Portfolio Management Process Flashcards
What is an investment?
An investment is the current commitment of dollars for a period of time in order to derive future payments that will compensate the investor for:
the time the funds are committed,
the expected rate of inflation during this time period, and
the uncertainty of the future payments.
What is the required rate of return?
risk free rate + risk premium
What is the goal of portfolio management process?
To come up with a portfolio of assets that corresponds to the return objective and the risk tolerance level of the client (individual or institutional) while respecting its constraints.
What happens in the planning phase of the portfolio management process?
Identification of client’s needs, definitions of the IPS
What happens in the execution phase of the portfolio management process?
Determination of the SAA, strategy choice, portfolio construction
What happens in the monitoring phase of the portfolio management process?
portfolio rebalancing, performance evaluation, reports
What is an IPS?
Written document governing the process of constructing a portfolio to meet the client’s investment objectives.
Why is the IPS necessary?
To have a standard for evaluating portfolio performance, to outline the client’s needs and preferences, to understand and articulate realistic investor goals, etc.
What are the components of the IPS?
introduction
statement of purpose
procedures
investment objectives
investment constraints
investment guidelines
evaluation and review
appendices
What are the 2 ways return objective may be stated?
Quantitatively or general goals
True or false: return objective is expressed in terms of both risk and return.
True
What is the way of stating the return objective typically used by institutional investors?
Quantitatively
What are the central objectives that a return objective stated as general goals can consist of?
Capital preservation: minimize the risk of loss.
Income generation: generate regular income (coupons, dividends) rather than capital gains.
Capital appreciation: growth of the portfolio in real terms to meet future need, mainly through capital gains (more inclined to bear risk)
What are the 2 factors determining the overall risk tolerance?
ability and willingness
In terms of ability to bear risk risk, what factors should we consider?
Total wealth (relative wealth and human capital) and 5 constraints (liquidity needs, time horizon, legal requirements, tax concerns, unique circumstances)
What is relative wealth?
Mainly represented by the relationship between the standard of living of the investor relative to his level of financial wealth. The measure of wealth from one investor to another is relative to his perception and his ability to answer his needs using his wealth. Are they a net saver or net spender?
What is human capital?
A measure of future earning power. It depends on the economic value of the investor on the market. If someone has more human capital, they will be much more comfortable bearing risk.
What are the factors that influence the value of human capital?
health
education
security job
motivation
When is client education needed?
When the client’s willingness to take risk does not fit with their ability to take risk. The client’s willingness to take risk remains the most important factor when client education fails.
What are the 3 psychographic models to analyse individual investors?
Barnewall
Baillard
CFA
How does the Barnewall model classify investors?
Passive investors: inherit, patiently save or slowly accumulate wealth via small consistent gains by working for others; executives and professionals; lower risk tolerance
Active investors: create wealth by risking their own capital; willing to give up security over control of their wealth creation; entrepreneurs; higher risk tolerance
How does the Baillard model classify investors?
Along 2 dimensions on how they approach life: level of confidence and method of action: careful to impetuous and confident to anxious
What are the 5 types of investors according to the baillard model?
individualist
adventurer
celebrity
guardian
straight arrow
In the Baillard model, which personalities are risk averse?
guardian and celebrity
In the Baillard model, which personalities have higher risk tolerance?
individualist (most people) and adventurer
According to the models based on the CFA Institute curriculum, what are the 4 personalities?
methodical, cautious, individualist and spontaneous
How are cautious investors (CFA)?
averse to losses and seek financial security
How are methodical investors (CFA)?
fact seeking generally conservative investors (more risk averse)
How are spontaneous investors (CFA)?
quick to make decisions and have higher portfolio turnover (less risk averse)
How are individualist investors (CFA)?
self-researchers and have confidence in their long-term decisions
What are the 5 constraints?
liquidity needs, time horizon, regulatory, fiscal and unique needs
What is liquidity?
Liquidity refers to the ability to turn investment assets into spendable cash in a short period of time without having to make significant price concessions to do so.
What is liquidity needs?
Refers to the probability that clients would need liquidity to meet their needs (level of spending, emergency reserve, events with a variable probability of occurrence).
Net saver, net spender or flat budget Intimately linked to the investment horizon for an individual.
True or false: The longer an investor’s time horizon, the more risk and less liquidity the investor can accept in the portfolio.
true
What are the 4 wealth accumulation lifecycle stages?
starting (25-49), accumulating (40-65), spending (65-80) and gifting (80+)
Are individual investors subject to regulatory constraints?
few
What is the prudent investment rule?
The prudent investment rule requires afiduciaryto invest trust assets as if they were her or his own. This managing investor should consider the needs of the trust’sbeneficiaries such as a family or employees that do not have a background in investing,the provision of regular income,and the preservation of trust assets and should avoid investments that are excessively risky. Today the rule is codified in theUniform Prudent Investor Act(UPIA) of 1992. –Ref: Investopedia
Besides an individual’s overall tax rate, what else regarding taxes should be concerned?
tax treatment of various types of investment accounts
True or false: Investors subject to high tax rates may prefer equities expected to record capital gains since CG tax rate is lower than the income tax rate.
true
What is strategic asset allocation?
Indicates a long-term target allocation for each asset class, with the portfolio being rebalances periodically to maintain the target allocation.
What are the 4 decisions involved in constructing a SAA?
What asset classes should be considered for investment?
What policy weights should be assigned to each eligible asset class?
What are the allowable allocation ranges based on policy weights?
What specific securities or funds should be purchased for the portfolio?
What is the goal of the SAA?
Determining a portfolio that is suitable for the client’s objectives and constraints.
According to Fidelity Canada, what should be the SAA when 20-42 years old?
canadian equity = 22%
US equity = 35%
international equity = 36%
fixed income = 7%
According to Fidelity Canada, what should be the SAA when 45 years old?
12% fixed income
88% equities
According to Fidelity Canada, what should be the SAA when 60 years old?
54% equities
45% fixed income
1% money market
According to Fidelity Canada, what should be the SAA when 70 years old?
50% fixed income
45% equity
5% money market
According to Fidelity Canada, what should be the SAA when 80 years old?
52% fixed income
21% equities
27%. money market
How does the average allocation change with a least risk averse investor?
+10% in equities
What is tactical asset allocation?
(In addition to SAA) An active management strategy that normally specifies a range for each asset class rather than a specific target allocation percentage.
The manager varies from SAA weights in order to take advantage of perceived ST opportunities.
Through tactical allocation , what can the PM do?
Overweight asset classes that should overperform in the short and medium term (weeks, months, years).
Underweight asset classes that should underperform in the short and medium term (weeks, months, years).
What is the difference between individual investors and institutional investors when it comes to return objectives?
individual: general
institutional: often precise
What is the difference between individual investors and institutional investors when it comes to risk tolerance?
individual: capacity vs willingness
individual: capacity = willingness
What is the difference between individual investors and institutional investors when it comes to investment horizon?
ind: depends on life cycle
ins: relates to maturity
What is the difference between individual investors and institutional investors when it comes to legal constraints?
ind: few
ins: high
What is the difference between individual investors and institutional investors when it comes to education?
ind: often necessary
ins: sometimes necessary
What is the return requirement of pension plans (defined benefit)?
the return that will adequately fund liabilities on an inflation-adjusted basis
What is the return requirement of pension plans (defined contribution)?
depends on stage of life of individual participants
What is the return requirement of foundations and endowments?
return that will cover annual spending, investment expenses and expected inflation
What is the return requirement of life insurance companies?
determined by rates used to determine policyholder reserves
What is the return requirement of non-life insurance companies?
determined by the need to price policies competitively and by financial needs
What is the return requirement of banks?
determined by cost of funds
What is the risk tolerance of pension plans (defined benefit)?
depends on plan and sponsor characteristics, plan features, funding status and workforce characteristics
What is the risk tolerance of pension plans (defined contribution)?
varies with the risk tolerance of individual participants
What is the risk tolerance of foundations and endowments?
determined by amount of assets relative to needs, but generally above-average or average
What is the risk tolerance of life insurance companies?
below average due to factors such as regulatory constraints
What is the risk tolerance of non life insurance companies?
below average due to factors such as regulatory constraints
What is the risk tolerance of banks?
varies
What are pension funds?
Pension funds are designed to save and invest in order to provide income for plan beneficiaries upon retirement.
What are the types of pension funds?
Defined Contribution pension plans (DC)
Defined Benefits pension plans (DB)
Hybrid pension plans
What are DC pension plans?
It’s an investment vehicle in which the amounts invested, or the contributions that the employer and the employee make to the plan are defined or specified but the benefits are not.
Employee assumes investment risk.
Who assumes the risk in DC pension plans?
employee
What are DB pension plans?
The employer has an obligation to provide certain benefits to employees when they retire. The future benefit is specified or defined.
Employer assumes investment risk.
Who assumes the investment risk in DB pension plans?
employer
Who is the primarily contributor in DB pension plans?
employer
Who is the primarily contributor in DC pension plans?
employee
What are the liabilities of the db fund?
Present value of future benefits promised to plan participants (active and retired employees)
Discount rate: based on the weighted average expectation of the plan’s strategic allocation
What are the assets of the DB fund?
Market value of all assets held by the fund
The return objective (and the strategic allocation) depends on the risk tolerance of the pension plan
How can the funded status of the plan be measured?
funded ratio = fair value of plan assets / PV of db obligations
What is the time horizon of DB funds?
maturity of the plan (since the horizon is usually infinite), it’s a function of the age of the employees, the ratio of employees, etc.
What is the regulatory aspect of DB pension funds?
aim for prudence and the reduction of conflicts of interest
What is the fiscal aspect of DB funds?
tax-exempt
What are foundations?
Foundations are nonprofit institutions set up to make grants to support specified charitable causes.
What are the types of foundations?
Aims to finance an organization (activities, research)
Aims to finance a general objective (cause, objective, project)
Legal distinctions depending on the country (none in Canada)
What are the characteristics of foundations?
Specific objectives (varies greatly from one foundation to another)
Nature of activities determines the performance objective
Trust company with mandated directors
What are the liquidity needs of foundations?
a function of the distribution rate of the foundation
What is the time horizon of foundations?
usually infinite, they may have a goal to reach after which the fund is dissolved
What are regulatory aspects of foundations?
Supervision of the directors to avoid embezzlement (trust)
Aims for prudence
what is the fiscal aspect of foundations?
tax-exempt
What are the particular circumstances of foundations?
Frequent constraints on the types of eligible investments (ecological, socially responsible, weaponry, etc.)
What are the tree categories of asset owners?
Retail
Private Wealth
Institutional
What are the 2 types of retail asset owner?
retail and mass affluent
What are the characteristics of retail asset owners?
low to medium financial literacy; none to low access to non-traditional investments, low tolerance for losses, low maintenance
What are the 2 types of private equities?
High and Ultra High Net Worth
Foundations
What is the level of assets of private equity?
very high
What are open-end funds?
Accepts new deposits or withdrawals of funds.
Transaction at the end of the day (NAV* at market close).
Issuance of units to depositors (fraction of a unit) .
what are closed-end funds?
Does not accept new funds (infrequent capital opening)
Shares traded on the secondary markets
Transaction value may deviate from the market value
What are etfs?
Close-end structure, shares traded on exchanges
Transactions at any time during trading hours
What are the traditional investments?
stocks and bonds
What are the traditional alternative investments?
private equity, commodities and real estate
What are the modern alternative investments?
hedge funds, managed futures and distressed securities
What are traditional investments?
Long-only, publicly traded investments in stocks.
Long investments in publicly traded bonds.
Cash.
What are alternative investments?
Are sometimes called illiquid or private asset classes
Almost exclusive reliance on active management (except for commodities).
What are the categories of alternative investments?
hedge funds
private capital
real estate
natural resources
infrastructure
other
What are the characteristics of alternative investments?
Illiquidity of underlying investments
Narrow specialization of investment managers
Alternative investments have a relatively low correlation of returns to traditional investments.
Alternative investments have less transparency and regulation compared to traditional investments.
Limited historical risk and return data.
Alternative investments have unique tax and legal issues.
Alternative investments have higher fees, usually made of performance (incentive) fees.
Alternative investments are usually concentrated portfolios.
Alternative investments usually have limitations on redemptions, such as lockups and gates.
Why do people invest in alternative investments?
Aim to improve the risk-return profile of the portfolio
Diversification (low correlation with traditional asset classes)
What are the top 3 alternative investments?
private equity, hedge funds and real estate
are derivatives and forex alternative investments?
no
who invests in alternative investments?
large public funds
endowments
growth-oriented sovereign wealth funds
family offices
What are the subcategories of real estate?
Residential, commercial and industrial.
What are the characteristics of real estate?
Income generation & protection against inflation.
Investments made directly or indirectly:
Direct investments: not very liquid, important initial investment, etc.
Other direct investments : Joint venture partnership
Indirect investments (REITs): listed real estate. More liquid, with usually higher management fees.
Are commodities a good hedge against inflation?
yes
What are the direct and indirect investments in commodities?
Direct investments: holding physical assets (problematic for perishable materials and potentially high storage costs).
Indirect investments: use of derivatives to obtain exposure to changes in the underlying (e.g. managed futures).
What are hedge funds?
Private and actively managed investment vehicles
Often employ aggressive strategies across asset classes
Investment in various non-traditional strategies to generate abnormal excess return “alpha” (with or without derivatives). We often talk about absolute return (≠ benchmark).
What are the characteristics of hedge funds?
Market neutral, long-short equity, managed futures. Arbitrage: Interest rates, Exchange rates, Convertible bonds. Various other non-traditional strategies.
Global macro, event-driven, emerging countries, etc.
Aims to offer low correlations compared to traditional asset classes (equities, bonds, money market).
What is private equity?
Refers to any ownership interest in an asset (or assets) that is not tradable in a public market
It can be broadly broken down into 3 groups: return-oriented strategies, debt strategies and natural resources strategies.
What are the characteristics of private equity?
Focused on strong long-term capital growth. Most firms are private
Aims to invest in unlisted (private) firms at different stages of development, or in difficulty.
What are the subcategories of private equity?
venture capital, buyouts and special situations (distressed debt and mezzanine financing)
What is venture capital?
Return-oriented strategy.
Company, project or product with high growth potential financed by a specialized investor (by industry and / or stage of development).
2/3 0ut of 10 first-stage ventures become profitable.
What are the stages of venture capital?
Seed stage: Financing for the development of an idea or a product; the investor (angel or firm) provides expertise and $.
Early stage: Business start-up, often in the development stage with limited workforce.
Later stage: Completed or very advanced product development. Firm might already generate revenue.
What are buyouts?
Return-oriented strategy.
Acquisition of assets or a business unit to restructure or enhance the acquisition; when the acquisition is made with a high amount of debt, it is qualified as an LBO (leverage buyout).
What is distressed debt?
Distressed debt: rescuing firms in financial difficulty in order to reorganize operations or liquidation of assets at a higher price
What is mezzanine financing?
Mezzanine financing: senior equity financing, but subordinated to debt usually including some form of participation (quasi equity or equity kicker (stock options, preferred shares)
what are the 3 types of asset owners in Canada’s asset management industry?
retail, private wealth, institutional
what are asset managers?
not legal owners of assets, they ought to manage in compliance with client’s IPS and IMA (inv management agreement)
who are institutional investors?
large portfolios, their investment knowledge is very high
what are the key types of institutional investors?
defined benefit pension plans, insurance companies, foundations and endowments
what is principal-agent conflict?
it arises when the asset owner and the manager’s interests don’t align
