CIPM Level 1 Flashcards
Members must
- act with integrity, competence, and diligence
- put profession and clients above self
- care and independence in analysis
- encourage others to be ethical
- promote health of market and society
- maintain/ improve professional competence
Professionalism
- knowledge of the law
- independence and objectivity
- misrepresentation
- misconduct
Integrity of capital markets
- material nonpublic information
- market manipulation
duties to client
- Fair Dealing
- Loyalty, prudence, and care
- suitability
- ask about experience, risk, goals, constraints, etc
- check decisions against answers to these questions
- Evaluate investments based upon this context
- Performance Presentation
- Preservation of confidentiality unless:
- illegal activities
- client permission
- Required by law
Duties to Employer
- Loyalty
- Additional Compensation
- Responsibilities of Supervisors
Analysis, Recommendations, Actions
- Diligence
- Be diligent in analysis
- Have reasonable support for actions
- Communication with Clients and prospective clients
- Disclose general investment process
- Disclose limitations/risks
- Use reasonable judgment
- disclose what is fact and opinion
- Record retention
Conflicts of interest
- Disclose conflicts of interest
- Priority of transactions\
- Referral Fees
Responsibility as CIPM Members
- Conduct as members
- reference to CIPM
4 questions of performance measurement
- How did portfolio achieve outcome and what are expected sources of future returns?
- Was observed performance luck or skill?
- Which managers should be hired/fired/kept?
- What info should be reported and how?
Book Value
Price at time of trade
Fair Value Price
The price it could be sold for
Unrealized gain/loss
Change in market value
Realized Gain/Loss
That value once it is redeemed(the asset is sold)
Issues with external cash flows
- Cash flows might not be manager decision so input of cash flows might not be fair
- Returns cannot be calculated based solely on beginning and ending value
- Exact dates and values of necessary events and flows may be expensive so can be approximated
When is time-weighted appropriate?
- When there is a need to neutralize impact of flows
- When comparing portfolios
- When measuring manager not fund
When is money-weighted appropriate?
- When accurate values are not available
- When manager is responsible for flows
- When time value of money matters
Ways to calculate composite returns
- Calculate returns using BMV weights
- Use weights from denominator of modified Dietz
- Calculate as a single portfolio
Attribution vs Contribution
Contribution doesn’t use a Benchmark
Returns based attribution
Looks at TF returns over time to look at factors (easiest and least accurate
Holdings based attribution
–misses transactions between measurement times so will not reconcile
Transactions based attribution
-uses both holdings and transactions and is the most accurate
Multi level attribution
Macro-Level: sponsor level
Micro- Level: manager level
Advantages of Factor Model
- Flexible
- Can use different models to capture different effects
- Can be made very sophisticated
Disadvantages of Factor Model
- Usually applied to single asset class
- Limited by factor used
- Can be significant computational costs
- Less consistency
- Can be less intuitive
Fixed Income return attribution
Duration: % change in bond price based on unanticipated change in interest rates
Convexity: nonlinearity in relationship between price and yield change
Credit Spread: Premium paid for riskier bond
Problems in return attribution
-Data input
- Residuals
* could be missing data
* missing categories
* missing instruments (i.e., currency effects)
* inconsistent return methodologies
*incomplete model
(arithmetic returns will not add up over time)
Off benchmark decisions
- You can handle it normally but give benchmark 0 weight
- Give allocation effect a zero for the sector
- Give the sector only an allocation effect
Benchmark Uses
- reference point
- instruction communication to manager
- instruction communication to consultant
- identification of risk
- interpretation of past performance
- manager selection/appraisal
- demonstrating compliance
Types of benchmarks
- absolute return
- manager universe
- broad market index
- factor-model based
- style index
- returns based
- custom security based
- peer group
properties of a valid benchmark
- unambiguous
- investable
- measurable
- appropriate
- reflective of current investment opinions
- specified in advance
- accountable
Evaluating benchmark quality
- Correlation between active return and style is statistically indistinguishable from zero
- Correlation between E (difference between portfolio and market) and style is greater than zero
- Standard deviation of A is less thanks standard deviation of E
- Betas should be stable over time
- Fore equities, benchmark should have low turnover (<15-20%)
- Should be investable without incurring high trading costs
- Low proportion of zero weight securities
- Should have high Coverage
Examples of inclusion criteria
- minimum trading price
- minimum available shares
- minimum liquidity
- company structure
- share types
- country assignment
Types of Benchmark weighting
- capitalization weighted
- value weighted
- price weighted
- equal weighted
- fundamental weighted
- optimization weighted
Free float inclusion criteria excludes:
- Cross ownership
- Large corporate/private holdings
- Employee owned shares
- IPO lockups
- government holdings
** Free float adjustment is particularly important in less developed countries
Index Rules
- reconstruction/rebalancing intervals
- corporate action handling
- dividend inclusion
Index tradeoffs
- Completeness vs investability
- Reconstitution and rebalancing frequency vs turnover
- Objective and transparent rules vs. judgment
Pros of weighting schemes
Market Cap- unambiguous, macro consistency, reflects CAPM, requires less rebalancing
Price- simple, long track record
Equal- Less influenced by large issuers
Fundamental- less subject to bubbles and market inefficiencies
Optimization based- plots on the efficient frontier of risk and reward
Cons of weighting schemes
Market cap-influenced by large issuers
Price- influenced by overpriced securities, stock splits reduce influence of successful companies, assumes investors hold one unit of every asset
Equal- small issuer bias, frequent rebalancing, small issuers might be too illiquid to be investable
Fundamental- often less diversified, might not be investable, often not fully known, tilted toward small cap, tend to outperform market cap bm’s although this isn’t really the goal of a benchmark
Optimization- can be over-concentrated in low risk securities, uses historical data that may not be good indicator of future
Problems with assigning a manager a style
- Often oversimplified and do not reflect n entire approach
- process is subjective and difference process gets different results
- fund may change over time
- designation often leads to peer group comparison which has its own problems
Bond index characteristics
- Issuer: Corporate, government, municipal, asset backed security, mortgage backed security
- Credit risk: investment grade, high yield
- Finer
- Corporate: industrial, utilities, financial
- Investment grade: AAA,AA,AA,BBB
Fixed Income Inclusion Criteria
country, credit risk, liquidity, maturity, sector
Typical list:
- publicly issued
- Nonconvertible
- Dollar denominated
- fixed coupon or one that changes regularly
- Maturity>1year
- meet minimum issue size
- fulfill necessary credit rating
Problems with bond indexes
- Bonds don’t trade as easily as socks so prices are often stale
- bond indexes are often based on appraised prices not traded prices
- using appraised value can bias standard deviation downward
- many bond indexes struggle with illiquidity (some will offer a more liquid subset to fix this)
- because bonds are so heterogeneous, seemingly similar indices can have very different returns
- Usually a lot of turnover due to updates for maturity, new issues, etc.
- Bums problem: more weight is given to big borrowers who are more likely to be down-graded
- Bonds that try to fix bum problem end up being even less liquid
Steps to create custom benchmark
- identify features of the manager’s process
- select securities appropriate for that process
- develop security weighting scheme and be sure to include cash
- review and make adjustments
- rebalance periodically
- document all changes
Hedge Fund Benchmark difficulties
- Hedge funds don’t have specific asset class
- They reflect manager attempts to exploit inefficiencies
- so…
- they can have unlimited universe
- they can vary a lot from one to another
- they can change over time
- they can be highly leveraged
- they often lack transparency
- traditional weights don’t apply
Hedge fund benchmark solutions
- Absolute returns X: Hedge funds change too much
- risk free benchmark X: HF’s are not risk free and risk changes when arbitrage comes into the picture
- broad market index X: Often weakly correlated
- manager universeX: survivorship bias,selection bias, and prices are reported infrequently and unverified
- Create custom benchmarks for long and short positions using returns-based or holdings based analysis
Components of Liability Portfolio
- Economy
- Past earnings
- Future Earnings
Liability relative benchmark is constructed to meet future obligations
Types of Risk
Financial
- Credit: Debtor doesn't pay - Market: assets are hard t trade or can't be traded - Liquidity: Broad category including changes in currency, interest, commodities, etc.
Non-Financial
- Operational risk- systems fail within company - Model risk- model fails or is misspecified - Settlement risk- the buyer fulfills his role but the counterparts fails to settle - Regulatory Risk - Legal/Contract risk - Tax Risk - Sovereign/Political Risk- government action - Accounting risk-uncertainty how to record a transaction
Risk measurement and attribution can be helpful for…
- investment policy definition
- portfolio construction
- portfolio analysis
- Enterprise Risk
Risk classification
- Ex ante
- Ex Post
- Stand alone
- idiosyncratic
- systematic
- Portfolio
- Absolute
- Relative
- Difference between risk of asset and liabilities is relative and is called surplus risk
- Difference between risk of investor trying to outperform bm and bm is relative and is called active risk
- Symmetric
- Asymmetric
Risk distribution
If mean>median, positive skewness
If mean
Total risk
Probability of extreme loss
Downside risk
Potential for loss
Problems with measures of downside risk
- symmetric risk values are more familiar and usable
- use only half available information so lack statistical power
- If returns are symmetric around mean, the downside risk adds no new info and if they are not, downside risk is less stable over time
- There are no ways to aggregate downside risk of multiple assets
- Target semi variance requires specification so adds subjectivity
Drawdown pros and cons
Pros
- often used for hedge funds and commodity funds because other metrics are less valid with returns that diverge from a normal distribution
- and because they often coincide well with the compensation plans of these vehicles
Cons
- Does not tell us much unless coupled with other information
- represents time series data into a single number so you get bad comparisons if you use different time-periods because ceteris paribus, longer periods can have larger drawdowns
Value at Risk Methods
- Analytical
- just requires average return and standard deviation
- assumes normality
- Historical
- assumes that past performance predicts future performance so new issunigs complicate calculation
- simply derives a P value using ranked returns (there is a 10% chance you will get the 10th highest return in a list of 10 returns)
- Monte Carlo
- can be very complicated but are great for portfolios like hedge funds where other assumptions are not appropriate
Investment Characteristics
- Valuation measures
- Interest rate sensitivity
- Sector Industry Classification
- Geographic Exposure
- Type of Issuer
- Investment Structure
- Credit Quality
- Liquidity
- Leverage
Types of Risk Appraisal
- Bottom up (security managed contribution to risk)
- Top Down
- Factor Exposure
Investment Appraisal Questions
- Do returns sufficiently compensate investor for risk
- How does portfolio compare to peers?
- Is performance from luck or skill?
Qualitative Considerations in Manager Selection
- Suitability
- Complementarity
- Firm
- People
- Investment Process
- Operational process
- Transparency
- Costs
Approaches to benchmarking managers
- Third party categorization
- Returns based style analysis
- Holdings based style analysis
- Manager Experience
Type 1 error
hire bad manager
Type 2 error
fire/don’t hire good manager
Manager evaluation parameters
- relative performance to peers and benchmark
- style drift
- operational issues
Manager Evaluation Questions
- Is there a difference between hired and not hired managers
- Are these differences consistent with investment philosophy?
- Are there identifiable factors driving the hire/fire decision?
- Are these factors consistent with investment philosophy?
- What is the added value of the hire/fire decision?
Implications of the hire/fire decisions
- performance implications
- transaction costs
- redemption fees
- hold backs
- tax liabilities
- portfolio implications
4 Attributions of effective risk reporting
- meaningful
- accurate
- consistent
- Timely
Active vsPassive Strategies
Passive- seek to capitalize on risk premiums
Active- Behavioral vs Structural inefficiencies
Pros and cons of SMAs
Pros
- ownership
- customization
- tax-efficiency
- transparency
Cons
- cost
- tracking risk
- investment behavior
Operational Red Flags
- Change in auditor
- Affiliated broker/dealer
- Inconsistent transparency
- Unconfirmed work history
- Legal issues
