Portfolio Management 3-228-07 Albert Lee Chun The Institutional

Portfolio Management 3-228-07 Albert Lee Chun The Institutional Environment Lecture 1 09-02-2008 1

Portfolio Management 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. Albert Lee Chun Portfolio Management 2

Course Outline 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 3

Evaluation You will be evaluated using the following criteria: Midterm Exam: (October 21st) 40% Final Exam: (December 14th) 40% Project: 20% 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. Albert Lee Chun Portfolio Management 4

Professor Albert’s Contact Info E-mail: Phone: Office: Office hours: [email protected] 514-340-5661 4.257 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. Albert Lee Chun Portfolio Management 5

Course Information Text Book: Bodie, Kane, Marcus, Perrakis, Ryan. Investments 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. Albert Lee Chun Portfolio Management 6

Course Information 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 « Investments », you may not be prepared to take this course. Albert Lee Chun Portfolio Management 7

Today’s Lecture Objective: (Chapter 4) To give an overview of institutional investing and institutions’ role in portfolio selection and management Investment companies Mutual funds Costs of investing in Mutual Funds Investment performance of mutual funds Index Funds Albert Lee Chun Portfolio Management 4-8 4-8 8

Investment Companies Albert Lee Chun Portfolio Management 4-9 4-9 9

Services of Investment Companies Investment companies pool funds into large portfolios. Advantages include: Diversification & divisibility Administration & record keeping Professional management Reduced costs Albert Lee Chun Commissions/Transaction costs Information costs Portfolio Management 4-10 4-10 10

Net Asset Value Net Asset Value Per Share: Used as a basis for valuation of investment company shares Selling new shares Redeeming existing shares Market Value of Assets Liabilities NAV Shares Outs tan ding Albert Lee Chun Portfolio Management 4-11 4-1111

Open-end and Closed-end Funds Managed funds Closed-end/ Open-end Load funds Shares Outstanding Closed-end: Do not redeem or issues shares Open-end: Can sell or redeem shares Pricing Open-end: Net Asset Value (NAV) Closed-end: Premium or discount to (NAV) Albert Lee Chun Portfolio Management 4-12 4-12 12

Closed-end Funds Albert Lee Chun Portfolio Management 13

Other Organizations Commingled funds Real estate funds Real estate limited partnerships Mortgage funds Segregated funds Hedge funds Albert Lee Chun Portfolio Management 4-14 4-14 14

Mutual Funds Albert Lee Chun Portfolio Management 4-15 4-15 15

Mutual Fund Listings Albert Lee Chun Portfolio Management 4-16 4-16 16

Growth of Mutual Funds Albert Lee Chun Portfolio Management 4-17 4-17 17

Investment Policies Money Market Fixed Income Balanced and Income Asset Allocation Equity Indexed Specialized Sector Albert Lee Chun Portfolio Management 4-18 4-18 18

Investment Policies 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 Albert Lee Chun Portfolio Management 19

Types of Mutual Funds Albert Lee Chun Portfolio Management 4-20 4-20 20

Largest Fund Families Albert Lee Chun Portfolio Management 21

Mutual Funds Returns The one-period rate of return on an investment in a open-ended fund is rate of income capital gains NAV t - NAV t -1 return t NAV t -1 Albert Lee Chun Portfolio Management 22

Example 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 rate of returnt income capital gains NAV t - NAV t -1 NAV t 5 15 1,010 - 1,000 3% rt 1,000 Albert Lee Chun Portfolio Management 23

Costs of Investing in Mutual Funds Albert Lee Chun Portfolio Management 4-24 4-24 24

Costs of Investing in Mutual Funds 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 Albert Lee Chun Portfolio Management 4-25 4-25 25

Costs of Mutual Funds Operating expenses Transaction fees Distribution fees 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) Albert Lee Chun Portfolio Management 26

Example 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. Albert Lee Chun Portfolio Management 27

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 : 5 15 1,010 - 970 - 2.4 - 15.15 - 30 1.25% rt 970 30 Albert Lee Chun Portfolio Management 28

Impact of Costs on Performance Albert Lee Chun Portfolio Management 29

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 Albert Lee Chun Portfolio Management 4-30 4-30 30

Investment Performance of Mutual Funds Albert Lee Chun Portfolio Management 4-31 4-31 31

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% Albert Lee Chun Portfolio Management 4-32 4-32 32

Performance vs. the Index Albert Lee Chun Portfolio Management 4-33 4-33 33

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. Albert Lee Chun Portfolio Management 34

Do winners stay winners? Albert Lee Chun Portfolio Management 4-35 4-35 35

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. Albert Lee Chun Portfolio Management 36

Survivorship Bias 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. Albert Lee Chun Portfolio Management 37

Sources of Information on Mutual Funds PALTrak (Morningstar) Wiesenberger’s Investment Companies (US) Morningstar (US) Investment Company Institute (US) Popular press (Globefund) Investment services (SEI, Comstat, etc.) Albert Lee Chun Portfolio Management 4-38 4-38 38

Index Funds Albert Lee Chun Portfolio Management 4-39 4-39 39

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% Albert Lee Chun Portfolio Management 40

Example 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% Vanguard Index Average The Average Managed Mutual Fund charges Trust 500 Managed Fund a 1.4% management fee for aMutual net annual return of 8.6% 255,000 After 10 years 228,000 After 20 years Albert Lee Chun 651,000 Portfolio Management 521,000 41

Index funds Advantages of index funds Management expenses are minimized Higher returns No load funds Slow turnover Underlying indexes experience slow turnover; Leads to lower commissions Tax efficiency Slow turnover leads to unrealized and untaxed capital gains Taxed when investment is sold Albert Lee Chun Portfolio Management 42

Index funds Disadvantages of index funds May be poorly managed There may be some tracking error: Tracking Error Return of index – Return on indexed portfolio Albert Lee Chun Portfolio Management 43

Index funds Tracking errors can occur due to: Management fees 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 ) Albert Lee Chun Portfolio Management 44

Index funds 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. Albert Lee Chun Portfolio Management 45

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 marketon-close prices Management fees are below 0.18% Albert Lee Chun Portfolio Management 4-46 4-46 46

ETF Products Albert Lee Chun Portfolio Management 4-47 4-47 47

Advantages of ETFs 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 Lower costs Albert Lee Chun Portfolio Management 48

Wealth Accumulation 1 invested in the following from end of 1925 to end of 1999 would have increased to : 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 Asset Class Even a fairly small annual return can create large longterm results n Method Ending Wealth Inflationof computation : (1 return) 3.1% 9.39 Albert Lee Chun Portfolio Management 49

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 2,845.63 after adjusting for inflation is worth in real terms: 1 x (1 0.030728)74 9.39 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 Albert Lee Chun Portfolio Management 50

Things to Read Readings for Today’s lecture. Chapter 4 Readings for Next Week: Chapter 5, sections 5.4 to 5.6 and 5.8 Chapter 23, sections 23.1 and 23.2 Albert Lee Chun Portfolio Management 51