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  • 1. Finance McGrawHill Primis ISBN: 0390320021 Text: Investments, Fifth Edition BodieKaneMarcus Course: Investments Instructor: David Whitehurst UMIST Volume 2 McGraw-Hill/Irwin abc

2. Finance Copyright 2003 by The McGrawHill Companies, Inc. All rights reserved. Printed in the United States of America. Except as permitted under the United States Copyright Act of 1976, no part of this publication may be reproduced or distributed in any form or by any means, or stored in a database or retrieval system, without prior written permission of the publisher. This McGrawHill Primis text may include materials submitted to McGrawHill for publication by the instructor of this course. The instructor is solely responsible for the editorial content of such materials. 111 FINA ISBN: 0390320021 This book was printed on recycled paper. 3. Finance Volume 2 BodieKaneMarcus Investments, Fifth Edition VII. Active Portfolio Management 919 27. The Theory of Active Portfolio Management 919 Back Matter 942 Appendix A: Quantitative Review 942 Appendix B: References to CFA Questions 978 Glossary 980 Name Index 992 Subject Index 996 iii 4. BodieKaneMarcus: Investments, Fifth Edition VII. Active Portfolio Management 27. The Theory of Active Portfolio Management 919 The McGrawHill Companies, 2001 C H A P T E R T W E N T Y S E V E N THE THEORY OF ACTIVE PORTFOLIO MANAGEMENT Thus far we have alluded to active portfolio management in only three instances: the Markowitz methodology of generating the optimal risky portfolio (Chapter 8); security analysis that generates forecasts to use as inputs with the Markowitz pro- cedure (Chapters 17 through 19); and fixed-income portfolio management (Chap- ter 16). These brief analyses are not adequate to guide investment managers in a comprehensive enterprise of active portfolio management. You may also be won- dering about the seeming contradiction between our equilibrium analysis in Part IIIin particular, the theory of ef- ficient marketsand the real-world environment where profit-seeking in- vestment managers use active manage- ment to exploit perceived market inefficiencies. Despite the efficient market hypoth- esis, it is clear that markets cannot be perfectly efficient; hence there are rea- sons to believe that active management can have effective results, and we dis- cuss these at the outset. Next we con- sider the objectives of active portfolio management. We analyze two forms of active management: market timing, which is based solely on macroeconomic factors; and security selection, which in- cludes microeconomic forecasting. We show the use of multifactor models in ac- tive portfolio management, and we end with a discussion of the use of imperfect forecasts and the implementation of security analysis in industry. 916 5. BodieKaneMarcus: Investments, Fifth Edition VII. Active Portfolio Management 27. The Theory of Active Portfolio Management 920 The McGrawHill Companies, 2001 CHAPTER 27 The Theory of Active Portfolio Management 917 27.1 THE LURE OF ACTIVE MANAGEMENT How can a theory of active portfolio management be reconciled with the notion that mar- kets are in equilibrium? You may want to look back at the analysis in Chapter 12, but we can interpret our conclusions as follows. Market efficiency prevails when many investors are willing to depart from maximum diversification, or a passive strategy, by adding mispriced securities to their portfolios in the hope of realizing abnormal returns. The competition for such returns ensures that prices will be near their fair values. Most managers will not beat the passive strategy on a risk- adjusted basis. However, in the competition for rewards to investing, exceptional managers might beat the average forecasts built into market prices. There is both economic logic and some empirical evidence to indicate that exceptional portfolio managers can beat the average forecast. Let us discuss economic logic first. We must assume that if no analyst can beat the passive strategy, investors will be smart enough to divert their funds from strategies entailing expensive analysis to less expensive passive strategies. In that case funds under active management will dry up, and prices will no longer reflect sophisticated forecasts. The consequent profit opportunities will lure back ac- tive managers who once again will become successful.1 Of course, the critical assumption is that investors allocate management funds wisely. Direct evidence on that has yet to be produced. As for empirical evidence, consider the following: (1) Some portfolio managers have produced streaks of abnormal returns that are hard to label as lucky outcomes; (2) the noise in realized rates is enough to prevent us from rejecting outright the hypothesis that some money managers have beaten the passive strategy by a statistically small, yet eco- nomically significant, margin; and (3) some anomalies in realized returns have been suffi- ciently persistent to suggest that portfolio managers who identified them in a timely fashion could have beaten the passive strategy over prolonged periods. These conclusions persuade us that there is a role for a theory of active portfolio man- agement. Active management has an inevitable lure even if investors agree that security markets are nearly efficient. Suppose that capital markets are perfectly efficient, that an easily accessible market- index portfolio is available, and that this portfolio is for all practical purposes the efficient risky portfolio. Clearly, in this case security selection would be a futile endeavor. You would be better off with a passive strategy of allocating funds to a money market fund (the safe asset) and the market-index portfolio. Under these simplifying assumptions the opti- mal investment strategy seems to require no effort or know-how. Such a conclusion, however, is too hasty. Recall that the proper allocation of investment funds to the risk-free and risky portfolios requires some analysis because y, the fraction to be invested in the risky market portfolio, M, is given by (27.1) where E(rM) rf is the risk premium on M, 2 M its variance, and A is the investors coeffi- cient of risk aversion. Any rational allocation therefore requires an estimate of M and E(rM). Even a passive investor needs to do some forecasting, in other words. Forecasting E(rM) and M is further complicated by the existence of security classes that are affected by different environmental factors. Long-term bond returns, for example, are y E(rM) rf .01A2 M 1 This point is worked out fully in Sanford J. Grossman and Joseph E. Stiglitz, On the Impossibility of Informationally Efficient Markets, American Econonic Review 70 (June 1980). 6. BodieKaneMarcus: Investments, Fifth Edition VII. Active Portfolio Management 27. The Theory of Active Portfolio Management 921 The McGrawHill Companies, 2001 driven largely by changes in the term structure of interest rates, whereas equity returns de- pend on changes in the broader economic environment, including macroeconomic factors beyond interest rates. Once our investor determines relevant forecasts for separate sorts of investments, she might as well use an optimization program to determine the proper mix for the portfolio. It is easy to see how the investor may be lured away from a purely passive strategy, and we have not even considered temptations such as international stock and bond portfolios or sector portfolios. In fact, even the definition of a purely passive strategy is problematic, because simple strategies involving only the market-index portfolio and risk-free assets now seem to call for market analysis. For our purposes we define purely passive strategies as those that use only index funds and weight those funds by fixed proportions that do not vary in response to perceived market conditions. For example, a portfolio strategy that always places 60% in a stock marketindex fund, 30% in a bond-index fund, and 10% in a money market fund is a purely passive strategy. More important, the lure into active management may be extremely strong because the potential profit from active strategies is enormous. At the same time, competition among the multitude of active managers creates the force driving market prices to near efficiency levels. Although enormous profits may be increasingly difficult to earn, decent profits to the better analysts should be the rule rather than the exception. For prices to remain effi- cient to some degree, some analysts must be able to eke out a reasonable profit. Absence of profits would decimate the active investment management industry, eventually allow- ing prices to stray from informationally efficient levels. The theory of managing active portfolios is the concern of this chapter. 27.2 OBJECTIVES OF ACTIVE PORTFOLIOS What does an investor expect from a professional portfolio manager, and how does this ex- pectation affect the operation of the manager? If the client were risk neutral, that is, indif- ferent to risk, the answer would be straightforward. The investor would expect the portfolio manager to construct a portfolio with the highest possible expected rate of return. The port- folio manager follows this dictum and is judged by the realized average rate of return. When the client is risk averse, the answer is more difficult. Without a normative theory of portfolio management, the manager would have to consult each client before making any portfolio decision in order to ascertain that reward (average return) is commensurate with risk. Massive and constant input would be needed from the client-investors, and the economic value of professional management would be questionable. Fortunately, the theory of mean-variance efficient portfolio management allows us to separate the product decision, which is how to construct a mean-variance efficient risky portfolio, and the consumption decision, or the investors allo