UChicago BUSE 30130 - 2018_L2_R51_SS17_pt2 (6 pages)

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2018_L2_R51_SS17_pt2



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2018_L2_R51_SS17_pt2

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6
School:
University of Chicago
Course:
Buse 30130 - Financial Statement Analysis
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Fixed Income Investments LOS 51 c Describe Analysis of Active Portfolio Management The Fundamental Law of Active Management Portfolio Management Economic Analysis Active Management and Trading Three components affecting expected information ratio 1 Information coefficient IC Measures manager skill 51 Analysis of Active Portfolio Management Part 2 Expected correlation between active returns and forecast active returns ex ante IC Ex post IC measures actual correlation between active returns and forecast active returns Typically ex ante IC has small positive values 0 2 26 Kaplan Inc LOS 51 c Describe LOS 51 c Describe Analysis of Active Portfolio Management The Fundamental Law of Active Management Correlation between actual active weights Wi and optimal active Wi weights Wi TC 1 for unconstrained portfolios TC 1 w constraints Wi and Wi will differ Number of independent bets forecasts of active return Kaplan Inc Forecast active return of asset i i i2 A N i2 2 Active portfolio risk std dev of active return Forecast active return of asset i squared i 1 i Forecast volatility of the active return of asset i Optimal weights positively related to forecast active 3 Breadth BR The Fundamental Law of Active Management Optimal weight of asset i 2 Transfer coefficient TC Analysis of Active Portfolio Management 27 Kaplan Inc return and negatively related to forecast active risk 28 1 LOS 51 c Describe LOS 51 c Describe Analysis of Active Portfolio Management Analysis of Active Portfolio Management Grinold 1994 Rule Ex ante IC Forecast active return of asset i The Fundamental Law Expected active portfolio return E R A Basic Fundamental Law i IC iSi E RA IC BR A Standardized scores with assumed variance 1 IR IC BR Full Fundamental Law 29 LOS 51 c Describe IR TC IC BR Constrained portfolios TC 1 actual weights optimal weights LOS 51 c Describe Analysis of Active Portfolio Management The Full Fundamental Law Optimal Level of Active Risk Constrained portfolios Actual security weights optimal weights TC 1 SRP2 SRB2 IR2 TC risk weighted correlation between optimal active weights and actual active weights RA TC COR Wi i Wi i IR RB SRB SRP2 SRB2 TC 2 IR 2 or TC Correlation wi i i i Kaplan Inc 30 Kaplan Inc Analysis of Active Portfolio Management i 1 Unconstrained portfolios TC 1 optimal weights E RA TC IC BR A Kaplan Inc N Wi i RA TC 31 Kaplan Inc IR RB SRB Sharpe ratio and optimal active risk for unconstrained portfolios Sharpe ratio and optimal active risk for constrained portfolios 32 2 LOS 51 c Describe LOS 51 c Describe Analysis of Active Portfolio Management Analysis of Active Portfolio Management Ex post Performance Measurement Clarke de Silva and Thorley 2005 Ex post decomposition of realized active return variance Conditional expected active return Two components E RA ICR TC ICR BR A 1 Variation due to realized IC TC2 Note that realized information coefficient forecasting skill over the period replaces the expected IC Actual active return conditional active return noise RA E RA ICR Noise Results from constraints to optimal portfolio structure 33 Kaplan Inc LOS 51 d Explain 2 Variation due to constraint induced noise 1 TC2 With a TC 0 8 64 of variation in performance is attributed to the variation in the realized IC and 36 comes from constraint induced noise LOS 51 e Compare Evaluate Analysis of Active Portfolio Management Analysis of Active Portfolio Management The Information Ratio and Manager Selection Investor chooses a combination of optimal risky portfolio and risk free asset depending on their risk tolerance Optimal risky portfolio portfolio with highest Sharpe ratio Comparison of Active Management Strategies Market timing versus security selection Information coefficient of a market timer N IC 2 C 1 N The actively managed portfolio with the highest information ratio will have the highest Sharpe ratio Given an information ratio and target level of active risk expected active return can be determined Kaplan Inc 34 Kaplan Inc E RA IR A 35 NC is the number of correct bets out of N bets made on the direction of the market Note that a market timer that is only correct about the direction of the market or a sector half the time will have an IC 0 Kaplan Inc 36 3 LOS 51 e Compare Evaluate LOS 51 e Compare Evaluate Analysis of Active Portfolio Management Analysis of Active Portfolio Management Example Active Management Strategies Solution Active Management Strategies Ben Dash a market timer makes bets on the direction of the market and is correct 53 of the time Ricardo Nunos a security selector makes monthly bets on 10 stocks with an information coefficient of 0 04 Nunos s IR IC BR 0 04 10 12 0 438 Dash s IC 2 correct 1 2 0 53 1 0 06 0 06 BR 0 438 0 438 BR 0 06 Both investors are unconstrained Calculate the number of bets Dash needs to make to match the information ratio of Nunos 37 Kaplan Inc LOS 51 e Compare Evaluate 2 Kaplan Inc 0 438 0 06 BR 53 29 approximately 53 38 LOS 51 e Compare Evaluate Analysis of Active Portfolio Management Note this is just correct incorrect bets Analysis of Active Portfolio Management Sector Rotation Sector Rotation Example Sector rotation applies market timing to rotate money into sectors expected to outperform other sectors Jeanette Grey makes monthly bets between the information technology and energy sectors She gives an overweighted sector a score of 1 and underweighted 1 By implication overweighting the IT sector implies underweighting the energy sector and visa versa Historically the return correlation between the sectors has been 0 4 and Jeanette has been correct 65 of the time In a two sector world healthcare and utilities 2 2 C healthcare 2 health utilitiesrhealth utilities utilities 1 2 C combined active risk Annualized active risk A C BR Annualized active return E RA IC BR C Kaplan Inc Use the data on the next slide to compute annualized active risk of the strategy and annualized expected return 39 Kaplan Inc 40 4 LOS 51 e Compare Evaluate LOS 51 e Compare Evaluate Analysis of Active Portfolio Management Analysis of Active Portfolio Management Sector Rotation Example Sector Rotation Solution Volatility of differential returns Quarterly Sector E R Benchmark Weight IT Energy 12 8 5 3 60 40 0 05 2 C IT2 2 IT EnergyrIT Energy Energy C 2 2 0 05 0 03 0 4 0 03 2 C 0 0469 or 4 69 per quarter month Five years of quarterly data 1 2 1 2 Annualized active risk 0 0469 4 9 38 41 Kaplan Inc LOS 51 e Compare Evaluate 42 Kaplan Inc LOS 51 e Compare Evaluate Analysis of


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