Manager selection and other

Question 1

Due diligence on investment manger

Answer 1

emphasize the sources and reasons behind the actual returns generated in the past
- must be an evaluation on the probability of repeated earnings sufficient or better returns in the future using the same inv. process.

Question 2

Manager universe

Answer 2

consist of only those manager who are subtle for the portfolio in terms of the objectives and constraints of the IPS, style and will reconcile between active and passive approaches.

Question 3

approaches to assign a pm to a benchmark

Answer 3

1. 3rd party categorization
2. return-based style analysis
3. Holding’s based style analysis
4. manager experience

Question 4

Quant analysis

Answer 4

• evaluate objectively in terms of distribution of past returns
• perf attribution and appraisal
• capture ratio examine performance in both good and weak market conditions
  = check for any significant drawdowns (peak-through decline in terms for specific time period)

Question 5

quantitative analysis issue

Answer 5

1. what is the likelihood that the same level of returns will continue in the future
2. does the manager’s inv. process accurate for all the relevant risks

Question 6

Philosophy:

Answer 6

focus on a specific arcade of market inefficiency to earn excess returns

Question 7

process / people

Answer 7

determine whether the strategy is feasible and if it’s possible to execute the strategy with given knowledge and skills of the employees

Question 8

portfolio

Answer 8

must be built in way that is consistent with the philosophy and process

Question 9

Type I Error

reject null, no value added

Answer 9

ho: no value added

retain the manager with no skill

receive much more attention than type iI because:

• notion of regret aversion by the decision maker
• an error of commission
• result exploit cost
• transparent to investor

Question 10

type iI error

null is not rejected, when in fact there was value added

Answer 10

fire the manager with skill

• errors of omission
• result in implicit/ opportunity cost
• not measurable
• not transparent

Question 11

preventing type iI error

Answer 11

indicative of problems with the hiring and firing of managers

solution:
track the subsequent performance of managers who were not hired as well as those who were fired.
It is important not to hire or fire managers because of short term performance or because of behavior bias.

Question 12

cost of type I and II errors

Answer 12

the greater the different in sample size and mean, the greater the cost of Type i and iI errors

• the wider the dispersion of returns between strong and weak managers, the easier its to distinguish between their relative skills
• decrease the difference in sample size and mean, increase std, the decrease the expected cost
• more efficient markets exhibits smaller difference in the dispersion of skilled and unskilled PM, result in lower costs

Type ii error occur i mean-reverting markets when strong managers are fired or managers who have weaker ST performance are fired and they subsequently outperform when market goes up.

Question 13

Returns-based style analysis RBSA

Answer 13

Top-down approach that involve estimating the risk exposure from a n actual return rises for a given period.

adv:
straightforward, typically does not require a large amount of additional data, or difficult to acquire data

disadvantage:

1. lack precision
2. may not reflect the current or future portfolio exposures
3. if the portfolio contains liquid securities, stale, prices may understate the risk exposure

Question 14

Holding-based style analysis HSBA

Answer 14

(most appropriate for equity based strategies)

Bottom up approach that estimates the risk exposures from the actual securities held in the portfolio at a point in time.

adv:

1. it allows for the estimation of current risk factors, proving an accurate view of the PM’s risk exposure
2. comparable across PM and through time

disadvantage:
1. more computational effort required
2. high dependence on the degree of transparency provided by pM
3. stale pricing and window dressing
4. not appropriate if the portfolio has high turnover

Question 15

capture ratio

> 1 POSTIVE asymmetry convex

Answer 15

determine how suitable a manager is with respect to the investor’s risk tolerance and time horizon

UC (upside ) look at capture when benchmark has positive return

UC > 1 outperformance

DC look at capture when benchmark has a negative return

DC < 1 outperformance

• can be used to confirm investment strategy

high beta, momentum-driven strategies, should have increase UC than value driven strategies, high UC and DC

low beta will have low UC and DC.

Question 16

Drawdown

Answer 16

a low-beta strategy may have lower absolute return but low risk in the form of lower drawdowns may result in better risk-add returns

• useful for identifying poor/poorly executed investment strategies, weak internal controls, and operational problems

Question 17

investment philosophy

Answer 17

exploit inefficiencies in financial market to generate excess return

Question 18

behavioral inefficiency

Answer 18

mis-pricing caused by other investors and their behavior bias, st in nature

Question 19

Structural inefficiency

Answer 19

offer because of laws and regulations, which can make them LT in nature

Given the amount of inefficient assets compared with the AUM of managers likely to exploit them provides some assurance that the inefficiency is repeatable. It would likely take some time for the inefficiency to converge to efficient valuation. The infrequent nature of the inefficiency and the zero marginal return suggest that the inefficiency is probably not worthwhile to pursue.

Question 20

Idea generation

Answer 20

unique info adv, trendy, and interpreted differently

Question 21

idea implementation/ signal capture

Answer 21

idea transformed into a investment position

2 key concerns:
repeatability process
its consistent with investment philosophy to determination and approval of investment position

Question 22

portfolio constitution

Answer 22

risk mgmt
consistent with inv. philosophy and process
allocation of long and short position
AUM increase overtime

Question 23

monitor the portfolio

Answer 23

hard stop losses, program make decisions

soft stop loses, human engagement required

Question 24

operational due diligence

Answer 24

i. firm
must operate as a successful business to ensure sustainability

a small firm that is independent owned may have greater flexibility than a large organization, but it may have a higher cost structure and lack financial support during market events

ii. investment vehicle SMAs vs. pooled investment
iii. evaluation of investment’s streams

Question 25

pooled investment

Answer 25

• bring together funds from all investors in one (MF, ETFs, HF)
• no custimization
• payment of accrued taxes in unrealized gains maybe required

Question 26

SMA:

Answer 26

• hold funds of 1 investor in a separate account
• higher transaction costs
• provide control, customization, tax efficiency, separate reporting and greater transparency
• allow client- specific objective/ constraints
• require an extra layer of due diligence

disadvantage:
- cost additional operation burden
- tracking risk: large asset required to fully replicate the index performance
- investment behavioral: subject to behavioral bias as they are unprofessional

Question 27

investment streams

Answer 27

liquidity from high to low:

• close-end fund
• ETFs

-open-ended funds

• HF (redemption lockup period and gates)
  adv: ability to have long inv. horizon not allowing investor to overreact to ST
  -invesmtnt in liquid premium
  disadvantage
• impaired ability to change portfolio allocations in response to change in the market
• PE
• VC fund due to capital calls

Question 28

fee structure/ performance fees

symmetrical structure with full upside and downside exposure

Answer 28

fee = base + performance sharing

the greater alignment between investor and manager incentives, but higher risk to manager due to full downside exposure

Question 29

bonus with full upside and limited downside exposures

Answer 29

fee = max( base, base + sharing of positive perf)

Question 30

bonus with limited upside and downsize potential

Answer 30

fee = max ( base, base + sharing of positive performances with limit)

Question 31

STD underestimate downside risk

Answer 31

(BEI active return - base fee) * sharing
= performance fee / base fee
= total billed fee

= long call on the portfolio return with a strike = based fee

Question 32

liquidity profiling and time-to-cash tables

Answer 32

1. determine potential cash in/outflows
2. establish a timeline that involves constrains a liquidity classification schedule (time-to-cash table)
   - amount of time needed to convert asset to cash
   - liquidity classification level
   - liquidity budget

Question 33

rebalancing and commitment

Answer 33

systematic rebalancing policies
-maintain LT strategies asset allocation

calendar and % range rebalancing with pre-determined acceptable ranges for various asset classes

automated adj. mechanisms - keep the portfolio risk profile relatively constant if there’s change from the target commitments

Question 34

street testing

Answer 34

based on any combination of history, statistical model, and scenario analysis

Question 35

derivatives

Answer 35

ideal method for rebalancing

a future overlay for rebalancing of many (but not all) asset classes without altering any of the asset allocation.

Question 36

liquidity premium increase with time horizon

Answer 36

value of put option

where the strike price is the marketable price of the liquidity asset

illiquid asset price = marketable asset- put price
illiquidity premium % = expected return on illiquid asset % - expected return on market asset %

Question 37

taking a long future position requires only minimum cash requirement for magin

Answer 37

form of leverage investment

any cash not require for margins can be used to inv. in other assets with differing levels of liquidity, or to meet other liquidity requirement

Question 38

options can be purchase at premium that are

Answer 38

only a fraction of the cost of underlying asset, thereby securing as a form of leverage.
Options can be sold to earn premium income that helps to generate liquidity.

Question 39

For P/E, capital calls are greater than capital distributions

Answer 39

resulting in a greater concentration of private equity

certain investment made by pm may restrict investors from withdrawing the funds during stressed market conditions, which decrease the polio’s overall liquidity.

Question 40

PE are not valued as frequent as public equity

Answer 40

activation of gates

the smoothing effect

Question 41

Time weighted return original Dizfz = R=

Answer 41

(EMV- BMV- CF)

/ (BMV+ 0.5 CF)

Question 42

Modified Dizfz: R-

Answer 42

(EMV-BMV-CF)

/ (BMV+ SUM OF wi* CFi)

Question 43

Aggregated method Rbmv+cf

Answer 43

= sum of EMV - sum of bmv - sum of cash flow

/ sum of BMv + sum(cash flow * wi)

Question 44

3 reasons deterioration may occur

Answer 44

• for private equity capital calls are greater than capital distribution, resulting a greater concentration of PE in the portfolio
• certain investment made by the pm may restrict investor from withdraw their funds during stressed market conditions, which decrease the portfolio overall liquidity

-PE investment are not valued as frequent. The lagged valuation mean there is a relation increase as % of portfolio and a relative low liquidity asset as a % of portfolio during stressed market condition. The % of asset available for meeting liquidity needs is reduced.

Question 45

Tracking error perspective

Answer 45

ETF face tracking error for reasons such as cash drag, and mandatory diversification

futures : liquidity and interest rate differentials

total return swap: have no tracking error