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9. Appendix Overview
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Appendix 1: Glossary
Active Portfolio Management
The pursuit of portfolio investment returns in excess of the benchmark, MSCI Denmark.
Active Return
Return relative to the Benchmark. E.g. if the portfolio return is 5% and the benchmark return is 3%, active return is 2%.
Active Risk
The risk of active return. This is also called the tracking error.
Alpha
The residual return. In the context of this thesis, alpha, also called value added, is the difference between portfolio and benchmark beta multiplied by active return.
Asset Allocation
The process of allocating funds into the portfolio. In this thesis asset allocation is conducted by means of Markowitz’ mean-variance portfolio model.
Benchmark
The reference index for active management. In this thesis, the reference index is the MSCI Denmark. The goal of the investor is to excess the benchmark return.
Information Ratio
The monthly expected residual return divided by the tracking error. Value added is proportional to the information ratio.
83 Market Index
The portfolio of all assets, MSCI World. The concept of market and benchmark index is separated in the context of this thesis. The market index is applied for measuring systematic risk of both benchmark and investment opportunities.
Market Timing
The ability to identify a point in time appropriate for repositioning the portfolios. The concept of market timing is based upon the belief that markets will provide positive return during periods between the processes tactical asset allocation.
R-Square
A statistic associated with regression analysis, where it describes the fraction of observed variation in data captured by the model. It varies between 0 and 1.
Portfolio Repositioning
Also referred to as portfolio reweighting. The process of altering the weight of portfolio assets in accordance with tactical asset allocation.
Opportunity Set
The investment indices available for active portfolio management. Ten sector indices constitute the investment opportunity set.
Residual Frontier
A set of portfolios, one for each level of residual return, alpha, with minimum residual risk.
Residual Return
It is the difference between beta adjusted excess return of the portfolio and benchmark.
84 Market Risk Premium
The expected excess return of the market index.
Sharpe Ratio
The ratio of monthly excess return to total risk.
Skill
The ability to accurately forecast returns. Skill is identified through market timing and measured using the information ratio.
Stationarity
Historical returns of the investment opportunities are said to be stationary as average returns and standard deviations are constant over time.
Strategic Asset allocation
Involves the fundamental choice of the investment opportunity set and benchmark.
Systematic Risk
It is also called market risk characterized by beta. It measures the sensitivity of a sector, portfolio or benchmark to the market. For every 1% return to the market we expect a beta times 1% return to the sector or benchmark. It is calculated as the covariance between a given index and the market portfolio divided by the variance of the market portfolio.
Tactical Asset Allocation
Tactical asset allocation seeks to obtain positive residual return by periodically changing sector positions in the portfolio.
85 t-statistic
The t-statistic helps test the hypothesis that a given estimate differs from zero. With some standard statistical assumptions, the probability that a variable with a true value of zero would exhibit a t-statistic greater than 1,96 in magnitude is less than 5%.
Tracking Error
See active risk.
Value Added
In the context of this thesis value added is the difference in portfolio and benchmark beta, multiplied by the active return. Value added depends upon the performance of the investment strategy.
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Appendix 3: Interview Guide
First, I would like you to tell me about what you do at Nordea Investment Management. I will afterwards ask you some questions within the areas of asset allocation and risk management.
Asset Allocation
An area within the literature of finance distinguishes between strategic asset allocation (SAA) and tactical asset allocation (TAA). SAA accepts that markets are efficient and applies a passive approach to its investment strategy. On the other hand, TAA is an investment strategy which concerns proactive portfolio repositioning, based on expectations with regards to the financial markets.
Thus, the difference between TAA and SAA is that TAA does not conduct one long-term based asset allocation process, but adjusts the portfolio to the market on a periodic basis.
Please provide your assessment upon these two types of asset allocation and you opinion with regards to the hypothesis of market efficiency?
1) Describe what you consider a good investment strategy with the objective of managing a portfolio consisting of stocks only.
2) Will you describe this strategy as passive or active portfolio management?
- If passive, is that based on the assumption that it is difficult to produce a return superior to what the passive market provides, and that opportunities for portfolio diversification are understated?
- If active, is this based on the conviction that it is in fact possible to outperform the passive market return?
- Other?
3) Is it your impression that the attempt to time the market by over- and underweighting portfolio assets based on e.g. sector characteristics, leads to superior return relative to passive investing, or to transaction costs too high to yield the return your estimations expected?
88 Risk Management
Risk is a universal concept, and numerous definitions exist, as investors has different perceptions of risk.
1) Please provide a definition of risk with regards to financial transactions.
2) Describe risk factors which Nordea’s stock portfolios are exposed to in particular.
3) What requirements do you think necessary for the active investor to conduct effective risk management?
4) How does Nordea Investment Management evaluate risk?
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