active portfolio management and portfolio construction

  • Published on
    17-Dec-2016

  • View
    212

  • Download
    0

Embed Size (px)

Transcript

<ul><li><p>MASTER THESIS, FALL 2012CAND.MERC. APPLIED ECONOMICS AND FINANCE</p><p>COPENHAGEN BUSINESS SCHOOL</p><p>AUTHOR: JOHAN CHRISTIAN HILSTEDDATE OF SUBMISSION: DECEMBER 14TH 2012</p><p>ACTIVE PORTFOLIO MANAGEMENT AND PORTFOLIO CONSTRUCTION</p><p>- IMPLEMENTING AN INVESTMENT STRATEGY</p><p>SUPERVISOR: JEPPE SCHOENFELDT</p><p>NUMBER OF PAGES: 77</p><p>NUMBER OF CHARACTERS: 145.260</p><p>SIGNATURE: </p></li><li><p>Active Portfolio Management and Portfolio Construction Implementing an Investment Strategy </p><p>1 </p><p>Abstract </p><p>This thesis aims at creating an investment strategy for active portfolio management to outperform the </p><p>MSCI Denmark from 1992 to 2011. The index development of the Danish stock market has been quite </p><p>impressive as it has performed remarkably better than other national indices. It is therefore interesting </p><p>to investigate whether active portfolio management constitutes a winning strategy superior to investing </p><p>in the MSCI Denmark. </p><p>There is no generally accepted approach to conduct active portfolio management. This thesis approaches </p><p>the subject by comparing two internationally diversified portfolios to the MSCI Denmark as benchmark - </p><p>one portfolio submitted to a 20% maximum asset representation restriction, the other portfolio left </p><p>unrestricted. </p><p>From investment strategy we conclude that combining strategic and tactical asset allocation constitutes </p><p>an appropriate investment strategy for active portfolio management, as it limits the long-term portfolio </p><p>investment opportunities and allows for short-term portfolio repositioning. The information ratio </p><p>constitutes the performance measure of active portfolio management, as it optimizes portfolio </p><p>construction by comparing expected returns of portfolio and benchmark the residual return. The Capital </p><p>Assets Pricing Model (CAPM) was utilized for return estimations for both investment opportunities and </p><p>benchmark. Mean-variance portfolio construction was conducted based upon investment opportunities </p><p>expected to outperform the benchmark. </p><p>The MSCI Denmark provides realized average monthly return of 0,65%, while the actively managed </p><p>portfolios produce average realized monthly return of 0,34% and 0,37%, respectively. In that regard, </p><p>active portfolio management has not outperformed the benchmark, and statistical findings cannot suggest </p><p>portfolio timing skill. However, considering the systematic risk adjusted return, both portfolios yield </p><p>significant alpha, or value added, with the unrestricted portfolio being the best performing portfolio. </p><p>In conclusion, active portfolio management cannot produce higher return than the MSCI Denmark, but has </p><p>proven to benefit the investor, as the market risk exposure justifies both inferior and superior portfolio </p><p>return to the benchmark. </p></li><li><p>Active Portfolio Management and Portfolio Construction Implementing an Investment Strategy </p><p>2 </p><p>Table of Contents </p><p>Abstract .......................................................................................................................................... 1 </p><p>1. Introduction ................................................................................................................................ 4 </p><p>1.1 Research Objectives ................................................................................................................................... 6 </p><p>1.1.1 Superior Research Objective ................................................................................................................... 6 </p><p>1.1.2 Subordinate Research Objectives ........................................................................................................... 6 </p><p>1.2 Structure of Thesis...................................................................................................................................... 7 </p><p>1.3 Methodology .............................................................................................................................................. 8 </p><p>1.3.1 Financial Assets and Risk ......................................................................................................................... 8 </p><p>1.3.2 Applied Theoretical Approach ............................................................................................................... 10 </p><p>1.3.3 Interviews .............................................................................................................................................. 11 </p><p>1.4 Assumptions and limitations .................................................................................................................... 12 </p><p>1.4.1 Assumptions .......................................................................................................................................... 12 </p><p>1.4.2 Limitations ............................................................................................................................................. 13 </p><p>1.5 Data .......................................................................................................................................................... 14 </p><p>1.5.1 Equity Sector Return Data ..................................................................................................................... 14 </p><p>2.Investment Strategy ................................................................................................................... 18 </p><p>2.1 Investment Strategy as the Source of Portfolio Performance ................................................................. 18 </p><p>2.2 Strategic Asset Allocation ......................................................................................................................... 19 </p><p>2.2.1 Discussing Empirical Findings and Brinson et.al. ................................................................................... 21 </p><p>2.3 Tactical Asset Allocation ........................................................................................................................... 23 </p><p>2.4 Professional Views upon Asset Allocation ............................................................................................... 24 </p><p>2.5 Benchmark and Investment Opportunities .............................................................................................. 25 </p><p>2.5.1 Benchmark............................................................................................................................................. 26 </p><p>2.5.2 Investment Opportunities ..................................................................................................................... 27 </p><p>2.6 Crafting the Investment Strategy ............................................................................................................. 30 </p><p>3.Active Portfolio Management ..................................................................................................... 33 </p><p>3.1 Defining Active Portfolio Management .................................................................................................... 33 </p><p>3.2 Performance Measure and Portfolio Added Value .................................................................................. 34 </p><p>3.2.1 Information Ratio .................................................................................................................................. 34 </p><p>3.2.2 Portfolio Value Added ........................................................................................................................... 35 </p></li><li><p>Active Portfolio Management and Portfolio Construction Implementing an Investment Strategy </p><p>3 </p><p>4.Risk and Return in Active Portfolio Management ........................................................................ 38 </p><p>4.1 Expected Return in Active Portfolio Management .................................................................................. 38 </p><p>4.1.1 Asset Pricing in an Active Setting .......................................................................................................... 38 </p><p>4.2 Risk Management ..................................................................................................................................... 46 </p><p>4.2.1 Investor Utility ....................................................................................................................................... 47 </p><p>4.2.2 Professional Views upon Risk and Risk Management ........................................................................... 47 </p><p>4.2.3 Risk Management and Risk Factors ....................................................................................................... 48 </p><p>4.2.4 Financial Risk ......................................................................................................................................... 49 </p><p>5.Portfolio Construction ................................................................................................................ 51 </p><p>5.1 Objective of Portfolio Construction ......................................................................................................... 51 </p><p>5.2 Choice of Portfolio Model ........................................................................................................................ 51 </p><p>5.3 Mean-Variance Application in an Active Setting ...................................................................................... 52 </p><p>5.3.1 The Model ............................................................................................................................................. 53 </p><p>5.3.2 Model Short-Comings ............................................................................................................................ 55 </p><p>5.3.3 Portfolio Repositioning and Transaction Costs ..................................................................................... 60 </p><p>5.4 Model Performance ................................................................................................................................. 63 </p><p>5.4.1 Sector Distribution ................................................................................................................................ 63 </p><p>6.Performance Evaluation of the Investment Strategy ................................................................... 67 </p><p>6.1 Return-Based Performance Analysis ........................................................................................................ 67 </p><p>6.1.1 Cross-Sectional Comparison .................................................................................................................. 67 </p><p>6.1.2 Market Timing ....................................................................................................................................... 69 </p><p>6.2 Analysis of Value Added ........................................................................................................................... 71 </p><p>7.Conclusion ................................................................................................................................. 75 </p><p>8.References ................................................................................................................................. 78 </p><p>9.Appendix Overview .................................................................................................................... 81 </p><p>Appendix 1: Glossary ...................................................................................................................................... 82 </p><p>Appendix 2: Sector Market Value and Correlation Matrix of Sector Return ................................................. 86 </p><p>Appendix 3: Interview Guide .......................................................................................................................... 87 </p><p>Appendix 4: Active Return and Testing for Return Stationarity..................................................................... 89 </p><p>Appendix 5: Expected Residual Return .......................................................................................................... 95 </p><p>Appendix 6: Portfolio Positions of Investment Opportunities ....................................................................... 97 </p></li><li><p>Active Portfolio Management and Portfolio Construction Implementing an Investment Strategy </p><p>4 </p><p>1. Introduction A common objective of the portfolio investor is to achieve a higher portfolio risk adjusted return as </p><p>opposed to investment in a single asset. Combining assets into a portfolio carries the opportunity of risk </p><p>reduction and at the same time acquiring a higher return compared to single asset investment. </p><p>As financial markets experience different phases, different regimes reside in the markets and many </p><p>investment portfolios incur both losses and gains if it is not managed in accordance with the investors </p><p>expectations to future market developments. For long-term investments such as pension investments, </p><p>incurring losses in the short term is of little concern as the investment time frame allows for the </p><p>opportunity to reduce such losses by gaining future positive returns. However, for some investors, in </p><p>practice, this is not a feasible strategy since they are constrained by consumptions and liabilities. </p><p>Accordingly, investors need to liquidate some of their investments in order to fulfill financial needs and </p><p>obligations. In other words, the investor buys and sells stocks, and the basis of this decision is the </p><p>conviction that abnormal investment returns can be gained. However, the efficient market hypothesis, </p><p>which can be traced back to Samuelson (1965) and Farma (1970), states that market prices incorporate all </p><p>information rationally and instantaneously, eliminating the possibility for the investor to achieve abnormal </p><p>returns and should this hypothesis hold in practice, the only optimal portfolio strategy would be to </p><p>conduct portfolio investment and hold the portfolio throughout a predetermined time frame1 2. </p><p>However, assuming stock markets are not efficient, in terms of market paradigm we turn to the adaptive </p><p>market hypothesis by Lo (2004) who acknowledges the problematic issue of the assumption of market </p><p>efficiency3. This paradigm carries some implications that necessitate portfolios to be actively managed. </p><p>First, a relationship between asset risk and return exists, but is unlikely to be stable over time. Second, </p><p>arbitrage opportunities arise over time. A third implication is that investment strategies might not perform </p><p>equally well in different economic environments. A fourth implication is survival, which is enabled by </p><p>evolving markets and financial technology. This thesis will not seek to investigate the extent of these </p><p>implications but yields an important conclusion: a portfolio has to be actively managed. The most </p><p> 1 Samuelson (1965): p. 43 </p><p>2 Farma (1970): p. 383 </p><p>3 Lo (2004): p. 18 </p></li><li><p>Active Portfolio Management and Portfolio Construction Implementing an Investment Strategy </p><p>5 </p><p>important reasons are the changing market behavior, and the advances in market research...</p></li></ul>