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CFA Exam Level 3 > Trading and Performance Evaluation > Flashcards

Trading and Performance Evaluation Flashcards

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1
Q

Motivations/Rationals

A
  • Profit Seeking
  • Risk Management Hedging Needs
  • Cash Flows Needs
  • Corporate Actions, Margin Calls, and Index Reconstitutions
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2
Q

Profit Seeking

A
  • Active portfolio managers are trying to outperform a benchmark by generating Alpha.
  • Done by trading securities that they believe are under/over-priced
  • Management needs to act on their insights before the rest of the market does
  • Key part is Alpha decay
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3
Q

Alpha Decay

A
  • Deterioration of Alpha once an investment decision has been made.
  • Management trades on the flow of daily news, and has a high urgency of trading
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4
Q

Dark Pools

A
  • Trading systems with low pre-trade transparency; trades cannot be seen until the trading occurs (post trade)
  • Disadvantages: Traders cannot see orders on the other side they don’t have any of the pre-traded likelihood that a trade will be executed
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5
Q

Lit Venue

A

High pre-trade transparency, you can see both sides of a trade when an order is entered “stock exchange”

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6
Q

Cash Flows Needs

A
  • Trades are primary caused by subscriptions in the fund or redemptions out of the fund
  • If a fund has a lot of illiquid holdings it will be difficult to invest new client funds in a short-term period
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7
Q

Cash Drag

A
  • Cash doesn’t earn a return which will reduce a portfolios return
  • To avoid cash drag a portfolio can use a cash equitization strategy (ETFs or derivatives)
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8
Q

Index Reconstitution

A

Overtime a index adds and remove securities

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9
Q

Factors that Dictated the Appropriate Trading Strategy

A
  1. Order Characteristics
  2. Security Characteristics
  3. Market Conditions
  4. Individual Risk Aversion
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10
Q

Order Characteristics

A
  1. Side of the Trade: The direction of the order (buy, sell, short sell)
  2. Absolute Size: The number of the securities being trade
  3. Relative Size: Orders that make up a higher percentage of the ADV will have a significant impact
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11
Q

Market Impact

A
  • Impact on the price of the shares by a large order “buying liquidity”
  • Market Impact costs and timing cost are inverse in nature
  • Upward pressure: act of buying a lot
  • Downward pressure: act of selling a lot
  • Large block order: Tries to trade overtime with less urgency to reduce the impact.
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12
Q

Security Characteristics

A
  1. Security Type: Different types, trade in different markets, and have different costs
  2. Short-Term Alpha:
  3. Price Volatility: If prices are fluctuating widely implies high execution risk.
  4. Security Liquidity: More liquidity the narrower the bid-ask spread.
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13
Q

Short-term Alpha

A

A high urgency trade due to capturing mispricing there will be a high rate of alpha decay for an active management

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14
Q

Impact and Execution Risk

A

These are Inverse if one goes up, the other goes down
* Market Impact costs: Trading to quickly information leakage
* Execution Risk: Trading too slowly; adverse price movement

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15
Q

Implicit Costs

A

Hidden, largest part to a trade’s costs
* Market (Price) Impact Cost: (Cost of buying liquidity) Actual execution price less the price when the order is presented to the broker (M - B)
* Opportunity Cost: (Cost of the investment idea) The difference in price when the order was cancelled and when the order was placed “missed trade”
* Execution Risks: (Timing, Delay, or Slippage Cost) The price when the broker presents the order to the market less the price when the original order was presented to the trader (B- T)
* Bid-Ask Spread

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16
Q

Explicated Costs

A

The tangible visible cost you can see:
* Commissions,
* Fees
* Stamp duties
* Taxes

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17
Q

Reference Price

A

Are a key impact for the actual costs of trading for post trade evaluation
* Pre-Trade
* Intra-Trade
* Post-Trade
* Price-Target

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18
Q

Pre-Trade Benchmarks

A

Know before the start of the trading there are 4-types
* Decisions “Benchmark” Price
* Previous Close: Closing price on the previous day
* Open Price: Opening price of the day
* Arrival Price

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19
Q

Decisions “Benchmark” Price

A

“Original/Initial” The original price when the investment was order initiation “conceive”.

A lot of orders are initiated when the market is closed to the previous day’s closing price is used.

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20
Q

Arrival Price

A

“Revised Benchmark Price”
* Market price when it was sent to the market for execution if the order was fulfilled
* If an order wasn’t fulfilled at a limit order price, then the limit price needs to change or the price of close of previous day.

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21
Q

Intraday Benchmarks

A

Based during the trading period
Normally used by the portfolio manager who trades passively over a day the ones included are:
* VWAP
* TWAP

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22
Q

Post-Trade Benchmarks

A

Determine after trading has been completed (most common is the closing price)

Disadvantages: The closing price is not known until after the trade has been completed; cannot access performance during the trading horizon

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23
Q

Price Target Benchmark

A
  • High urgency for with high alpha decay
  • For profit seeking portfolio managers trying to earn a short-term alphas
  • Is quick strategy that would purchase a security below a predetermined price
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24
Q

High-Touch Approach

A

High level of human interaction, for large block trades, and/or less liquid markets
1. Principal Trade: Agency
2. Agency Trade: Broker

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25
Q

Principal trades

A
  • “Agency” they can act as the buyer to any seller or the seller to any buyer
  • Done using the dealer’s own inventory
  • Dealer/market makers assume all the risk in executing the order, priced into their spread “bid-ask”
  • Other markets: Quoted driven, OTC, and RFQ markets
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26
Q

Agency Trades

A
  • Where the broker finds the other side of the trade
  • Risk for the execution remains with the portfolio manager or trader.
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27
Q

Electronic Trading

A
  • Trading via computers, done in more liquid markets
  • The trading is order driven cause it allows the buyer and sellers to advertise their limit orders in a central limit order book
  • Allows direct market access (DMA)
  • Algorithmic trading
  • Provides anonymity
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28
Q

Direct Market Access (DMA)

A

Allows a person on the buy side to access the order book of the exchange directly through the structure the broker has.

Used for:
* Small currency trades
* Buy-side traders for exchange-traded derivatives (particularly smaller trades)

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29
Q

Algorithmic Trading

A

Use of programs rules to electronically trade order for trade execution or profit seeking

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30
Q

Trade Execution Algorithms

A

Execution algorithms that trade by specified rules set by the portfolio manager to meet their

Specific objectives they have:
* Scheduled algorithms
* Liquidity seeking
* Arrival Price
* Dark Strategies or liquidity aggregators
* Smart order routers

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31
Q

Schedule Algorithms

A
  • Percentage of volume participating algorithm will send order on a volume participation schedule
  • They execute trades using rules driven based on a historical time period or historical volume
  • Are most appropriate for smaller orders in liquid markets that have less urgency to execute the trade while, trying to minimize the market impact
  • Market Impact cost decreased; execution risk increased

Disadvantages:
* They continue to trade at any price can be adverse
* May not fill the order in the specified time in there is a lack of trading.

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32
Q

Volume-Weighted Average Price (VWAP)

A
  • Schedule Algorithm
  • Weighted average of execution price during the day where the weight is applied is the proportion of the days trading volume
  • Breaks the trade down and sending the order based on historical intraday volumes
  • Trades more at the opening and the closing not the trading day and not so much in the middle of the day

Disadvantages:
* Not useful if a trader is a significantly part of the trading volume
* Unethical; Can simply trade at the end of the day to execute a trade order
* If prices are moving Down = only execute buy orders
* If prices are moving Up = only execute sale which would be above the VWAP

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33
Q

Time-Weighted Average Price (TWAP)

A
  • Schedule Algorithm
  • Used for thinly traded stocks
  • Is the equal weighted average price of all trades over a specific trading horizon
  • Ignores actual volume good for highly fluctuating volume throughout the day.
  • Excludes Potential Trade Outliers
  • Equal number of shares are being traded over the period of the day.
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34
Q

Liquidity Seeking Algorithms

A
  • Opportunistic Algorithms
  • Try to take advantage of favorable liquidity conditions
  • Will use both Lit and Dark venues to get their trades done
  • For large orders in less liquid markets
  • Have a high urgency to mitigate market impact costs
  • Concerns for when management displays their limit orders that can lead to information leakages.
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35
Q

Arrival Price Algorithms

A
  • Try to trade close to market prices, prevailing at the time the trade is entered
  • Trades more aggressively than other algorithms
  • For small orders in more liquid markets
  • For managers that believe the price will move adversely and has a high urgency to trade
  • Market Impact cost increased; execution risk decreased
  • For profit seeking management with high alpha decay.
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36
Q

Dark Strategies Liquidity Aggregators

A
  • Execute strategies in the dark pools venues
  • Aggregators trying to optimize the trade across multiple dark venues
  • For large orders in illiquid markets
  • For management that does not have to execute the whole order immediately
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37
Q

Smart Order Routers (SOR)

A
  • Algorithmics that try to determine the best destination (Dark or Lit venues) to route an electronic order
  • Tries to find the best market pricing
  • Appropriate for small market orders, low market impact, where the price/market moves very quickly
  • For small limit orders with low information leakage
38
Q

Crossing Network Order

A

Electronic trading order with anonymity (not urgent trading)

39
Q

Execution Price

A
  • The actual price a security was bought or sold at
  • Relates to shares transacted in the market and corresponds to price drift from buying (which can increase the market price) or selling (which can decrease the market price).
40
Q

Implementation Shortfall

A
  • Another way to calculate trade cost but is more comprehensive
  • Takes a portfolio wide perspective
  • Most enact approach to cost measurement
  • It captures all elements of transaction costs
  • Can be decomposed into all different costs
  • Is a frontloaded strategy that can be adjusted to aggressively execute an order when the order has a high urgency.
41
Q

Paper Portfolio vs Actual Portfolio Return

A
  • Paper return: hypothetical return, at the original decision price with not cost
  • Actual return: net of all the cost

Difference Between is the total cost of executing the trade can be presented
* A dollar amount
* Percentage amount
* Per share amount of the initial order
* Basis points amount

42
Q

Mid-Quote

A

The average of the best bid and best offer.
* Uses a benchmark to see if it’s too over/under valued
* Can be used to calculate an effective spread
* If the mid-quote is not be available, cannot use a mid-quote as a benchmark
* To measure your implicit cost another alternative to use is the VWAP

43
Q

Cancellation Price

A

Market price of a security is order is not fully executed on the remaining portion of the traded is canceled

44
Q

Keys Areas of the Trade Policy for the Trade Management

A
  • Best Execution: Meaning of
  • Optimal Trading Approach: Factors that determine
  • Eligible Brokers and Venues: List of the approved
  • Monitoring: Any details of the process that are used by the asset management
45
Q

Best Execution Trade-Offs

A
  • Nature of the trade and order size
  • Execution price
  • Trading costs
  • Execution speed
  • Execution risk
  • Settlement risk
46
Q

Performance Measurement

A
  • Componet of Portfolio Evaluation
  • Calculating both a return and the risk over a time period(s)
  • Can be looked at it on a relative or absolute benchmark (target, specify in advance)
47
Q

Performance Attribution

A
  • Componet of Portfolio Evaluation
  • Determine what are the key factors generated the performance of the account.
  • Explains how the return was achieved given the level of risk taken
48
Q

Performance Appraisal

A
  • Componet of Portfolio Evaluation
  • Looks at different ratios to see if the performance was by effected by investment decision, the market price, or by chance
  • Renders a professional judgement of the fund
  • Design to asses if the portfolio manager where the investment results are due to skill or luck
  • Can the portfolio manager outperform their benchmark on a risk adjusted basis consistently
49
Q

Return Attribution

A

Evaluates the impact that active management decisions have on the funds returns

50
Q

Risk Attribution

A
  • Done in sync with return attribution and analyzes the active management decisions and impact on portfolio risk
  • Risk is generally compared to portfolio appropriate benchmark and also calculated on absolute terms
51
Q

Micro Attribution Analysis

A
  • Done at the individual Portfolio management level (the specific manager)
  • Tries to determine or verify what the portfolio managers actual did, what they said they would do, and to understand what are the actual factors/drivers of the portfolio return
52
Q

Macro Attribution

A
  • Done on a fund sponsor level
  • Quantifying the fund sponsor decisions to deviate from the SAA or TAA and the timing when they made their decisions
53
Q

Equity Attribution Method’s

A
  1. Brinson-Hood-Beebower (BHB)
  2. Factor-based Attribution Model
54
Q

Brinson-Hood-Beebower (BHB) Model

A

Quantifies a portfolio return into 3 attribution effects this shows the value added
1. Allocation effect: Pure selector allocation
2. Security selection effect: security selection; within sector selection
3. Interaction Effect: allocation selection interaction

55
Q

Allocation Effect

A
  • Decision to under/over-weight specific sector weightings in the portfolio vs the benchmark
  • Purely capture the portfolio managers ability to select outperforming sectors and avoid underperforming ones.
56
Q

Selection Effect: Within Sector Selection

A
  • Was the decision to under/over-weight within certain sectors vs a benchmark a good or bad decision
  • Portfolio managers stock picking skills
57
Q

Interaction Effect

A
  • “Plug” residual amount of the benchmark
  • It considered to be a really good if it captures the style and the effect it should be zero
  • It must sum up the total return with the others effects (allocation and selcetion) to 100%
58
Q

Fundamental Factor Model

A

Used where a portfolio’s sensitively to additional factor can be tested and example is the Carhart Model.

59
Q

Exposure Decompositions

A
  • Duration based
  • Top-Down approach, process the segments risk by same specific attributed or characteristics
  • Tries to quantify what arises from interest rate risk
  • Segments the portfolio by its market value weights
  • Assigns securities to the difference duration bucket, by the nature of each security
60
Q

Yield Curve Decomposition - Duration Based

A
  • Can be top down or bottom up
  • Uses both YTM and duration to calculate price return
  • Looks what factors that drive the return when the YTM changes
  • It requires a lot more data because it has to performed on the portfolio and the benchmark
61
Q

Yield Curve Decomposition – Full Pricing Based

A
  • Alternative to the Yield Curve Decomposition
  • Securities can be repriced by using spot rates
  • The use of spot rates is known as the full repricing method
  • It is the most accurate measure of reprising securities as its more in depth
  • It will bemore difficult and costly.
62
Q

Liability-Based Benchmark

A
  • Used when a specific liability needs to be paid in the future
  • Will focus on the cash flows when they are needed as the liabilities come due
  • It might limit the number and type of investment choices such as inflation-adjusted bonds, nominal bonds, high quality stock
63
Q

What are the qualities of a good benchmark

A

S – Specified in Advance: The benchmark is known by the portfolio manager and fund sponsor before the investment period
A – Appropriate: the benchmark has a consistent style or approach
M – Measurable: The benchmark’s value or calculated on a reasonable basis
U – Unambiguous: Clearly identities and weights of securities that make up the benchmark
R – Reflective of Current Investment Options: Whatever is in the benchmark or expertise of those securities in the benchmark
A – Accountable: portfolio manager accepts the applicability of the benchmark in advance and agrees to it any difference is only their active decisions make
I – Investable: We can replicate the benchmark passively and can forgo active management if desired.

64
Q

Absolute Benchmark

A
  • A return objective that tries to get a desired return that exceeds a minimum target return, or return of a specific percentage
  • Disadvantage: Will fail the investability test, not an investable benchmark
65
Q

Broad-Based Market Index Benchmark

A
  • Measures performance of a broad category of assets (like the S&P 500)
  • Disadvantage: May be inappropriate if the management style deviates from the style reflected in the index
66
Q

Style Index Benchmark

A
  • Represents specific portions of an asset category based on natural characteristics (value or growth)

Disadvantage:
* Some of the style indexes can contain weights on security and sectors that might not be appropriate or prudent
* Different definitions of investment style

67
Q

Factor-Model Benchmark

A
  • Specify a set of a factor exposures to a return of an account measures the sensitivity to risk exposures

Disadvantage:
* Focusing on factor exposure might not be easily explained
* The data and modeling are not always available and might be expensive
* May be ambiguous which can lead to misspecifications

68
Q

Return-Based Benchmark

A
  • Looks at portfolio return and tries to explain the return
  • Based on sensitivity to style indexes/approaches

Disadvantage:
* Might not reflect what is currently owned or is willing to own
* Not good at detecting (Style drift)
* For any meaningful analysis we need enough data to come up with a statical significant pattern of style exposures

69
Q

Manager Universe Benchmark

A
  • Median Manager, the fund at the middle, where funds are ranked from highest to lowest

Disadvantage:
* Doesn’t fit any of the criteria but being measurable
* Subject to the survivorship bias (not unbiased)

70
Q

Customized Benchmark

A
  • Satisfies all of the criteria
  • Designed to reflect the management security allocation and investment process
  • Also, knowns as a “normal portfolio” the universe of all the potential securities that are investable the management can select from

Disadvantage:
* If you allow a manager to create their own benchmark they will use one that is easy to beat
* Expensive to contract and maintain them

71
Q

Sharpe Ratio

A
  • Assumes returns are normally distributed risk adjusted measure of performance
  • Considers the risk relative return per unit of risk

Disadvantage:
* It doesn’t differentiate between volatility that is upward or downward; it takes all volatility into account.
* There is a penalty for all volatility even good volatility

72
Q

Treynor Measure

A
  • Similar to the Sharpe-ratio but uses beta only considers systematic risk (by using beta)
  • Considers the risk-relative return per unit of systematic risk
  • Disadvantage: Only useful to evaluate portfolios that are well diversified.
73
Q

Information Ratio

A
  • Ex-ante future returns expected it’s a standard deviation of error
  • Used to measure a portfolios performance with a benchmark, but accounts for differences in risks.
  • Rewards per incremental unit of risk created by deviating from the benchmark holdings
74
Q

Appraisal Ratio

A
  • Raito of returns to risks from active management
  • The active return per unit for a unit of active risks
  • Considers the managers value per unit of non-systemic risk
75
Q

Sortino Raito

A
  • Very Similar to the Sharpe ratio
  • Only considers the standard deviation of the downside risk
  • Clients are more concerned with risks of negative returns
  • Penalizes bad volatility by considering returns only below the minimum accepted return
  • For investments that have non-systematical or skew return distributions
  • Considers target-relative return per unit of downside risks
76
Q

Capture Ratio

A
  • Determines the management relative performance when a market is either up or down
  • This both would be the opposite in an upward market
  • Downside capture vs upside capture

If the capture ratio is:
* >1 positively asymmetrical convex return profile more upside than downside
* <1 negative asymmetrical concave return profile more downside vs upside

77
Q

Drawdown

A
  • Represents the peak to trough loss in portfolio value during a continues period of negative returns
  • Measures the total time from the start of the drawdown until recovery to the previous peak

Can be broken-down into:
* Drawdown Phase
* Recovery Phase

78
Q

Drawdown Duration

A

Total time that is full recover form a drawdown when a drawdown begins to when up to a cumulative drawdown reverse cand becomes zero

79
Q

Maximum Drawdown

A

Occurs at the very end of the drawdown phase and right before it hits the recovery phase it’s the point at which the cumulative drawdown is at its highest

80
Q

Time Weighted Rate of Return

A

is used to evaluate the external managers returns because they ignore factors they have no discretion.

81
Q

Type 1 Error

A
  • Rejecting the HO when in fact it is true
  • Believe the manager adds value when they do not
  • Are easier to determine because we can measure a manager’s vs a benchmark
  • Results in costs associated in retaining management is weak
82
Q

Type 2 Error

A
  • Accepting the HO when in fact it is false, Beta Error
  • Believe the manager does not add value, when they do
  • Errors are harder to determine as how do we compare them (there are opportunity costs)
  • If there is an excessive number of type-2 errors indicates that there is a problem of hiring and firing
  • Bad decision result in cost associated with not retaining these managers

Solutions to Prevent Type 2 Errors:
* Reduce by tracking the subsequent performance of those managers that were not hired or fired
* When there is any type of personal changes should not be done by short-term performance

83
Q

AUM fees

A
  • Fees based on a percentage of assets under management.
  • The assets will grow due to manager skill and effective marketing
  • Over the short term, market cycles can affect AUM for reasons not linked to the manager.
  • The principal-agent problem can occur
  • This potential conflict is addressed through performance-based fees.
84
Q

Performance-based fees

A
  • Fees designed to reward manager performance.
  • May be based on absolute returns, or benchmark-relative returns.
  • Symmetrical exposure: Manager earns a base fee and shares in the gains/losses of the fund
  • Capped symmetrical exposure: Manager shares in gains above the base fee up to a limit, but not losses

Asymmetrical (upside) exposure:
* The manager shares in gains above the base fee, but not losses
* Offers the manager unlimited upside and capped downside, similar to a call option.

85
Q

Issue with Performance Fees

A
  • Create tension when base fees must be paid in periods of poor performance.
  • Reduce variability in net returns
  • Cause managers to unethically favor clients
  • Cause delay in realizing investments until performance fees can be earned
  • Cause hedge fund managers to return capital to investors when significantly below the high-water mark
86
Q

Transactions-based Attribution Method

A
  • Most effective for active stock selection portfolios
  • Captures both the holdings and the transactions (purchases/sales) completed within the period
  • Allow the entire excess return to be quantified and explained
87
Q

Returns-based Attribution Method

A

Most appropriate when the underlying portfolio holdings are not readily available with sufficient frequency at the required level of detail (hedge funds).

88
Q

Holdings-based Attribution Method

A
  • Most appropriate for investment strategies with little turnover (passive strategies)
  • Only references the beginning-of-period and end-of-period holdings and ignores individual transactions.
89
Q

Quality of Investment Personnel

A
  • Sufficient expertise and experience
  • Sufficient depth to execute the strategy
  • Exposure to key-person risk
  • Incentives to reduce personnel turnover
  • Consistent investment strategy
90
Q

Trade Error Logs

A
  • Trade policy document should describe the factors used in determining how an order can be executed in an optimal manner for a given scenario.
  • Any resulting gains/losses need to be disclosed to the compliance department and documented in a trade error log.
  • The priority is to ensure errors are resolved in a way that prevents adverse impact for the client, not to ensure complete disclosure.

CFA Exam Level 3 (13 decks)

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