Part 4. Portfolio Management: Overview

Question 1

Portfolio perspective

Answer 1

This refers to evaluating individual investments by their contribution to the risk and return of an investors portfolio.

modern portfolio theory - extra risk from holding only a single security is not rewarded with higher expected investment returns.

Question 2

Diversification ratio

Answer 2

• It is calculated as the ratio of risk of an equally weighted portfolio of n securities (measured by its standard deviation of returns) to the risk of a single security selected random from n securities.
• if average standard deviation of returns for n stocks is 25%, and standard deviation of returns for an equally weighted portfolio of n stocks is 18%, the diversification ratio is 18/25 = 0.72.
• lower diversification ratio indicates a greater risk-reduction benefit from diversification
• during periods of financial crisis, diversification provides less reduction of risk.

Question 3

3 major steps in portfolio management:

Answer 3

1. Planning:

• Determine clients needs and circumstances, including clients return objectives, risk tolerance, constraints, and preferences.
• Create and periodically review and update an investment policy statement (IPS) that spells out these needs and circumstances.

2. Execution:
   - Construct the client portfolio by determining suitable allocations to various asset classes based on IPS, and expectations about macroeconomic variables such as inflation, interest rates and GDP growth.
   - Identify attractively priced securities within an asset class for client portfolios based on valuation estimates from security analysts.
3. Feedback:

• Monitor and rebalance portfolio to adjust asset class allocations and securities holdings in response to market performance.
• Measure and report performance relative to performance benchmark specified in the IPS.

Question 4

Endowment

Answer 4

• A fund that is dedicated to providing financial support on an ongoing basis for a specific purpose.
  i. e. US - many universities have large endowment funds to support their programs.

Question 5

Foundation

Answer 5

A fund established for charitable purposes to support specific types of activities or to fund research related to a particular disease for a continuing basis, without decreasing the real value of portfolio assets.

Question 6

Defined contribution pension plan

Answer 6

This is a retirement plan in which firm contributes a sum each period to the employees retirement account.

Contribution is based on multiple factors; including years of service, the employee’s age, compensation, profitability, or even percentage of employees contribution.

Firm makes no promise to employee regarding the FV of plan assets, and investment decisions are left to employee who assumes all the investment risk.

Question 7

Defined benefit pension plan

Answer 7

• The firm promises to make periodic payments to employees after retirement.
• The benefit is based in employees years of service, and compensation at or near retirement.
  e. g. employee may earn benefit of 2% of her final salary for each year of service, so 20 years of service and final salary of $100,000 would receive £40,000 (100,000 x 2% x 20) each year upon retirement until death.
• Employer assumes investment risk, making contributions to fund established to provide promised future benefits.
• Poor investment performance increases amount of required employer contributions to fund.

Question 8

Active management

Answer 8

They attempt to outperform a chosen benchmark through manager skill, for example by using fundamental or technical analysis.

Question 9

Passive management

Answer 9

They attempt to replicate the performance of a chosen benchmark index, include traditional broad market index tracking a smart beta approach focusing on exposure to a particular market risk factor.

Question 10

Trends in asset management

Answer 10

1. Market share for passive management has been growing overtime, due to lower fees charged questioning whether active managers add value over time on risk-adjusted basis, especially in developed efficient markets.
2. Amount of data available to asset managers has grown exponentially, encouraging investments in IT, and 3rd party services to process data, attempting to capitalise on info quickly to make investment decisions.
3. Robo-advisors offer investors advice and recommendations based on investment requirements and constraints using computer algorithm, lowering barriers to entry into asset management industry.

Question 11

Mutual funds

Answer 11

A form of pooled investments, where each investor owns shares representing ownership of a portion of overall portfolio.

NAV (net asset value) = total net value of assets in fund / number of shares issued.

Open end fund = investors can buy newly issued shares at NAV, where shares can be redeemed at NAV, but fee is charged for ongoing management.

• no-load funds = not charge add. fees for purchasing/redeeming shares.
• load funds = charge either up-front fees, redemption fees or both.

Closed end fund = professionally managed pools of investor money that do not take new investments into the fund or redeem investor shares

Question 12

Money market funds

Answer 12

Invest in ST debt securities and provide interest income with very low risk of changes in share value.

Question 13

Bond mutual funds

Answer 13

Invest in fixed income securities, differentiated by bond maturities, credit ratings, issuers and types.

e.g. gov. bond funds, tax-exempt bond funds, high yield bond funds, global bond funds.

Question 14

Stock mutual funds

Answer 14

1. Index funds - passively managed; where portfolio is structured to match the performance of a particular index such as S&P 500.
2. Actively managed funds - management selects individual securities with the goal of producing returns greater than those of their benchmark indexes, they have higher management fees and turnover of portfolio securities leading to greater liabilities than passive funds.

Question 15

ETFs

Answer 15

• They are similar to mutual funds, but investors can buy and sell EFT shares in the same way as shares of stock.
• Management fees are generally low, though trading ETFs results in brokerage costs.
• They are passively managed, and special redemption provisions are designed to keep their prices very close to their NAVs.
• They can be sold short, purchased on margin and traded at intra-day prices.
• Most investors receive any dividend income on portfolio in additional fund shares.
• They may produce less capital gains liability, as sales of shares do not require fund to sell any securities.

Question 16

Separately managed account

Answer 16

This is a portfolio that is owned by a single investor and managed according to that investors needs and preferences.

No shares are issued, as single investor owns the account.

Question 17

Hedge funds

Answer 17

• They are pools of investor funds that are not regulated to the extent that mutual funds are, and are limited to number of investors who can invest in the fund.
• They are often sold to qualified investors who have minimum amount of overall portfolio wealth, and minimum investments can be quite high between $250,000 and $1m.

Question 18

Private equity/venture capital funds

Answer 18

They invest in portfolios of companies often with the intention to sell them later in public offerings.

Managers of funds may take active roles in managing companies in which they invest.

Question 19

Buyout funds

Answer 19

This involves taking a company private by buying all available shares usually funded by issuing debt, and the company is then restructured to increase cash flow.

Investors typically exit investment within 3-5 years.