Finance 450 Active vs. Passive Portfolio Management.

Finance 450Finance 450

Active vs. Passive Portfolio Active vs. Passive Portfolio ManagementManagement

What is “alpha”?What is “alpha”? Alpha = the amount by which the market is Alpha = the amount by which the market is

beaten, after adjusting for riskbeaten, after adjusting for risk What is alpha for the market as a whole?What is alpha for the market as a whole? Alpha for market as a whole is zeroAlpha for market as a whole is zero

• So, on average, portfolios are ON the SMLSo, on average, portfolios are ON the SML Provides conceptual value of CAPMProvides conceptual value of CAPM

• Regardless of whether market is efficient, it is still a Regardless of whether market is efficient, it is still a zero-sum gamezero-sum game

Burden of active managerBurden of active manager• In order to win (i.e., beat the market), someone else has In order to win (i.e., beat the market), someone else has

to loseto lose Key question = what is special about you (and Key question = what is special about you (and

about your knowledge) that will allow you to be about your knowledge) that will allow you to be the one that wins?the one that wins?

Generating alphaGenerating alpha

Are there ways to consistently Are there ways to consistently generate alpha?generate alpha?

See portfolio manager performance See portfolio manager performance example:example:

Portfolio Manager’s Performance:Portfolio Manager’s Performance:Past Three YearsPast Three Years

Previous Three Years: S&P 500 Fund

Manager

Compound Annual Return -4.98% -22.01%

Total Return -14.20% -52.56%

Portfolio Manager’s Performance:Portfolio Manager’s Performance:Past Four YearsPast Four Years

Previous Four Years: S&P 500 Fund

Manager

Compound Annual Return 0.50% -14.19%

Total Return 2.02% -45.77%

Portfolio Manager’s Performance:Portfolio Manager’s Performance:Past Five YearsPast Five Years

Previous Five Years: S&P 500 Fund

Manager



Portfolio Manager’s Performance:Portfolio Manager’s Performance:Past Six YearsPast Six Years

Previous Six Years: S&P 500 Fund

Manager

No. of Down Years 2 of 6 4 of 6



Generating alphaGenerating alpha Would you have invested with this Would you have invested with this

manager?manager? Who is this manager with this horrible Who is this manager with this horrible

record?record? Warren Buffett, of course!!!Warren Buffett, of course!!! Portfolio = investment in Berkshire-Portfolio = investment in Berkshire-

Hathaway, over the period of 1970 – 1975Hathaway, over the period of 1970 – 1975 Note: while stock price lagged market Note: while stock price lagged market

substantially, book value per share grew substantially, book value per share grew faster than market each year except 1975; faster than market each year except 1975; this is a metric with which Buffett is more this is a metric with which Buffett is more concernedconcerned

Generating alphaGenerating alpha As we have seen previously in discussing the As we have seen previously in discussing the

EMH, value stocks tend to outperform growth EMH, value stocks tend to outperform growth stocksstocks

Concomitantly, Warren Buffett has the best Concomitantly, Warren Buffett has the best investment record in history, becoming the 2investment record in history, becoming the 2ndnd richest man in the world in the processrichest man in the world in the process

However, as we have just now seen, although However, as we have just now seen, although value wins on average, over the long run, it does value wins on average, over the long run, it does notnot win perfectly consistently! win perfectly consistently!

Instead, the markets tend to cycle, with different Instead, the markets tend to cycle, with different styles of investment performing well at different styles of investment performing well at different timestimes

Book to Market as a Predictor of Return:Book to Market as a Predictor of Return:Value (positive Value (positive ) tends to outperform Growth (negative ) tends to outperform Growth (negative ))

ValueValue

GrowthGrowth

0%0%

5%5%

10%10%

15%15%

20%20%

2525%%

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1010998877665544332211

High Book/Market Low Book/MarketHigh Book/Market Low Book/Market

Rolling Annualized Average 5-year Difference Rolling Annualized Average 5-year Difference Between the Returns to Value and Growth Composites:Between the Returns to Value and Growth Composites:

The Market cycles between Value and Growth,The Market cycles between Value and Growth,But Value Wins on AverageBut Value Wins on Average

-20%-20%

-10%-10%

0%0%

10%10%

20%20%

30%30%

40%40%

50%50%

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Empirical Regularities:Empirical Regularities:Sources of alphaSources of alpha

Three categories that tend to outperform over the Three categories that tend to outperform over the long run:long run:• ValueValue stocks vs. Growth stocks stocks vs. Growth stocks• SizeSize: Small caps tend to outperform large caps: Small caps tend to outperform large caps• MomentumMomentum: stocks with momentum (earnings or price) : stocks with momentum (earnings or price)

tend to beat stocks without momentumtend to beat stocks without momentum However, the payoffs to all of these tend to cycle!However, the payoffs to all of these tend to cycle!

• A typical portfolio manager, being judged on a quarter-by-A typical portfolio manager, being judged on a quarter-by-quarter basis, would have been fired long before if he had quarter basis, would have been fired long before if he had the same record as Buffett for 1970 – 1975!the same record as Buffett for 1970 – 1975!

• (In fact, he fired himself during this period!)(In fact, he fired himself during this period!) None of these beats the market perfectly consistentlyNone of these beats the market perfectly consistently

• A typical portfolio manager would need to try to cycle along A typical portfolio manager would need to try to cycle along with the market, in order to keep from ever lagging too far with the market, in order to keep from ever lagging too far behind itbehind it

Empirical Regularities:Empirical Regularities:Sources of alphaSources of alpha

Beating the market consistently would require Beating the market consistently would require some sort of rotation strategy in order to profit some sort of rotation strategy in order to profit from the type of securities that are performing from the type of securities that are performing well in the given type of marketwell in the given type of market

But - combination of “fat tails” and “volatility But - combination of “fat tails” and “volatility clustering” (discussed previously) can cause clustering” (discussed previously) can cause problems!problems!• Best performance for a given style is likely to follow Best performance for a given style is likely to follow

closely on the heels of its worst performance, and much closely on the heels of its worst performance, and much of the movement for the style is likely to come in a of the movement for the style is likely to come in a relatively short burst (thus, if you miss it, it’s gone)relatively short burst (thus, if you miss it, it’s gone)

• E.g.: 40% of the stock market gains for the entire decade E.g.: 40% of the stock market gains for the entire decade of the 1980’s occurred during a mere 10 trading days !of the 1980’s occurred during a mere 10 trading days !

• So efforts to cycle with the market and keep from falling So efforts to cycle with the market and keep from falling too far behind it also make it much more difficult to beat too far behind it also make it much more difficult to beat the market!the market!

Sources of alpha:Sources of alpha:Advantage of Individual InvestorsAdvantage of Individual Investors

““Individual investors enjoy a key advantage over professionals Individual investors enjoy a key advantage over professionals in one critical respect. You can pick and choose stocks and bide in one critical respect. You can pick and choose stocks and bide your time unflustered by the fierce and often corrosive your time unflustered by the fierce and often corrosive quarterly performance sweepstakes, especially in hostile quarterly performance sweepstakes, especially in hostile market climates. Value investing … demands sober reflection. market climates. Value investing … demands sober reflection. Scarce to begin with, sober reflection gets even scarcer as bull Scarce to begin with, sober reflection gets even scarcer as bull markets progress.”markets progress.”

• John Neff, “John Neff on investing”John Neff, “John Neff on investing” Nonetheless, if one wants to try to cycle or rotate with the Nonetheless, if one wants to try to cycle or rotate with the

market and still stay ahead (or at least not get too far behind),market and still stay ahead (or at least not get too far behind),

• Maturity diversification could be beneficialMaturity diversification could be beneficial picking a variety of stocks that are expected to pay off picking a variety of stocks that are expected to pay off

over different time horizonsover different time horizons

• Two good authors are Peter Lynch and John NeffTwo good authors are Peter Lynch and John Neff

• William O’Neill could also be usefulWilliam O’Neill could also be useful

Passive versus Active Passive versus Active Equity Portfolio ManagementEquity Portfolio Management

Goal of Active ManagementGoal of Active Management• Generate alpha with some consistencyGenerate alpha with some consistency• Very difficult to doVery difficult to do

Goal of Passive ManagementGoal of Passive Management• Recognizes difficulty of generating alphaRecognizes difficulty of generating alpha• Instead focuses on minimizing “omega” (Instead focuses on minimizing “omega” (= =

“tracking error”) and trying to match the “tracking error”) and trying to match the underlying indexunderlying index

Passive versus Active ManagementPassive versus Active Management Passive equity portfolio managementPassive equity portfolio management

• Designed to match market performanceDesigned to match market performance• Usually tracks an index over timeUsually tracks an index over time• Managers are judged on how well they track the Managers are judged on how well they track the

target indextarget index• Typically entails a long-term buy-and-hold Typically entails a long-term buy-and-hold

strategystrategy Active equity portfolio managementActive equity portfolio management

• Attempts to outperform some passive Attempts to outperform some passive benchmark portfolio on a risk-adjusted basisbenchmark portfolio on a risk-adjusted basis

Passive Equity Portfolio Passive Equity Portfolio Management TechniquesManagement Techniques

Full replicationFull replication

SamplingSampling

Quadratic optimization or programmingQuadratic optimization or programming

Full ReplicationFull Replication

All securities in the index are purchased in All securities in the index are purchased in proportion to weights in the indexproportion to weights in the index

This helps ensure close trackingThis helps ensure close tracking But, increases transaction costs, But, increases transaction costs,

particularly with dividend reinvestmentparticularly with dividend reinvestment

SamplingSampling

Buys a representative sample of stocks in Buys a representative sample of stocks in the benchmark index according to their the benchmark index according to their weights in the indexweights in the index

Fewer stocks means lower commissionsFewer stocks means lower commissions Reinvestment of dividends is less difficultReinvestment of dividends is less difficult But, will not track the index as closely, so But, will not track the index as closely, so

there will be some there will be some tracking errortracking error Frequently used in conjunction with Frequently used in conjunction with

quadratic optimization (see below)quadratic optimization (see below)

Expected Tracking Error Between the S&P 500 Expected Tracking Error Between the S&P 500 Index and Portfolio Samples of Less Than 500 Index and Portfolio Samples of Less Than 500

StocksStocksFigure 22.1

500 400 300 200 100 0

2.0

1.0

3.0

4.0

Expected Tracking Error (Percent)

Number of Stocks

Quadratic Optimization Quadratic Optimization (or programming techniques)(or programming techniques)

Variation of Markowitz portfolio optimizationVariation of Markowitz portfolio optimization

But rather than maximize E(R) while minimizing But rather than maximize E(R) while minimizing ,,

Instead maximize Instead maximize (= expected excess return) (= expected excess return) while minimizing while minimizing (= expected tracking error) (= expected tracking error)

Efficient Frontier forEfficient Frontier for Enhanced/Optimized Index Funds Enhanced/Optimized Index Funds

Efficient Frontier

p

Tracking Error ()p0

An Overview of Active Equity An Overview of Active Equity Portfolio Management StrategiesPortfolio Management Strategies

Goal is to earn a portfolio return that exceeds Goal is to earn a portfolio return that exceeds the return of a passive benchmark portfolio, the return of a passive benchmark portfolio, net of transaction costs, on a risk-adjusted net of transaction costs, on a risk-adjusted basisbasis

Practical difficulties of active managerPractical difficulties of active manager• Transactions costs must be offsetTransactions costs must be offset• Risk can exceed passive benchmarkRisk can exceed passive benchmark

““Tilting” portfolio away from benchmark tends to increase Tilting” portfolio away from benchmark tends to increase total risk of portfolio compared to total risk of benchmarktotal risk of portfolio compared to total risk of benchmark

Technical StrategiesTechnical Strategies

Somewhat less commonly used Somewhat less commonly used

Contrarian investment strategyContrarian investment strategy Price momentum strategyPrice momentum strategy Earnings momentum strategy Earnings momentum strategy

Fundamental StrategiesFundamental Strategies

Much more commonly usedMuch more commonly used

Top-down versus bottom-up approachesTop-down versus bottom-up approaches Asset and sector rotation strategiesAsset and sector rotation strategies

Selection ProcessSelection Process

Two general approaches:Two general approaches:1.1. Top-down, three-step approachTop-down, three-step approach

– Tries to beat the market quarter by quarterTries to beat the market quarter by quarter– Over the short term, performance of a company is Over the short term, performance of a company is

dominated by business cycle and performance of dominated by business cycle and performance of industryindustry

– Similarly, performance of stock price over the short Similarly, performance of stock price over the short term is dominated by movements in overall market term is dominated by movements in overall market and industry segmentsand industry segments

Selection ProcessSelection Process

Two general approaches:Two general approaches:2.2. Bottom-up, stock valuation, stock picking Bottom-up, stock valuation, stock picking

(stock screening) approach(stock screening) approach– Willing to drift further away from market with hope Willing to drift further away from market with hope

of greater profits over the long runof greater profits over the long run– Over the long run, stock price will be driven by Over the long run, stock price will be driven by

performance of underlying companyperformance of underlying company– What Buffett’s approach entails, since he plans to What Buffett’s approach entails, since he plans to

hold stock much longer than length of typical hold stock much longer than length of typical business cyclebusiness cycle

Top-Down, Three-Step ApproachTop-Down, Three-Step Approach

1. General economic influences1. General economic influences• Decide how to allocate investment funds among countries, and Decide how to allocate investment funds among countries, and

within countries to bonds, stocks, and cashwithin countries to bonds, stocks, and cash• Two components – geographic allocation and asset class allocationTwo components – geographic allocation and asset class allocation

2. Industry influences2. Industry influences• Determine which industries will prosper and which industries will Determine which industries will prosper and which industries will

suffer on a global basis and within countriessuffer on a global basis and within countries• Must understand cyclical vs. structural effectsMust understand cyclical vs. structural effects

3. Company analysis3. Company analysis• Determine which companies in the selected industries will prosper Determine which companies in the selected industries will prosper

and which stocks are undervaluedand which stocks are undervalued

Three General Categories of Active Three General Categories of Active Management StrategiesManagement Strategies

Correspond with three stages of top-down approach:Correspond with three stages of top-down approach:• Market timing - shifting funds into and out of stocks,

bonds, and T-bills depending on broad market forecasts and estimated risk premiums

• Shifting funds among different equity sectors and industries (sector rotation) or among investment styles (e.g., theme investing) to catch hot concepts before the market does

• Stockpicking - individual issues

Sector RotationSector Rotation

Position a portfolio to take advantage of the Position a portfolio to take advantage of the market’s next movemarket’s next move

Screening can be based on various stock Screening can be based on various stock characteristics:characteristics:• ValueValue• GrowthGrowth• P/EP/E• CapitalizationCapitalization• Sensitivity to economic variablesSensitivity to economic variables

Value versus GrowthValue versus Growth

Growth stocks will outperform value Growth stocks will outperform value stocks for a time and then the opposite stocks for a time and then the opposite occursoccurs

Over time value stocks have offered Over time value stocks have offered somewhat higher returns than growth somewhat higher returns than growth stocksstocks


Growth-oriented investor will:Growth-oriented investor will:• focus on EPS and its economic determinantsfocus on EPS and its economic determinants

• look for companies expected to have rapid EPS look for companies expected to have rapid EPS growthgrowth

• assumes constant P/E ratio, assumes constant P/E ratio,

• so, as earnings grow, price will grow so, as earnings grow, price will grow concomitantlyconcomitantly


Value-oriented investor will: Value-oriented investor will: • focus on the price componentfocus on the price component

• not care as much about current earningsnot care as much about current earnings

• assume the P/E ratio is below its natural levelassume the P/E ratio is below its natural level

• note: P/Book is probably a better measure of note: P/Book is probably a better measure of value than is P/Evalue than is P/E

Approaches to Valuation of Approaches to Valuation of Common StockCommon Stock

How do you determine whether a stock is a good How do you determine whether a stock is a good value?value?

Two general approaches have been developed:Two general approaches have been developed:

1.1. Discounted cash-flow valuationDiscounted cash-flow valuation Present value of some measure of cash flow, such Present value of some measure of cash flow, such

as dividends, operating cash flow, and free cash as dividends, operating cash flow, and free cash flowflow

2.2. Relative valuation techniqueRelative valuation technique Value estimated based on its price relative to Value estimated based on its price relative to

significant variables or metrics of value, such as significant variables or metrics of value, such as earnings, cash flow, book value, or salesearnings, cash flow, book value, or sales

Valuation Approaches Valuation Approaches and Specific Techniquesand Specific Techniques

Approaches to Equity ValuationApproaches to Equity Valuation

Discounted Cash Flow Techniques

Relative Valuation Techniques

• Present Value of Dividends (DDM)

•Present Value of Operating Cash Flow

•Present Value of Free Cash Flow

• Price/Earnings Ratio (PE)

•Price/Cash flow ratio (P/CF)

•Price/Book Value Ratio (P/BV)

•Price/Sales Ratio (P/S)

Approaches to the Approaches to the Valuation of Common StockValuation of Common Stock

These two approaches have some factors in These two approaches have some factors in commoncommon

Both are affected by:Both are affected by:• Investors’ required rate of returnInvestors’ required rate of return

kkVV How to estimate – CAPM, APT, Haugen’s model?How to estimate – CAPM, APT, Haugen’s model?

• Estimated growth rate of the variable usedEstimated growth rate of the variable used ggVV Will vary depending on stage in industry life cycleWill vary depending on stage in industry life cycle

Using the Using the DiscountedDiscounted Cash FlowCash Flow Valuation ApproachValuation Approach

Requires some measure of cash flow that will be discountedRequires some measure of cash flow that will be discounted• DividendsDividends

Discount at cost of equityDiscount at cost of equity• Free cash flow to equityFree cash flow to equity

Discount at cost of equityDiscount at cost of equity• Operating cash flowOperating cash flow

Discount at Weighted Average Cost of Capital (WACC)Discount at Weighted Average Cost of Capital (WACC) Provides estimate of value for company as a whole Provides estimate of value for company as a whole

(aggregate value of stock plus aggregate value of bonds)(aggregate value of stock plus aggregate value of bonds) Estimated future cash flows are discounted back to the Estimated future cash flows are discounted back to the

present to provide some measure of the absolute value of the present to provide some measure of the absolute value of the company or its stockcompany or its stock

With constant expected future growth, form of model is With constant expected future growth, form of model is simple, though application can still be problematicsimple, though application can still be problematic

Why and When to Use the Why and When to Use the RelativeRelative Valuation Techniques Valuation Techniques

Provides information about how the Provides information about how the market is currently valuing stocks – market is currently valuing stocks – compare stock to:compare stock to:• aggregate marketaggregate market• alternative industriesalternative industries• individual stocks within industriesindividual stocks within industries

But no guidance as to whether valuations But no guidance as to whether valuations are appropriate – best used when:are appropriate – best used when:• have comparable entitieshave comparable entities• aggregate market is not at a valuation extremeaggregate market is not at a valuation extreme

Final Comments on ValuationFinal Comments on Valuation

In the end, as with much in finance, In the end, as with much in finance, valuation is at least as much of an art as a valuation is at least as much of an art as a sciencescience

Ben Graham’s analogy: you don’t have to Ben Graham’s analogy: you don’t have to know someone’s exact weight to be able know someone’s exact weight to be able to say whether they are “fat” or “skinny”to say whether they are “fat” or “skinny”

New EnterpriseNew Enterprise example example• Wide range of values from valuationWide range of values from valuation• But even at lowest end, book value still way But even at lowest end, book value still way

undervaluedundervalued


Valuation entails / requires some vision of the futureValuation entails / requires some vision of the future• In a real sense, investing means betting on some vision of In a real sense, investing means betting on some vision of

the futurethe future But, interaction of business cycle effects vs. industry But, interaction of business cycle effects vs. industry

life cycle effects can confound vision of futurelife cycle effects can confound vision of future• Internet stocks = beginning of industry life cycle + upswing Internet stocks = beginning of industry life cycle + upswing

in business cyclein business cycle• New England Wire & Cable = downturn in business cycle + New England Wire & Cable = downturn in business cycle +

ending of industry life cycleending of industry life cycle Note – industry life cycle is not always the same Note – industry life cycle is not always the same

thing as the company’s life cycle:thing as the company’s life cycle:• Studebaker example – transitioned from Conestoga wagons Studebaker example – transitioned from Conestoga wagons

(early 1800’s) to farm wagons (later 1800’s) to farm trucks (early 1800’s) to farm wagons (later 1800’s) to farm trucks (early 1900’s) to automobiles (through early 1960’s)(early 1900’s) to automobiles (through early 1960’s)


New England Wire and CableNew England Wire and Cable example example Jorgie’s visionJorgie’s vision

• Problems are temporary, driven by downturn in Problems are temporary, driven by downturn in business cyclebusiness cycle

• When economy (and gov’t infrastructure spending) When economy (and gov’t infrastructure spending) turn back up, company will turn aroundturn back up, company will turn around

• W&C division is a positive NPV projectW&C division is a positive NPV project Larry the Liquidator’s visionLarry the Liquidator’s vision

• Problems are permanent, caused by obsolescence and Problems are permanent, caused by obsolescence and foreign competitionforeign competition

• Company has moved past the peak of the industry life Company has moved past the peak of the industry life cyclecycle

• W&C division is a negative NPV projectW&C division is a negative NPV project

Finance 450 Active vs. Passive Portfolio Management.

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