Spring2022PAK

Question 1

What are the Insights of MPT (4)

Answer 1

1) Diversification across less correlated assets tends to reduce portfolio risk
2) Avoid concentrated sources of risk.
3) Patience is rewarded and total risk should be spread relatively evenly over time.
4) Look at expected return of each investment in relation to impact it has on risk of overall portfolio (i.e., marginal contribution to portfolio risk).

Question 2

Total return and risk of two assets portfolio

Answer 2

Question 3

Condition for optimal allocation for a two assets (domestic/international) portfolio

Answer 3

Shift allocation from domestic equities to international equities (or vice versa) up to the point where ratio of expected excess returns to the marginal contribution to portfolio risk is the same for both assets:

Question 4

Three legs of financial accounting control

Answer 4

1. Planning 2. Budgeting 3. Variance monitoring

Question 5

Two measures of risk

Answer 5

1. VaR = maximum dollar earnings/loss potential associated with a given level of statistical confidence over a given period of time 2. Tracking error (TE) = standard deviation of excess returns (i.e., the difference between the portfolio’s returns and the benchmark’s returns)

Question 6

Liquidity duration of a security

Answer 6

liquidity duration = number of shares held / [(%) x (daily volume)] where % = threshold do not wish to exceed

Question 7

Objectives of performance measurement tools (4)

Answer 7

1. Determine whether manager generates superior risk-adjusted performance vs. peer group 2. Determine whether manager generates consistent excess risk-adjusted performance vs. benchmark 3. Determine whether returns achieved are sufficient to compensate for risk assumed in cost/benefit terms 4. Provide basis for identifying managers whose processes generate high-quality excess risk-adjusted returns

Question 8

Performance measure tools (5)

Answer 8

1. The Green Zone = (i) produce portfolio with risk characteristics comparable to target, (ii) achieve actual risk levels that approximate target 2. Attribution of returns = attribute sources of returns to individual assets and/or common factors 3. Share Ratio and Information Ratio 4. Alpha versus the benchmark 5. Alpha versus the peer group

Question 9

Sharpe Ratio

Answer 9

Excess of portfolio return over risk free rate divided by standard deviation of portfolio

Question 10

Information Ratio

Answer 10

Excess of portfolio return over benchmark return divided by tracking error

Question 11

Alpha vs. Benchmark Performance Measurement Tool - Strengths and Weaknesses

Answer 11

STRENGTHS 1. Distinguish between excess returns due to leverage vs. skill 2. Allows for mgmt to opine whether excess returns are due to skill or luck 3. Easy to calculate (alpha, beta, and tests of significant are easy to calculate) 4. Beta shows if returns are due to overweight or underweight WEAKNESSES 1. May not be sufficient data points to conclude about statistical significant of alpha and beta

Question 12

Alpha vs. Peer Group Performance Measurement Tool - Strengths and Weaknesses

Answer 12

STRENGTHS 1. Distinguish between excess returns due to leverage vs. skill 2. Allows for mgmt to opine whether excess returns are due to skill or luck 3. Easy to calculate (alpha, beta, and tests of significant are easy to calculate) 4. Tests whether manager has generated excess returns in comparison to the peer group WEAKNESSES 1. May not be sufficient data points to conclude about statistical significant of alpha and beta 2. Returns of peer group are biased due to survivorship biases 3. Usually easier to generate larger risk-adjusted excess returns managing smaller sums and there is wide variation amounts under management among peers.

Question 13

Two main classes of investment risk

Answer 13

1. Market risk 2. Active management risk

Question 14

Asset classes overlooked by smaller plans (6)

Answer 14

1. Real estate 2. High yield bonds 3. International equities 4. Emerging markets 5. Hedge funds 6. Private equity

Question 15

Costs created by investment programs

Answer 15

1. Investment management - costs paid directly to those managing the portfolio 2. Custody - costs paid to the custodian bank for holding assets 3. Transaction costs - costs paid to brokers and intermediaries for providing liquidity 4. Administration - costs paid to the CFO, pension fund oversight department, consultants, lawyers, accountants, transfer agents, payment agents, technology, etc.

Question 16

Traditional vs. Quantitative Equity Portfolio Management (EPM - Similarities (4)

Answer 16

1. Both employ economic reasoning to identify a small set of key drivers of equity values 2. Both use observable data to measure key drivers 3. Both use expert judgements to develop ways to map key drivers into final stock selection decision 4. Both evaluate performance over time

Question 17

Traditional vs. Quantitative Equity Portfolio Management (EPM - Differences (1)

Answer 17

1. The main difference is how they perform their steps.

Question 18

Five Proxies for Liquidity (Goldman’s model)

Answer 18

1. Order size 2. Average trading volume 3. Market capitalization 4. Stock price volatility 5. Stock price level

Question 19

Four steps for building a quantitative return-forecasting model (Goldman’s model)

Answer 19

1. Identify a set of potential return forecasting variables or signals 2. Test the effectiveness of each signal, by itself or in combination(s) 3. Determine the appropriate weight for each signal 4. Blend the model’s views with market equilibrium to arrive at reasonable forecasts for expected returns

Question 20

How to compute Tracking Error

Answer 20

Question 21

Two approaches to constructing an efficient portfolio

Answer 21

RULES BASED SYSTEM 1. Simple rules/approaches that partially control exposures to small number of risks 2. One approach is called Stratified Sampling - it ranks stocks within buckets based on a few key risk factors (sector and size). 3. The manager invests heavily in the higher-ranked stocks within each bucket while keeping portfolio’s weight in each bucket close to that of the benchmark PORTFOLIO OPTIMIZATION APPROACH 1. Better method for balancing expected returns against different sources of risk, trade costs, and investor constraints 2. An optimizer uses computer algorithms to find set of weights that maximizes the portfolio’s expected return for a given level of risk

Question 22

Risks when investing in fixed income assets (risk, description, drivers, measures)

Answer 22

Question 23

Risk exposures of fixed income benchmarks (4)

Answer 23

1. Duration risk 2. Sector risk 3. Credit risk 4. Currency risk

Question 24

Active management strategies for fixed income portfolio (6)

Answer 24

1. Duration timing 2. Yield curve positioning 3. Sector allocation 4. Security selection 5. Country allocation 6. Currency allocation

Question 25

What is a hedge fund?

Answer 25

A hedge fund is an unconstrained, loosely regulated investment vehicle for which a portion of manager compensation is a performance fee

Question 26

Key characteristics of hedge funds (7)

Answer 26

1. Constraints 2. Regulation 3. Fee structure 4. Lack of transparency 5. Short lives 6. Illiquidity 7. Capacity constraints

Question 27

Four categories of hedge funds

Answer 27

1. Relative value - convertible arbitrage, equity arbitrage, fixed income arbitrage 2. Event driven - merger arbitrage, special situations, high-yield/distressed debt 3. Equity long/short - geography (US, Europe, Japan, etc.), industry (technology, energy, etc.), style (value, growth, small, etc.) 4. Tactical trading - managed futures, global macro

Question 28

Types of private equity (6)

Answer 28

1. Angel investor 2. Incubator 3. General venture capital 4. Late/Cross over venture capital 5. Mezzanine/buyout 6. Distressed/restructuring

Question 29

Why invest in private equity? (2)

Answer 29

1. Information advantage - private equity manager can have informational advantage in assessing transactions and making investment decisions 2. Active management - best private equity investors often control companies and boards of directory, choose management, drive strategy, and affect operation and financial decisions

Question 30

Importance of performance attribution (8)

Answer 30

1. Investment program is incomplete without thorough evaluation of performance relative to objectives 2. Performance evaluation provides “quality control” check 3. Performance evaluation is part of feedback step of investment management process 4. Performance evaluation enhances effectiveness of Investment Policy by acting as feedback and control mechanism 5. Performance evaluation identifies fund’s strengths and weaknesses 6. Performance evaluation attributes the fund’s results to key decisions. 7. Performance evaluation provides evidence to Trustees that investment program is being conducted in appropriate/effective manner 8. Increased complexity of institutional investment management requires increased/more sophisticated performance evaluation from fund sponsor’s perspective

Question 31

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