portfolio theory Flashcards
correlation summary table
table 20
commission on equity and gilts
equity
> 10-20bps for large institutional trades
> 100-150bps for smaller trades
gilts
> 0.5%-1% for trades lower than £5k nv
> 0 for trades £1mill nv
stamp duty on certified shares and SDRT on dematerialised shares
0.5% to the nearest £5
0.5% to nearest 1p
MM exempt
AIM securities exempt
PTM (panel on takeover and mergers)
£1 charge for trades over £10k
MM exempt
capacity of fund, Vangelisti 2006
threshold capacity
wealth maximizing capacity
terminal capacity
threshold capacity
level of AUM beyond which the fund cannot achieve its objectives
wealth maximizing capacity
level of AUM that maximises the amount of wealth created in both returns to the investor and the mngmnt
terminal capacity
level of AUM that reduces the investor’s return, net of transaction costs, to 0
tracker funds methods
> replication
stratified sampling (buying the most influential shares within each sector)
synthetic (buying futures and holding cash in the bank)
optimisation (using historic analysis to determine which stocks have most accurately tracked the index)
tracking error causes
> inexact replication (weightings, investment style, characteristics, volatility or beta)
costs
changes in constituents
TE
TOTAL RETURN OF PORTFOLIO - TOTAL RETURN OF BENCHMARK
=(SUM(Rp-Rb)^2/N-1)^1/2
+/-50bps
top-down management
- asset allocation
- sector selection
- stock selection
asset allocation
strategic - long-term allocation
tactical - small changes to take advantage of short-term market shifts
technology and financial markets
utilities
high betas and are aggressive stocks perform well in rising markets
low betas and are defensive stocks performing less badly in falling mrkts
fundamental analysis and technical analysis
identifying stocks that are undervalued
the focus is on market behaviour rather than features of the stock e.g. trends in price movements , predicting these trends helps them outperform the market
value funds: contrarian investors
firms with low share price to book value
> expect to experience cyclical rebound or company turnaround
value funds: conservative approach
high yielding stocks expected to maintain or increase dividends
smartbeta
way to create weghtings
decomposing excess returns: total return
return on
asset allocation
+
stock selection
+
currency
+
interaction (impact of trading stocks actively - timing and selection)
bonds : total return
yield to maturity
+
interest rate effect
+
sector/quality
+
residual effect
stock market perfectly efficient
> perfect info
all info is public
market already price info
no transaction costs
no earnings surprises
weak EMH
> current market price reflects historic share price info
contradicts technical analysis
semi strong EMH
> current market prices reflect historic prices + all other public info
strong EMH
> current market prices reflect historic prices + all other public info + private info
information processing errors
> memory bias
overconfidence
confirmation bias
conservatism bias (too slow to updating beliefs)
sample-size neglect
decision making errors
> framing bias
regret avoidance
loss aversion (take on more risk to avoid loss)
endowment rate (expect a higher selling price than what they bought)
financial amnesia reasons
> incentive structures (incentivize mngmt to take detrimental decisions)
moral hazard (wider economy carrying risk)
behavioural finance biases (cognitive dissonance: group think, overconfidence)
holding period return
> (end value - start value)/start value *100%
does not account for timing of cash flows
not useful for OEIC, unit trusts , pension funds money goes in and out often
MWRR
> performance measure for a fund that experiences withdrawals and deposits
comparing portfolios : both portfolios received/withdrew at the same time
can overstate returns when fund does well and vv because affected by timing and size of CF
affected by timing and size of flows into fund
TWRR
> unaffected by timing and size of cashflows
change in value of fund b4 cash * change in value after cash
equal weighting to timing and cash flows
standard deviation - correlation. at times of extreme global events
> correlations become more strongly positive
beta
change in return of portoflio / change in return of market portfolio
covariance(R_jR_m)/var(R_m)
variance of portfolio return
beta^2*variance of return on mrkt + variance of unsystematic return
drawdown measure (difference be/een peak and subsequent trough) adv and dis
adv
> easy to measure
> easy to understand
dis
> longer time series tend to have greater drawdown
> large and uncertain error distribution
VaR
> max potential change in value of a portfolio of financial instrument with a given probability
evaluates performance of risk takers ad used for regulatory requirements
no info on severity of loss
3 ways :
historical return approach (identifies probabilities)
variance-covariance method (assumes normal distribution and uses standard deviation to assess probabilities)
monte carlo approach (simulations on random variations of historical data, outcomes used to generate probabilities)
SML
R_j=r_f + beta_j(R_m-r_f)
information ratio
ER/standard deviation_ER
(ER - arithmetic mean of excess returns over the benchmark)
sharpe ratio
(R_p-R_f)/standard deviation_p
treynor ratio well diversified-fund
(R_p-R_f)/beta_p
jensen measure
R_p-R_capm
benchmark beta for capm
decompsing jensen return to portoflio
risk-free return
+
benchmark return
+
market timing
+
stock selection
ex-post (look back at historic risk and performance) and ex-ante (sets visible target before event but many assumptions)
Treynor and Sharpe
ex-post
Jensen
ex-ante
shift
twist
spread
incr. or decr. of yield curves across maturities
yield curve steepened or flatened
differnece in yield be/een issuers yield and gvnments risk-free rate
risk adjusted returns also Treynor for bonds
(R_p-R_f)/(D_p/D_m)
D_p
weighted avg duration of the portfolio
CAPM in bond portoflios
ER_b=R_f+(D_b/D_m)(ER_m-R_f)
actively mnged bonds
policy switch - switching be/een two different bonds
anomaly switch - switching be/een two similar bonds to take adv of mispricing
riding the yield curve
credit risk mngmnt
passively mngd bonds
to protect against interest rate risk and re-investment risk :
> cash matching
> immunisation (larger range of bonds) - need to match duration of bonds to duration liabilities
assumptions:
flat yield curve
shifts only parallel
shift occurs before first cash flow payment
1. bullet portfolios (duration of bonds within portfolio same to the duration of the portfolios liabilities
pos: more available bonds
neg: need rebalancing to maintain immunisation effect
2. barbell portfolios (average duration of bonds match duration liabilities)
pos: even more bonds available
neg : greater re-balancing
>contingent immunisation (for active mngrs if failed to achieve returns …. switch to passively mnged immunised portfolios until liability dte)
contigent immunisation
active mngrs change to passive mnged immunised portfolios until liability date
LDI strategy
future liabilities must be predicted accurately
use derivative products to reduce effects of interest rates and inflation
> CF forecasts
acceptable risk specified by trustees
mngmnt ability to outperform mrkt
implementation of LDI strategy - can use derivatives - and consideration of additional investment vehicles
risk:
duration difference be/een target return and actual return
volatility of surplus measures the probability of a shortfall
bottom up approach
focus is on stock selection
event driven or tactical trading basis
closet index funds
> actively managed
active share close to 0
HPR , MWRR, TWRR do not account for
risk
autocorrelation of standard deviation
current returns correlated to future returns
total risk
specific risk + systematic risk
CAPM assumptions
> borrow and lend at the same risk free rate
same investment period
well diversified investors
no tax or transaction costs
max return for min risk
same expectations about returns and standrd deviation
arbitrage pricing model
using market risk factors to predict and judge the performance of an asset
> for each firm the sensitivity to market factors is different
> each investor has a unique portfolio of betas
> goal: derive rate of return which will be used to to price asset
dominance of a fund
where one fund achieves better return for the same level of risk or lower
duration of a bond
measure of the interest rate risk of that portfolio
relative duration
Dp/Dm
advantage of a cash-matching strategy
shifts in the yield curve do not have adverse effects.
