Questions - Part 2 Flashcards
Six benefits to a thoughtfully developed investment policy statement (IPS)
1) Articulates the investor’s long-term investment objectives and outlines policies and procedures to help meet those objectives.
2) Provides guidance around the risk tolerance and investment beliefs of the investor and governing bodies.
3) Monitors the investment program and measures outcomes against objectives.
4) Helps new staff, board, and investment/finance committee members get up to speed on the investments.
5) Allows the investor to maintain focus on important strategic issues and take a holistic view of how the investment program ties back to goals and activities.
6) Serves as a road map for the fiduciaries and provides guidance through all phases of a market cycle.
Role of the Board
The board is the highest governing body and is responsible for approving the investment policy statement and target asset allocation strategy. The investment committee makes investment recommendations and final decisions.
Two potential ways the asset allocation guidelines for defined benefit plans can be customized
The defined benefit’s asset allocation can be de-risked as the funded status rises, or a hedge ratio policy could be put into place.
A hedge ratio policy reduces the interest rate risk as the funded status improves.
Why might quantitatively focused standards be problematic regarding manager selection and retention?
Quantitatively focused standards and watch lists are generally discouraged as a means of monitoring managers as this could put the asset owner in a position of being forced to prematurely terminate a manager. Instead, manager selection should be driven by a variety of considerations, both quantitative and qualitative.
Six Advantages of Large Endownments
Aggressive asset allocation
Effective research by the investment manager
First-mover advantage
Access to a network of talented alumni
Acceptance of liquidity risk
Sophisticated investment staff and board oversight
NAV Adjustment for Illiquid Investment
The net asset value adjusts slowly to changes in public market valuation. As a result, in periods of crisis, prices of liquid assets decline rapidly and investors may react by only rebalancing within the liquid assets, while slowly changing allocations to relatively illiquid alternative investments (by modifying the size of future commitments).
Concerns of Country with Large % of Revenues Tied to a Commodity
1) the volatility of oil prices can create a volatile income stream for country ABC. This is a concern for the country because government spending is likely more stable than oil prices.
2) it is unclear how long these oil revenues will continue, as the oil reserves of the country will not last forever (i.e., there is a concern regarding depletion).
3) the government of country ABC would like to have a diversified economy, ideally earning tax revenues from other industries, rather than depending almost exclusively on oil revenues.
Four common motivations which may lead to the establishment of a sovereign wealth fund
1) Protect the economy and fiscal budget of country ABC from a possible decline or volatility in income from oil;
2) Assist the central bank to offset redundant liquidity;
3) Build up the level of savings for future generations, especially considering that country ABC is mainly an oil exporting country, and thus the situation that caused the surplus is at a reasonable risk for depletion or reversal;
4) Invest the money saved in infrastructure or projects that promote economic growth today to strengthen a sector of the economy or grow a specific industry, and thus help diversify away from oil revenues.
Dutch Disease
1) Increase local wages in oil and shift workers to that industry
2) Flood of money into the country forces up value of local currency.
Causes de-industrialisation of the manufacturing sector
Family Office and Safe Harbour
In the U.S., family offices were allowed to operate under a “safe harbor” with the SEC in the past. This safe harbor allowed family offices to accept up to 15 outside clients. However, with the 2010 passage of the Dodd-Frank Act by the U.S. government, this safe harbor was abolished from the U.S. securities laws. Therefore, if a family office accepts $1 from a non-family member, it may be required to register with the SEC.
Completion vs Concentration Portfolio
A completion portfolio is a collection of assets that is managed with the objective of diversifying the aggregated risks of the concentrated portfolio. The assets purchased should have a low correlation to the assets held in the company stock portfolio (the concentrated portfolio).
Conflicts of Interests (Family Offices with Different Advisors / Managers)
When a wealthy family allocates capital to different financial advisers and managers, it usually encourages competition among outside money managers and creates incentives that can be detrimental to the family. A family office removes these possible conflicts by producing structures where the interests of the total family, external money managers, and the family office are aligned toward common objectives. For example, by combining the money of the family members, the family office can negotiate fee breaks and other beneficial conditions that a single family member may not be able to achieve. Finally, by taking more asset management in-house family offices mitigate external conflicts of interest and have a greater power to negotiate fees.
Amaranth
Not multi-strat (focussed on one strategy)
No stop losses
No concentration limits
How is behavioral finance related to fund failures
Behavioral finance attempts to explain the potential influence of cognitive, emotional, and social factors in opposition to evidence and reason. For example, these factors can lead fund managers to take enormous risks to try to offset losses in the face of evidence that a strategy is not working. These biases can also lead investors with overconfidence to select managers that are more likely to commit fraud because the managers are playing to the emotions of the investors.
List four major lessons from tail events
Leverage
Over-Confidence
Quantitative Systems (difficult to predict all the risks)
Crooks (large fees)
Difference indicated by the use of “a” to denote an intercept rather than α
“a” is used to represent variables estimated in and outputted from a statistical procedure, in this case the y-intercept. α is used to represent the true and unobservable variables
Three approaches to benchmarking managed futures performance
1) Consists of using an index of long-only futures contracts.
2) Peer groups, where managed futures are usually benchmarked to indices representing active or passive futures trading.
3) CTAs may be compared to passive benchmarks of futures trading. These passive indices correspond to the performance of an individual trading system (as opposed to the performance of CTAs themselves).
RE vs NAREIT Volatility
Smoothing
Leverage
Three key observations behind the financial economics of delta-hedging between an option and its underlying asset
(1) Delta-hedging is not a directional speculation on the stock price
(2) if a stock is efficiently priced, all trading strategies on that stock have an NPV of zero
(3) delta-hedging is part of a speculation on volatility.
Correlation of commodity sectors
Energy sector commodities do not have high positive correlations with other sectors, because higher energy prices can weigh on economic growth and therefore slow down demand for other commodities.
Five components of risk management
Risk Reporting (Who)
Dimensions of Risk (What)
Frequency of Data Collection (When)
Investment/Position Level (Where)
Aggregation and Systems Development (How).
Three methods for approximating short-term valuations for illiquid securities
Capital statement valuations
Discounted cash flow model-based calculations,
Customized index-based calculations.
Monthly Data Collection
Position and manager changes
Non-investment qualitative risks such as business, legal, regulatory, and compliance.
Position and manager turnover, top positions, exposures, cash, cash flow,
illiquid/miscellaneous positions and qualitative risks reports.
Qualitative elements of risk management (4)
Business operations,
Legal,
Regulatory,
Compliance
Systematic managed futures strategy Risk
Model risk,
Trade execution,
Lack of volatility/trend or trend reversals
Leverage
Long/short equity strategy Risk
Macro analysis,
Sector,
Idiosyncratic security selection risk,
Dispersion risk
Key Person Risk
1) constructing an investment process that is less reliant on one individual,
2) purchasing key person insurance policies,
3) using extraordinary redemption rights triggered by the departure of a key person, or
4) maintaining a “bench” of alternative investment opportunities and adequately diversifying the existing portfolio
Seven categories of quantitative information
(CHHAV-GF)
CTA and managed futures exposures
Historical performance
Historical risk measurement review
Asset allocations and capital balances
Various activity reports
Gross contribution
Fixed income reports
Five categories of qualitative information
(DAWK-O)
Descriptive information
Activities log
Watch or focus list summary
Key information
Other information
Cybersecurity Potential Losses
Proprietary investment methods (algorithms, models, analytics, and research),
Confidential information on individuals and organizations,
Investments,
Sales and distribution, and
Business management.
Three models of risk management structure
1) CEO/President as Risk Manager,
2) COO/CFO as Risk Manager, and
3) Chief Investment Officer as Risk Manager.
Four key concepts of risk-neutral modelling
1) There is often an infinite number of sets of values that are consistent with a particular value for a financial derivative.
2) Expected risk premiums in a risk-averse world are generally unobservable.
3) The derivative’s value obtained from Q-measures is identical to the no-arbitrage values that must exist in a risk-averse world using P-measures.
4) Since Q-measures are tractable, they are used in risk-neutral modeling under those conditions in which actual derivative prices must match risk-neutral model prices.
Purpose of PCA
The process of PCA reduces the dimensionality of a matrix of multiple asset classes. Rather than relying on potentially hundreds or thousands of inputs, PCA seeks to find a few factors that explain most of the data’s variation.
Down Market Beta
The down market beta, bi,d is the responsiveness of the fund’s return to the market return when the market return is less than the riskless rate (i.e., when the market’s excess return is negative or “down”).
Why would an analyst use a rolling window analysis of the systematic risk exposures of an investment strategy rather than a single analysis based on the entire dataset?
The analyst is concerned about style drift (specifically, systematic risk exposures that change through time). By using a short-term analysis that moves through time the analyst can get estimates of the change in risk exposures through time.
Two major shortcomings of an empirical study that examines performance persistence of funds by comparing the correlation of returns in an earlier period with returns in a subsequent period when returns are based on appraised values?
(1) The results could be driven by serial correlation in returns that does not reflect true performance correlations, and
(2) the returns are not risk-adjusted.
Appraisals not representing of the underlying RE market
Sample Selection Bias
