Investment Analysis

and
Portfolio Management

Active Portfolio Management

 Customized Benchmark
• Broad-based index may not be appropriate for all
money managers as they may consider only a
subset of the universe of stocks for investment
choice
• Also the benchmark needs to be weighted in the
same fashion as the proportion in which manager
normally invests in different components of his/her
portfolio
• Required for judging the stock selection skill of the
money manager
• Aggregate of all customized benchmarks may be
used to choose mix of managers and manage risk
exposure compared to a broad-based index 2
Ways to create
Customized Benchmark
• Matching Manager’s stock selection
– Based on analysis of manager’s past pickings
– A series of screens (sequencing is important) may be
used to isolate the manager’s domain from the
universe of stocks
– Helped by communication with manager or
assessment of his/her selection criteria
– Weighting the stocks – while normal indices are
capitalization weighted, managers usually do equal
weighting
– Resulting subset may be evaluated by comparing with
the manager’s portfolio as to portfolio characteristics 3
Ways to create
Customized Benchmark contd. …
• Matching manager’s portfolio based on
underlying factors
– Matching of portfolio characteristics based on factor
exposures in a factor model
– Subset is usually bigger than stock-matching
– Screening criteria is obtained by risk factor
exposures over time
– Existing factors proxy for missing factor
– A persistent unintentional bet may be construed as a
valid factor
4
Ways to create
Customized Benchmark contd. ….
• Matching manager’s portfolio by style
– Returns pattern of the portfolio is regressed against
the returns of a few style indices so as to arrive at the
mix of individual indices which match the portfolio
returns
– Alphas are completely captured by indices and error
terms and benchmarking results in identifying broad
asset categories
– Alternatively, portfolio characteristics which tend to
generate return, are attempted to be matched with the
mix of individual index characteristics
– Both results highly dependent upon choice of indices 5
Problems with
Customized Benchmark
• Over-customization will lead to
– Elimination of Alpha
– Non-identification of returns due to sectoral
under/over weightage
– Non-identification of returns due to higher/lower bets
in certain stocks
• Benchmarks with equally weighted stocks creates
difficulty for fund management
• Broad-based benchmarks enable comparison
across managers 6
 Factor Models Revisited
• Types of Factor Models
– Statistical Models
– Macroeconomic Factor Models
– Fundamental Factor Models
• Individual factors are grouped under categories
(conversely, multiple proxies are identified for
each attribute)
• Factor betas (regression coefficients) are obtained
through multiple regression between stock returns
for each period and unexpected changes in
macrofactor variables or fundamental factor levels 7
 Factor Models visit continues
• Betas are usually subjected to cross-sectional
standardization to make comparison feasible
• Factor returns are calculated by regressing the
periodic returns on universe of stocks against that
particular factor values
• Estimated returns are simply the aggregate of all
(factor betas x factor returns)
• For predicting returns, factor returns and factor
betas need to be predicted using methods ranging
from simple average to statistical time series
analysis
8
 Factor Models visit continues
• Portfolio’s sensitivity to a given factor risk is a
weighted average of the factor sensitivity of the
stocks in the portfolio
• Based on prediction as to future factor values,
portfolios may be formed to match a benchmark
in all risk dimensions, tilt in a particular direction
and earn a specified excess return

9
 Commonality in the determinants of
expected stock returns - Haugen
• Attribute Risk – payoff to risk variable positive
• Attribute Liquidity – higher liquidity leads to
lower bid-ask spread and cost of trading – payoff
negative
• Attribute Cheapness – relative magnitude of
market price to current cash flows - payoff
negative
• Attribute Growth Potential – probability for faster
than average growth in future – payoff positive
• Technical Factors – history of stock returns -
payoff negative (1 month), positive (6-12 months),
negative (3-5 years) 10