Portfolio Management 3-228-07 Albert Lee Chun Lecture 1 The Institutional Environment 09-02-2008
This course Portfolio Management complements the course Investments (2-201-99) by exploring various issues underlying asset management. This is the most fundamental attribute of any professionally managed portfolio. Even if most of the concepts presented in class are specific to portfolios consisting of shares or stock market indices, the majority of these concepts apply to a wide variety of financial asset categories. In this course, students will become familiar with fundamental concepts of portfolio management including efficient frontier portfolios, multifactor models, financial asset pricing models, market efficiency and the performance evaluation of professionally managed portfolios.
Sessions 1 and 2 : The Institutional Environment
Sessions 3, 4 and 5: Construction of Portfolios
Sessions 6 and 7: Capital Asset Pricing Model
Session 8: Market Efficiency
Session 9: Active Portfolio Management
Session 10: Management of Bond Portfolios
Session 11: Performance Measurement of Managed Portfolios
You will be evaluated using the following criteria:
Midterm Exam: ( October 21st ) 40%
Final Exam: ( December 14th ) 40%
The midterm and final exams are 3 hours long.
The exams will be closed book.
For the exams, you are allowed to have a single-sided, 8.5 x 11 inch “cheat sheet”, where you can write all the information you want.
Old exams will not be made available.
Professor Albert’s Contact Info E-mail: [email_address] Phone: 514-340-5661 Office: 4.257 Office hours: By Appointment Only Please do not be shy about contacting me if you have questions about the material! I will hold individual office hours as needed. I’m happy to chat with you about the course or about your future plans.
Text Book : Bodie, Kane, Marcus, Perrakis, Ryan.
8th Canadian edition,
2008, McGraw-Hill Ryerson.
Course Reader :
“ Textbook 3228A”
You will need to get a copy
of this as we will assign readings from it.
Zonecours.hec.ca : Slides from lectures, exercices, solutions, announcements, etc., will be posted here.
Prerequisites: It is important that you have taken and passed the course « Investments » and to a lesser extent « Options and Futures » . If you do not have a strong background in finance at the level of « I nvestments », you may not be prepared to take this course .
Objective: (Chapter 4) To give an overview of institutional investing and institutions’ role in portfolio selection and management
Costs of investing in Mutual Funds
Investment performance of mutual funds
Investment Companies 4-
Investment companies pool funds into large portfolios.
Diversification & divisibility
Administration & record keeping
Services of Investment Companies 4-
Net Asset Value Per Share: Used as a basis for valuation of investment company shares
Selling new shares
Redeeming existing shares
Net Asset Value 4-
Open-end and Closed-end Funds
Closed-end: Do not redeem or issues shares
Open-end: Can sell or redeem shares
Open-end: Net Asset Value (NAV)
Closed-end: Premium or discount to (NAV)
Real estate funds
Real estate limited partnerships
Other Organizations 4-
Mutual Funds 4-
Mutual Fund Listings 4-
Growth of Mutual Funds 4-
Balanced and Income
Investment Policies 4-
Statement about their objective:
Aggressive growth equity funds
Emerging markets equity funds
Growth and income equity funds
High yield fixed income funds
Mortgage-backed bond funds
Types of Mutual Funds 4-
Largest Fund Families
Mutual Funds Returns
The one-period rate of return on an investment in a open-ended fund is
Invest $1000 in a mutual fund
After 90 days, liquidated at NAV of $1,010.
During the 90 days you received:
A $5 income disbursement
A $15 capital gain disbursement
Costs of Investing in Mutual Funds 4-
Entry fees ( Front-end loads )
Diminish investor’s initial NAV
Many no-load funds exist
Many load funds charging between 0 and 8.5% exist
Exit fees (redemption or Back-end loads )
Declines toward zero the longer the fund is held
Most funds charge no exit fees
Costs of Investing in Mutual Funds 4-
Costs of Mutual Funds
Cover the costs of buying/selling securities
In the US: allowed to deduct up to 1% of their assets per year to pay for sales commissions and promotional expenses
Management Expense Ratio (MER)
$1,000 in a fund with up-front load fee of 3%.
1% per year annual management fee
Redemption fee of 1.5%
After 90 days, liquidated at NAV of $1,010 .
During the 90 days you received:
a $5 cash dividend disbursement and
a $15 capital gain disbursement.
Costs of Mutual Funds
Return over the 90-day period
Management fees in dollars over 90 days :
0.01 x (90/365) x $970 = $2.4
Redemption fee in dollars
$1,010 x 1.5% = $15.15
90-day return :
Impact of Costs on Performance
Trading Scandal with Mutual Funds
Late trading – allowing some investors to purchase or sell later than other investors
Market timing – allowing investors to buy or sell on stale net asset values
Example: Exploiting time-zone differences
Net effect is to transfer wealth from existing owners to the new purchasers or sellers
Investment Performance of Mutual Funds 4-
First Look at Mutual Fund Performance
Benchmark portfolio: Wilshire 5000 Index.
Figure 4.4 shows that average mutual fund performance is generally less than broad market performance measured by the index.
Return on average mutual fund was below the Whilshire 5000 index 21 out of 35 years from 1971 to 2005.
The average return on the index exceeded that of the mutual fund by 1%
Performance vs. the Index 4-
Is Performance Due to Skill?
The must be good mangers and bad managers.
So do good managers consistently outperform the index?
To test this, we seek evidence of persistence in returns.
If good performance is due to skill then those who rank in the top performing half in one period would be expected to do well in the next period.
Do winners stay winners? 4-
Persistence in Fund Performance
The Malkiel study suggests that some funds show consistent strong performance but it seems to only be true in the 70s.
Other studies using Canadian data are suggestive of good managers outperforming the market this is also inconclusive.
Other studies suggest that bad performance is more likely to persist than good performance.
Yet worst performing funds go out of business.
So when looking at mutual fund rankings of 5 year returns, we should remember there are many funds that failed to survive 5 years.
Hence, the performance of the surviving firms will be upward biased.
This is known as a survivorship bias .
Wiesenberger’s Investment Companies (US)
Investment Company Institute (US)
Popular press (Globefund)
Investment services (SEI, Comstat, etc.)
Sources of Information on Mutual Funds 4-
Index Funds 4-
Costs of Index vs. Mutual Funds
Index funds do not need as large a staff
Decisions about what stock to buy have already been made based on index commitment.
Savings are passed along to investors
Average management fee for a managed common stock mutual fund: 1.4%
Management fee for Vanguard Index Trust in the US : 0.18%
Investments’ performance over the long run
Initial investment of $100,000
Assume a 10% gross annual return for both funds:
Vanguard Index Trust 500 Mutual Fund charges a 0.18% management fee for a net annual return of 9.82%
The Average Managed Mutual Fund charges a 1.4% management fee for a net annual return of 8.6%
Vanguard Index Trust 500 Average Managed Mutual Fund After 10 years $255,000 $228,000 After 20 years $651,000 $521,000
Advantages of index funds
Management expenses are minimized
No load funds
Underlying indexes experience slow turnover;
Leads to lower commissions
Slow turnover leads to unrealized and untaxed capital gains
Taxed when investment is sold
Disadvantages of index funds
May be poorly managed
There may be some tracking error:
Tracking Error = Return of index – Return on indexed portfolio
Tracking errors can occur due to:
Manager didn’t invest in all target index securities.
Weighting scheme differed from that of the target index.
Delayed reaction to changes in targeted index
Manager may try to ‘outsmart’ the market (enhanced indexing)
Use of derivatives of the securities rather than the securities themselves ( lower commissions )
To reduce tracking error, portfolio may contain more of the different securities contained within the target index.
As the number of different securities held within the portfolio increases, the commissions are likely to be higher.
Portfolio managers may try to reduce trading costs but this can increase the chance of tracking error.
Exchange Traded Funds
ETFs allow investors to trade index portfolios like shares of stocks.
Examples – iShares, SPDRs and Vipers
Indexed with same weights used in the target index
Unlike mutual funds:
Order executed immediately—not at market-on-close prices
Management fees are below 0.18%
ETF Products 4-
Advantages of exchange index traded funds
Trade continuously. Can be bought/sold throughout the day rather than just market-on-close prices
Can sell short, and can do so on a down-tick
They usually cannot use derivatives so investors are not subject to counterparty risks
i.e. won’t have tracking error from the misuse of derivatives
Advantages of ETFs
1$ invested in the following from end of 1925 to end of 1999 would have increased to :
Even a fairly small annual return can create large long- term results
Method of computation : (1 + return) n = Ending Wealth
Asset Class Annual Return Ending Wealth S&P 500 11.3% $2,845.6 Small company stock index 12.6% $6,640.7 Long-term corporate bond index 5.6% $56.38 Long-term government bond index 5.1% $40.22 Intermediate-term government bond 5.2% $43.93 U.S. Treasury Bills 3.8% $15.64 Inflation 3.1% $9.39
A Note of Inflation
Inflation : the purchasing power of $1 is not the same from year-to-year (it decreases)
$1 of purchases made in 1925 would cost $9.39 by 1999
$1 x (1 + 0.030728) 74 = $9.39
$2,845.63 after adjusting for inflation is worth in real terms:
$2,845.63 $9.39 = $303.05
While the accumulated real wealth is much lower than the nominal wealth, it is still an impressive number