Active Portfolio Management

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Notes: Active Portfolio Management

By Zhipeng Yan

Active Portfolio Management
By Richard C. Grinold and Ronald N. Kahn

Part I Foundations......................................................................................................... 2 Chapter 1 Introduction..................................................................................................... 2 Chapter 2 Consensus Expected Returns: The CAPM ..................................................... 3 Chapter 3 Risk ................................................................................................................. 3 Chapter 4 Exceptional Return, Benchmarks, and Value Added...................................... 5 Chapter 5 Residual Risk and Return: The Information Ratio ......................................... 6 Chapter 6 The Fundamental Law of Active Management .............................................. 9 Part II Expected Returns and Valuation....................................................................... 11 Chapter 7 Expected Returns and the Arbitrage Pricing Theory .................................... 11 Chapter 8 Valuation in Theory ...................................................................................... 13 Chapter 9 Valuation in Practice..................................................................................... 13 Part III Implementation ................................................................................................ 14 Chapter 10 Forecasting................................................................................................ 14 Chapter 11 Information Analysis ............................................................................... 16 Chapter 12 Portfolio Construction.............................................................................. 18 Chapter 13 Transactions Costs, Turnover, and Trading............................................. 22 Chapter 14 Performance Analysis .............................................................................. 24 Chapter 15 Benchmark Timing .................................................................................. 29 Chapter 16 Summary .................................................................................................. 30

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Notes: Active Portfolio Management

By Zhipeng Yan

Active Portfolio Management
By Richard C. Grinold and Ronald N. Kahn

Part I

Foundations Introduction

Chapter 1

I. A process for active investment management The process includes researching ideas, forecasting exceptional returns, constructing and implementing portfolios, and observing and refining their performance. II. Strategic overview 1. Separating the risk forecasting problem from the return forecasting problem. 2. Investors care about active risk and active return (relative to a benchmark). 3. The relative perspective will focus us on the residual component of return: the return uncorrelated with the benchmark return. 4. The information ratio is the ratio of the expected annual residual return to the annual volatility of the residual return. The information ratio defines the opportunities available to the active manager. The larger the information ratio, the larger the possibility for active management. 5. Choosing investment opportunities depends on preferences. The preference point toward high residual return and low residual risk. We capture this in a mean/variance style through residual return minus a (quadratic) penalty on residual risk (a linear penalty on residual variance). We interpret this as “riskadjusted expected return” or “value added.” 6. The highest value added achievable is proportional to the squared information ratio. The information ratio measures the active management opportunities, and the squared information ratio indicates our ability to add value. 7. According to the fundamental law of active management, there are two sources of information ratio: IR = IC * BR -...
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