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  • MASTER THESIS, FALL 2012CAND.MERC. APPLIED ECONOMICS AND FINANCE

    COPENHAGEN BUSINESS SCHOOL

    AUTHOR: JOHAN CHRISTIAN HILSTEDDATE OF SUBMISSION: DECEMBER 14TH 2012

    ACTIVE PORTFOLIO MANAGEMENT AND PORTFOLIO CONSTRUCTION

    - IMPLEMENTING AN INVESTMENT STRATEGY

    SUPERVISOR: JEPPE SCHOENFELDT

    NUMBER OF PAGES: 77

    NUMBER OF CHARACTERS: 145.260

    SIGNATURE:

  • Active Portfolio Management and Portfolio Construction Implementing an Investment Strategy

    1

    Abstract

    This thesis aims at creating an investment strategy for active portfolio management to outperform the

    MSCI Denmark from 1992 to 2011. The index development of the Danish stock market has been quite

    impressive as it has performed remarkably better than other national indices. It is therefore interesting

    to investigate whether active portfolio management constitutes a winning strategy superior to investing

    in the MSCI Denmark.

    There is no generally accepted approach to conduct active portfolio management. This thesis approaches

    the subject by comparing two internationally diversified portfolios to the MSCI Denmark as benchmark -

    one portfolio submitted to a 20% maximum asset representation restriction, the other portfolio left

    unrestricted.

    From investment strategy we conclude that combining strategic and tactical asset allocation constitutes

    an appropriate investment strategy for active portfolio management, as it limits the long-term portfolio

    investment opportunities and allows for short-term portfolio repositioning. The information ratio

    constitutes the performance measure of active portfolio management, as it optimizes portfolio

    construction by comparing expected returns of portfolio and benchmark the residual return. The Capital

    Assets Pricing Model (CAPM) was utilized for return estimations for both investment opportunities and

    benchmark. Mean-variance portfolio construction was conducted based upon investment opportunities

    expected to outperform the benchmark.

    The MSCI Denmark provides realized average monthly return of 0,65%, while the actively managed

    portfolios produce average realized monthly return of 0,34% and 0,37%, respectively. In that regard,

    active portfolio management has not outperformed the benchmark, and statistical findings cannot suggest

    portfolio timing skill. However, considering the systematic risk adjusted return, both portfolios yield

    significant alpha, or value added, with the unrestricted portfolio being the best performing portfolio.

    In conclusion, active portfolio management cannot produce higher return than the MSCI Denmark, but has

    proven to benefit the investor, as the market risk exposure justifies both inferior and superior portfolio

    return to the benchmark.

  • Active Portfolio Management and Portfolio Construction Implementing an Investment Strategy

    2

    Table of Contents

    Abstract .......................................................................................................................................... 1

    1. Introduction ................................................................................................................................ 4

    1.1 Research Objectives ................................................................................................................................... 6

    1.1.1 Superior Research Objective ................................................................................................................... 6

    1.1.2 Subordinate Research Objectives ........................................................................................................... 6

    1.2 Structure of Thesis...................................................................................................................................... 7

    1.3 Methodology .............................................................................................................................................. 8

    1.3.1 Financial Assets and Risk ......................................................................................................................... 8

    1.3.2 Applied Theoretical Approach ............................................................................................................... 10

    1.3.3 Interviews .............................................................................................................................................. 11

    1.4 Assumptions and limitations .................................................................................................................... 12

    1.4.1 Assumptions .......................................................................................................................................... 12

    1.4.2 Limitations ............................................................................................................................................. 13

    1.5 Data .......................................................................................................................................................... 14

    1.5.1 Equity Sector Return Data ..................................................................................................................... 14

    2.Investment Strategy ................................................................................................................... 18

    2.1 Investment Strategy as the Source of Portfolio Performance ................................................................. 18

    2.2 Strategic Asset Allocation ......................................................................................................................... 19

    2.2.1 Discussing Empirical Findings and Brinson et.al. ................................................................................... 21

    2.3 Tactical Asset Allocation ........................................................................................................................... 23

    2.4 Professional Views upon Asset Allocation ............................................................................................... 24

    2.5 Benchmark and Investment Opportunities .............................................................................................. 25

    2.5.1 Benchmark............................................................................................................................................. 26

    2.5.2 Investment Opportunities ..................................................................................................................... 27

    2.6 Crafting the Investment Strategy ............................................................................................................. 30

    3.Active Portfolio Management ..................................................................................................... 33

    3.1 Defining Active Portfolio Management .................................................................................................... 33

    3.2 Performance Measure and Portfolio Added Value .................................................................................. 34

    3.2.1 Information Ratio .................................................................................................................................. 34

    3.2.2 Portfolio Value Added ........................................................................................................................... 35

  • Active Portfolio Management and Portfolio Construction Implementing an Investment Strategy

    3

    4.Risk and Return in Active Portfolio Management ........................................................................ 38

    4.1 Expected Return in Active Portfolio Management .................................................................................. 38

    4.1.1 Asset Pricing in an Active Setting .......................................................................................................... 38

    4.2 Risk Management ..................................................................................................................................... 46

    4.2.1 Investor Utility ....................................................................................................................................... 47

    4.2.2 Professional Views upon Risk and Risk Management ........................................................................... 47

    4.2.3 Risk Management and Risk Factors ....................................................................................................... 48

    4.2.4 Financial Risk ......................................................................................................................................... 49

    5.Portfolio Construction ................................................................................................................ 51

    5.1 Objective of Portfolio Construction ......................................................................................................... 51

    5.2 Choice of Portfolio Model ........................................................................................................................ 51

    5.3 Mean-Variance Application in an Active Setting ...................................................................................... 52

    5.3.1 The Model ............................................................................................................................................. 53

    5.3.2 Model