1. Goal: Earn a portfolio return net of transaction costs and expenses that exceeds the return of a passive benchmark portfolio (most often an index)

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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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1. Costs & Fees

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

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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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Asset AllocationStocks, Bonds, Money Market

Sector AllocationOverweighting and underweighting based

on industry, size, or value vs. growthIndividual Stock Selection

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

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Logic: Market is fairly efficient. Too difficult to overcome 1 - 2% costs of running an active equity portfolio.

Don’t try to beat the market, just equal it and keep expenses to a bare minimum.

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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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Passive portfolios that track an index and sell shares to investors are called Index Funds.

(Ex: Vanguard 500 Index which tracks the S&P 500.)

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

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

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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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1. R-Squared: Measures how closely the fund is moving with the benchmark index.

This measures tracking, but not

costs!

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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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Example SPDRs: Depositary receipts on the S&P 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

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