Investments Bodie Kane Marcus

Finance
Course: Investments Volume 2

Instructor: David Whitehurst UMIST

McGraw-Hill/Irwin

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McGraw−Hill Primis ISBN: 0−390−32002−1 Text: Investments, Fifth Edition Bodie−Kane−Marcus

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Copyright ©2003 by The McGraw−Hill Companies, Inc. All rights reserved. Printed in the United States ofAmerica. Except as permitted under the United States Copyright Act of 1976, no part of this publication may be reproduced or distributed in any form or by any means, or stored in a database or retrieval system, without prior written permission of the publisher. This McGraw−Hill Primis text may include materials submitted to McGraw−Hill for publication by the instructor of this course. The instructor issolely responsible for the editorial content of such materials.

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ISBN: 0−390−32002−1

Finance

Volume 2
Bodie−Kane−Marcus • Investments, Fifth Edition VII. Active Portfolio Management
919 919 942 942 978 980 992 996

27. The Theory of Active Portfolio Management
Back Matter

Appendix A: Quantitative Review Appendix B: References to CFA Questions Glossary Name IndexSubject Index

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VII. Active Portfolio Management

27. The Theory of Active Portfolio Management

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THE THEORY OF ACTIVE PORTFOLIO MANAGEMENT
Thus far we have alluded to active portfolio management inonly three instances: the Markowitz methodology of generating the optimal risky portfolio (Chapter 8); security analysis that generates forecasts to use as inputs with the Markowitz procedure (Chapters 17 through 19); and fixed-income portfolio management (Chapter 16). These brief analyses are not adequate to guide investment managers in a comprehensive enterprise of active portfolio management. Youmay also be wondering about the seeming contradiction between our equilibrium analysis in Part III—in particular, the theory of efficient markets—and the real-world environment where profit-seeking investment managers use active management to exploit perceived market inefficiencies. Despite the efficient market hypothesis, it is clear that markets cannot be perfectly efficient; hence there arereasons to believe that active management can have effective results, and we discuss these at the outset. Next we consider the objectives of active portfolio management. We analyze two forms of active management: market timing, which is based solely on macroeconomic factors; and security selection, which includes microeconomic forecasting. We show the use of multifactor models in active portfoliomanagement, and we end with a discussion of the use of imperfect forecasts and the implementation of security analysis in industry.

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27. The Theory of Active Portfolio Management

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CHAPTER 27 The Theory of Active Portfolio Management

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THE LUREOF ACTIVE MANAGEMENT
How can a theory of active portfolio management be reconciled with the notion that markets are in equilibrium? You may want to look back at the analysis in Chapter 12, but we can interpret our conclusions as follows. Market efficiency prevails when many investors are willing to depart from maximum diversification, or a passive strategy, by adding mispriced securities to theirportfolios in the hope of realizing abnormal returns. The competition for such returns ensures that prices will be near their “fair” values. Most managers will not beat the passive strategy on a riskadjusted basis. However, in the competition for rewards to investing, exceptional managers might beat the average forecasts built into market prices. There is both economic logic and some empirical...