Portfolio Management

Question 1

Explain the creation/redemption process of ETFs and the function of authorized participants.

Answer 1

Authorized participants (APs) can create additional shares by delivering the creation basket to the ETF manager.

Redemption is similarly conducted by tendering ETF shares and receiving a redemption basket.

The creation/redemption mechanism is key to keeping the price of an ETF in a tight range around the NAV of the portfolio of securities it holds.

Question 2

Describe how ETFs are traded in secondary markets.

Answer 2

ETFs are traded just like other shares on the secondary markets.

Question 3

Describe sources of tracking error for ETFs.

Answer 3

Tracking error is the annualized standard deviation of the daily tracking difference.

Sources of tracking error include:

• fees and expenses of the fund
• sampling, and optimization used by the fund
• the fund’s investment in depository receipts (DRs)
• changes in the index
• regulatory and tax requirements
• fund accounting practices
• asset manager operations

Question 4

Describe factors affecting ETF bid–ask spreads.

Answer 4

ETF spreads are positively related to:

• the cost of creation/redemption
• the spread on the underlying securities
• the risk premium for carrying trades until close of trade
• the APs’ normal profit margin.

ETF spreads are negatively related to the probability of completing an offsetting trade on the secondary market.

Creation/redemption fees and other trading costs can influence spreads as well.

Question 5

Describe sources of ETF premiums and discounts to NAV.

Answer 5

ETF premium (discount) % = (ETF price – NAV) / NAV

Sources include:

• Timing difference for ETFs with foreign securities traded in different time zones
• Stale pricing for infrequently traded ETFs

Question 6

Describe costs of owning an ETF.

Answer 6

ETF costs include trading cost and management fees.

• Short-term investors focus on lower trading costs.
• Longer-term, buy-and-hold investors seek lower management fees.
• Trading costs tend to be lower for more-liquid ETFs.

Question 7

Describe types of ETF risk.

Answer 7

Risks of investing in ETFs include:

• counterparty risk (common for ETNs)
• fund closures
• expectation-related risk

Question 8

Identify and describe portfolio uses of ETFs.

Answer 8

Portfolio uses of ETFs include the following:

• *1. Efficient portfolio management:** including liquidity management, portfolio rebalancing, portfolio completion, and transition management.
• *2. Asset class exposure management:** including core exposure to an asset class or sub-asset class as well as tactical strategies.
• *3. Active investing:** including smart beta, risk management, alternatively weighted ETFs, discretionary active ETFs, and dynamic asset allocation.

Question 9

Describe arbitrage pricing theory (APT), including its underlying assumptions and its relation to multifactor models.

Answer 9

The arbitrage pricing theory (APT) describes the equilibrium relationship between expected returns for well-diversified portfolios and their multiple sources of systematic risk.

The APT makes only 3-key assumptions:

1. unsystematic risk can be diversified away in a portfolio
2. returns are generated using a factor model
3. no arbitrage opportunities exist.

Question 10

Define arbitrage opportunity and determine whether an arbitrage opportunity exists.

Answer 10

An arbitrage opportunity is defined as an investment opportunity that bears no risk and has no cost, but provides a profit.

Arbitrage is conducted by forming long and short portfolios; the proceeds of the short sale are used to purchase the long portfolio.

The factor sensitivities (betas) of the long and short portfolios are identical and the net exposure to systematic risk is zero.

Question 11

Describe and compare macroeconomic factor models, fundamental factor models, and statistical factor models.

Answer 11

A multifactor model is an extension of the one-factor market model; in a multifactor model, asset returns are a function of more than one factor. There are three types of multifactor models:

Macroeconomic factor models: assume that asset returns are explained by surprises (or shocks) in macroeconomic risk factors. Factor surprises are defined as the difference between the realized value of the factor and its consensus expected value.

Fundamental factor models: assume asset returns are explained by the returns from multiple firm-specific factors.

Statistical factor models: use multivariate statistics to identify statistical factors that explain the covariation among asset returns.

Question 12

Explain sources of active risk and interpret tracking risk and the information ratio.

Answer 12

Active return is the difference between portfolio and benchmark returns (RP − RB), and active risk is the standard deviation of active return over time.

Active risk is determined by the manager’s active factor tilt and active asset selection decisions:

active risk squared = active factor risk + active specific risk

The information ratio is active return divided by active risk

Question 13

Describe uses of multifactor models and interpret the output of analyses based on multifactor models.

Answer 13

Multifactor models can be useful for risk and return attribution and for portfolio composition. In return attribution, the difference between an active portfolio’s return and the benchmark return is allocated between factor return and security selection return.

Multifactor models can also be useful for portfolio construction. Passive managers can invest in a tracking portfolio, while active managers can go long or short factor portfolios.

A factor portfolio is a portfolio with a factor sensitivity of 1 to a particular factor and zero to all other factors. It represents a pure bet on a single factor and can be used for speculation or hedging purposes.

A tracking portfolio is a portfolio with a specific set of factor sensitivities that are odesigned to replicate the factor exposures of a benchmark index.

Question 14

Describe the potential benefits for investors in considering multiple risk dimensions when modeling asset returns.

Answer 14

Multifactor models enable investors to take on risks that the investor has a comparative advantage in bearing and avoid the risks that the investor is unable to absorb.

Question 15

Explain the use of value at risk (VaR) in measuring portfolio risk.

Answer 15

Value at risk (VaR) is an estimate of the minimum loss that will occur with a given probability over a specified period expressed as a currency amount or as percentage of portfolio value.

Question 16

Calculate the expected return on an asset given an asset’s factor sensitivities and the factor risk premiums.

Answer 16

Expected return = risk-free rate + ∑(factor sensitivity) × (factor risk premium)

Question 17

Compare the parametric (variance–covariance), historical simulation, and Monte Carlo simulation methods for estimating VaR.

Answer 17

Parametric method: uses the estimated variances and covariances of portfolio securities to estimate the distribution of possible portfolio values, often assuming a normal distribution.

Historical simulation: uses historical values for risk factors over some prior lookback period to get a distribution of possible values.

Monte Carlo simulation: draws each risk factor change from an assumed distribution and calculates portfolio values based on a set of changes in risk factors; repeated thousands of times to get a distribution of possible portfolio values.

Question 18

What is VaR?

Answer 18

The x% VaR is calculated as the minimum loss for the current portfolio, x% of the time, based on an estimated distribution of portfolio values.

Question 19

Describe advantages and limitations of VaR.

Answer 19

Advantages of VaR:

• Widely accepted by regulators.
• Simple to understand.
• Expresses risk as a single number.
• Useful for comparing the risk of portfolios, portfolio components, and business units.

Disadvantages of VaR:

• Subjective in that the time period and the probability are chosen by the user.
• Very sensitive to the estimation method and assumptions employed by the user.
• Focused only on left-tail outcomes.
• Vulnerable to misspecification by the user.

Question 20

Describe extensions of VaR.

Answer 20

Conditional VaR (CVaR): is the expected loss given that the loss exceeds the VaR. Sometimes referred to as the expected tail loss or expected shortfall.

Incremental VaR (IVaR): is the estimated change in VaR from a specific change in the size of a portfolio position.

Marginal VaR (MVaR): is the estimate of the change in VaR for a small change in a portfolio position and is used as an estimate of the position’s contribution to overall VaR.

Relative VaR (Ex ante tracking error): measures the VaR of the difference between the return on a portfolio and the return on the manager’s benchmark portfolio.

Question 21

Describe sensitivity risk measures and scenario risk measures and compare these measures to VaR.

Answer 21

Sensitivity analysis: is used to estimate the change in a security or portfolio value to an incremental change in a risk factor.

Scenario analysis: refers to estimation of the effect on portfolio value of a specific set of changes in relevant risk factors.

A scenario of changes in risk factors can be:

• historical
• based on a past set of risk factors changes that actually occurred
• hypothetical

Question 22

Demonstrate how equity, fixed-income, and options exposure measures may be used in measuring and managing market risk and volatility risk.

Answer 22

Equity risk: is measured by beta (sensitivity to overall market returns).

The interest rate risk: of fixed-income securities is measured by duration (sensitivity to change in yield) and convexity (second-order effect, change in duration).

Options risk: is measured by delta (sensitivity to asset price changes), gamma (second-order effect, change in delta), and vega (sensitivity to asset price volatility).

Market risk: can be managed by adjusting portfolio holdings to control the exposures to these various risk factors.

Question 23

Describe the use of sensitivity risk measures and scenario risk measures.

Answer 23

Stress test: based on either sensitivity or scenario analysis uses extreme changes to examine the expected effects on a portfolio or organization.

Reverse stress test: is designed to identify scenarios that would result in business failure.

Sensitivity and scenario risk measures provide additional information about portfolio risk but do not necessarily provide probabilities or, in the case of sensitivity measures, the sizes of expected changes in risk factors and portfolio value.

Question 24

Describe advantages and limitations of sensitivity risk measures and scenario risk measures.

Answer 24

Sensitivity analysis: provides estimates of the relative exposures to different risk factors, but does not provide estimates of the probability of any specific movement in risk factors.

Scenario analysis: provides information about exposure to simultaneous changes in several risk factors or changes in risk correlations, but there is no probability associated with a specific scenario.

Question 25

Explain constraints used in managing market risks, including risk budgeting, position limits, scenario limits, and stop-loss limits.

Answer 25

Risk budgeting: begins with determination of an acceptable amount of risk and then allocates this risk among investment positions to generate maximum returns for the risk taken.

Position limits: are maximum currency amounts or portfolio percentages allowed for individual securities, securities of a single issuer, or classes of securities, based on their risk factor exposures.

Stop-loss limit: requires that an investment position be reduced (by sale or hedging) or closed out when losses exceed a given amount over a specified time period.

Scenario limit: requires adjustment of the portfolio so that the expected loss from a given scenario will not exceed a specified amount.

Question 26

Explain how risk measures may be used in capital allocation decisions.

Answer 26

Firms use risk measures by adjusting expected returns for risk when making capital allocation decisions.

Question 27

Describe risk measures used by banks, asset managers, pension funds, and insurers.

Answer 27

Banks are concerned with many risks including asset-liability mismatches, market risk for their investment portfolio, their leverage, the duration and convexity of their portfolio of fixed-income securities, and the overall risk to their economic capital.

Asset managers are most concerned with returns volatility and the probability distribution of either absolute losses or losses relative to a benchmark portfolio.

Pension fund managers are concerned with any mismatch between assets and liabilities as well as with the volatility of the surplus.

P&C companies are concerned with the sensitivity of their investment portfolio to risk factors, the VaR of their economic capital, and scenarios that incorporate both market and insurance risks as stress tests of the firm.

Life insurers are concerned with market risks to their investment portfolio, any mismatch between assets and liabilities, and scenarios that would lead to large decreases in their surplus.

Question 28

Describe objectives in backtesting an investment strategy.

Answer 28

Backtesting uses past data to evaluate whether a particular investment strategy would have produced excess returns historically. This assessment allows an investor to assess the risk and return to optimize their investment process and strategy.

Question 29

What are the 3-steps and procedures in backtesting an investment strategy?

Answer 29

The three steps in backtesting an investment strategy are:

1. Strategy design:

• Specify the investment hypothesis and goals.
• Determine the investment process and rules of the strategy.
• Select key parameters.

2. Historical investment simulation:

• For each period, assemble a portfolio according to the previously determined rules.
• Rebalance the portfolio over time based on those investment rules.

3. Analysis of output:

• Compute performance statistics, (risk and return).
• Calculate other relevant metrics, such as turnover.

Rolling-window backtesting: an investor makes use of a walk-forward process, calibrates or fits trade signals or factors based on this rolling window, periodically rebalances the portfolio, and then evaluates portfolio performance over time.

Question 30

Interpret metrics and visuals reported in a backtest of an investment strategy.

Answer 30

The backtest of an investment strategy will produce return metrics, such as average return, and risk measures, such as volatility and downside risk.

Visuals used in a backtest of an investment strategy often include return distribution plots.

Question 31

Identify problems and bias in a backtest of an investment strategy.

Answer 31

Problems in a backtest of an investment strategy include the following:

1. Survivorship bias: When using data that only includes entities that have persisted until today.
2. Look-ahead bias: When using information that would have been unavailable at the time of the investment decision.
3. Data snooping: When a model is chosen based on backtesting performance.

Cross-validation: is when a model is first fitted using training data, and then its performance is assessed using separate testing data.

Question 32

Evaluate and interpret a historical scenario analysis.

Answer 32

Scenario analysis: is a method for investigating the performance and risk of investment strategies under different structural regimes.

Stress testing: examines the performance of a strategy under the most adverse combinations of events and scenarios.

If asset returns do not follow a multivariate normal distribution, scenario analysis and simulation can provide a more complete picture of investment strategy performance.

Question 33

Contrast Monte Carlo and historical simulation approaches.

Answer 33

Historical simulation: observations are randomly chosen from the historical dataset so that each observation has an equal probability of being selected.

Monte Carlo simulation: a statistical distribution is specified and calibrated using historical return data. When the assets or factors are correlated, a multivariate distribution should be used rather than modeling each asset or factor on a standalone basis.

Question 34

Explain inputs and decisions in historical simulation and interpret a simulation.

Answer 34

Historical simulation is relatively simple it depends on the assumption that randomness in the future can be predicted using return distributions from the past.

Historical simulation sometimes makes use of bootstrapping, whereby random samples are drawn with replacement. Bootstrapping is useful when the number of simulations needed is large relative to the size of (historical) dataset.

Question 35

Demonstrate the use of sensitivity analysis.

Answer 35

Sensitivity analysis is a method for evaluating how a target variable varies due to changes in the input variables.

Sensitivity analysis can overcome the shortcomings of a traditional Monte Carlo simulation, because it is not limited to multivariate normal distributions (do not take into account fat tails or negative skewness).

Question 36

Explain the notion that to affect market values, economic factors must affect one or more of the following: 1) default-free interest rates across maturities, 2) the timing and/or magnitude of expected cash flows, and 3) risk premiums.

Answer 36

The value of any asset can be computed as present value of its expected future cash flows discounted at an appropriate risk-adjusted discount rate.

Risky cash flows require the discount rate to be higher due to inclusion of a risk premium.

Question 37

Explain the role of expectations and changes in expectations in market valuation.

Answer 37

Market prices reflect current expectations. Only changes in expectations cause a change in market price.

Question 38

Explain the relationship between the long-term growth rate of the economy, the volatility of the growth rate, and the average level of real short-term interest rates.

Answer 38

Interest rates are positively related to GDP growth rate and to the expected volatility in GDP growth due to a higher risk premium.

Question 39

Explain how the phase of the business cycle affects policy and short-term interest rates, the slope of the term structure of interest rates, and the relative performance of bonds of differing maturities.

Answer 39

When the economy is in recession, short-term policy rates tend to be low. Investor expectations about higher future GDP growth and inflation as the economy comes out of recession lead to higher longer-term rates. This leads to positive slope of the yield curve.

Conversely, an inversely sloping yield curve is often considered a predictor of future recessions.

Question 40

Describe the factors that affect yield spreads between non-inflation-adjusted and inflation-indexed bonds.

Answer 40

Break-even inflation rate (BEI) = yield on non-inflation indexed bonds − yield on inflation indexed bonds

BEI is comprised of two elements: expected inflation (θ) and risk premium for uncertainty in inflation (π).

Question 41

Explain how the characteristics of the markets for a company’s products affect the company’s credit quality.

Answer 41

Spreads for issuers in consumer cyclical sector widen considerably during economic downturns compared to spreads for issuers in the consumer non-cyclical sector.

Question 42

Explain how the phase of the business cycle affects Cyclical and Non-Cyclical industries.

Answer 42

Cyclical industries: (durable goods and consumer discretionary) tend to be extremely sensitive to the business cycle; their earnings rise during economic expansions and fall during contractions.

Non-cyclical: or defensive industries tend to have relatively stable earnings.

Question 43

Explain how the phase of the business cycle affects credit spreads and the performance of credit-sensitive fixed-income instruments.

Answer 43

Credit spreads tend to rise during times of economic downturns and shrink during expansions. When spreads narrow, lower-rated bonds tend to outperform higher-rated bonds.

Question 44

Explain the relationship between the consumption hedging properties of equity and the equity risk premium.

Answer 44

Equities are generally cyclical; they have higher values during good times and have poor consumption hedging properties. Therefore, the risk premium on equities should be positive.

Question 45

Describe cyclical effects on valuation multiples.

Answer 45

Price multiples tend to follow the business cycle:

• multiples rise during economic expansions (as analysts revise growth estimates upward)
• multiples fall during contractions (as growth estimates are revised downward).

Question 46

Describe how economic analysis is used in sector rotation strategies.

Answer 46

Relative outperformance of sectors can be discerned ex post. Ex ante forecasting of this outperformance is the objective of active managers.

Question 47

Describe the economic factors affecting investment in commercial real estate.

Answer 47

Commercial real estate has equity-like and bond-like characteristics.

The valuation depends on:

• the rental income stream
• the quality of tenants
• the terminal value at the end of the lease term

The discount rate for commercial real estate includes a risk premium for uncertainty in terminal value and also for illiquidity.

Question 48

Describe how value added by active management is measured

Answer 48

value-added = active return = active portfolio return − benchmark return

portfolio active return = Σ(active weight of security i × return of security i).

Active return is composed of two parts: asset allocation return plus security selection return.

Asset Allocation = Change in Weights x Return on the Benchmark

Security Selection = Weight of the Portfolio x the Change in Returns

Question 49

Describe and interpret the fundamental law of active portfolio management, including its component terms—transfer coefficient, information coefficient, breadth, and active risk (aggressiveness).

Answer 49

The 3 components of the information ratio are:

1. Information coefficient (measure of manager’s skill)
2. Breadth (number of independent active bets)
3. Transfer coefficient (constraints on manager’s active management).

For an unconstrained portfolio, TC = 1.

Question 50

Explain how the information ratio may be useful in investment manager selection and choosing the level of active portfolio risk.

Answer 50

An investor will always choose the active manager with the highest information ratio regardless of her risk aversion.

The investor will combine this optimal active portfolio with the benchmark to create a portfolio with a suitable level of optimal risk based on her risk preferences.

Question 51

Compare active management strategies, including market timing and security selection, and evaluate strategy changes in terms of the fundamental law of active management.

Answer 51

The information coefficient of a market timer = IC = 2(% correct) − 1

The fundamental law can also be used to evaluate active sector rotation strategies.

Question 52

Describe the practical strengths and limitations of the fundamental law of active management

Answer 52

While the fundamental law can be used for:

• Evaluating market timing
• Security selection
• Sector rotation strategies

The limitations of the fundamental law include:

• Bias in measurement of the ex-ante information coefficient
• Lack of true independence while measuring breadth of an active strategy

Question 53

Explain the components of execution costs, including explicit and implicit costs.

Answer 53

Explicit trading costs include:

• Brokerage
• Taxes
• Fees

Implicit costs include:

• Bid-ask spread
• Price impact
• Slippage
• Opportunity cost

Question 54

Calculate and interpret effective spreads and VWAP transaction cost estimates.

Answer 54

Effective spread = 2 × (per-share effective spread transaction cost)

VWAP transaction cost = trade size × (side) × (trade VWAP – benchmark VWAP)

where: side = + 1 for buy orders and –1 for sell orders

Question 55

Describe the implementation shortfall approach to transaction cost measurement.

Answer 55

Implementation shortfall is the difference in value between a hypothetical (or paper) portfolio in which the trade is fully executed with no cost, and the value of the actual portfolio.

Question 56

Describe factors driving the development of electronic trading systems.

Answer 56

The factors driving the development of electronic trading systems include:

• lower cost
• higher accuracy
• provision for audit trails
• fraud prevention
• continuous market during trading hours

Question 57

Describe market fragmentation.

Answer 57

Market fragmentation results when a security trades in multiple markets.

Trading algorithms such as liquidity aggregation and smart order routing seek to overcome the challenges posed by market fragmentation.

Question 58

Identify and contrast the types of electronic traders.

Answer 58

Electronic traders include:

• news traders
• dealers
• arbitrageurs
• front runners
• quote matchers
• buy-side traders

Question 59

Describe characteristics of Latency and uses of electronic trading systems.

Answer 59

Latency: is defined as the time lapse between the occurrence of an event and execution of a trade based on that event.

Electronic trading systems allow low-latency traders a competitive advantage by jumping the order queue.

Question 60

Describe comparative advantages of low-latency traders.

Answer 60

Electronic market traders employ:

• advanced orders
• trading tactics
• trading algorithms

Electronic markets enable:

• hidden orders
• leapfrogging algorithms
• flickering quotes
• electronic arbitrage
• machine learning

Question 61

Describe the risks associated with electronic trading and how regulators mitigate them.

Answer 61

Risks of electronic trading include:

• HFT arms races at a disadvantage to small traders
• increases in systemic risk due to runaway algorithms
• fat finger errors
• overcharge orders
• malevolent orders

Question 62

Describe abusive trading practices that real-time surveillance of markets may detect.

Answer 62

Real-time surveillance and monitoring of electronic markets seek to detect market abuses and potential crises as they unfold, allowing for a faster response.

Abusive trading practices include:

• front running
• market manipulation.

Question 63

What are some Market manipulation activities?

Answer 63

Market manipulation activities include:

• trading for price impact
• rumormongering
• wash trading
• spoofing
• bluffing
• gunning the market
• squeezing and cornering

Question 64

Maximum drawdown

Answer 64

The worst cumulative loss ever sustained by an asset or portfolio. More specifically, maximum drawdown is the difference between an asset or a portfolio’s maximum cumulative return and its subsequent lowest cumulative return.

Question 65

Inter-temporal rate of substitution

Answer 65

The ratio of the marginal utility of consumptions periods in the future (the numerator) to the marginal utility of consumption today (the denominator).