Portfolio Management COPY Flashcards
Portfolio Perspective
Evaluating individual investments by their contribution to the risk and return of an investor’s portfolio (diversification)
Modern Portfolio Theory
Equilibrium expected returns for securities and portfolios that are a linear function of each security’s or portfolio’s market risk
Diversification Ratio
Ratio of the risk of an equally weighted portfolio of n securities (standard deviation of returns) to the risk of a single security selected at random from the n securities
Endowment
Fund that is dedicated to providing financial support on an ongoing basis for a specific purpose
Foundation
Fund established for charitable purposes to support specific types of activities or research (long horizon, high risk tolerance, little need for liquidity)
Banks
Earn more on the bank’s loans and investments than the bank pays for deposits (low risk, adequate liquidity)
Insurance Companies
Invest customer premiums with the objective of funding customer claims as the occur (life insurance long horizon, P&C shorter)
Investment Companies
Manage the pooled funds of many investors
Mutual Funds
Manage pooled funds in particular styles (index, growth, bond, etc.) and restrict their investments to particular subcategories of investments or regions
Sovereign Wealth Funds
Pools of assets owned by a government
Defined Contribution Pension Plan
Retirement plan in which the firm contributes a sum each period to the employee’s retirement account (based on factors such as years of service, age, compensation, etc.). Investment decisions left to employee
Defined Benefit Pension Plan
Firm promises to make periodic payments to employees after retirement (based on years of service and employee’s compensation at or near retirement). Employer assumes investment risk
Planning Step
Analysis of investor’s risk tolerance, return objectives, time horizon, tax exposure, liquidity needs, income needs
Investment Policy Statement
Details investor’s investment objectives and constraints. Specify objective benchmark. Update every few years, or when investor’s objectives change significantly
Execution Step
Analysis of the risk and return characteristics of various asset classes to determine how funds will be allocated to the various asset types
Top Down Analysis
Examine current economic conditions and forecasts (GDP growth, inflation, interest rates)
Bottom Up Security Analysis
Identify individual names within an industry that appear undervalued
Feedback Step
Over time, investor circumstances change, as will asset class performance (actual weights of assets in the portfolio will change with asset prices). Measure portfolio performance and evaluate to benchmark and IPS
Rebalance
Adjust allocations of various asset classes over time back to their desired percentages
Pooled Investments
Single portfolio that contains investment funds from multiple investors
Mutual Funds
Each investor owns shares representing ownership of a portion of the overall portfolio (NAV of assets/shares issued is NAV of each share). Charge a fee for management
Open End Fund
Investors can buy newly issued shares at the NAV. Newly invested cash is invested by mutual fund managers. Sold at NAV once a day (closing asset price)
Redeem
Investors can sell back shares to fund at the NAV
No Load Funds
Do not charge additional fees for purchasing shares (up front fees) or redeeming shares (redemption fees)
Load Funds
Charge either up front, redemption fees or both
Closed End Funds
Professionally managed pools of investor money that do not take new investments into the fund or redeem investor shares. Shares trade like equity shares. Management fees. Can reinvest dividends in additional shares
Money Market Funds
Invest in short term debt securities and provide interest income with very low risk (NAV set to one currency unit)
Bond Mutual Funds
Invest in fixed income securities. Differentiated by maturities, credit ratings, issuers, types
Index Funds
Passively managed. Constructed to match the performance of a particular index
Actively Managed
Management selects individual securities with the goal of producing returns greater than those of their benchmark indexes (higher management fees). Higher turnover of portfolio securities
Exchange Traded Funds
Purchases and sales are made in the market, usually passively managed, keep market prices very close to NAV. Can be sold short, purchased on margin, traded at intraday prices. Less cap gains liability
Separately Managed Account
Portfolio owned by a single investor and managed according to that investor’s needs and preferences. Single investor owns entire account
Hedge Fund
Pools of investor funds that are not regulated to the extent that mutual funds are. Limited to the number of investors who can invest in the fund (high minimum investment, qualified investors only)
Long/Short Fund
Buy securities that are expected to outperform the overall market and sell securities short that are expected to underperform overall market
Equity Market Neutral Funds
Long/short funds with long stock positions that are just offset in value by stocks sold short (profitable in both up and down markets as long as longs outperform shorts)
Bias
Long/short fund dedicated to a larger long position relative to short sales, or greater short position relative to long positions
Event Driven Funds
Invest in response to one time corporate events (mergers and acquisitions)
Fixed Income Arbitrage Funds
Take long and short positions in debt securities, attempt to profit on minor mispricings while minimizing effects of interest rate changes
Convertible Bond Arbitrage Funds
Take long and short positions in convertible bonds and equity shares they can be converted into in order to profit on relative mispricing between the two
Global Macro Fund
Speculate on changes in international interest rates and currency exchange rates, using derivatives and leverage
Buyout Funds (Private Equity)
Buy entire public companies and take them private. Funded with significant increase in firm’s debt (leveraged buyout). Fund reorganizes firm to increase cash flow, pay down debt, increase equity value, then sell firm or parts in public offering or to another company (3-5 years)
Venture Capital Funds
Invest in companies in their start up phase, with intent to grow them into valuable companies that can be sold publicly via an IPO or sold to an established firm
Holding Period Return
Percentage increase in the value of an investment over a given time period
Arithmetic Mean Return
Simple average of a series of periodic returns
Geometric Mean Return
Compound annual rate. Less than arithmetic mean when rates of return vary each period
Money Weighted Return
Internal rate of return on a portfolio based on all of its cash inflows and outflows (dividends and interest are outflows –> negative), beginning value and deposits are inflows)
Gross Return
Total return on a security portfolio before deducting fees (commissions are deducted)
Net Return
Return after fees have been deducted
Pretax Nominal Return
Return prior to paying taxes
After Tax Nominal Return
Return after tax liability is deducted
Real Return
Nominal return adjusted for inflation. Measures the increase in an investor’s purchasing power
Leveraged Return
Return to an investor that is a multiple of the return on the underlying asset (gain or loss on the asset as a percentage of an investor’s cash investment)
Covariance
Extent to which two variables move together over time (positive move together, negative move in opposite directions)
Correlation
Standardized measure of co-movement (covariance divided by products of standard deviations)
Correlation Coefficient
Pure measure of co-movement of two stocks’ returns bounded by -1 and +1
Minimum Variance Portfolios
Portfolios that have the lowest standard deviation of all portfolios with a given expected return
Minimum Variance Frontier
For each level of expected portfolio return, vary the portfolio weights on the individual assets to determine the portfolio that has the least risk
Efficient Frontier
Portfolios that have the greatest expected return for each level of risk (the top portion of the minimum variance frontier)
Global Minimum Variance Portfolio
Portfolio on the efficient frontier that has the least risk
Utility Function
Represents investor’s preferences in terms of risk and return (degree of risk aversion)
Indifference Curve
Plots combinations of risk (std. dev.) and expected return among which an investor is indifferent (assume these are the only two things investors care about). Utility is same for all positions across curve
Risk Aversion Coefficient
More risk averse investor will have a steeper indifference curve (more risk averse requires relatively greater increase in expected return to compensate for increase in risk)
Two Fund Separation Theorem
All investors’ optimum portfolios will be made up of some combination of an optimal portfolio of risky assets and the risk free asset
Capital Allocation Line
Line representing possible combinations of risk free assets and the optimal risk free asset
Market Portfolio
Investors may choose different portfolio weights for the risk free and risky asset, but all investors will use the same risky portfolio (all investors that hold any risky assets hold the same portfolio of risky assets)
Capital Market Line
Optimal capital allocation line for all investors under the assumption of homogeneous expectations (plots only efficient portfolios, std. dev. on x axis)
Market Risk Premium
Difference between the expected return on the market and the risk free rate
Passive Investment Strategy
Investors believe market prices are informationally efficient (invest in index of risky assets that serves as proxy for market portfolio, and allocation portion to risk free asset)
Active Portfolio Management
Invest more than the market weights in securities believed to be undervalued and less than market weight in securities believed to be overvalued
Unsystematic Risk
Risk that is eliminated by diversification (unique, diversifiable, firm-specific)
Systematic Risk
Risk that cannot be diversified away (nondiversifiable, market risk)
Return Generating Models
Estimate the expected returns on risky securities based on specific factors (estimate sensitivity of returns to each specific factor) –> macroeconomic, fundamental, statistical
Multifactor Models
Use macroeconomic factors (GDP, growth, inflation, consumer confidence) and fundamental factors (earnings growth, firm size)
Factor Sensitivity
Expected excess return for Asset i is sum of each of the betas for Asset i multiplied by the expected value of that factor for the period
Single Index Model
Excess return is product of the factor weight, Beta and rhe risk factor
Market Model
Estimate a security’s (or portfolio’s) beta and to estimate a security’s abnormal return based on the actual market return
Beta
Sensitivity of an asset’s return to the return on the market index in the context of the market model 9covariance of the asset’s return with the market’s return)
Regression
Estimation procedure that fits a line to a data plot
Least Squares Regression
Line that minimizes the sum of the squared distances of the points plotted from the line –> line of best fit
Security Characteristic Line
Regression line where the slope is the beta of Asset i
Security Market Line
Line plotted using the relationship between risk and the return for individual assets using systematic risk (covariance between the asset and the market) –> CAPM Beta on the x axis
Above SML: Undervalued (buy)
Below SML: Overvalued (sell or short)
On SML: Properly valued
Sharpe Ratio
Excess returns per unit of portfolio risk. Higher ratio indicates better risk adjusted performance. Sharpe ratios of all portfolios along the CML are the same. It is the slope of the CAL
M Squared
Same portfolio rankings as Sharpe ratio, stated in percentage terms. Excess return on levered portfolio over market portfolio
Treynor Measure
Excess returns per unit of systematic risk
Jensen’s Alpha
Percentage of portfolio return above that of a portfolio or security with the same beta that lies on the SML (difference between active manager’s estimate of security’s expected return and CAPM expected return)`
Investment Policy Statement
Begin with investor’s goals in terms of risk and return. Expectations in terms of returns must be compatible with investor’s tolerance for risk
IPS
- Description of Client
- Statement of the Purpose
- Statement of Duties and Responsibilities
- Procedures
- Investment Objectives
- Investment Constraints
- Investment Guidelines
- Evaluation of Performance
- Appendicies
Absolute Risk Objective
Stated in terms of the probability of specific portfolio results, either percentage losses or dollar losses, rather than strict limits on portfolio results (nominal terms or real returns)
Relative Risk Objectives
Relate to a specific benchmark (can also be in terms of probability). Peer performance benchmarks frowned upon (no way to match investment return by portfolio construction before the fact)
Ability to Bear Risk
Depends on financial circumstances (investment horizons, client assets vs. their liabilities, more insurance, secure job)
Willingness to Bear Risk
Based on investor’s attitudes and beliefs about investments (risk aversion or risk tolerance)
Investment Constraints
RRTTLLU: Risk, return, time horizon, tax liability, liquidity, legal restrictions, unique constraints
Liquidity
Ability to turn investment assets into spendable cash in a short period of time without having to make significant price concessions to do so
Time Horizon
Longer an investor’s time horizon, the more risk and less liquidity the investor can accept in the portfolio
Tax Situation
Overall tax rate, and tax treatment of various types of investment accounts
Legal and Regulatory
Trust, corporate and qualified investment accounts may be restricted by law from investing in particular types of securities and assets (may also be percentage allocation restrictions)
Unique Circumstances
Specific preferences and restrictions on which securities and assets may be purchased (ethical, religious, diversification needs)
Strategic Asset Allocation
Specifies the percentage allocation to the included asset classes (correlation of returns within an asset class should be relatively high, correlation between asset classes should be relatively low)
Alternative Investments
Hedge funds, private equity, commodity funds, artwork, intellectual property rights
Tactical Asset Allocation
Varying from strategic asset allocation weights in order to take advantage of perceived short term opportunities
Security Selection
Deviations from index weights on individual securities within an asset class
Risk Budgeting
Sets an overall risk limit for the portfolio and allocates a portion of the permitted risk to the systematic risk of the strategic asset allocation, tactical asset allocation, risk from security selection
Core Satellite Approach
Invests the majority portion of the portfolio in passively managed indexes and invests a smaller portion in active strategies
Risk Management
- Identify the risk tolerance of the organization
- Identify and measure the risks that the organization faces
- Modify and monitor these risks
Risk Management Framework
- Establishing processes and policies for risk governance
- Determine risk tolerance
- Identify and measure existing risks
- Manage and mitigate risks to achieve optimal bundles
- Monitor risk exposures over time
- Communicate across the organization
- Perform strategic risk analysis
Risk Governance
Senior management’s determination of the risk tolerance of the organization, elements of optimal risk exposure strategy, framework for oversight
Credit Risk
Uncertainty about whether the counterparty to a transaction will fulfill its contractual obligations
Liquidity Risk
Risk of loss when selling an asset at a time when market conditions make the sales price less than the underlying fair value
Market Risk
Uncertainty about market prices of assets and interest rates
Operational Risk
Risk that human error or faulty organizational processes will result in losses
Solvency Risk
Risk that the organization will be unable to continue to operate because it has run out of cash
Regulatory Risk
Risk that the regulation environment will change, imposing costs on the firm or restricting its activities
Governmental/Political Risk
Risk that the political actions outside a specific regulatory framework (increased tax rates) will impose significant costs
Legal Risk
Uncertainty about the organization’s exposure to future legal action
Model Risk
Risk that asset valuations based on the organization’s analytics models are incorrect
Tail Risk
Risk that extreme events are more likely than the organization’s analysis indicates (especially from incorrectly concluding distribution of outcomes is normal)
Accounting Risk
Risk that organization’s accounting policies and estimates are judged to be incorrect
Longevity Risk
Living longer than expected so that assets run out
Standard Deviation
Measure of the volatility of asset prices and interest rates (risk on a stand alone basis)
Beta
Measures the market risk of equity securities and portfolios of equity securities (risk reduction benefits of diversification)
Duration
Measure of the price sensitivity of debt securities to changes in interest rates
Delta
Sensitivity of derivatives values to the price of the underlying asset
Gamma
Sensitivity of delta to changes in the price of the underlying asset
Vega
Sensitivity of derivatives values to the volatility of the price of the underlying asset
Rho
Sensitivity of derivatives values to changes in the risk free rate
Downside Risk
Uncertainty about the probability of extreme (negative) outcomes
Value at Risk (VaR)
Minimum loss over a period that will occur with a specific probability (minimum capital requirements)
Conditional VaR (CVaR)
Expected value of a loss, given that the loss exceeds a minimum amount (measure of loss given default)
Stress Testing
Examines the effects of a specific (usually extreme) change in a key variable such as an interest rate or exchange rate
Scenario Analysis
What if analysis of expected loss but incorporates changes in multiple inputs
Avoiding Risks
Not engaging in the activity with the uncertain outcome (comes from top management)
Preventing Risks
Benefits of reducing or eliminating the risk are judged to be greater than the cost of doing so
Diversification
Offers a way to more efficiently bear a specific risk
Self-insurance
The means that the organization will bear any associated losses from the risk factors chosen to take on
Risk Transfer
Another party takes on the risk (insurance) –> benefits of risk reduction are greater than the costs of insurance
Surety Bond
Insurance company has agreed to make a payment if a third party fails to perform under the terms of a contract or agreement with the organization
Fidelity Bonds
Pay for the losses that result from employee theft or misconduct
Risk Shifting
Way to change the distribution of possible outcomes and is accompanied primarily with derivative contracts
