Portfolio Management Flashcards
Elements of the portfolio management process
- Evaluating investor and market characteristcs
- Developing an investment policy statement
- Determining an asset allocation strategy
- Measuring and evaluating performance
- Monitoring dynamic investor objectives and capital market conditions
Main roles of the IPS
- Be readily implemented by current or future investment advisers (i.e., it is easily transportable).
- Promote long-term discipline for portfolio decisions.
- Help protect against short-term shifts in strategy when either market environments or portfolio performance cause panic or overconfidence.
Arbitrage pricing theory (APT)
Arbitrage pricing theory (APT) is a linear model with multiple systematic risk factors priced by the market. However, it does not identify the specific risk factors. Assumptions include:
- Unsystematic risk cna be iversified away in a portfolio
- Returns are generated using a factor model
- No arbitrage opportunities exist
General classifications of multifactor models
- Macroeconomic factor models: asset returns are explained by surprises (or “shocks”)
- Funndamental factor models: asset returns are explained by multiple firm-specific factors
- Statistical factor models
Value at Risk (VaR)
Value at risk (VaR) measures downside risk of a portfolio. It has three components: the loss size, the probability (of a loss greater than or equal to the specified loss size), and a time frame.
Parametric (Variance-covariance) method
Assuming normality, we can use the portfolio variance formula to estimate the mean and variance of portfolio returns. Once we have estimated these parameters, we can identify portfolio VaR as the value bounding the left-hand tail of the distribution.
Pros and Cons of Var
Pros:
- Simple
- Allows risk of different portfolios, asset classes, or trading operations to be compared
- Can be used for performance evaluation
- Allows allocation of VaR (Risk budgeting) and optimize the allocation of capital given the firm’s determination of the maximum VaR
- Global banking regulators accept VaR as a measure of financial risk
- Reliability of VaR can be verified by backtesting
Cons:
- Can be significantly affected by the choices (loss percentage, lookback period, distribution assumptions, and parameter estimates)
- Assumption of normality leads to understimates of downside risk
- Liquidity often falls significantly when asset prices fall. A VaR which does not account for this will understate the actual losses incurred when liquidating positions that are under extreme price pressure.
- Correlations increase during periods of financial stress, which leads to understimate the magnitude of potential losses.
- Many aspects of risk are not quantified or included
- Only focuses on downside risk
Extensions of VaR
- Conditional VaR: the CVaR is also referred to as the expected tail loss or expected shortfall. The CVaR is expected loss given that the loss is in the left-hand tail past the VaR.
- Incremental VaR: change in VaR from a change in the portfolio allocation to a security
- Marginal VaR: the change in VaR for a 1% increase in the security’s weight. Both MVaR and IVaR can be used to estimate the change in VaR
- Ex ante tracking error (relative VaR), measures the VaR of the difference between the return on a portfolio and the return on its manager’s benchmark portfolio.
Components of discount rate
- Real risk-free discount rate (R).
- Expected inflation (π).
- Risk premium reflecting the uncertainty about the cash flow (RP).
Closet index fund
A closet index fund is a fund that is purported to be actively managed but in reality closely tracks the underlying benchmark index. These funds will have a Sharpe ratio similar to that of the benchmark index, a very low information ratio, and little active risk. After fees, the information ratio of a closet index fund is often negative.
Fund with zero systematic risk
A fund with zero systematic risk (e.g., a market-neutral long-short equity fund) that uses the risk-free rate as its benchmark would have an information ratio that is equal to its Sharpe ratio. This is because active return will be equal to the portfolio’s return minus the risk-free rate, and active risk will be equal to total risk.
Information coefficient (IC)
The information coefficient (IC) is a measure of a manager’s skill. IC is the ex-ante(i.e., expected), risk-weighted correlation between active returns and forecasted active returns. The ex-post information coefficient, ICR measures actual correlation between active returns and expected active returns.
Transfer Coefficient (TC)
The transfer coefficient (TC) can be thought of as the correlation between actual active weights and optimal active weights. The optimal active weight for a security is positively related to its expected active return and negatively related to its expected active risk. For an unconstrained active portfolio, the active weights will be equal to the optimal weights and TC = 1. For a constrained portfolio (e.g., constraints on short positions or active risk), TC may be less than 1.
Breadth
Breadth (BR) is the number of independent active bets taken per year.
Three factors determine the information ratioL
- The information coefficient (IC)
- The transfer coefficient (TC)
- Breadth (BR)
