Ch07 Portfolio management.docx

PORTFOLIO MANAGEMENT Formulate an Appropriate Investment Policy: The determination of portfolio policies—referred to as the investment policy statements is the first step in the investment process. It summarizes the objectives, constraints, and preferences for the investor. A recommended approach in formulating ah investment policy statement is simply to provide information, in the following order, for any investor individual or institutional: Objectives: Return requirements Risk tolerance Followed by: • Constraints and Preferences: o Liquidity o Time horizon o Laws and regulations o Taxes o Unique preferences and circumstances Objectives: Portfolio objectives are always going to center on return and risk, because these are the two aspects of most interest to investors. Indeed, return and risk are the basis of all financial decisions in general and investing decisions in particular. Investors seek returns, but must assume risk in order to have an opportunity to earn the returns. Furthermore, an individual can be a composite of these stages at the same time. The four stages are: Accumulation Phase: In the early stage of the life cycle, net worth is typically small, but the time horizon is long. Investors can afford to assume large risks. Consolidation Phase: In this phase, involving the mid-to-late career stage of the life cycle when income exceeds expenses, an investment portfolio can be .accumulated. A portfolio balance is sought to provide a moderate trade-off between risk and return. Spending Phase: In this phase, living expenses are covered from accumulated assets rather than earned income. Although some risk taking is still preferable, the emphasis is on safety, resulting in a relatively low position on the risk-return trade-off. Gifting Phase: In this phase, the attitudes about the purpose of investments changes. The basic position on the trade-off remains about the same as in phase 3. Establishing a Portfolio Risk Level: Investors should establish a portfolio risk level that is suitable for them, and then seek the highest returns consistent with that level of risk. We will assume here that investors have a 227 Investment Analysis & Portfolio Management long-run horizon. If not, they probably should avoid stocks, or at least minimize any equity position. Assuming you are a long-term investor, and that you own an S&P 500-type portfolio, ask yourself what is the worst that is likely to happen to you as an investor in stocks. Ignoring the Great Depression, which hopefully will not occur again, consider the worst events that have, occurred. During the bear market of 1973 to 1974, investors could have lost about 37 percent of their investment in S&P 500 stocks. During the bear market of 2000 to 2002, investors could have lost over 40 percent. Therefore, it is reasonable to assume that with a long-time horizon, investors will face one or more bear markets with approximately 40 percent declines. This is in line with the long-term standard deviation of S&P 500 returns of about 20 percent with two standard deviations on either side of the mean return encompassing 95 percent of all returns. If an investor can accept a loss (at least on paper) of approximately 40 percent once or twice in an investing life time, and in otherwise optimistic about the economy and about stocks, the investor can assume the risk of U.S. stocks. On the other hand, if such a potential decline is unacceptable, an investor will have to construct a portfolio with a lower risk profile. For example, a portfolio of 30 percent stocks and 50 percent Treasury bills would cut the risk in half. Other alternatives consisting of stocks and bonds would also decrease the risk. Inflation Considerations: An investment policy statement often will contain some statement about inflation-adjusted returns because of the impact of inflation on investor results over long periods of time. For example, a wealthy individual's policy statement may be stated in terms of maximum. After tax, inflation-adjusted total return consistent with the investor's rise profile, whereas another investor's primary return objective may be stated as inflation-adjusted capital preservation, perhaps with a growth-oriented mix to reflect the need for capital growth over time. Inflation is clearly a problem for investors. The inflation rate of 13 percent in 1979 to-1980 speaks for itself in terms of the awful impact it had on investors' real wealth. But even with a much lower inflation—say, 3 percent--the damage is substantial. It can persist steadily, eroding values. At a 3 percent inflation rate, for example, the purchasing power of a dollar is cut in half in 10s than 25 years. Therefore, someone retiring at age 60 who lives to approximately age 85 and does not protect him or herself from inflation will suffer a drastic decline in purchasing power over the years. The very low inflation rates of the late 1990s and early 2000s probably lulled many investors into thinking that inflation is no longer a serious problem, and that they did not need to consider this issue as being very important. However, for the last 80 or so years, the compound annual rate of inflation has been approximately 3 percent. It is reasonable to assume that in the future inflation will| be higher than it has been recently, and therefore this is an issue that investors need to consider. Constraints and Preferences: To complete the investment policy statement, these items are described for a particular investor as the circumstances warrant. Since investors vary widely in their constraints and preferences, these details may also vary widely. Time Horizon Investors need to think about the time period involved in their investment plans. The objectives being pursued may 228 Investment Analysis & Portfolio Management require a policy statement that speaks to specific planning horizons. In the case of an individual investor, for example; this could well be the investor's expected lifetime. In the case of an institutional investor, the time horizon can be quite long. For example, for a company with a defined benefit retirement plans whose employees are young; and which has no short-term liquidity needs, the time horizon can be quite long. Liquidity Needs: Liquidity is the ease with, which an asset can be sold without a sharp change in price as the result of selling. Obviously, cash equivalents (money market securities) have high liquidity, and are easily sold at close to face value. Many stocks also have great liquidity, but the price at which they are sold will reflect their current market valuations. Investors’ must decide how likely they are to sell some part of their portfolio in the short run. As part of the asset allocation decision, they must decide how much of their funds to keep in cash equivalents. Tax Considerations: Individual investors, unlike some institutional investors, must consider the impact of taxes on their investment programs. The treatment of ordinary income as opposed to capital gains is an important issue, because typically there is a differential tax rate. Furthermore, the tax laws in United States have been changed several times, making it difficult for investors to forecast the tax rate that will apply in the future. In addition to the differential tax rates and their changes over time, the capital gains component of security returns benefits from the fact that the tax is not payable until the gain is realized. This tax deferral is, in effect a tax-free loan that remains invested for the benefit of the taxpayer. As -explained below, some securities become “locked up” by the reluctance of investors to pay the capital gains that will result from selling the securities. Retirement programs offer tax sheltering whereby any income and/or capital gains taxes are avoided until such time as the funds are withdrawn. Investors with various retirement and taxable accounts must grapple with the issue of which type of account should hold stocks as opposed to bonds (given that bonds generate higher current Income). Legal and Regulatory Requirements: Investors must obviously deal with regulatory requirements growing out of both common law and the rulings and regulations of state and federal agencies. Individuals are subject to relatively few such requirements, whereas a particular institutional portfolio, such as an endowment fund of a pension fund, is subject to several legal and regulatory requirements. With regard to fiduciary responsibilities, one of the most famous concepts is the Prudent Man Rule. This rule, which concerns fiduciaries, goes back to 1830, although it was not formally stated until more than 100 years later. Basically, the rule states that a fiduciary, in managing assets for another party shall act like people of prudence, discretion and intelligence act in governing their own affairs. The important aspect of the Prudent Man Rule is its flexibility; because interpretations of the rule can change with time and circumstances. Unfortunately, some judicial rulings have specified a very strict interpretation, negating the, value of flexibility for the time period and 229 Investment Analysis & Portfolio Management circumstances involved. Also unfortunately, in the case of state laws governing private trusts the standard continues to be applied to individual investments rather than the portfolio as a whole which violates all of the portfolio-building principles. One of the important pieces of federal legislation governing institutional investors is the Employment Retirement Income Security Act, referred to as ERISA. This act, administered by the Department of Labor, regulates employer-sponsored retirement plans. It requires that plan assets be diversified and that the standards being applied under the act be applied to management of the port/olio as a whole. The investment policy thus formulate is an operational statement. It clearly specifies the actions to be taken to try to achieve the investor's goals, or objectives, given the preferences of the investor and any constraints imposed. Although portfolio investments consider aliens are often of a qualitative nature, they help to determine a quantitative statement of return and risk requirements that are specific to the needs of any particular investor. Unique Needs and Circumstances: Investors often face a variety of unique circumstances. For example, a trust established on their behalf may specify that investment activities be limited to particular asset classes, or even specified assets. Or in individual may feel that their life span is threatened by illness and wish to benefit within a certain period of time. Determine and Quantify Capital Market Expectations: Having considered their objective's and constraints, the next step is to determine a set, of investment strategies based on the policy statement. Included here ape such issues as asset allocation portfolio diversification and the impact of taxes. Once the portfolio strategies are developed, they are used along with the investment manager's expectations' fit the capital market and' for individual assets to choose a portfolio of assets. Most importantly, the asset allocation decision must be made. Forming Expectations: The forming of expectations involves two steps: Macroexpectational factors: These factors influence the market for bonds, stocksand other assets on both a domestic and international basis. These are expectations about the capital markets. Microexpectational influences: These factors invoke the cause agents that underliethe desired return and risk estimates and influence the selection of a particular asset for a particular portfolio. Rate of Return Assumptions: Most investors base their actions on some 'assumptions about the rate of return expected from various assets, obviously it is important to investors to plan their investing activities on realistic rate of return assumptions. Investors should study carefully the historical rates of return available in such sources as the data provided by Ibbotson Associates or the comparable data. We know the historical mean returns, both arithmetic and geometric, and the standard deviation of the returns for major asset classes such as stocks, bonds and bills. 230 Investment Analysis & Portfolio Management Asset Allocation: The asset allocation decision involves .deciding the percentage of investable funds to be placed in stocks, bonds, and cash equivalents. It is the most important investment decision made by investors, because it is the basic determinant of the return and risk taken. The returns of a well-diversified portfolio within a given asset class are highly correlated with the returns of the asset class itself. Within an asset class, diversified portfolios will tend to produce similar returns over time. However, different asset classes are likely to produce results that ire quite dissimilar. Therefore, differences in asset allocation will be the key factor over time causing differences in portfolio performance. The Asset Allocation Decision: Factors to consider in making the asset allocation decision include the investor's return requirements (current income versus future income), the investor's risk tolerance, and the time horizon. This is done in conjunction with the investment manager's expectations about the Capital markets and about individual assets. How asset allocation decisions are made by investors remains a subject that is not fully understood. It is known that actual allocation decisions often differ widely from how investors say they will allocate assets. Types of Asset Allocation: William Sharpe has outlined several types of asset allocation. If all major aspects of the process have been considered, the process is referred to as integrated asset' allocation. These include issues specific to an investor, particularly the investor's risk tolerance, and issues pertaining to the capital markets, such as predictions concerning expected returns, risks, and correlations. If some of these steps are omitted, the asset allocation approaches are more specialized. Such approaches include: Strategic asset allocation: This type of .allocation is usually done once every fewyears; using simulation procedures to determine the likely range of outcomes associated with each mix. The investor considers the range of outcomes for each mix; and chooses the preferred one, thereby establishing a long-run or strategic asset mix. Tactical asset allocation: This type of allocation is performed routinely, as part ofthe ongoing process of asset management. Changes in asset mixes are driven by changes in predictions concerning asset returns. As predictions of the expected returns on stocks, bonds, and other assets change, the percentages of these assets held in the portfolio changes. In effect, tactical asset allocation is a market timing approach to portfolio management intended to increase exposure to a particular market when its performance is expected to be good and decrease exposure when performance is expected to be poor. Changes in Investor's Circumstances: An investor's circumstances can change for several reasons. These can be easily organized on the basis of the framework for determining portfolio policies outlined above. 231 Investment Analysis & Portfolio Management Change in Wealth: A change in wealth may cause an investor to behave differently, possibly accepting more risk in the case of an increase in wealth, or becoming more risk averse In the case of, a decline in wealth. Change in Time Horizon: Traditionally, we think of investors aging and becoming more conservative in their investment approach. Change in Liquidity Requirements: A need for more current income could increase the emphasis on dividend-paying stocks, whereas a decrease in current income requirements could lead to greater investment in small stocks whose potential payoff may be, years in the future. Change in Tax Circumstances: An investor who moves to a higher tax bracket may find municipal bonds more attractive. Also, the timing of the realization of capital gains can become more important. Change in Legal / Regulatory Considerations: Laws affecting investors change regularly, whether tax laws or laws governing retirement accounts, annuities, and so forth. Change in Unique Needs and Circumstances: Investors face a number of possible changes during their life depending on many economic, social, political, health; and work-related factors. Rebalancing the Portfolio: Even the most carefully constructed portfolio is not intended to remain intact without change. Portfolio managers spend much of their time monitoring their portfolios and doing portfolio rebalancing. The key is to know when arid how to do such rebalancing because a trade-off is involved the cost of trading versus the cost of not trading. The cost of trading involves commissions, possible impact on market price, and. the time involved in deciding to trade. The cost of not trading involves holding positions that are not best suited for the portfolio’s owner, holding positions that violate the asset allocation plan, hording a portfolio that is no longer adequately diversified and so forth. One of the problems involved in rebalancing is the "lock-up" problem. This situation arises in taxable accounts subject to capital gains taxes. Even at low level of turnover the tax liabilities generated can be larger than the gains achieved by the active management driving the turnover. In the absence of taxes, such, as with tax deferred IRA and 401(k) plans, investors would simply seek to hold those securities with the highest risk adjusted expected, rates of return. Performance Measurement: The portfolio management process is designed to facilitate making investment decisions in an organized, systematic manner. Clearly, it is important to evaluate the effectiveness, of the overall decision-making process. The measurement of portfolio performance allows investors to determine the success of the portfolio management process and of the portfolio manager. It is a key part of monitoring the investment strategy that was based on investor objectives, constraints and preferences. Performance measurement is important to both those who employ a professional portfolio manager, on their behalf as, well as to those who invest personal funds. It allows investors to evaluate the risks that are being taken, the reasons for the success or failure of the investing program; and the costs of any restrictions that may have been placed on the 232 Investment Analysis & Portfolio Management investment manager. Unresolved issues remain in performance measurement despite the development of an entire industry to provide data and analyses of expost performance. Nevertheless, it is a critical part of the investment management process, and the logical capstone in its, own right of the entire study of investments. EVALUATION OF INVESTMENT PERFORMANCE Framework for Evaluating Portfolio Performance: When evaluating a portfolio's performance, certain factors must be considered. Assume that in early 2004 you are evaluating the Go Growth mutual fund, a domestic equity fund in the category of large growth (it emphasizes large-capitalization growth stocks). This fund earned a total return of 20 percent for its shareholders for 2003. It claims in an advertisement that it is the #1 performing mutual funds in its category. As a shareholder, you are trying to assess Go Growth’s performance. SOME OBVIOUS FACTORS TO CONSIDER IN MEASURING PORTFOLIO PERFORMANCE: Differential Risk Levels: Based on our discussion throughout this text of the risk-return trade-off that underlies all investment actions, we can legitimately say relatively little about Go Growth’s performance. The primary reason is-that investing is always a two-dimensional process based on both return and risk. These two factors are opposite sides of the same coin, and both must be evaluated if intelligent decisions are to be made. Therefore, if we know nothing about the risk of this fund, little can be said about its performance. After all, Go Growth's managers may have taken twice the risk of comparable portfolios to achieve this 20-percent return. Given the risk that all investors face, it is totally inadequate to consider only the returns from various investment alternatives. Although all investors prefer higher returns, they are also risk averse. To evaluate portfolio performance properly, we must determine whether the returns are large enough given the risk involved. If we are to assess portfolio performance correctly, we must evaluate performance on a risk-adjusted basis. Differential Time Periods: It is not unusual to pick up a publication from the popular press and see two different mutual funds of the same type—for example, small-capitalization growth funds or balanced funds—advertise themselves as the #1 performer. Each of these funds is using a different time period over which to measure performance. For example, one fund could use the 10 years ending December 31, 2003, whereas another fund uses the five years ending June 30, 2003.GoGrowth could be using a one-year period ending on the same date or some other combination of years. Mutual fund sponsors may emphasize different time periods in promoting their performance. Funds can also define the group or index to which comparisons are made. Although it seems obvious when one thinks about it, investors tend not to be careful when making comparisons of portfolios over various time periods. As with the case of differential risk, the time element must be adjusted for if valid performance of portfolio results is to be obtained. Appropriate Benchmarks: A third reason why we can say little about the performance of Go Growth is that it’s 20 percent return given its, risk, is meaningful only when compared to a legitimate alternative. 234 Investment Analysis & Portfolio Management Obviously, if the average-risk fund or the market returned 25 percent in 2003, and Go Growth is an average-risk fund, we would find its performance unfavorable. Therefore, we must make relative comparisons in performance measurement, and an important related issue is the benchmark to be used in evaluating the performance of a portfolio. It is critical in evaluating portfolio performance to compare the returns, obtained on the portfolio being evaluated with the returns that could have been obtained from a comparable alternative. The measurement process must involve relevant and obtainable alternatives; that is, the benchmark portfolio must be a legitimate alternative that accurately reflects the objectives of the portfolio being evaluated. An equity portfolio consisting of Standard & Poor's Composite 500 Index (S&P 500) stocks should be evaluated relative to the S&P 500 index or other equity portfolios that could be constructed from the Index, after adjusting for the risk involved. On the other hand, a portfolio of small-capitalization stocks should not be judged against the benchmark of the S&P 500. Or, if a bond portfolio manager's objective is to invest in bonds rated A or higher, it would be inappropriate to compare his or her performance with that of a junk bond manager. It may be more difficult to evaluate equity funds that hold some mid-cap and small stocks while holding many S&P 500 stocks. Comparisons for this group can be quite difficult. Constraints on Portfolio Managers: In evaluating the portfolio manager rather than the portfolio itself, an investor should consider the objectives set by (or for), the manager and any constraints under which he or she must operate. For example if a mutual fund's objective is to invest in small speculative stocks investors must expect the risk to be larger than that of a fund invested in S&P 500 stocks with substantial swings in the annual realized returns. It is imperative to recognize the importance of the investment policy statement pursued, by a portfolio manager in determining the portfolio's results in many cases he investment policy determines the return and/or the risk of the portfolio. For example, Brinson, Hood, and Bee bower found that for a sample of pension plans the asset allocation decision accounted for approximately 94 percent of the total variation in the returns to these funds. In other words, more than 90 percent of the movement in a fund's returns, relative to the market returns, is attributable to a fund's asset allocation policy. If a portfolio manager is obligated to operate under certain constraints these must be taken into account. For example, if a portfolio manager of an equity fund is prohibited from selling short, it is unreasonable to expect the manager to protect the portfolio in this manner in a bear market. If the manager is further prohibited from trading in options and futures the only protection left in a bear market may be to reduce the equity exposure. Other Considerations: Of course, other important issues are involved in measuring the portfolio's performance, including evaluating the manager as opposed to the portfolio itself if the manager does not have full control over the portfolio's cash flows. It is essential to determine how well diversified the portfolio was during the evaluation period, because, diversification can reduce portfolio risk. 235 Investment Analysis & Portfolio Management All investors should understand that even in today's investment World of computers and databases, exact, precise universally agreed-upon methods of portfolio evaluation remain an elusive goal. One popular press article summarized the extent of the problem by noting that "most investors ... don't have the slightest idea how well their portfolios are actually performing." This article suggests some do-it-yourself techniques as well, as some “store-bought solutions" and discusses some new trends in the money management industry 10 provide investors with better information. Investors can use several "well-known, techniques to assess, the actual performance of a portfolio relative to one or more alternatives. In the final analysis, when investors are selecting money managers to turn their money over to, they evaluate these managers only on the basis of their published performance statistics. If the published "track record" looks good, that is typically enough to convince many investors to invest in, a particular mutual fund. However, the past is no guarantee of an investment manager's future. Short-term results may be particularly misleading. Return and Risk Considerations: Performance measurement begins with portfolio valuations and transactions translated into rate of return. Prior to 1965, returns were seldom related to measures of risk. In. eval-uating portfolio performance, however, investors must consider both the realized return and the risk that was assumed. Therefore, whatever measures or techniques are used these parameters must be incorporated into the analysis. MEASURES OF RETURN: When portfolio performance is evaluated, the investor should be concerned with the total change in wealth. A proper measure of this return is the total return (TR), which captures both the income component and the capital gains (or losses) component of return. Note that the Performance Presentation Standards require the use of total return to calculate performance. In the simplest case, the market value of a portfolio can be measured at the beginning and ending of a period, and the rate of return can be calculated as Rp=VE -VB? VB Where VE is the ending value of the portfolio and VB is its beginning value. This calculation assumes that no funds were added to or withdrawn from the portfolio by the client during the measurement period. If such transactions occur, the portfolio return as calculated, Rp may not be an accurate measure of the portfolio's performance. For example, if the client adds funds close to the end of the measurement period, would produce inaccurate results, because the ending value was not determined by the actions of the portfolio manager. Although a close approximation of portfolio performance might be obtained by simply adding any withdrawals or subtracting any contributions that are made very close to the end of the measurement period, timing issues are a problem. Dollar-Weighted Returns: Traditionally, portfolio measurement consisted of calculating the dollar-weighted rate of return (DWR), which is equivalent to the internal rate of return (IRR) used in several 236 Investment Analysis & Portfolio Management financial calculations. The IRR measures the actual return earned on a beginning portfolio value and on any net contributions made during the period. The DWR equates all cash flows, including ending market value, with the beginning market value of portfolio. Because the DWR is affected by cash flows to the portfolio it measures the rate of return to the portfolio owner. Thus, it accurately measures the investor's return. However because the DRW is heavily affected by cash flows, it is inappropriate to use when making comparisons to other portfolios or to market indexes, a key factor in performance measurement. In other words, it is a misleading measure of the manager's ability, because the manager does not have control over the timing of the cash inflows and outflows. Clearly, if an investor with $1,000,000 allocates these funds to a portfolio manager by providing half at the beginning of the year and half at mid-year, that portfolio value at the end of the year will differ from another manager who received the entire $1,000,000 at the beginning, of the year. This is true even if both managers had the same two 6-month returns during that year. Time-Weighted Returns: In order to evaluate a manager's performance properly, we should use the time-weighted rate of return (TWR). TWRs are unaffected by any cash flows to the portfolio; therefore, they measure the actual rate of return earned by the portfolio manager. We wish to determine how well the-portfolio manager performed regardless of the size or timing of the cash flows. Therefore, the time-weighted rate of return measures the compound rate of growth of the portfolio during the evaluation period. It is calculated by computing the geometric average of the portfolio subperiod returns. That is, we calculate the geometric mean of a set of return relatives (and subtract out the 1.0). Which Measure to Use: The dollar-weighted return and, the time-weighted return, can produce different results, and at times these differences are substantial. In fact, the two will produce identical results only in the case of no withdrawals or contributions during the evaluation period and with all investment income being reinvested. The time-weighted return captures the rate of return actually earned by the portfolio manager, whereas the dollar-weighted return captures the rate of return earned by the portfolio owner. For evaluating the performance of the portfolio manager, the time-weighted return should be used, because he or she generally has no control over the deposits and withdrawals made by the clients. The objective is to measure the performance of the portfolio manager independent of the actions of the client, and this is better accomplished by using the time weighted return. RISK MEASURES: Why can we not measure investment performance on the basis of a properly calculated rate of return measure? After all rankings of mutual funds are often done this way in the popular press, with one-year, three-year, and sometimes five-year returns shown. Are rates of return, or averages, good indicators of performance? Differences in risk will cause portfolios to respond differently to changes in the overall market and should be accounted for in evaluating performance. We now know that the two prevalent measures of risk used in investment analysis are total 237 Investment Analysis & Portfolio Management risk and non-diversifiable or systematic risk. The standard deviation for a portfolio's set of returns can be calculated easily with a calculator or computer and is a measure of total risk. As we know from portfolio theory, part of the total risk can be diversified away. Beta, a relative measure of systematic risk, can be calculated with any number of software programs, However, we must remember that Betas are only estimates of systematic risk. Betas can be calculated using weekly, monthly, quarterly, or annual data, and each will produce a different estimate. Such variations in this calculation could produce differences in rankings which use beta as a measure of risk. Furthermore, betas can be unstable, and they change over time. Risk-Adjusted Measures of Performance: Based on the concepts of capital market theory, and recognizing the necessity to incorporate return and risk into the analysis, three researchers— William Sharpe, Jack Treynor, and Michael Jensen— developed measures of portfolio performance in the 1960s. These measures are often referred to .as the composite (risk-adjusted') measures of portfolio performance, meaning that .they incorporate 'both realized return and risk into the evaluation. These measures are often still used, as evidenced by Morningstar, perhaps the best-known source of mutual fund information, reporting the Sharpe ratio explained below. The Sharpe Performance Measure: William Sharpe, whose contributions to portfolio theory have been previously discussed, introduced a risk-adjusted measure of portfolio performance called the reward–to-variability ratio (RVAR) based on his work in capital market theory. This measure uses a benchmark based on the expost capital market line. This measure can be defined as: RVAR = [TRp - RF] / SDp = excess return / risk TRp = the average TR for portfolio p during some period of time RF = he average risk-free rate of return during the period SDp = the standard deviation of return for portfolio p during the period TRp – RF = the excess return (risk premium) on portfolio p The Treynor Performance Measure: At approximately the same time as Sharpe's measure was developed (the mid-1960s), jack Treynor presented a similar measure called the reward-to-volatility ratio (RVOL) like Sharpe, Treynor sought to relate the return on a portfolio to its risk. Treynor, however, distinguished between total risk and systematic risk, implicitly assuming that portfolios are well diversified; that is, he ignored any diversifiable risk. He used as a benchmark the ex post security market line. In measuring portfolio performance, Treynor introduced the concept of the characteristic line which was used to partition a security's return into its systematic and non-systematic components. It is used in a similar manner with portfolios, depicting the relationship between the returns on a portfolio and those of the market. The slope of the characteristic 238 Investment Analysis & Portfolio Management line measures the relative volatility of the fund's returns. As we know, the slope of this line is the beta coefficient, which is a measure of the volatility (or responsiveness) of the portfolio's returns in relation to those of the market index. Characteristic lines, can be estimated by regressing each portfolio's returns on the market proxy returns using either raw returns for the portfolios and raw proxy returns or excess portfolio returns and excess1 market proxy it turns where the risk-free rate has been subtracted out: The latter method is theoretically better and is used here. Treynor's measure relates the average excess return on the portfolio during some period (exactly the same variable as in the Sharpe measure) to its systematic risk as measured by the portfolio's beta. The reward-to-volatility ratio is: RVOL = [TRp - RF] / ?p = Average excess return on portfolio p ?p = the beta for portfolio p In this case, we are calculating the excess return per unit of systematic risk. As with RVAR, higher values of RVOL indicate better portfolio performance. Portfolios can be ranked on their RVOL, and assuming that the Treynor measure is a correct measure of portfolio performance, the best performing portfolio can be determined. Comparing the Sharpe and Treynor Measures: Given their similarity, when should RVAR or RVOL be used, and. why? Actually, given the assumptions underlying each measure, both can be said to be correct. Therefore, it is usually desirable to calculate both measures for the set of portfolios being evaluated. The choice of which to use could depend on the definition of risk. If an investor thinks it correct to use total risk, RVAR is appropriate; however, if the investor thinks that it is correct to use systematic risk, RVOL is appropriate. What about the rankings of a set of portfolios using the two measures? If the portfolios are perfectly diversified that is, the correlation coefficient between the portfolio return and the market-return is l.0 the rankings –will be identical. For typical large, professionally managed portfolios, such as broad- based equity mutual funds, the two-measures often provide identical, or almost identical, rankings. As the portfolios become less well diversified, the possibility of differences in rankings increases. This leads to the following conclusions about these two measures: RVAR takes into account how well diversified a portfolio was during the measurement period. Differences in rankings between the two measures can result from substantial differences in diversification in the portfolio. If a portfolio is inadequately diversified, its RVOL ranking can be higher than its RVAR ranking. The nonsystematic risk would not affect the RVOL calculation. Therefore, a portfolio with a Jaw amount of systematic risk and a large amount of total risk could show a high RV0L value and a low RVAR; value. Such a difference in ranking results from the substantial difference in the amount of diversification of the portfolio. This analysis leads to an important observation about the Sharpe and Treynor measures. Investors who have all (or substantially all) of their assets in a portfolio of securities should 239 Investment Analysis & Portfolio Management rely more on the Sharpe measure, because it assesses the portfolio's total return in relation to total risk, which: includes any unsystematic risk assumed by the investor. However for those investors, whose portfolio constitutes only one (relatively) small part of their total assets that is, they have numerous other assets systematic risk may well be the relevant risk. In these circumstances, RVOL Is appropriate, because it considers only systematic or non-diversifiable risk. Measuring Diversification: Portfolio diversification is typically measured by correlating the returns on the portfolio with the returns oh the market index, this is accomplished as part of the process of fitting a characteristic, line whereby the' portfolio's returns are regressed: against the market's returns. The square of the correlation coefficient produced as a part of the analysis, called the coefficient of determination, or R2, is used to, denote the degree of diversification. The coefficient, of determination indicates the percentage of the variance in the portfolio's returns that is explained by the market's-returns. If the fund is totally diversified, the R2 will approach 1.0, indicating that the fund's returns are .completely explained by the market's returns: The lower the coefficient of determination, the less the portfolio returns are attributable to the market's returns. This indicates that other factors, which could have been diversified away, are being allowed to .influence-the portfolio's returns. Jensen's Differential Return Measure: A measure related to Treynor’s RVOL is Jensen's differential return measure (or alpha). Jensen's measure of performance like Treynor's measure is based on the capital asset pricing model (CAPM). The expected return for any security (i) or, in this case, portfolio (p) is given as; E (Rpt) = RFt + ?p (E (RMt) – RFt) Problems with Portfolio Measurement: Using the three risk-adjusted performance measures just discussed to evaluate portfolios is not without problems. Investors should understand their limitations, and be guided accordingly. First, these measures are derived from capital market theory and the CAPM and are therefore dependent on the assumptions involved with this theory. For example, it the Treasury bill rate is not a satisfactory- proxy for the risk-free rate, or if investors cannot borrow and lend at the risk-free rate this will have an impact on these measures of performance. An important assumption of capital market theory that directly affects the use of these performance measures is the assumption of a marker portfolio that can be proxied by a market index. We have used the S&P 500 Index as a market proxy, as is often. However, there are potential problems. Although a high correlation exists among most of the commonly used market proxies this does not eliminate the problem that some may be efficient but others are not. According to Roll, no unambiguous test of the CAPM has yet been conducted. This point should be kept in mind when we consider performance measures based on the CAPM, such as the Treynor and Jensen; measures. 240 Investment Analysis & Portfolio Management The movement to global investing increases the problem of benchmark error. The efficient frontier changes when foreign securities are added to the portfolio. The measurement of beta will be affected by adding foreign securities. Given that a world portfolio is likely to have a smaller variance than the S&P 500 Index, any measure of systematic risk is likely to be smaller. A long evaluation period is needed to determine successfully performance that is truly superior. Over short .periods, luck can overshadow all else, but luck cannot be expected to continue. According to some estimates, the number of years needed to make such an accurate determination is quite large. OTHER ISSUES IN PERFORMANCE EVALUATION: Monitoring Performance: Portfolio evaluation of managed portfolios should be a continuing process. The results of the portfolio must be calculated using some of the techniques discussed above. In addition, a monitoring process should evaluate the success of the portfolio relative to the objectives and constraints of the portfolio's owners. Performance Attribution: Most of this chapter has considered how to measure a portfolio manager's performance. However, portfolio evaluations also to concern with the reasons why a manager did better or worse than a properly constructed benchmark with complete risks adjustment. This part of portfolio evaluation is called performance attribution, which seeks to determine, after the fact, why a particular portfolio had a given return over some specified time period and, therefore, why success or failure occurred. Typically, performance attribution is a top-down approach; it looks first at the broad issues and progresses by narrowing the investigation its purpose is to decompose the total performance of a portfolio into specific components that can be associated with specific decisions made by the portfolio manager. . Performance attribution often begins with, the policy statement that guides the management of the portfolio; the portfolio normally would have a set of portfolio weight to be used. If the manager uses a different set, this will account for some of the results. In effect, we are looking at the asset allocation decision. If the manager chooses to allocate portfolio funds differently than the weights that occur in the benchmark portfolio, what are the results? After this analysis performance attribution might analyze sector (industry) selection and security selection. Did the manager concentrate on or avoid certain sectors, and if so what were the results? Security selection speaks for itself. Part of this process involves identifying-a benchmark of performance to use in comparing the portfolio results. This bogey is designed to measure passive results, ruling out both asset allocation and security selection decisions. Any differences between the portfolio's results and the bogey must be attributable to one or more of these decisions made by the portfolio manager. Another way to think about performance attribution is to recognize that performance 241 Investment Analysis & Portfolio Management different from a properly constructed benchmark comes from one of two sources, or both: Market timing Security selection Techniques are available to decompose the performance of a portfolio into these two components. THE ROLE OF DERIVATIVE ASSETS A Banker and corporate treasure perambulate past in pet shop window and spy a dog for sale. The banker buys it for $5, then sells it to treasure for $10. A few days later, the banker wants it back, so he bids $20. The dog keeps changing hand until the banker buys it for $1 million. Then the dog escapes from the bank and is killed by a car. The treasurer is furious: “Couldn’t you have been more careful?” he complains to the banker. “Don’t you realize how much money we were making in that dog?” INTRODUCTION: Derivative assets get their name from the fact that their value derives from some other asset. A coupon for a free Big Mac is not inherently valuable; the paper on which it is printed is virtually worthless. We all agree that the coupon is valuable for what it represents: the chance to get a $ 2.50 sandwich for nothing. The coupon is a simple derivative asset. The best- known derivative assets are futures and options are the focus of this chapter. Many other kinds of derivative assets, such as swaps, swaptions, and inverse floaters, have vastly different risk characteristics. Plain vanilla derivative assets are enormously useful to corporate treasurers, mutual funds, endowments, pension funds, and financial institutions. At the same time, they are widely misunderstood by the general public, by Congress, and by many people in the investment business (including many who should know better). Ralph Mercer, writing in Global Finance, states, “The adoption of generic term ‘derivative’ (i.e., derived from something else’) to describe a complex spectrum of financial products, was a public relation disaster.” Derivatives are not all the same; some are inherently speculative, some are highly conservative. BACKGROUND: The Rationale for Derivative Assets: The first organized derivatives exchange in the United States was probably the Chicago Board of Trade, founded in 1848. This future exchange developed in order to bring stability in agricultural prices. The farmer’s problem is easy to understand. Everyone’s wheat was harvested at essentially the same time. As it arrived at market in quantity, principles of economics prevailed. The huge supply caused prices to decline sharply, with the decline aggravated by farmers who sold “at any price” for fear they would not be able to sell at all. Later, during the winter, prices rose because of consistent demand in the face of dwindling supply. The future market enabled farmers to eliminate or reduce their price risk, the risk of not knowing the ultimate proceeds from the sale of their crops. It serves this same function today. Using futures, the farmers could (if they wished) promise to deliver their crop in the future at a known a price, thereby reducing anxiety and promoting market stability. Of equal importance is the fact that financial managers can use derivatives to eliminate the price risk of their stock, bond, and foreign currency portfolios or obligations. Today’s communication technology brings us virtually instantaneous information about events such as earthquakes in Turkey, airline accidents, world trade balances, and Federal Reserve Board interest rate activity. These events influence the value of our investments. Experienced investors are seldom 100 percent bullish or 100 percent bearish. The constant 243 Investment Analysis & Portfolio Management arrival of new information means the investment process is dynamic. Positions need to be constantly reassessed and portfolios adjusted. DERIVATIVE ASSETS AND THE NEWS: Current Events: Newspapers in recent years have been full of reports on various businesses that have lost billions “investing in derivatives.” Orange county, California; Proctor and Gamble; Metalgesellschaft; Gibson Greeting Cards are a few of firms receiving particularly voluminous press coverage. Brokerage firms have been deluged with calls from individuals asking if there are any “derivatives” in their account. Reminiscent of Seven Up’s “no caffeine” advertising that infuriated the soft drink industry a number of years ago and set off the subsequent caffeine-free range, some money market mutual funds bill themselves as “derivative free.” Difficulty in educating the user is a perennial problem in the investments business. It is hard enough to get the typical citizen to understand that stock pays dividends, not interest and that you can sell abound before its 30-year life is up. Puts, calls, futures, and other derivatives is the outside the vocabulary of all but the best informed. Bonds, in fact, provide a good example of quandary in which rational people might find themselves immersed during a discussion of derivatives. Suppose a county treasure bond $1 million par value pf the principal portion of the stripped U.S. Treasury bond as a long-term investment, full expecting to hold the bond for its 30-year life. Risk of Derivative Assets: One of the most important things a finance professional can learn about derivative asset is that they neutral products. Futures and options are not inherently risky, dangerous, inappropriate, or anything else. Their risk depends on what an investor does with them. A person responsible for the management of someone else’s money has a fiduciary responsibility to act prudently. Legal experts in this area have struggled for years with the fact that the term speculation is almost impossible to define adequately. People will agree that church endowment funds, the YWCA, and public library should not “speculate” with entrusted funds, but there is no consensus on what it means. Some books say that a speculation is anything accompanied by a chance of loosing money. If this definition is accepted, then common stock is an ineligible investment, because the stock market certainly experiences ups and downs. Almost, everyone recognizes the necessity of equities in long-term portfolios, so this definition is unsatisfactory. The same definitional problem plagues the user of derivative assets. The public overwhelmingly views futures and options as “super risky” even though few folks with this opinion ca tell you what they are. You can explain that insurance policies, adjustable rate mortgages, and football tickets are derivative assets, but, as the philosopher said, “To prove the thing is not enough; you must convince someone to accept it.” We will see in the following chapters that futures and options make life much simpler for portfolio managers and that policies precluding their use are usually ill conceived. Listed vs. Over-the-Counter Derivatives: 244 Investment Analysis & Portfolio Management Before ending this discussion, one more point needs to be made. There is a world of difference between an exchange-traded asset and one created as a private transaction between two parties. An APR Microsoft call from the Chicago Board Options Exchange, for instance, is a listed option. As such, it has standardized characteristics, is guaranteed by the Options Clear Corporations, is fungible and can be quickly traded if desired. The vast majority, if not all, of the derivative horror stories deal with derivatives that are not exchange- traded. They are called over-the-counter derivatives. A large, multinational firm might approach several money center banks and ask each to design and price a product carefully defined degree of protection against market risk, interest rate risk, and foreign exchange rate risk. Each of the banks wants to provide the service, and each knows that other institutions are bidding on the job. One of the fascinating things about the derivatives business is that a product can be built for the client in many different ways. One version might be sturdy (and expensive), capable of withstanding volatility and unexpected shocks in the marketplace. Another product might be much less expensive, but prone to explode into a million pieces if the market moves too much in the wrong direction. Often the client lacks the sophistication to understand these differences, and buys the product largely on the basis of the lower cost. Unexpectedly large increases in interest rates caused this latter situation to occur with the derivative products used by the unlucky firms of the 1990s newspapers headlines. As investor can still get in trouble with inappropriate use of listed derivative. Outright speculation is always dangerous, and leverage should be used judiciously. Still a well-conceived derivatives strategy is part of good management at many businesses. Risk is a fact of life, and derivatives are a helpful tool in dealing with it. We don’t like fires, but that should not mean we hate the fire department.