Active vs Passive

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Active vs Passive
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ACTIVE EQUITY MANAGEMENT

• Goal Earn a portfolio return net of
  transaction costs and expenses that exceeds the
  return of a passive benchmark portfolio (most
  often an index) on a risk-adjusted basis.

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Challenges (Active)

• 1. Costs Fees
• Transaction Costs and fees range from 1 - 2
  of assets under management on average. (hurdle)

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Challenges (Active)

• 2. Appropriate Evaluation of Performance
• Difficulty differentiating Luck from Skill
• Appropriate Risk-Adjustment Model?
• (CAPM vs Fama-French Factor Model vs
• Other Models)

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Themes of Active Mgmt

• Asset Allocation
• Stocks, Bonds, Money Market
• Sector Allocation
• Overweighting and underweighting based on
  industry, size, or value vs. growth
• Individual Stock Selection

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Backtesting

• Test to see if trading rules would have worked
  using historical data.
• Subject to data mining criticisms as you can
  always find some patterns. It does not mean that
  they will persist in the future.

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Terminology

• Quadratic Programming Efficient frontier
  optimization in Mean/Variance Space based on
  Expected Returns, Standard Deviations, and
  Correlations

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Passive Equity Management

• Logic Market is fairly efficient. Too difficult
  to overcome 1 - 2 costs of running an active
  equity portfolio.
• Dont try to beat the market, just equal it and
  keep expenses to a bare minimum.

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Passive Features

• Portfolio is built without using technical or
  fundamental analysis.
• Buy Hold The securities are purchased and then
  held with only occasional re-balancing (reinvest
  dividends, a change in the index etc..)

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Index Funds

• Passive portfolios that track an index and sell
  shares to investors are called Index Funds.
• (Ex Vanguard 500 Index which tracks the SP
  500.)

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Index Funds

• Manager Performance Judged by how well he/she
  tracks the index and by the costs generated to
  do so.

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Index Fund Types

• 1. Full Replication Buy all stocks in the index
  in proportion to their weights in the index.

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Index Fund Types

• 2. Sampling Buy the stocks with larger index
  weights hold a representative sample of the
  others.
• Benefit Relative Full Replication Lower
  commissions (less stocks to purchase and to
  reinvest dividends).
• Drawback Relative Full Replication Will be
  Tracking Error

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Evaluating Index Fund Manager Performance

• R-Squared Measures how closely the fund is
  moving with the benchmark index.
• This measures tracking, but not costs!

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Exchange Traded Funds

• An alternative to buying shares in an Index Fund.
• Depositary receipts with underlying stocks in an
  index held in deposit by the financial
  institution that issued certificates.
• Shares are traded like a stock but represent a
  claim on the portfolio.

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Exchange Traded Funds

• Example SPDRs Depositary receipts on the SP
  500.
• Buy like a share of stock no fund marketing fees
  (means lower expenses).
• No cash on hand to handle fund flows.
• Trade when market open not just at market close
  price.
• Can be shorted or purchased with margin.
• Some new ETFs are actively managed