Portfolio Construction (10.27.24) Flashcards
Correlation between equities and hyperinflation
Negative
Negative screening
(ESG) approach that consists of excluding investments in certain sectors, companies, or practices
Positive-screening
Including sectors, companies, practices, etc.
Best in class approach
(ESG) implementation approach that seeks to identify the most favorable companies in an industry based on ESG considerations
Goal of ESG integration
Reduce financial risks and/or enhance financial returns by identifying and valuing risks or opportunities that are not typically identified and valued
Thematic Investing
Investing in companies with positive exposure to ESG mega trends
Examples of thematic investing
clean energy, green technology, sustainable agriculture, gender diversity, or affordable housing
Impact investing
Seeks to achieve targeted social or environmental objectives along with measurable financial returns through engagement with a company or by direct investment in projects or companies
4 Roles of Equities in Portfolio
1) Capital appreciation
2) Dividend Income
3) Diversification with other asset classes
4) Hedge against inflation
Optional stock dividends
Type of dividend in which shareholders may elect to receive either cash or new shares, option can be sold
Securities Lending
A form of collaterized lending that may be used to generate income for portfolios
Stock lending
Securities lending involving the transfer of equities
Dividend Capture
Trading strategy, where equity PM purchases stocks just before their ex-dividend dates, holds these stocks through ex-dividend date to earn the right to receive the dividend, and subsequently sells the shares
High-water mark
A measure that reflects the fund’s maximum value as of a performance fee payment date net of fees
5 Costs associated with owning and managing an equity portfolio
1) Management fees
2) Performance fees
3) Administration fees
4) Marketing and Distribution Costs
5) Trading costs
Buffering
Establishing ranges around breakpoints that define whether a stock belongs in one index or another
Packeting
Splitting stock positions into multiple parts
3 Advantages of market cap weighted index
1) Mean variance efficient
2) Reflects a strategy’s investment capacity
3) Liquidity weighted index
Most common form of market-cap weighting
Free-float weighting - adjust each constituent’s shares outstanding for closely held shares that are not generally available to the investing publicP
Price-weighted index
Weight of each stock is its price per share divided by the sum of all share prices in the index (DJI and Nikkei 225)
3 Roles of Fixed-Income securities in portfolios
1) Diversification (low correlation with equities)
2) Regular cash flows
3) Inflation-hedging potential (inflation-linked bonds)
For an index to become the benchmark for an equity investment strategy, what are the 3 initial requirements
1) rules based
2) transparent
3) investable
Two broad categories of fixed-income mandates
1) Liability based mandates
2) Total return mandates
Liability-based mandates definition and 4 types of
Mandates managed to match or cover expected liability payments (future cash outflows) with future projected cash inflows, also called asset/liability management (ALM)
1) Cash-flow matching
2) Duration matching
3) Derivatives overlay
4) Contingent immunization
Cash flow matching
Immunization approach that attempts to ensure that all future liability payouts are matched precisely by cash flows from bonds or fixed-income derivatives
Duration matching
Immunization approach based on the duration of assets and liabilities. Ideally, the liabilities being matched (the liability portfolio) and the portfolio of assets (the bond portfolio) should be affected similarly by a change in interest rates
Contingent immunization
Hybrid approach that combines immunization with an active management approach when the asset portfolio’s value exceeds the present value of the liability portfolio
Total Return Mandates definition and 3 types
Managed to either track or outperform a market-weighted fixed-income benchmark, such as the Bloomberg Barclays Global Aggregate Bond Index
1) Pure indexing
2) Enhanced indexing
3) Active management
Pure indexing
Attempts to replicate a bond index as closely as possible, targeting zero active return and zero active risk
Active return
Return on a portfolio minus the return on the portfolio’s benchmark
Active risk
Annualized standard deviation of active returns
Tracking risk (tracking error)
The standard deviation of the differences between a portfolio’s returns and its benchmarks returns
Enhanced indexing approach
Maintains a close link to the benchmark but attempts to generate a modest amount of outperformance relative to the benchmark
Active management
Portfolio management approach that allows risk factor mismatches relative to a benchmark index causing potentially significant return differences between the active portfolio and the underlying benchmark
Macauley Duration (MacDur)
Weighted average of the time to receipt of the bond’s promised payments, where the weights are the shares of the full price that correspond to each of the bond’s promised future payments
Modified Duration (ModDur)
MacDur / (1+Yield per period), which estimates percentage price change (including accrued interest) for a bond given a change in its yield to maturity
Effective Duration
Sensitivity of the bond’s price to a change in a benchmark yield curve (using a parallel shift in the benchmark yield curve
Essential to the measurement of the interest rate risk of a complex bond where future cash flows are uncertain
Key Rate Duration
A measure of a bond’s sensitivity to a change in the benchmark yield curve at a specific maturity point or segment…helps identify shaping risk for a bond/portfolio – that is, its sensitivity to changes in the shape of the benchmark yield curve (yield curve becoming steeper or flatter or showing more or less curvature)
Empirical duration
A measure of interest rate sensitivity that is determined from market data…run a regression of bond price returns on changes in a benchmark interest rate
Money Duration
A measure of the price change in units of the currency in which the bond is denominated
Price value of a basis point (PVBP)
An estimate of the change in a bond’s price give an 1bp change in yield to maturity. PVBP scales money duration so that it can be interpreted as money gained or lost for each basis point change in the reference interest rate
Convexity
A second-order effect that describes a bond’s price behavior for larger yield movements. It captures the extent to which the yield/price relationship deviates from a linear relationship
If positive, expected return of the bond will be higher than the return of the identical-duration, lower-convexity bond if interest rates change
A bond with higher convexity might be expected to have a lower yield to maturity than a similar-duration bond with less convexity
What does nominal convexity calculations assume
Cash flows do not change when yields to maturity change
Effective convexity
A curve convexity statistic that measures the secondary effect of a change in a benchmark yield curve. A pricing model is used to determine the new prices when the benchmark curve is shifted upward (PV+) and downward (PV-) by the same amount (delta curve), holding other factors constant
Macauley duration properties for zero-coupon (option free) bonds:
MacDurs increase linearly with maturity (30-year zero has 3x duration of 10-year zero)
Convexity properties for zeros
Convexity is approximately proportional to duration squared (30-year zero has 9x convexity as 10-year zero)
Convexity of coupon-paying bonds vs. zeros
Coupon-paying bonds have more convexity than zeros of the same duration
In fact, the more widely dispersed a bond’s cast flows are around the duration point, the more convexity it will exhibit (zero will have lowest convexity of all bonds of a given duration)
Bond portfolio duration
Sensitivity of a portfolio of bonds to small changes in interest rates, calculated as the weighted average of time to receipt of the aggregate cash flows or weighted average of the individual bond durations of the portfolio
Modified duration of a bond portfolio
Indicates percentage change in the market value given a change in the yield to maturity
When is convexity more valuable as a measure
when YTM are more volatile
How can a portfolio’s convexity be altered
By shifting the maturity/duration distribution of bonds in the portfolio, by adding individual bonds with the desired convexity properties, or by using derivatives
Effective duration formula
(PV-) - (PV+) / (2 * delta curve * PV0)
Effective convexity formula
(PV-) + (PV+) - (2*PV0) / (PV0 * delta curve ^2)
Spread duration
Change in bond price for a given change in yield spread, also called OAS duration when OAS is the yield measure used
Duration times spread (DTS)
Weighting of spread duration by credit spread in order to incorporate the empirical observation that spread changes for lower-rated bonds tend to be consistent on a percentage, rather than absolute, basis
Portfolio dispersion
Captures the variance of the times to receipt of cash flows with respect to the duration, used in measuring interest rate immunization for liabilities
measures the extent to which the payments are spread out around the duration
higher cash flow dispersion leads to an increase in convexity
Relative Value
Concept that describes the selection of the most attractive individual securities to populate the portfolio with, using ranking and comparing
Private wealth management
Financial planning and investment management to help individual investors, particular HNW and UHNW, manage their wealth
HNW individual minimum threshold
1 million
UHNW individual minimum threshold
30 million
7 phases of the wealth life cycle
1) Education phase
2) Early career phase
3) Career development phase
4) Peak accumulation phase
5) Preretirement phase
6) Early retirement phase
7) Late retirement phase
Human capital
Net present value of an individual’s future expected labor income
5 Main components of an IPS
1) Client’s background and investment objectives
2) Investment program parameters
3) Portfolio asset allocation ranges
4) Portfolio management processes
5) Duties and responsibilities of the involved parties
Personal assets
Personal property that is not expected to appreciate in value
Gini coefficient
A measure of inequality of wealth, or i, that ranges from 0 (perfect equality) to 1 (perfect inequality)
Lorenz Curve
A measure of the cumulative percentage of wealth owned by each percentage of the population
Family office
Private firm that offer a range of wealth management services tailored specifically for ultra high net work individuals
Expected return for fixed income
(coupon income) +/- (rolldown return) +- (expected change in price due to investor’s view of benchmark yield) +- expected change in price due to investor’s view of yield spreads) +- (expected change in price due to investor’s view of currency value changes)
Rolldown return
Results from the bond “rolling down” the yield curve as the time to maturity decrease, assuming zero interest rate volatility
(bond price as of end of horizon period - bond price beginning of horizon period) / bond price beginning of horizon period
Expected change in price based on investor’s view of benchmark yield
(-ModDur * Delta Yield) + (1/2 * convexity * delta yield^2)
Expected change in price base don investor’s views of yield spreads
(-ModSpreadDur * delta spread) + (1/2 * convexity * delta spread^2)
Rolling yield
coupon income + rolldown return
Easiest component to estimate in fixed income returns
coupon income
Limitations of the Expected Return Decomposition of Fixed Income
1) Assumes all intermediate cash flows of the bond are reinvested at the yield to maturity
2) Ignores local richness/cheapness effects and potential financing advantages
Leverage
Use of borrowed capital to increase the magnitude of portfolio positions
Leveraged portfolio return
Portfolio return / portfolio equity
[return on invested funds * (value of portfolio equity + borrowed funds) - (borrowed funds * borrowing rate) ] / value of portfolio equity
return + V(b) / V(e) * (return - cost of funds)
Leverage of futures contract
(notional value - margin) / margin
Interest on repo
Dollar interest = principal amount * repo rate * (term of repo/360)
Haircut
Amount by which the collateral’s value exceeds the repo principal amount
Rebate Rate
The portion of the collateral earnings rate that is repaid to the security borrower by the security lender
collateral earnings rate - security lending rate
Rebate rate when securities are difficult to borrow
negative
Types of liabilities
Type 1: amount of cash outlay - known; timing of cash outlay - known
Type 2: amount of cash outlay - known; timing of cash outlay - unknown
Type 3: amount of cash outlay - unknown; timing of cash outlay - known
Type 4: amount of cash outlay - unknown; timing of cash outlay - unknown
Type 1 Liability example and measure for interest rate sensitivity
traditional bond no embedded option
MacDur, ModDur, PVBP
Type 2 liability example and measure for interest rate sensitivity
Callable and puttable bonds
term life insurance policy (timing of death unknown)
Effective Duration
Type 3 liability example and measure for interest rate sensitivity
floating rate notes
Effective Duration
Type 4 liability example and measure for interest rate sensitivity
property insurance
Effective Duration
Immunized Portfolio convexity
(MacDur^2 + MacDur + Dispersion) / (1+Cash flow yield)^2
Unsmoothing
An adjustment to the reported return series if serial correlation is detected
Capital Contribution (CC) in year t
RC * (CC - PIC)
RC = rate of contribution
CC = Capital commitment
PIC = paid in capital
Placeholders for alts
high yield = private credit
REITs = private real estate
energy/commodity futures = private real assets
General guideline for time investment in alternative
15 years
3 Primary approaches to determine how much to put into alts
1) Monte Carlo
2) Optimization techniques
3) Risk-factor based approach
Longevity Risk
The risk of outliving your assets
greatest in later retirement phase of wealth life cycle
Performance measures for institutional investor vs individual investor
institutional - benchmark
individual - goal
Risk measures for institutional investor vs. individual investor
institutional - quantitative metrics
individual - risk of not meeting the goal
Tax drag
the negative effects of taxes on an investments’ returns
5 Defining characteristics of an institutional investor
1) Scale (size of assets)
2) Long-term investment horizon
3) Regulatory Frameworks
4) Governance framework
5) Principal-agent issues
Canada model
Characterized by a high allocation to alternatives. Unlike the endowment model, however, the Canada model relies more on ~internally managed assets~
The innovative features of the Canada model are the: a) reference portfolio, b) total portfolio approach, and c) active management
Key elements that affect DB cash flows
1) Service/tenure
2) Salary/earnings
3) Mortality/longevity
5 Types of Sovereign Wealth Funds
1) Budget stabilization fund
2) Development fund
3) Savings fund
4) Reserve fund
5) Pension reserve fund
Budget Stabilization Fund investment objective and allocation
Capital preservation
Dominated by fixed-income investments because of their defensive nature
Development funds investment objective and allocation
Support a nation’s economic development with the ultimate goal of raising a country’s long-term economic growth
Savings fund investment objective and allocation
ensure wealth transfer to future generations
Tilted toward growth assets, equities, and alternatives due to long investment horizons
Reserve funds investment objective and allocation
Achieve a rate of return above the return the government must pay on its monetary stabilization bonds, thereby eliminating the negative cost-of-carry of holding excess FX reserves
Similar to savings funds (growth assets, equities), but less to alternatives because of higher liquidity needs
Pension reserve funds investment objective and allocation
earn sufficient returns to maximize the likelihood of being able to meet future unfunded pension, social security, and/or health care liabilities of plan participants as they arise
Tilted toward equities with significant allocation to alternative assets, such as real assets and infrastructure, private equity and debt markets, and hedge funds
Types of foundations
1) Community foundations
2) Operating foundations
3) Corporate foundations
4) Private grant-making foundations
Community foundation
Charitable organizations that make social or educational grants for the benefit of a local community, funded by public donations
Operating foundation
Organizations that exist to operate a not-for-profit business for charitable purposes, funded by individual donors or donor families
Corporate foundation
Established by businesses, funded by profits
Private grant-making foundation
Established by individual donors or donor families to support specific types of charities, largest foundations in US are these
3 Different types of endowment spending policies
1) Constant Growth rule: provides a fixed amount annually to the university, adjusted for inflation
2) Market value rule: endowment pays a pre-specified percentage (spending rate) of the moving average of asset values, typically between 4% and 6%
3) Hybrid rule: Spending is calculated as a weighted average of the constant growth and market value rules
How much do private foundations in the US need to pay out of their assets to be eligible for tax-exempt status
5%
Two types of insurance companies
1) Life insurers
2) Property and casualty insurers
Effective spread
spread that traders would have observed if the quoted ask or the bid were equal to the trade price
2 * (trade price - (ask price + bid price) /2) : buy orders
trade size * (midpoint - trade price)
Implementation shortfall
The difference between the return for a notional or paper portfolio, where all transactions are assumed to take place at the manager’s decision price, and the portfolio’s actual return, which reflects realized transactions, including all fees and costs
Volume-weighted average price (VWAP)
widely used benchmark price to estimate transaction costs
trade size * (trade VWAP - VWAP benchmark) for buy orders
trade size * (VWAP benchmark - trade VWAP) for sell orders
When VWAP is problematic
1) When the trades being evaluated are a substantial fraction of all trades in the VWAP benchmark
2) When the trades took place at the same rate as the other trades in the market
Market fragmentation
Trading the same instrument in multiple venues
High frequency traders (HFTs)
complete round trips composed of a purchase followed by a sale within a minute or quicker
Low-latency traders
News traders who trade on electronic news feeds and certain parasitic trades, hold their positions for as long as a day or longer
Parasitic traders
Speculators who base their predictions about future prices on information they obtain about orders that other trades intend or will soon intend, to fill
includes, front runners
3 Needs for speed for electronic traders
1) Taking: Trading before others
2) Making: providing liquidity
3) Cancelling: canceling orders
Latency
the elapsed time between the occurrence of an event and a subsequent action that depends on that event
Are peer comparisons good indexes for benchmarking alts returns
no
Return hierarchy
1) Private equity
2) Public equity
3) Private credit
4) Public real estate
5) private real estate
6) hedge funds
7) commodities
8) broad fixed income
9) govt bonds
10) cash
Primary limitations of traditional asset allocation approach to define an opportunity set
overestimates the portfolio diversification and obscure primary risk drivers
primary strength of traditional asset allocation
easy to understand and communicate, and useful for managing liquidity
Traditional asset allocation approach
categorizes investments based on asset classes such as equities, bonds, and real estate, focusing on diversification across those asset classes to manage risk and achieve desired returns
Risk Factor-Based asset allocation apporach
categorizes investments based on their exposure to specific risk factors like market risk, size, value, and liquidity, with a focus on identifying and managing the underlying risk factors that drive investment returns
primary strengths of risk factor-based asset allocation
provides a more precise risk management framework and helps in identifying common risk factors across different investments
Primary limitations of risk factor-based approaches
sensitive to historical data and can be challenging to implement (high overhead)
Where in the IPS does it include the investor’s preference for investments that reflect environmental and social concerns
asset classes preference & constraints
what key information should be included in the background of the IPS
client’s name, age, personal details, personal and business assets’ market value, individual accounts, tax status of the accounts, specifics about tax jurisdictions where income and capital gains are taxed, and description of the family
Capital sufficiency analysis
The process of evaluating whether a client has sufficient capital resources to achieve their financial goals and objectives; it considers the client’s assets, liabilities, income, expenses, risk tolerance, time horizon, and other relevant factors
What is the discount rate for the estimation of the value of human capital (future income)
nominal risk-free rate + volatility metric for uncertainty of future earnings
What happens to value of human capital over time
decreases over time until retirement
Tax drag on deferred taxes on income relative to accrual taxes
Deferred taxes decrease tax drag
What is included in the other investment preferences category of IPS
legacy holdings such as shares of a former employer or an investment the client wishes to make countering the wealth manager’s advice
flickering quotes
exposed limit orders that electronic traders submit and then cancel shortly thereafter, often within a second in order to test the market or to avoid having the orders executed
bluffing
submitting orders and arranging trades to influence other traders’ perceptions of value
bluffers often prey on momentum trades,
spoofing
trading practice in which traders place exposed standing limit orders to convey an impression to other trades that the market is more liquid that it is or to suggest to other trades that the security is under or over valued
How does MVO typically allocate to alternative investments
MVO typically overallocates to the private alternative asset classes because of underestimated risk due to stale pricing and the assumption that returns are normally distributed
cannot easily accommodate the characteristics of most alts
What should liquidity planning account for with private assets when taking into account or forecasting a potential bear market
General partners may exercise an option to extend the life of the fund
how well does systematic risk explain risk and return patterns of public assets vs. private assets
very well for public assets, but far less for private assets because private assets use appraisal based valuation
Correlation between public real estate and equities
fairly high, positive correlation, as well as high positive equity beta
best asset classes to diversify public equities
Fixed income: governments, inflation-linked, investment grade credit
Real assets: public real assets (energy, metal, etc.), private real assets (timber, etc.)
Hedge funds: absolute return
best asset classes for income
Fixed income: high-yield credit, private credit
Real estate: public real estate, private real estate
Real assets: private real assets
best asset classes for capital growth
Equities: public equity, private equity
Real assets: private real assets
the most appropriate investment for funds committed to private real estate investments while waiting for capital calls
REITS because they have the most similar return and risk characteristics and will help maintain the strategic asset allocation set out
how does MVO characterize asset risk
standard deviation
Mean-CVaR Optimization
focuses on minimizing the expected shortfall (CVaR) beyond a certain confidence level, while also considering the mean return
downside of Mean-CVar
can be more complex to implement and requires more computational power and data
how to choose between mvo and mean-cvar
if there is a large allocation to alts, that signifies complexity in the current plan so mean-cvar, also because mvo is bad at incorporating alts
if the goal is minimizing tail risk, mean-cvar
governance framework that is similar between institutional investors and alternative investments
institutional investors usually operate under a formal governance framework, such as an investment committee, or investment office
Maximum discount rate permitted for pension plans
High-grade bond yields average over the last 25 years
Is an overfunded pension plan an asset to the company’s shareholders
yes, because the surplus can potentially be used to reduce future contributions from the company, improve the company’s financial stability, and enhance shareholder value
What does ASC 715, compensation - retirement benefits state
an overfunded (underfunded) plan must appear as an asset (liability) on the balance sheet on the corporate sponsor
mortality risk of defined benefit plan vs defined contribution plan
defined benefit plan pools mortality risk and spreads it across all participants because anyone that dies prematurely leaves assets for the rest of the plan, whereas each individual contributor assumes mortality risk with DC plan
modified duration of bank’s equity capital after restructuring (formula)
D(E) = (A/E) * D(A) - (A/E - 1) * D (L) * (delta i/delta y)
A/E = 1/ideal equity capitalization ratio
D(A) = ideal modified duration of assets
D(L) = ideal modified duration of liabilities
delta i / delta y = change in yield on liabilities
which asset classes have the most excess kurtosis (downside risk)
- Private real estate **
- Public Real estate
- HF Equity market neutral
- HF distressed
- Private equity
qualitative considerations in alts strategy
1) key person risk
2) style drift
3) complexity
4) client/asset turnover - performance
how often should ips be reviewed
annually or when material changes occur in investor circumstances or the market environment
risk tolerance metric for DB pension fund
surplus volatility (standard deviation of asset returns in excess of liability returns) or shortfall risk if the plan is overfunded
risk tolerance metric for sovereign wealth funds
probability of investment losses (or probability of not maintaining purchasing power)
risk tolerance metric for endowments and foundations
volatility of total returns (standard deviation of total returns)
standard deviation of shareholder capital
(A/E)^2 * (StD (equity returns))^2 + (A/E-1)^2 * (StD (liability returns))^2 - (2 * A/E * A/E -1 * StD (Equity returns) * StD (liability returns) * correlation of equity and liability returns)
square root of that ^
