTMENT
49
Slide 50
What are the risks involved in investment in foreign
securities? How do you measure benchmark returns on foreign
investments? Are there benefits to diversification in foreign
securities? ISSUES BAHATTIN BUYUKSAHIN, JHU INVESTMENT 50
Slide 51
Foreign Exchange Risk Variation in return related to changes in
the relative value of the domestic and foreign currency Total
return = investment return & return on foreign exchange Its not
possible to completely hedge a foreign investment FOREIGN EXCHANGE
RISK BAHATTIN BUYUKSAHIN, JHU INVESTMENT 51
Slide 52
Return in US is a function of two factors: 1. Return in the
foreign market 2.Return on the foreign exchange RETURNS WITH
FOREIGN EXCHANGE BAHATTIN BUYUKSAHIN, JHU INVESTMENT 52
Slide 53
FIGURE 25.2 STOCK MARKET RETURNS IN U.S. DOLLARS AND LOCAL
CURRENCIES FOR 2005 BAHATTIN BUYUKSAHIN, JHU INVESTMENT 53
Slide 54
TABLE 25.3 RATES OF CHANGE IN THE U.S. DOLLAR AGAINST MAJOR
WORLD CURRENCIES, 2001 2005 (ANNUALIZED FROM MONTHLY DATA) BAHATTIN
BUYUKSAHIN, JHU INVESTMENT 54
Slide 55
HEDGING EXCHANGE RATE RISK Futures or forward markets are used
to eliminate the risk of holding another asset The U.S. investor
can lock in a riskless dollar- denominated return either by
investing in UK bills and hedging exchange rate risk or by
investing riskless U.S. assets BAHATTIN BUYUKSAHIN, JHU INVESTMENT
55
Slide 56
Political Risk Services Group Ratings Rank countries with
respect to political risk, financial risk and economic risk Assign
composite rating from very high risk to very low risk based on the
above elements of risk COUNTRY SPECIFIC RISK BAHATTIN BUYUKSAHIN,
JHU INVESTMENT 56
Slide 57
TABLE 25.4 COMPOSITE RISK RATINGS FOR OCTOBER 2004 AND NOVEMBER
2003 BAHATTIN BUYUKSAHIN, JHU INVESTMENT 57
Slide 58
TABLE 25.5 THE THREE RATINGS THAT COMPRISE ICRGS COMPOSITE RISK
RATING BAHATTIN BUYUKSAHIN, JHU INVESTMENT 58
Slide 59
TABLE 25.6 CURRENT RISK RATINGS AND COMPOSITE RISK FORECASTS
BAHATTIN BUYUKSAHIN, JHU INVESTMENT 59
Slide 60
TABLE 25.7 COMPOSITE AND POLITICAL RISK FORECASTS BAHATTIN
BUYUKSAHIN, JHU INVESTMENT 60
Slide 61
TABLE 25.8 POLITICAL RISK POINTS BY COMPONENT, OCTOBER 2004
BAHATTIN BUYUKSAHIN, JHU INVESTMENT 61
Slide 62
Evidence shows international diversification is beneficial Its
possible to expand the efficient frontier above domestic only
frontier Its possible to reduce the systematic risk level below the
domestic only level DIVERSIFICATION BENEFITS BAHATTIN BUYUKSAHIN,
JHU INVESTMENT 62
Slide 63
TABLE 25.9 RISK AND RETURN ACROSS THE GLOBE, 2001 2005
(DEVELOPED COUNTRIES AND EMERGING MARKETS) BAHATTIN BUYUKSAHIN, JHU
INVESTMENT 63
Slide 64
FIGURE 25.3 ANNUALIZED STANDARD DEVIATION OF INVESTMENTS ACROSS
THE GLOBE ($ RETURNS, 2001 2005) BAHATTIN BUYUKSAHIN, JHU
INVESTMENT 64
Slide 65
FIGURE 25.4 BETA ON U.S. STOCKS ACROSS THE GLOBE, 20012005
BAHATTIN BUYUKSAHIN, JHU INVESTMENT 65
Slide 66
FIGURE 25.5 ANNUALIZED AVERAGE $ RETURN OF INVESTMENTS ACROSS
THE GLOBE, 2001 2005 BAHATTIN BUYUKSAHIN, JHU INVESTMENT 66
Slide 67
FIGURE 25.6 STANDARD DEVIATION OF INVESTMENTS ACROSS THE GLOBE
IN U.S. DOLLARS VERSUS LOCAL CURRENCY, 2001 2005 BAHATTIN
BUYUKSAHIN, JHU INVESTMENT 67
Slide 68
TABLE 25.10 CORRELATION FOR ASSET RETURNS: UNHEDGED AND HEDGED
CURRENCIES BAHATTIN BUYUKSAHIN, JHU INVESTMENT 68
Slide 69
TABLE 25.11 CORRELATION OF U.S. EQUITY RETURNS WITH COUNTRY
EQUITY RETURNS BAHATTIN BUYUKSAHIN, JHU INVESTMENT 69
Slide 70
FIGURE 25.7 INTERNATIONAL DIVERSIFICATION BAHATTIN BUYUKSAHIN,
JHU INVESTMENT 70
Slide 71
FIGURE 25.8 EX POST EFFICIENT FRONTIER OF COUNTRY PORTFOLIOS,
2001 2005 BAHATTIN BUYUKSAHIN, JHU INVESTMENT 71
Slide 72
FIGURE 25.9 EFFICIENT FRONTIER OF COUNTRY PORTFOLIOS (WORLD
EXPECTED EXCESS RETURN =.6% PER MONTH) BAHATTIN BUYUKSAHIN, JHU
INVESTMENT 72
Slide 73
FIGURE 25.10 REGIONAL INDEXES AROUND THE CRASH, OCTOBER
14OCTOBER 26, 1987 BAHATTIN BUYUKSAHIN, JHU INVESTMENT 73
Slide 74
FIGURE 25.11 EFFICIENT DIVERSIFICATION BY VARIOUS METHODS
BAHATTIN BUYUKSAHIN, JHU INVESTMENT 74
Slide 75
FIGURE 25.12 DIVERSIFICATION BY MARKET CAPITALIZATION: NATIONAL
MARKETS VERSUS REGIONAL FUNDS BAHATTIN BUYUKSAHIN, JHU INVESTMENT
75
Slide 76
FIGURE 25.13 DIVERSIFICATION BENEFITS OVER TIME BAHATTIN
BUYUKSAHIN, JHU INVESTMENT 76
Slide 77
TABLE 25.12 WEIGHTING SCHEMES FOR EAFE COUNTRIES BAHATTIN
BUYUKSAHIN, JHU INVESTMENT 77
Slide 78
PERFORMANCE ATTRIBUTION WITH INTERNATIONAL Extension to
consider additional factors Currency selection Country selection
Stock selection Cash and bond selection BAHATTIN BUYUKSAHIN, JHU
INVESTMENT 78
Slide 79
TABLE 25.13 EXAMPLE OF PERFORMANCE ATTRIBUTION: INTERNATIONAL
BAHATTIN BUYUKSAHIN, JHU INVESTMENT 79
Slide 80
CHAPTER 26 Hedge Funds
Slide 81
HEDGE FUNDS CHARACTERISTICS Investment pooling Transparency
Limited liability partnerships Provide minimal information
Investors No more than 100 sophisticated investors Investment
strategies Wide range of investments BAHATTIN BUYUKSAHIN, JHU
INVESTMENT 81
Slide 82
HEDGE FUNDS CHARACTERISTICS CONTINUED Liquidity Lock-up periods
Compensation structure Charge a management fee plus a substantial
incentive fee BAHATTIN BUYUKSAHIN, JHU INVESTMENT 82
Slide 83
HEDGE FUND STRATEGIES Directional Bets that one sector or
another will outperform other sectors Non directional Exploit
temporary misalignments in security valuations Buys one type of
security and sells another Strives to be market neutral BAHATTIN
BUYUKSAHIN, JHU INVESTMENT 83
Slide 84
TABLE 26.1 HEDGE FUND STYLES BAHATTIN BUYUKSAHIN, JHU
INVESTMENT 84
Slide 85
STATISTICAL ARBITRAGE Uses quantitative systems that seek out
many temporary misalignments in prices Involves trading in hundreds
of securities a day with short holding periods Pairs trading Pair
up similar companies whose returns are highly correlated but one is
priced more aggressively Create a market-neutral position Data
mining BAHATTIN BUYUKSAHIN, JHU INVESTMENT 85
Slide 86
ALPHA TRANSFER Separate asset allocation from security
selection Invest where you find alpha Hedge the systematic risk to
isolate its alpha Establish exposure to desired market sectors by
using passive indexes BAHATTIN BUYUKSAHIN, JHU INVESTMENT 86
Slide 87
PURE PLAY EXAMPLE FROM THE TEXT Manage a $1.5 million portfolio
Believe alpha is >0 and that the market is about to fall Capture
the alpha of 2% per month = 1.20 S&P 500 Index is S 0 = 1,440
=.02 r f =.01 Hedge by selling S&P 500 futures contracts
BAHATTIN BUYUKSAHIN, JHU INVESTMENT 87
Slide 88
PURE PLAY EXAMPLE CONTINUED The dollar value of your portfolio
after 1 month: The dollar proceeds from your futures position:
BAHATTIN BUYUKSAHIN, JHU INVESTMENT 88
Slide 89
FIGURE 26.1 A PURE PLAY. PANEL A, UNHEDGED POSITION. PANEL B,
HEDGED POSITION BAHATTIN BUYUKSAHIN, JHU INVESTMENT 89
TABLE 26.2 STYLE ANALYSIS FOR A SAMPLE OF HEDGE FUNDS BAHATTIN
BUYUKSAHIN, JHU INVESTMENT 91
Slide 92
LIABILITY AND HEDGE FUND PERFORMANCE Hedge funds tend to hold
more illiquid assets than other institutional investors Aragon
Typical alpha may be interpreted as an equilibrium liquidity
premium than a sign of stock-picking ability Santa Effect Higher
returns reported in December Stronger for lower-liquidity funds
BAHATTIN BUYUKSAHIN, JHU INVESTMENT 92
FIGURE 26.2 HEDGE FUNDS WITH HIGHER SERIAL CORRELATION IN
RETURNS, AN INDICATOR OF ILLIQUID PORTFOLIO HOLDINGS, EXHIBIT
HIGHER SHARPE RATIOS BAHATTIN BUYUKSAHIN, JHU INVESTMENT 94
Slide 95
HEDGE FUND PERFORMANCE AND SURVIVORSHIP BIAS Backfill bias
Hedge funds report returns to database publishers only if they
choose to Survivorship bias Unsuccessful funds that cease operation
stop reporting returns and leave a database Only successful funds
remain BAHATTIN BUYUKSAHIN, JHU INVESTMENT 95
Slide 96
HEDGE FUND PERFORMANCE AND CHANGING FACTOR LOADINGS Hedge funds
are designed to be opportunistic and have considerable flexibility
to change profiles If risk is not constant Alphas will be biased if
a standard, linear index model is used BAHATTIN BUYUKSAHIN, JHU
INVESTMENT 96
Slide 97
FIGURE 26.3 CHARACTERISTIC LINE OF A PERFECT MARKET TIMER
BAHATTIN BUYUKSAHIN, JHU INVESTMENT 97
Slide 98
FIGURE 26.4 CHARACTERISTIC LINES OF STOCK PORTFOLIO WITH
WRITTEN OPTIONS BAHATTIN BUYUKSAHIN, JHU INVESTMENT 98
Slide 99
TABLE 26.4 INDEX MODEL RESULTS FOR HEDGE FUNDS, ALLOWING FOR
DIFFERENT UP- AND DOWN-MARKET BETAS BAHATTIN BUYUKSAHIN, JHU
INVESTMENT 99
Slide 100
BLACK SWANS AND HEDGE FUND PERFORMANCE Nassim Taleb: Many hedge
funds rack up fame through strategies that make money most of the
time, but expose investors to rare but extreme losses Examples: The
October 1987 crash Long Term Capital Management BAHATTIN
BUYUKSAHIN, JHU INVESTMENT 100
Slide 101
FEE STRUCTURE IN HEDGE FUNDS Typical hedge fund fee structure
Management fee of 1% to 2% of assets Incentive fee equal to 20% of
investment profits beyond a stipulated benchmark performance
Effectively call options on the portfolio with a strike price equal
to current portfolio value High water mark The fee structure can
give incentives to shut down a poorly performing fund BAHATTIN
BUYUKSAHIN, JHU INVESTMENT 101
Slide 102
FIGURE 26.5 INCENTIVE FEES AS A CALL OPTION BAHATTIN
BUYUKSAHIN, JHU INVESTMENT 102
Slide 103
FUNDS OF FUNDS Invest in several other hedge funds Optionality
can have a big impact on expected fees Fund of funds pays an
incentive fee to each underlying fund that outperforms its
benchmark even if the aggregate performance is poor Diversification
can actually hurt the investor in this case BAHATTIN BUYUKSAHIN,
JHU INVESTMENT 103
Slide 104
FUNDS OF FUNDS CONTINUED Spread risk across several different
funds Investors need to be aware that these funds of funds operate
with considerable leverage If the various hedge funds in which
these funds of funds invest have similar investment styles,
diversification may illusory BAHATTIN BUYUKSAHIN, JHU INVESTMENT
104
Slide 105
EXAMPLE 26.6 INCENTIVE FEES IN FUNDS OF FUNDS A fund of funds
is established with $1 million invested in each of three hedge
funds Hurdle rate for the incentive fee is a zero return Each fund
charges an incentive fee of 20% The aggregate portfolio of the fund
of funds is -5% Still pays incentive fees of $.12 for every $3
invested Fund 1Fund 2Fund 3Fund of Funds Start of year (millions)
$1.00$2.00$1.00$3.00 End of year (millions) $1.20$1.40$0.25$2.85
Gross rate of return 20%40%-75%-5% Incentive fee (millions)
$0.04$0.08$0.00$0.12 End of year, net of fee $1.16$1.32$.25$2.73
Net rate of return16%32%-75%-9% BAHATTIN BUYUKSAHIN, JHU INVESTMENT
105
Slide 106
CHAPTER 27 The Theory of Active Portfolio Management
Slide 107
OVERVIEW Treynor-Black model Optimization using analysts
forecasts of superior performance Adjusting model for tracking
error Adjusting model for analyst forecast error Black-Litterman
model BAHATTIN BUYUKSAHIN, JHU INVESTMENT 107
Slide 108
TABLE 27.1 CONSTRUCTION AND PROPERTIES OF THE OPTIMAL RISKY
PORTFOLIO BAHATTIN BUYUKSAHIN, JHU INVESTMENT 108
Slide 109
TABLE 27.2 STOCK PRICES AND ANALYSTS TARGET PRICES FOR JUNE 1,
2006 BAHATTIN BUYUKSAHIN, JHU INVESTMENT 109
Slide 110
FIGURE 27.1 RATES OF RETURN ON THE S&P 500 (GSPC) AND THE
SIX STOCKS, JUNE 2005 MAY 2006 BAHATTIN BUYUKSAHIN, JHU INVESTMENT
110
Slide 111
TABLE 27.3 THE OPTIMAL RISKY PORTFOLIO WITH THE ANALYSTS NEW
FORECASTS BAHATTIN BUYUKSAHIN, JHU INVESTMENT 111
Slide 112
TABLE 27.4 THE OPTIMAL RISKY PORTFOLIO WITH CONSTRAINT ON THE
ACTIVE PORTFOLIO (W A < 1) BAHATTIN BUYUKSAHIN, JHU INVESTMENT
112
Slide 113
FIGURE 27.2 REDUCED EFFICIENCY WHEN BENCHMARK IS LOWERED
BAHATTIN BUYUKSAHIN, JHU INVESTMENT 113
Slide 114
TABLE 27.5 THE OPTIMAL RISKY PORTFOLIO WITH THE ANALYSTS NEW
FORECASTS (BENCHMARK RISK CONSTRAINED TO 3.85%) BAHATTIN
BUYUKSAHIN, JHU INVESTMENT 114
Slide 115
ADJUSTING FORECASTS FOR THE PRECISION OF ALPHA How accurate is
your forecast How should you adjust your position to take account
of forecast imprecision Must quantify the uncertainty by examining
the forecasting record of previous forecasts by same forecaster The
adjusted alpha: BAHATTIN BUYUKSAHIN, JHU INVESTMENT 115
Slide 116
FIGURE 27.3 HISTOGRAM OF THE ALPHA FORECAST BAHATTIN
BUYUKSAHIN, JHU INVESTMENT 116
STEPS IN THE BLACK-LITTERMAN MODEL Step 1: Estimate the
covariance matrix from historical data Step 2: Determine a baseline
forecast Step 3: Integrating the managers private views Step 4:
Developing revised (posterior) expectations Step 5: Apply portfolio
optimization BAHATTIN BUYUKSAHIN, JHU INVESTMENT 118
Slide 119
FIGURE 27.5 SENSITIVITY OF BLACK- LITTERMAN PORTFOLIO
PERFORMANCE TO CONFIDENCE LEVEL (VIEW IS CORRECT) BAHATTIN
BUYUKSAHIN, JHU INVESTMENT 119
Slide 120
FIGURE 27.6 SENSITIVITY OF BLACK- LITTERMAN PORTFOLIO
PERFORMANCE TO CONFIDENCE LEVEL (VIEW IS FALSE) BAHATTIN
BUYUKSAHIN, JHU INVESTMENT 120
Slide 121
THE BL MODEL AS ICING ON THE TB CAKE Suppose that you have two
portfoliosone for the US and one for Europe The model would be run
as two separate divisions Each division would compile values of
alpha relative to their own passive portfolio Relative performance
of the two markets can be expected to add information to the
independent macro forecasts for the two economies Portfolios need
to be optimized separately BAHATTIN BUYUKSAHIN, JHU INVESTMENT
121
Slide 122
VALUE OF ACTIVE MANAGEMENT Model for estimation of potential
fees Kane, Marcus, and Trippi derive an annuitized value of
portfolio performance measured as a percent of funds under
management The percentage fee that investors would be willing to
pay for active services can be related to the difference between
the square of the portfolio Sharpe ratio and that of the passive
portfolio Source of the power of the active portfolio is the
additive value of the squared information ratios BAHATTIN
BUYUKSAHIN, JHU INVESTMENT 122
Slide 123
TABLE 27.6 M-SQUARE FOR THE PORTFOLIO, ACTUAL FORECASTS
BAHATTIN BUYUKSAHIN, JHU INVESTMENT 123
CONCLUDING REMARKS The gap between theory and practice has been
narrowing in recent years The CFA is expanding knowledge base in
the industry Specific lack of application of the Treynor-Black
model may be related to lack of application of adjusting for
analysts errors BAHATTIN BUYUKSAHIN, JHU INVESTMENT 125
