Week 2 Notes:

Active Investing Basics

Konark Saxena ∗

September 20, 2023

Abstract

These notes are intended to introduce FINS5517 students to portfolio manage-

ment concepts for active funds.

∗
School of Banking and Finance, R316 UNSW Busines School, University of New South Wales, Sydney,
Australia. Email: k.saxena@unsw.edu.au.
1 The Basics of Active Investing
Active investing is a strategy employed by fund managers and investors aiming to
outperform a benchmark index or a predefined set of assets, often referred to as the
“benchmark”. The primary objective of active investing is to generate returns that are
higher than what the benchmark offers, while ideally controlling for benchmark-related
risks. Here we discuss some preliminaries required to understand portfolio management
concepts in active investing.

1.1 Returns on an active (or any) portfolio:

To calculate the return of an portfolio given its weight vector wa and the returns of
each asset in vector r, you can use the following formula:

n
X
Portfolio Return (R) = wa,i · ri
i=1

Where:

- n is the number of assets in the portfolio.

- wa,i is the weight of asset i in the active portfolio. It is an element of the weight
vector wa

- ri is the return of asset i. It is an element of the return vector r Returns are ideally
at a horizon based on the time the weights were traded on to the next period when the
weights were re-examined.

Here’s how you can calculate the portfolio return step by step:

1. Multiply each asset’s weight in the active portfolio (wa,i ) by its corresponding return
(ri ).

2. Sum up the results of these multiplications for all assets in the portfolio.

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 The resulting value, denoted by ra , will be the return of the active portfolio. This
formula allows you to compute the portfolio return based on the weightings of assets in
the active portfolio and their individual returns.

In Excel, you can use the SUMPRODUCT function to calculate the return on a portfolio
by multiplying the weight column with the return column for each asset. Here are the
steps to do this:

Assuming you have a spreadsheet with the following structure:

Asset Weight wa Return r

Asset 1 0.2 0.1

Asset 2 0.3 0.15
Asset 3 0.25 0.12
Asset 4 0.15 0.08
Asset 5 0.1 0.18

And you want to calculate the return of the portfolio, which is the sum of (Weight *
Return) for each asset.

1. In an empty cell where you want the portfolio return to appear, enter the following
formula:

=SUMPRODUCT(B2:B6, C2:C6)

Here’s what this formula does:

• B2:B6 refers to the range of weights (0.2, 0.3, 0.25, 0.15, 0.1).

• C2:C6 refers to the range of returns (0.1, 0.15, 0.12, 0.08, 0.18).

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 The SUMPRODUCT function multiplies each weight by its corresponding return, and
then it sums up these products. This effectively calculates the weighted sum of
returns for all assets in the portfolio.

2. Press Enter to calculate the portfolio return.

The cell containing this formula will display the portfolio return, which is the sum of the
weighted returns for all assets in the portfolio.

In this example, if you follow these steps, the result will be:

Portfolio Return = 0.1315 or 13.15%

This means that the portfolio’s return, based on the given weights and returns for
each asset, was 13.15%.

1.2 What is the benchmark of an active portfolio?

A benchmark is a standard or reference point that portfolio managers use to evaluate
the performance of an investment portfolio. It serves as a comparison tool and provides a
basis for assessing how well a portfolio is doing relative to a specific market or investment
universe.

• Common Benchmarks: Common benchmarks include market indices like the

S&P 500, the Dow Jones Industrial Average, or fixed-income indices like the Bloomberg
Barclays U.S. Aggregate Bond Index. These benchmarks represent the performance
of a specific segment of the financial markets.

• Purpose: The primary purpose of a benchmark is to establish a performance stan-

dard. Portfolio managers aim to achieve returns that either match or, ideally, exceed
the benchmark’s returns while managing risk effectively.

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1.2.1 The Role of a Benchmark Provider
Benchmark providers are entities responsible for creating and maintaining benchmarks.
These providers offer critical services to portfolio managers, and one of their key roles is to
regularly send data on the weights of the benchmark components to portfolio managers.
Here’s how it works:

1. Data Updates: Benchmark providers typically send data updates to portfolio

managers on a regular basis, often daily or at shorter intervals. These updates
include information about the current composition of the benchmark, including the
weights of individual securities or assets within the benchmark.

2. Benchmark Transparency: The data sent by benchmark providers offer trans-

parency into how the benchmark is constructed and the relative importance of each
component. This transparency is crucial for portfolio managers to understand the
benchmark they are trying to outperform.

A benchmark usually tracks a predefined subset of assets or an index that represents a

specific part of the market or asset class (rather than tracking the whole market portfolio).
For instance, in the context of Australian stocks, the ASX20 is a benchmark that consists
of the largest 20 stocks on the ASX (Australian Securities Exchange).

1.2.2 Benchmark Weights

Benchmark weights are typically determined by market capitalization. The compo-
sition of the benchmark portfolio is structured based on the market capitalization of its
constituent assets, reflecting their respective market sizes. An alternative to market cap-
italization is the utilization of the market value of free float, which denotes the publicly
tradable shares not held by insiders.

Market capitalization weights, also referred to as market-cap weights or capitalization-

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weighted indices, constitute a prevalent weighting methodology in financial markets for
constructing stock market indices and portfolios. These weights are contingent on the
market capitalization (market cap) of individual companies or assets within the index or
portfolio. Market capitalization is computed by multiplying the current market price of
a stock by its total outstanding shares. Below, we delve into the calculation of market
capitalization weights, accompanied by an Excel example:

Calculation of Market Capitalization Weight (wb,i ) for an Individual Asset

Recall that market capitalization of an asset is the product of the Market Price ($)
and Number of Shares Outstanding.

Market capitalization weights, or simply cap-weights, measure the value of the asset
with respect to the total value of the portfolios.

Calculation of Total Portfolio Value (P ): The total value of the portfolio (P ) is the
sum of the market caps of all assets in the portfolio:

n
X
P = (P rice of Asset i × N umber of Shares of Asset i)
i=1

Where:

n is the number of assets in the portfolio.

P rice of Asset i is the market price of asset i.

N umber of Shares of Asset i is the total number of shares of asset i held in the portfolio.

Calculation of market capitalization weight vector (wp ): The market capitalization

weight for the entire portfolio is computed as the market cap of each asset divided by the

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total portfolio value:
M arket Cap of Asset i
wp,i =
P

Where:

wp,i is the market capitalization weight of asset i.

M arket Cap of Asset i is the market capitalization of asset i.

P is the total value of the portfolio.

Excel Example Let’s illustrate market capitalization weights with an Excel example for
a portfolio of three stocks. The following table shows the data:

Asset Market Price ($) Number of Shares Market Cap ($)

Stock A 50 1000 =B2*C2

Stock B 75 800 =B3*C3
Stock C 40 1200 =B4*C4

Total =SUM(D2:D4)
To calculate market capitalization weights:

(i) In cell E2, compute the market capitalization weight for Stock A:

D2
wp,i =
D5

= D2/D5

(ii). Copy cell E2 to the remaining cells to calculate the market capitalization weight
in column E.

Cells in column E will display the market capitalization weights for each stock in the
portfolio. These weights, denoted as (wb,i ), represent each stock’s proportion of the total

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portfolio value.

1.3 Goal of Active Managers

Note that benchmark capitalization weights can be determined without making any
predictions about which companies will perform better or worse in the future. However,
these weights do take into account the publicly available information about these com-
panies. In other words, companies that are expected by the market to perform well will
have a higher market capitalization and, consequently, a greater weight in the portfolio.
Therefore, these weights essentially mirror the market’s collective expectations regarding
the relative value of different companies.

For active fund managers, their role revolves around identifying what might be over-
looked or underestimated in the market’s valuations. Their goal is to outperform the
market by uncovering opportunities that the broader market may have missed or un-
dervalued. This involves conducting in-depth research and analysis to make informed
investment decisions that can potentially yield superior returns compared to those dic-
tated solely by benchmark weights. In essence, active managers aim to capitalize on
market inefficiencies and divergences from their assessments of a company’s true worth,
ultimately seeking to deliver added value to their clients’ portfolios.

In essence, the primary objective of an active manager is to intentionally diverge from

the benchmark portfolio by adjusting the weights assigned to the same set of assets.
This adjustment results in the creation of a distinct portfolio, denoted as portfolio a,
characterized by a unique weight vector wa . The ultimate aim is to engineer portfolio a
in such a way that it generates anticipated returns that surpass those of the benchmark
portfolio, denoted as portfolio b, which maintains a separate weight vector wb .

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1.3.1 Key Metrics and calculations
Relative Returns (rra ): Active management involves seeking positive relative re-
turns compared to a benchmark. Relative returns (rra ) are calculated as the difference
between the return of the active portfolio (ra ) and the return of the benchmark (rb ), using
the formula:
rra = ra − rb = (wa − wb )′ r,

where:

rra is the relative return of the active portfolio.

wa and wb are the weight vectors of the active and benchmark portfolios, respectively.

r represents the vector of returns for the underlying assets.

Excel Example for Relative Returns: Suppose you have an Excel spreadsheet with
columns for asset names, active portfolio weights (wa ), benchmark weights (wb ), and
asset returns (r). You have 5 assets in rows 2 to 6. You can calculate relative returns
(rra ) by first taking the difference of weights in a new column G, and then multiplying
this difference with the column C with the returns, and adding it up over all assets in the
rows of the spreadsheet:

rra := SU M P RODU CT (C2 : C6, G2 : G6)

This formula multiplies the difference between active and benchmark weights by the asset
returns and then sums the products.

Tracking Error (TE):

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 Tracking Error is a metric used in finance to measure the difference in performance
between an investment portfolio, often a mutual fund or an exchange-traded fund (ETF),
and its benchmark index. It quantifies how well the portfolio tracks or replicates the
returns of the chosen benchmark. A tracking error is expressed as a percentage difference.

This measures the extent to which an active portfolio’s performance diverges from the
benchmark. It helps investors manage and control the overall risk in their portfolio while
seeking better returns through active management. TE is calculated as the standard
deviation of the relative returns:

rP
¯ a )2
(rra − rr
TE = ,
n−1

where:

T E is the tracking error.

rra are the individual relative returns of the active portfolio.

¯ a is the mean of relative returns.

rr

n is the number of observations (time periods).

Excel Example for Tracking Error : In Excel, assuming you have relative returns (rra )
calculated in a column G, you can compute tracking error in cell H2 using the formula:

T E := ST DEV.S(G2 : G6)

This formula calculates the population standard deviation of the relative returns.

Example: Active Fund Tracking ASX-100

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 Let’s consider an active fund that aims to outperform the ASX-100, while not taking
on too much active risk. So they replicate the performance of the ASX-100 index, which
represents the top 100 companies listed on the Australian Securities Exchange (ASX) for
most securities, but outperform on some. The active fund’s goal with a tight tracking
error target is to closely follow the returns of the ASX-100, while taking some active bets
to outperform it.

Over a Three-Year Period

• The active fund records annual returns of 12%, 8%, and 10%.

• The benchmark index, which is designed to track the ASX-100, achieves annual
returns of 11%, 8%, and 8%.

Calculation of Tracking Error To calculate the tracking error, we’ll take the differences
between the active fund’s returns and the ASX-100’s returns:

1. Year 1: active fund return - Benchmark return = 12% - 11% = 1%

2. Year 2: active fund return - Benchmark return = 8% - 8% = 0%

3. Year 3: active fund return - Benchmark return = 10% - 8% = 2%

Now, calculate the average of these differences to determine the relative return:

Average relative return: rra = Time-Average of (ra − rb )

Where:

ra is the active fund’s portfolio return.

rb is the benchmark (ASX-100) return.

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 So, the average out-performance rra over 3 years is an average of 1%. This is also its
alpha, if the beta=1. Recall that rra = ra − βa rb .

Now, calculate the standard deviation of these differences to determine the tracking
error:

Tracking Error = Standard Deviation of (ra − rb )

The tracking error is standard deviation of these returns (1%, 0, 2%), which is 1%.

Interpretation In this example, the tracking error of the active fund is 1%. This
indicates that, on average, over the three-year period, the active fund’s returns deviated
from the ASX-100’s returns by approximately 1%. This means that the fund returns an
out-performance or relative return of rra = 1% on average, though its performance in any
given year can be 1% above or below that of the average rra .

A lower tracking error suggests that the active fund is doing a good job of replicating
the ASX-100 index’s returns, as the deviations between the two are relatively small.

Investors would likely view this low tracking error as an indication that fund is not
taking on too much active risk. They might even conclude that it is essentially a closet
indexer, which means it is not taking too many active decisions or conducting much
active research. This makes it a suitable choice for those seeking performance similar
to the ASX-100, but with a little alpha (Assumings its r. However, other factors like
expenses, liquidity, and investment goals should also be considered when evaluating this
ETF for investment.

Beta (βa )
This measures the sensitivity of the active portfolio’s returns to systematic market move-
ments. This is the regression slope when the returns of active returns is the independent

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variable, and the returns of the benchmark portfolio is the dependent variable. We will
discuss why this is a relevant measure of risk in more detail in future weeks.

Beta is calculated as the covariance of the active portfolio returns with the benchmark
returns divided by the variance of benchmark returns:

Cov(ra , rb )
βa = ,
Var(rb )

where:

βa is the beta of the active portfolio.

ra is the return of the active portfolio.

rb is the return of the benchmark.

Excel Example for Beta In Excel, you can compute beta (βa ) using the formula in cell
AA2:
βa := COV ARIAN CE.S(X2 : X7, Y 2 : Y 7)/V AR.S(Y 2 : Y 7)

qhere X2 : X6 are the cells with the active portfolio returns, and Y 2 : Y 6 are the
benchmark returns.

Equivalently, you can compute beta (βa ) using the regression slope formula:

βa := SLOP E(X2 : X7, Y 2 : Y 7)

Alpha (αa ) This represents the active portfolio’s excess return relative to the bench-
mark, adjusted for systematic risk (beta) of the active portfolio. Equivalently, it is the
regression intercept of a regression of the active portfolio returns on the benchmark re-

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turns. It is calculated as:
αa = ra − βa · rb = wa′ α,

where:

αa is the alpha of the active portfolio.

βa is the beta of the active portfolio.

ra is the return of the active portfolio.

rb is the return of the benchmark.

wa represents the weight vector of the active portfolio.

α is the vector of abnormal or unexpected returns for the underlying assets.

Excel Example for Alpha Suppose you have an Excel spreadsheet with columns for
asset names, active portfolio returns (ra ) in Column X and benchmark return (rb ) in
Column Y. You can calculate alpha (αa ) using the formula:

αa = IN T ERCEP T (X2 : X7, Y 2 : Y 7)

Where AA2 is the beta of the active portfolio, and AB2 is the benchmark return.

To identify where the performance of the active portfolio is coming from, it sometimes
helps to calculate the alpha of each stock in the portfolio αi . With a column for αi in the
spreadsheet Column G, and the active weights in Column H, you can also calculate the
active portfolio αa as:

αa = SU M P RODU CT (G2 : G7, H2 : H7)

Active Share

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 Clients often wonder how actively their mutual fund manager is managing your in-
vestments. Active Share provides a way of measuring this.

In the world of finance, research has repeatedly shown that, on average, mutual fund
managers tend to underperform their benchmark indexes, especially after factoring in fees
and taxes. In 2006, Martijn Cremers and Antti Petajisto, researchers at the Yale School of
Management, introduced a novel method called Active Share to gauge the level of active
management employed by mutual fund managers and to identify those who outperform.

What is Active Share? Active Share is a metric that measures the percentage of a
portfolio’s stock holdings that differ from those in the benchmark index. Mutual fund
managers with a high Active Share have been found to outperform their benchmark
indexes, suggesting that Active Share is a significant predictor of fund performance.

Analyzing 2,650 funds spanning the period from 1980 to 2003, Cremers and Petajisto
discovered that the top-performing active funds, those with an Active Share of 80% or
higher, outperformed their benchmarks by 2-2.71% before fees and by 1.49-1.59% after
fees. This finding defies conventional wisdom, as other research has consistently shown
that, on the whole, active fund managers tend to underperform benchmark indexes.

Active Share is also valuable for identifying "closet indexers"—managers who claim
to be active but whose portfolios closely resemble the benchmark. Identifying closet
indexers is crucial because active management fees can hinder benchmark outperformance
for investors holding similar portfolios.

The study revealed that the percentage of assets managed by funds with an Active
Share below 60% surged from 1.5% in 1980 to 40.7% in 2003. Simultaneously, the per-
centage of assets managed by funds with an Active Share greater than 80% decreased
from 58% in 1980 to 28% in 2003. This shift cannot be entirely attributed to the growth
of index funds. In 1980, there were few non-index funds with an Active Share below 60%.

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By 2003, funds with Active Share below 60% constituted 20% of funds and 30% of assets
under management.

Furthermore, Active Share and excess performance were higher among funds with
fewer assets under management. Recent studies confirm that, on average, actively man-
aged portfolios underperform benchmark indexes. From 2002 to 2017, only about 8% of
active funds outperformed passive indexes. When accounting for taxes and trading costs
generated by active management, this figure dwindled to just 2%.

How is Active Share Calculated? Active Share is calculated by summing the absolute
differences between the weight of each holding in the manager’s portfolio and the weight
of the same holding in the benchmark index, and then dividing by two.

N
1X
Active Share = |wa,i − wb,i |
2 i=1

For instance, if a benchmark index consists of only one stock, and a manager decides
to invest half the portfolio in that stock and half in another, the Active Share would be
50%. This result implies that 50% of the manager’s portfolio deviates from the benchmark
index.

Calculating Active Share Using Excel To demonstrate how Active Share is calculated,
let’s consider an example using an Excel file called active_investing.xlsx. This file
contains data for the ASX200 index. The dataset structure is as follows:

Security Ticker Weight in Passive Index Weight in Active Fund

Security 1 Ticker1 Weight_p1 Weight_a1

Security 2 Ticker2 Weight_p2 Weight_a2
... ... ... ...

Here’s how you can calculate Active Share using Excel:

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 1. In cell E2, subtract the weight of the security in the active fund from the weight in
the passive index for each security. For example, in cell E2:

= D2 − C2

2. In cell F2, calculate the absolute difference for each security. In cell F2:

= ABS(E2)

3. In cell F3, calculate the sum of absolute differences for all securities. In cell F3:

= SU M (F 2 : F n)

4. In cell F4, divide the sum of absolute differences by 2. In cell F4:

= F 3/2

5. In cell F5, calculate Active Share as a percentage. In cell F5:

= (F 4) × 100%

Now, cell F5 will display the Active Share percentage for your portfolio.

Remember to replace n with the row number of the last security in your dataset,
and adjust F3 and F4 to refer to column F and rows n + 1 and n + 2.

While the Active Share study offers intriguing insights, investors should exercise cau-
tion when applying its findings. The benchmark-beating results of high Active Share

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managers represent an average performance, not a guarantee of individual fund perfor-
mance.

Assuming that all high Active Share managers will outperform their benchmarks would
be misleading. The data merely suggests that, on average, managers with high Active
Share portfolios outperform their low Active Share counterparts.

Ultimately, it is possible that some high Active Share managers may underperform
their benchmarks, while others excel. Relying solely on Active Share to choose a manager
could lead to selecting one who falls short of benchmark performance.

In conclusion, Active Share is a valuable tool for evaluating mutual fund investments.
However, it should be considered alongside other analysis tools for a comprehensive as-
sessment of performance potential.

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2 Active Investing
Constructing an excel sheet to calculate alpha is much easier than finding alpha.
Finding good active positions is a complex task. Simply relying on intuition is inade-
quate, given the vast number of experienced managers and market participants. As more
investors pile into underpriced securities, their prices tend to rise, eroding their under-
pricing status. To succeed, active managers must identify securities that others have not
yet recognized as underpriced or overpriced.

The active manager must choose strategic deviations from a benchmark to seek su-
perior returns, while managing risks. Active managers employ various techniques and
insights to identify opportunities that can lead to outperformance. It’s a dynamic and
rigorous approach to investing that requires expertise and a deep understanding of the
markets in which they operate.

2.1 Pitching an Active China Fund to a Super Fund

To understand how active managers can add value to end investors, let’s consider a fic-
tional dialogue between an active manager and an institutional investor. Active managers
regularly meet with investors, such as superannuation funds, to explain their approach
and the reasons why they expect to beat the benchmark. They highlight their expertise
in navigating specific markets and their commitment to delivering superior returns.

[Scene: A sleek and modern meeting room with floor-to-ceiling windows overlooking
the stunning Sydney Opera House. Sarah, the superannuation fund manager, enters the
room, her curiosity piqued as she anticipates an insightful meeting with a renowned active
fund manager specializing in China investments.]

Sarah (Superannuation Fund Manager): [Thinking to herself ] I wonder what

this meeting will reveal about their active strategy in China. There’s a lot of buzz about

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this fund manager’s expertise. Maybe there’s something intriguing to learn here.

[As Sarah takes her seat at the conference table, the active fund manager, Mr. Chen,
steps forward, projecting an air of confidence and experience.]

Mr. Chen (Active Fund Manager): [With a warm smile] Welcome, Sarah. It’s a
pleasure to have you here today. I understand you’re keen to explore the potential of our
active fund in the Chinese market.

Sarah: [Nodding] Yes, Mr. Chen. I’ve heard great things about your track record in
navigating the Chinese investment landscape. I’m eager to learn more about your active
strategy.

Mr. Chen: [Eager to share his insights] Of course, let’s dive right in. China has
certainly witnessed its share of rapid growth, but we’re now in a phase of mature growth.
This shift poses both challenges and opportunities, and we’re well-prepared to navigate
this dynamic landscape.

Sarah: [Engaged and attentive] Go on.

Mr. Chen: [Explaining] We recognize that in many sectors, the era of hyper growth
may be behind us. However, we’ve honed our expertise in identifying firms that are
positioned to thrive in this competitive, mature environment. Our active approach means
we’re not afraid to seek out value and opportunity, even amidst uncertainty.

Sarah: [Impressed ] I see. And what about the recent changes in the global investment
landscape?

Mr. Chen: [Confidently] That’s an excellent question, Sarah. We’ve noticed a

significant decline in overseas funds flowing into China for new investment ideas. This
is where our active strategy truly shines. While passive investors may shy away from
uncertainty, we see it as an opportunity. Our flexible and adaptive approach allows us to

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uncover hidden gems that passive strategies may overlook.

Sarah: [Intrigued ] So, you’re saying that your fund can thrive in this changing envi-
ronment?

Mr. Chen: [Enthusiastically] Absolutely. We thrive on change and uncertainty.

We’ve built a reputation for finding opportunity when others hesitate. And our long-
term focus means we’re not just chasing short-term gains but positioning ourselves for
sustainable growth.

Active Strategies: [Mr. Chen shifts the conversation to their active investment
strategies.]

Mr. Chen: [Explaining] To achieve our goal of outperforming the market, we employ
a variety of active strategies. Finding good active positions is a complex task. Relying
solely on intuition is inadequate, given the vast number of experienced managers and
market participants. As more investors pile into underpriced securities, their prices tend
to rise, eroding their underpricing status. To succeed, active managers must identify
securities that others have not yet recognized as underpriced or overpriced. Let me explain
how we approach this.. [Mr. Chen’s wave his hands in the air and starts counting with
his fingers the different ways in which his active strategies can generate value.]

Systematic Evaluation: [He states] Active managers need to employ a system-

atic evaluation processes. We use a set of criteria, including financial metrics, growth
prospects, and management quality, to assess potential investments. These criteria are
aggregated into a single rating, guiding our selection of firms to invest in.

Unique Strategies: [Mr. Chen leans forward, emphasizing their unique approach.]
We go to great lengths to gather insights. We may use unconventional data sources,
such as satellite imagery, to analyze a company’s operations. We’ve even used private
helicopters to visit remote areas critical to a business. These unique strategies help us

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uncover insights that others may miss.

Challenges and Adaptation: [He acknowledges the challenges of the mature growth
phase.] It’s important to acknowledge that the era of hypergrowth in many sectors may be
over. However, this doesn’t mean that opportunities have disappeared. Instead, it requires
a shift in focus towards finding firms that are well-positioned to succeed in this more
competitive and mature environment. Many companies in China are already adjusting
to this new reality, and their ability to navigate these challenges will determine their
long-term success.

Sector Opportunities: [Mr. Chen leans back, painting a broader picture.] In the
long term, we expect certain sectors, especially those beyond the property market, to
perform exceptionally well. Chinese companies aiming to expand internationally, coupled
with government policies that encourage this trend, create opportunities for investors who
position themselves strategically.

Policy Response and Data Dependence: [He continues to discuss their adaptive
investment strategy, long-term focus, and their assessment of China’s policy response and
data dependence. Mr. Chen emphasizes their commitment to a long-term vision and the
potential for market share growth for Chinese companies expanding overseas.]

Sarah: [Impressed by the pitch] Well, Mr. Chen, your insights and approach are
certainly compelling. I appreciate your transparency and expertise. It’s clear that your
active fund has a unique edge in the evolving Chinese investment story.

Mr. Chen: [Grateful for the opportunity] Thank you, Sarah. We believe that part-
nering with your superannuation fund could be mutually beneficial. Our goal is to help
you seize the potential for growth in this ever-changing landscape.

[As Sarah leaves the meeting, she’s not only impressed by Mr. Chen’s insights but also
intrigued by the potential for growth in China. She can’t help but feel optimistic about

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the possibilities presented by the active fund’s strategy in China. The meeting overlooking
the iconic Sydney Opera House has provided her with valuable insights and a potential
investment opportunity for her superannuation fund.]

2.2 Active Portfolio Management Tasks

Active portfolio managers have the responsibility of constructing and managing port-
folios that aim to beat the benchmark while adhering to certain guidelines and constraints.
Here’s how the process typically works:

1. Benchmark as a Reference: A benchmark is agreed upon which serves as a

reference point against which the portfolio’s performance is measured. The objective
is to generate returns that exceed those of the benchmark.

2. Balancing Act: Active portfolio managers face a balancing act. On one hand, they
strive to overweight or underweight certain securities or asset classes to potentially
generate alpha (excess returns) and beat the benchmark. On the other hand, they
must be cautious about deviating too far from the benchmark to manage tracking
error, which measures the portfolio’s deviation from the benchmark’s returns.

3. Risk Management: Portfolio managers must manage risk effectively. They are
often given a maximum allowable tracking error, which represents the expected
deviation from the benchmark’s returns. Staying within this limit is crucial to
ensure that the portfolio’s risk remains within acceptable bounds.

4. Security Selection: Active portfolio managers engage in security selection, which

involves identifying individual securities or assets that have the potential to out-
perform those in the benchmark. They use various analytical tools and research to
make these selections.

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 5. Ongoing Monitoring: Portfolio managers continuously monitor the portfolio’s
performance relative to the benchmark. Adjustments may be made to the portfolio’s
weights to capitalize on opportunities or manage risk as market conditions change.

2.3 Forecasting Alphas From Analyst Ratings

A portfolio manager works with a team of buy-side analysts to help construct an active
portfolio expected to beat their benchmark.

Buy-side analysts, like sell-side analysts, form views and recommendations of which
assets are overvalued and give them sell or strong sell ratings; and they form views of
which assets are undervalued and give them buy or strong buy ratings. Lets first briefly
discuss the roles of such analysts.

2.3.1 Buy-Side vs. Sell-Side Analysts: Differences and Roles

Much has been made of the "Wall Street analyst" as though it were a uniform job
description. However, there are significant differences between buy-side and sell-side an-
alysts.

Sell-Side Analysts

Sell-side analysts are typically believed to provide unbiased opinions based on propri-
etary research of a company’s securities. Their responsibilities include:

• Following a list of companies, often within the same industry.

• Providing regular research reports to their firm’s clients.

• Building financial models to project a firm’s financial results.

• Interacting with various sources, including customers, suppliers, competitors, and

industry experts.

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 • Assigning ratings such as Buy, Sell, or Hold when initiating coverage on a company.

• Convincing institutional clients to direct their trading through their firm’s trading
desk.

• Providing valuable information and being the first to share new insights with clients.

Buy-Side Analysts

In contrast, buy-side analysts are more focused on achieving high-alpha ideas and
avoiding major mistakes. Their responsibilities include:

• Conducting broad research and utilizing information from sell-side analysts.

• Identifying potential risks and considering what can go wrong with investment ideas.

• Deepening their knowledge in their area of responsibility.

• Developing lists of trusted sell-side analysts as valuable information sources.

• Paying for sell-side research indirectly through soft dollars.

• Depending on the quality of their recommendations for compensation.

Both types of analysts are essential, but their roles, compensation structures, and
responsibilities differ significantly. Sell-side analysts focus on information flow and access
to management, while buy-side analysts prioritize the quality of their recommendations
and the overall success of their funds.

Key Differences

There are several key differences between buy-side and sell-side analysts, including:

• Compensation: Sell-side analysts often have a wider compensation range, while

successful buy-side analysts, especially at hedge funds, can earn significantly more.

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 • Working Conditions: Sell-side analysts may work longer hours and frequently travel,
making buy-side analysis arguably less stressful.

• Role: Accuracy is crucial for buy-side analysts, whereas sell-side analysts are more
focused on information flow.

• Research: Sell-side analysts provide detailed research on industries or sectors, while

buy-side analysts often rely on sell-side research.

• Regulation: Buy-side analysts have fewer restrictions on share ownership, disclo-

sures, and outside employment according to regulators.

Understanding the roles and differences between buy-side and sell-side analysts is
essential for investors. Ratings provided by analysts can influence stock prices, but they
should be considered alongside other factors. Buy-side analysts aim to deliver high-alpha
ideas, while sell-side analysts often provide valuable information for trading decisions.
The choice between buy-side and sell-side careers involves differences in compensation,
responsibilities, and regulations.

The recommendations of Wall Street analysts are often relied on by investors when
deciding whether to buy, sell, or hold a stock. Media reports about these brokerage-firm-
employed (or sell-side) analysts changing their ratings often affect a stock’s price. But do
these ratings truly matter?

2.4 Rio Tinto’s Brokerage Recommendation

Let’s examine what these Wall Street analysts have to say about Rio Tinto (RIO)
before discussing the reliability of brokerage recommendations and understanding the
roles of buy-side and sell-side analysts.

Rio Tinto currently holds an average brokerage recommendation (ABR) of 2.00 on

a scale of 1 to 5, where 1 represents "Strong Buy" and 5 represents "Strong Sell." This

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 Figure 1: Analyst Ratings Scale

ABR is calculated based on recommendations (Buy, Hold, Sell, etc.) made by 10 brokerage
firms. An ABR of 2.00 indicates a "Buy" recommendation.

Of the 10 recommendations contributing to the ABR, six are "Strong Buy," represent-
ing 60% of all recommendations.

2.5 Converting Analyst Forecasts to Alpha Forecasts

To generate alpha forecasts for stocks, you can take one of two broad approaches:

Direct Forecasting Approach:

Use a dividend discount model or similar methods to directly forecast the expected
return for each security. Calculate the expected return of the benchmark index. Compute
the relative expected return (alpha) of each stock by subtracting the expected return of
the benchmark index from the expected return of each stock.

Alpha Forecasting Rule of Thumb Approach:

In the context of forecasting stock alpha, analysts often play a crucial role in providing

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 Figure 2: Rio Tinto Ratings - September 2023

ratings for stocks. These ratings, typically ranging from 1 to 5, are essential for investors in
making buy, sell, or hold decisions. However, to use these ratings effectively in forecasting
alpha, we follow a specific process.

Analyst Ratings Standardization:

• Initially, we gather analyst ratings for various stocks, where ratings range from 1
(indicating a strong buy) to 5 (indicating a strong sell).

• These raw ratings need to be transformed into a standardized distribution. Stan-

dardization is essential to ensure that ratings from different analysts and stocks are
on a common scale, allowing for meaningful comparisons.

Calculation of the Score Parameter:

• Once the analyst ratings are standardized, we use them as the basis for calculating
the Score parameter. The Score parameter represents the degree to which a stock
is favored or disfavored based on analyst consensus.

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Figure 3: Ratings and Expected Alpha Distributions

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 • This calculation involves statistical methods that transform the standardized ratings
into a Score that quantifies the analyst sentiment towards each stock.

One way of calculating the score parameter is:

Rating − M ean(Rating)
Score =
StandardDev(Rating)

Alpha Forecasting:

• With the Score parameter in hand, we integrate it into the alpha forecasting process.

• Alpha, in this context, represents the expected relative return of each stock con-
cerning a benchmark or market index.

• The formula used to estimate alpha takes into account the Score, along with other
factors, such as the information coefficient (IC) and the expected volatility.

Alpha = E[IC] · (Score · E[V olatility])

• The information coefficient (IC) measures the correlation between analyst forecasts
and subsequent returns. We will discuss how this is calculated next week.

• Score, derived from the standardized analyst ratings, reflects the market sentiment
towards a stock.

• E[Volatility] represents the expected volatility or risk associated with a stock’s future
returns.

Understanding E[Volatility]:

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 • E[Volatility] plays a crucial role in the alpha forecasting equation. It represents the
expected variability or dispersion in returns compared to the consensus expected
returns of all investors.

• Essentially, it quantifies the uncertainty or risk associated with a stock’s future

performance.

• By multiplying the Score by E[Volatility], we construct alpha, which indicates the

expected relative return of a stock.

• This multiplication accounts for how much variability we expect in returns compared
to the consensus expected returns that produce the benchmark weights. Stocks that
analysts believe are likely to perform better are assigned higher values along the
distribution of future alphas. Conversely, stocks that analysts believe will perform
worse are assigned lower values along the expected distribution of future alphas. We
will discuss this in more detail in Week 4.

• The distribution of future alphas is typically centered around 0, indicating that, on

average, stocks are expected to perform in line with the market or benchmark. The
spread or width of this distribution is determined by E[Volatility].

In essence, by standardizing analyst ratings and incorporating them as the Score

parameter, analysts and investors can harness this valuable information to forecast stock
alpha, helping them identify potential opportunities and risks in the market.

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