Advanced Portfolio Management
ADMS 4501 – Winter 2012 – Lois King
Lecture 11 – Chapter 15 – Equity P/M Strategies – Mar 22
- Passive investment management
o Long-term buy-and-hold strategy.
o Usually tracks and index over time.
o Designed to match market performance.
o Manager is judged on how well they track the target index.
- Active equity portfolio management
o Attempts to outperform a passive benchmark portfolio on a risk-adjusted
basis by seeking the ‘alpha’ value.
Passive Equity Portfolio Management Strategies
- Attempt to replicate the performance of an index.
o May slightly underperform the target index due to fees and commissions.
- Strong rationale for this approach.
o Costs of active management (1 to 2%) are hard to overcome in risk-
- Many different market indexes are used for tracking portfolios.
Index Portfolio Construction Techniques
- Full replication
o All securities in the index are purchased in proportion to weights in the
o This helps ensure close tracking.
o Increases transaction costs, particularly with dividend reinvestment.
o Buys a representative sample of stocks in the benchmark index according
to their weights in the index.
o Fewer stocks means lower commissions.
o Reinvestment of dividends is less difficult.
o Will not track the index as closely, so there will be some tracking error.
- Quadratic optimization (or programming techniques)
o Historical information on price changes and correlations between
securities are input into a computer program that determines the
composition of a portfolio that will minimize tracking error with the
o Relies on historical correlations, which may change over time, leading to
failure to track the index.
Tracking Error and Index Portfolio Construction
- The goal of the passive manager should be to minimize the portfolio’s return
volatility relative to the index, i.e. to minimize tracking error. Methods of Index Portfolio Investing
- Index fund
o In an indexed portfolio, the fund manager will typically attempt to replicate
the composition of the particular index exactly or through sampling.
o Change those positions anytime the composition of the index itself is
o Low trading and management expense ratios.
o Advantage: provide an inexpensive way for investors to acquire a
o Depository receipts that give investors a pro rata claim on the capital gains
and cash flows of the securities that are held in deposit by a financial
institution that issued the certificates.
o One big advantage of ETFs over index mutual funds is that they can be
bought and sold (and short sold) like common stock.
Active Equity Portfolio Management Strategies
- Goal is to earn a portfolio return that exceeds the return of a passive benchmark
portfolio, net of transaction costs, on a risk-adjusted basis (‘alpha’).
o Need to select an appropriate benchmark.
- Practical difficulties of active manager.
o Transactions costs must be offset by superior performance vis-à-vis the
o Higher risk-taking can also increase needed performance to beat the
Active Portfolio Management – Fundamental Strategies