Portfolio Construction

1
Portfolio Construction

• Asset Class Mix
• Construct An Index Portfolio
• Construct An Active Portfolio
• Yale University Investments Office

2
Management Strategies

• Passive portfolio management
• Market index funds
• Sector index funds
• Exchange Traded Funds (ETFs)
• Fund of funds

3
Management Strategies

• Active portfolio management
• Stock funds
• Arbitrage funds
• Hedge funds
• Portfolio management in inefficient markets
• Venture funds
• Buyout funds
• Restructure funds

4
Asset Class Mix

• Assets in efficient markets
• Government bonds, money market instruments
  (CP), Bank deposits, Cash
• Assets in slightly inefficient markets
• Corporate bond, Inflation-adjusted bond, Junk
  bond, Asset-backed security
• Assets in moderately inefficient markets
• Publicly traded stock, Convertible bond, Real
  estates, REITs (real estate investment trusts),
  Commodities
• Assets in highly inefficient markets
• Private equity, Venture fund, Restructure
  fund, Buyout fund

5
Portfolio Construction

• Portfolio construction requires several inputs
• The current portfolio
• Alphas benchmark and cash neutral alphas
• Covariance estimates
• Transactions cost estimates the cost of moving
  from one portfolio to another
• An active risk aversion
• Portfolio revision How often should you revise
  your portfolio whenever you receive new
  information?

6
Portfolio Implementation

• What portfolio would we choose given inputs
  unreasonable and noisy?
• (Input alphas, covariance, active risk
  aversion, and transaction cost)
• Alpha analysis can adjust the alphas into line
  with managers desires for risk control and
  anticipated source of value added.

7
Portfolio Implementation

• Portfolio construction techniques include
  screening, stratified sampling, linear
  programming, and quadratic programming.
• Screens Rank the stocks by alpha and rebalance
• Stratification Split the list of followed stocks
  into exclusive categories (risk control)
• Linear or quadratic programming

8
Hedge Assets

• Derivatives
• Futures
• Forward
• Options
• Swap
• Insurance
• Short Selling

9
Construct A Passive Index Portfolio

• Selecting an index to track, depended upon the
  objective of the investor
• Benchmark index
• Taiwan 50 (TTT), SP500, Russell2000, MSCI
  country index
• Tracking error when the amount an index portfolio
  deviates from its benchmark index

10
Russell 2000 Index

The Russell 2000 Index offers investors access to
the small-cap segment of the U.S. equity
universe. The Russell 2000 is constructed to
provide a comprehensive and unbiased small-cap
barometer and is completely reconstituted
annually to ensure larger stocks do not distort
the performance and characteristics of the true
small-cap opportunity set. The Russell 2000
includes the smallest 2000 securities in the
Russell 3000.
11
Vanguard Group Inc.

• Vanguard marked a milestone of its own when
  assets in Vanguard's U.S. mutual funds surpassed
  1 trillion in 2006.

12
Construct A Passive Index Portfolio

• Method of indexation
• - Full replication buy all the stocks in the
  index and in the same proportion
• - Stratification sampling track the index by
  holding only a sample of stocks in proportion to
  their market cap
• - Optimizing ensure the sample stocks to have
  the same characteristics as the index regarding
  certain attributes, such as size, volatility,
  growth, PER, and PBR

13
Haugen and Bakers Portfolio (FAJ, 1996)

• Construct an active portfolio based on
  multifactor models
• Risk beta, APT beta, return volatility, earnings
  volatility, debt ratio, and interest coverage
• Liquidity market cap, price per share, turnover
• Price level earnings-to-price, book-to-price,
  dividend-to-price, cash flow-to-price, and
  sales-to-price
• Growth potential earnings growth, profit margin,
  capital turnover, and return on equity
• Technical 1-, 6-, 12-, 24-, and 60-month excess
  returns

14
Construct A Diversified Portfolio in Inefficient
Markets

• A Case Study
• Yale University Investments Office