1

Active Asset Management Project Using the Single-Index Model

The project for this semester is to develop a portfolio for the coming month that will create alpha. The
portfolio will comprise six individual investments plus the market, which is represented by the
S&P 500. The basic framework is outlined in Bodie, Kane, and Marcus, Investments, chapters 8 and
27. And Spreadsheet 8.1 will be the template for your work. This Spreadsheet is on Blackboard.
You are a US dollar-based investment manager. You are long and short, and your company, RBS
Investment Advisors, invests in any region of the world and sector of the market. Your marketing
brochures state that your goal is to maximize the clients total rate of return for a 1-month holding
period. Your approach is to invest the bulk of client funds in the broad market by buying SPY, the
State Street SPDR for the S&P Index. This provides diversification against what we cannot anticipate,
and there is a lot we have not been able to anticipate in the past two years.
Over the years you have earned your management fee by being successful picking a few stocks that
will significantly outperform or underperform the market. Thats how you have provided alpha to
your clients. Each client portfolio has two components: a passive component represented by SPY, and
an active component represented by your best picks, which you are long, and your worst picks, which
you are short.
RBSIA is now reassessing the outlook for the next month. The investment committee will meet soon
to decide how to position client funds. That is, what firm/sector specific risks is the committee willing
to accept so that RBSIA has a good chance of beating the market?
Once the committee makes it choices, the task becomes finding the optimal weights for the
investments in the active portfolio and finding the optimal distribution between the passive and active
portfolios.
And so we begin.
The technical requirements for your analysis are:
1.) Estimate the betas for your chosen stocks/ETFs. Save the output, including the residuals, so
you can calculate the STDs of the systematic and firm-specific components of the return.
2.) Calculate the correlations of the regression residuals. This step will reveal how well your
investments approximate one of the key assumptions of the Single-Index Model: that the firmspecific risk for any company is uncorrelated with the firm-specific risk of any other company.
3.) Calculate the covariance matrix using the method of the Single-Index Model (SIM). That is,
the off-diagonal elements are equal to ijM2, and the on-diagonal elements, which are the
variances, equal i2M2. Also, calculate the covariance matrix using the standard method.
Comparing the two methods will also reveal how well your investments approximate the
assumptions of the SIM.
These steps are straightforward, and can be accomplished using Excel. How this analysis is completed
for Spreadsheet 8.1 is included in the pages that follow. I have included a copy of the Spreadsheet that
provides all the formulas that are used to produce the values in the table. This is a big help in
understanding the analytics behind active asset management. You will see how the Index Model
Covariance Matrix, the Information Ratio, optimal weights, and your projected Sharpe Ratio are all
calculated. This explanatory document is, also, posted on Blackboard. To view Spreadsheet 8.1 with

2
formulas in the cells, rather than calculated values, do: Tools, Formula Auditing, then Formula
Auditing Mode in Excel. You will need to print Auditing Mode in Landscape format.
How should you go about choosing stocks/ETFs?
There are many possible methods, but one approach is to begin by thinking about global themes, and
then drill down as you search for investments that reflect your ideas.
Some questions to consider are:
a.) What is the economic outlook for the coming month? When will the recession end? When will
the Fed begin to raise interest rates? What will be the fate of the dollar?
b.) How will the broad market perform given your views about economic fundamentals?
c.) Given your macro view, what regions of the world or sectors of the market will recover
soonest? Which regions or sectors will lag the overall market? Large cap US stocks? Global
pharmaceuticals? European Financials? You can be long six stocks/ETFs that you believe will
outperform the market. You can be short six stocks/ETFs that you have confidence will
underperform the market. Or, more likely, you be long some and short some.
Once the macro thinking is done, then the forecasting begins.
You will need to forecast:
a.) the market risk premium, cell B45 of Spreadsheet 8.1.
b.) the individual alphas for each investment in your active portfolio, cells C44 to H44.
Some thoughts on how to proceed.
Keep the alphas small. This is the advice of many practitioners and scholars. You cannot predict
alpha with any precision, and your results, that is the optimal weights and projected Sharpe ratio, can
be very sensitive to alpha forecasts. So instead of claiming a lot of precision which will not be
achieved, it is suggested that you use your forecasted alphas as a means to make a general statement
about the expected return on a stock.
That is, use only five different alphas: +2%, +1%, 0, -1%, and -2%. For stocks that you believe will
beat the market by a lot, whatever that means, use an alpha of +2%. For stocks that you believe will
beat the market by a small amount use +1%. The same reasoning applies for stocks that you believe
will underperform the market. Essentially there are five generic categories of expected return that
should be used: the stock will beat the market by a lot, by a little, will return about the same as the
market, will underperform by a little, or a lot.
Now this is just a suggestion, and is not required. If you have strong convictions about who will be
the winners and who will be the losers, go for it. Remember no guts, no glory. But you must
recognize the risks that RBSIA is taking with client funds, with the retirement wealth of clients who
have become your friends. Do you want to have to tell them they are not moving to Hilton Head next
year because your firm lost their money?
Also, read the relevant pages of chapters 8 and 27 in the text. The authors do a nice job, especially in
chapter 27, about explaining the process and trade-offs of active asset management.
Other random comments.

3
I found all the data I needed in Yahoo!Finance. It is easy to download to an Excel spreadsheet month
end prices that are adjusted for dividends and splits.
If you use Excel to run your regressions, be sure to check the residuals box. This will save the
residuals, which you will need for the analysis. To do regression in Excel: do Tools, Data Analysis,
then Regression.
You might well decide to invest in an ETF that was created a year or two ago. There are not enough
data points to run a statistically reliable equation. Say, for example, you think nuclear power or
alternative energies generally will do well. There are ETFs for both of these themes, but the ETFs did
not exist before 2006. What do you do? ETFs are usually created to track an index, and the index
might have a long history. Use the index as the dependent variable in your regression, and then
forecast alpha for the ETF.
Experiment with alpha and the market risk premium. Increase every alpha by one percentage point.
Increase alpha one percentage point for one investment at a time. Increase the market risk premium
one percentage point. In each case, what happens to the optimal weights and to the projected portfolio
alpha? What happens to the Information Ratio when you change alpha or the market risk premium?
Notice in Spreadsheet 8.1 that the projected Sharpe Ratio for the active portfolio, cell C61 is less than
the Sharpe for the passive portfolio, cell B61. Yet, the projected Sharpe for the complete portfolio,
cell J61, exceeds the Shape for both the passive and active portfolios. Why do you think this occurs?
The Requirements.
a.) A completed Spreadsheet 8.1 for your portfolio;
b.) A report given to me by the end of semester that discusses your methodology and results.
i.) Specifically, how did your group choose the six stocks and how did your group choose the
projected alphas? Also, how did you forecast the market risk premium?
ii.) Comment on whatever you think is interesting about your results.
For example, are the betas what you thought they would be? Are you comfortable
with the portfolio beta, cell C58, or is it too high for your clients?
Are the residual correlations low? How similar are the two covariance matrices? That
is, did the Single-Index Model provide a robust framework for using security analysis to make
investment decisions? Or, in your opinion, is the SIM inferior to the full blown Markowitz
Mean Variance Optimization model?
And finally, is your portfolio worth the effort, or is the client better off with just the
passive portfolio? How much value has RBSIA provided for its clients?

Documents posted on Blackboard:

1.) Active Asset Management Project Description, which is this Word document.
2.) Spreadsheet 8.1, which is in Excel.