Trading Performance & Evaluation

Question 1

4 categories of trade motivation

1. Profit seeking

What is alpha decay and what does it do to urgency?

2. Risk management
3. cash flow needs
4. corporate actions margin calls and index reconstitution.

Which type is a portfolio manager researching short and long term stocks to buy with an end of day client withdrawal?

Answer 1

1. Profit seeking - Active manager seeks to outperform benchmark. Seeking undervalued or overvalued stocks.

Alpha decay is a function of how quickly a piece of information takes to be incorporated into a securities price. Information moving quickly into a price shows high alpha decay. Low alpha decay creates lower trade urgency)

2. Risk management. Portfolio traded to maintain risk exposure such as target beta, duration or interest rate environment driven decisions.
3. Cash flow needs. Margin calls would require immediate liquidation (high urgency). Fund redemptions (low urgency). Greater emphasis on time vs price.
4. corporate actions and index reconstitution. Mergers and acquisitions or spinoffs may require trading. Income managers may need to sell holdings inf dividends are cancelled.

Short and long term research is profit seeking high and low urgency for the long term stocks. Cash flow needs low urgency is for end of day sales in liquid stocks.

Question 2

4 Key factors dictate appropriate strategy

Order Characteristics

Security characteristics
Liquidity effect on impact?

Market conditions

Individual risk aversion

Answer 2

Order Characteristics = SIDE & SIZE - Side (buy or sell), Size (large amount transacted creates larger market impact), Relative size ( % of ADV)

Security characteristics - Security type, short term alpha for active managers experiencing high rate of alpha decay, price volatility and security liquidity (low liquidity = low market impact).

Market conditions - Mainly affecting trading cost due to volatility and liquidity levels. Liquidity crises where deviations from liqudity patterns occur due to periods of crisis.

Individual risk aversion - High risk aversion managers will trade more urgently.

Question 3

4 categories for trade execution benchmarking to see how your price received compares to benchmark prices in a session for post trade evaluation:

Pretrade benchmarks

Intraday benchmarks
Which removes outliars?

Posttrade benchmarks

Price target benchmarks

Someone who wants to avoid outliars would pick which?
Short term alpha manager would choose which?
Index and mutual funds would choose which?

Answer 3

Pretrade - A reference price which is known before trading. Used by short term alpha managers.
Decision price = the security price at the time portfolio manager decided to trade.
Previous close ‘price target pegged at close the previous day’
Opening price
Arrival price (instruction price)

Intraday - VWAP (average price of all trades weighted by volume) and TWAP (equal weighted so removes outliars) (risk re-balance managers, client redemption)

Post trade - determined after trading is completed. CLOSING price is most often used. Used by mutual funds and Index funds who wish to execute at the end of the day.

Price target benchmark - Perceived fair value of a stock ie if you believe shares are undervalued you’d keep buying them below your price target benchmark price. (short term alpha managers)

Question 4

High touch approach trades implementation 2

Principal trades:

Agency trades:

Answer 4

High touch for less liquid, low urgency fixed income markets such as MBS.

Principal trades: Required for large block trades. Quote driven, OTC or off-exchange markets. Plus request for quote (RFQ).

Agency trades where broker finds the other side of the trade.

Question 5

When is each of the below algorithms appropriate regarding urgency and order size?
Liquidity seeking
POV Algorithm
Arrival Price

Answer 5

Liquidity seeking = Large orders with high urgency. Large trades relative to ADV can be managed well.
POV Algorithm = Low urgency traded over a trading session. 10% participation of ADV.
Arrival Price = High urgency in LIQUID stocks only.

Question 6

Scheduled algorithms—percent-of-volume (POV), VWAP, and TWAP algorithms

POV algorithms (a.k.a. participation algorithms)

3 reasons to choose a scheduled algorithm.

Which one is most likely to complete a trade within a trading day?

Answer 6

POV algorithms (a.k.a. participation algorithms) trade more (less) when volume increases (decreases) (e.g., “participate as 10% of traded volume will participate in 10% of market volume until trade completes”).
Advantage: They automatically exploit increased liquidity when available. Good for large low urgency equity trades.
Disadvantage: They continue to trade at any (potentially adverse) price, and may not fill the order in a specified time if there is a lack of trading.

TWAP releases over a specified time period.
+ ENSURES shares trade within a time period
+ ignores outliars
- Shares trade evenly during times of low liquidity

VWAP releases over a specified time
+ time slicing based on volume means higher volumes at open and close. May NOT complete an illiquid trade.

Useful for trades who do not expect adverse price movements during a trade horizon
Traders who have greater risk tolerance.
Relatively small trades relative to daily volume (no more than 5-10%)

Which one is most likely to complete a trade within a trading day? TWAP

Question 7

SFDL Buy $8.50 10,000 20,000 Urgency: High
TWEL Buy $32.31 5,000 100,000 Low
UDSL Sell $2.05 1,000,000 1,000,000 Low

Liquidity seeking, scheduled algo or high touch?

Answer 7

SFDL should be purchased using a liquidity-seeking algorithm. The low liquidity in the market and the high order size make minimization of market impact a key consideration. Plus high urgency.

TWEL should be purchased using a scheduled algorithm. The low urgency, With low order size and relatively high liquidity, a scheduled algorithm such as POV, VWAP, or TWAP is most appropriate

UDSL should be sold using a high-touch principal approach. This order represents 100% of the ADV; hence, using an algorithm is not appropriate due to the high possibility of information leakage

Question 8

Best execution

Answer 8

Best execution seeks the best possible result for clients

Execution price.
Trading costs.
Speed and likelihood of execution and settlement.
Order size and liquidity.
Nature of the trade (e.g., urgency of the trade).

Not necessarily lowest cost. It could be distressed shares sold at a discount by a CFO who wants to avoid leakage.

Question 9

Evaluating a firms trading procedure, four key areas:

1. Meaning of best execution
2. Factors that determine the optimal execution approach.
3. List of eligible brokers and execution venues
4. Process for monitoring execution arrangements

Answer 9

1. Meaning of best execution - general term used by regulators to describe the duty of asset managers to seek the best possible result for clients
2. Factors that determine the optimal execution approach. Urgency and size of order, Liquidity of security, available venues, reason for trades.
3. List of eligible brokers and execution venues - best practice is to establish a best execution monitoring committee (BEMC)
4. Process for monitoring execution arrangements - The approved broker list should be constantly monitored for representational issues, trading error frequency, criminal actions, and financial stability.

Question 10

When is each of the below trade styles appropriate?
Open auction
Closing auction
Passive trading over the day?

Answer 10

Open auction - for high urgency short term alpha trades trying to capture a mispricing.
Closing auction - mutual funds seeking the NAV of a fund to meet redemptions.
Passive trading over the day - low urgency when not attempting to capture short term alpha

Question 11

Comment on the below algorithms (order size, liquidity of stock, volume)

Dark strategies/liquidity aggregators

Smart orders routing (SOR)

Direct Market Access

Arrival price

Liquidity seeking

Answer 11

Darks strategies = Illiquid stocks. Trade on opaque dark pools. They are used to reduce information leakage. Used when order size is large relative to market volumes, with ‘wide bid-ask spreads’.

Smart orders routing will search everywhere on lit and dark markets in order to execute at the best price. Best for small orders less than the quantity posted on bid or offer or stocks which trade on multiple venues.

Direct Market Access - low touch, smaller liquid trades.

Arrival price = Liquid stocks, little market impact expected (Instruction price) These algorithms ‘front load’ volume when the trade is entered in order to stay near to the instruction price.

Liquidity seeking = Large orders looking for low market impact. Used for stocks with sizable liquidity. Aims to reduce informaiton leakage. Can also be appropriate for thinly traded stocks where liquidity is EPISODIC.

Question 12

3 stages of performance evaluation

1.Performance measurement

2. Performance attribution =
   - Return attribution
   - Risk attribution

Effective attribution =

83. Performance appraisal =

Answer 12

What performance did the fund achieve during the period (performance measurement)?

Performance attribution = Identified drivers of investment returns and explains HOW excess performance or risk was achieved. Should account for ALL of a portfolios return or risk exposures.
- Return attribution = analyses impact of active investment decisions
- Risk attribution = analyses the risk consequences of those decisions

Effective attribution = Reconciliation of the total portfolio return or risk exposure

Performance appraisal = Uses results of risk, return and attribution analyses to asses the QUALITY of a portfolios performance.

Question 13

The three main approaches to conducting performance attribution:

1. Returns-based attribution
   Different to Returns based style analysis
2. Holdings-based attribution
3. Transactions-based methods attribution

Which is used when holding detail is unavailable?
Which is a beginning of period measure and which is measured over a period?
Which is most complex and accurate?

(Analogous to returns and holdings based style analysis)

Which struggle with illiquid assets?

Answer 13

1. Returns-based attribution- regresses total portfolio returns OVER A PERIOD against major risk factors (for example, systematic risk, size, value) Least accurate because does not consider underlying holdings. fundamental factor-based model.
   A returns-based style analysis is a top-down approach that is used to estimate a portfolio’s sensitivities to security market indices. It uses objective risk exposures that are derived from the manager’s actual return series. Appropriate when underlying portfolio information is unavailable.
2. Holdings-based - uses a snapshot of a portfolio at a single point in time and is subject to window dressing. It is a bottom up look through of portfolio holdings to assess the active sector/stock selection bets of the manager and their contribution to active return. More accurate than returns-based because it considers underlying holdings.
3. Transactions-based methods - improves upon the holdings-based attribution by including the impact of any trades executed during the evaluation period. Most accurate method. Highest data requirements.
   Highest complexity

Both struggle with illiquid assets

Question 14

Macro attribution.

Micro attribution

Answer 14

Performance attribution on the decisions made by the ASSET OWNER and FUND SPONSOR is called a macro attribution. Evelyn Partners Asset Allocation Committee. (Together, the investment committee and the internal investment staff would be referred to as the fund sponsor.)

PORTFOLIO MANAGER level decisions is called micro attribution. Jersey Investment team.

Question 15

Which risk attribution technique?

A EMN systematic scoring stocks on proprietary risk factors with absolute return target
Bottom up stock picker with relative return target
Market timer using technical analysis top down and absolute return target

Marginal contribution to total risk
Marginal contribution to tracking risk
Factor’s marginal contribution to total and specific risk

Answer 15

A EMN systematic scoring stocks on proprietary risk factors = Marginal contribution to total risk if using an absolute return target.
Bottom up stock picker = Marginal contribution to tracking risk with a relative return target.
Market timer using technical analysis = Factor’s marginal contribution to total and specific risk and absolute return target

Question 16

Seven primary types of benchmarks Advantages and Disadvantages

Absolute
Broad market indexes
Style indexes
Factor-model-based.
Returns-based
Manager universes
Custom security-based

Answer 16

absolute benchmark is a return objective that aims to exceed a minimum target return. Adv Simple and straightforward benchmark. Disadvantage:
Absolute return objective is not an investable benchmark

Broad market indexes - S&P 500 adv = well recognized dis = manager style may deviate

Style indexes - (1) large-capitalization growth, (2) large-capitalization value, (3) small-capitalization growth, and (4) small-capitalization value. adv - They are widely available, widely understood by clients. Dis = Some style indexes can contain weightings in certain securities and sectors that may be larger than considered prudent.

Factor models involve relating a specified set of factor exposures to the returns on an account. CAPM, Adv - It provides managers and sponsors with insight into the manager’s style by capturing factor exposures that affect an account’s performance. Dis - Focusing on factor exposures is not intuitive to all managers or sponsors. The data and modeling are not always available and may be expensive to obtain.

Returns-based benchmarks are constructed using (1) the managed account returns over specified periods and (2) corresponding returns on several style indexes for the same periods. adv - Useful where the only information available is account returns. Generally easy to use and intuitive. dis - Will not work when applied to managers who change style.

Manager universes. The median manager or fund from a broad universe of managers or funds (that follows a similar investment process) is used as the benchmark. The median manager is the fund that falls at the middle when funds are ranked from highest to lowest by performance. Advantage: It is measurable. Dis - Manager universes are subject to “survivor bias,” as underperforming managers often go out of business and their performance results are then removed from the universe history.

Custom security-based benchmarks are designed to reflect the manager’s security allocations and investment process. Adv - Allows fund sponsors to effectively allocate risk across investment management teams. Dis - It can be expensive to construct and maintain.

Question 17

A portfolio return can be broken up into three components: market, style, and active management.

Portfolio return equation M, S A

Style return (S) =

Active management return (A)

Answer 17

P = M + S + A

S = B - M
A = P - B

portfolio return = return on market index + excess return from style + overall portfolio return surplus to the benchmark

P = portfolio manager return
M = Market return
S = incremental return due to investment style
B = return of managers style benchmark
A = incremental alpha (manager value added)

Question 18

Three hedgefund benchmarks

Answer 18

Rf rate -
broad market indexes - Broad market indexes are not appropriate to use as a benchmark for hedge funds because hedge funds cover a wide range of investment strategies.
hedge fund peer universes - not likely to match those of a specific hedge fund.

Question 19

Real estate benchmarks issues

Answer 19

Benchmark returns are self-reported, so some subjectivity and/or bias may be present.
Benchmarks that are value-based could be biased toward the most expensive properties or geographical areas.
There is a lack of comparability with benchmark returns given that some benchmarks use leverage while others do not.

Question 20

PE benchmark issues

Answer 20

The metric used is usually IRR, taking into account all investment cash flows since inception plus the ending investment value. Key problems with such benchmarks include managers using different methods of valuation, which makes comparison more difficult. In addition, IRR may be biased by losses or gains occurring near the beginning of an investment.

Question 21

Commodity benchmark issues

Answer 21

Benchmarks for commodity investments are usually based on futures as opposed to actual assets. This may result in significant differences between the benchmark and the commodity investments portfolio, which reduces the comparability. Similar to other alternative investments, the different amounts of leverage employed by portfolios versus benchmarks

Question 22

Managed Derivatives

Distressed Securities

Answer 22

Peer-group benchmarks are similar to those used for hedge funds and will potentially exhibit the same issues as hedge fund peer-group-based benchmarks such as survivorship bias.

Given the illiquidity and severe lack of marketability of distressed securities, it is almost impossible to determine an appropriate benchmark. Should the financial state of a distressed company become better, it may become more liquid. A significant amount of time to occur

Question 23

Quantitative Analysis should be evaluate objectively through what?

Qualitative Analysis of manager selection includes investment and operational due diligence.

What is performance attribution used for? Does it show quality of decisions or performance?

Which type of risk assessment is used for Top Down approaches to risk?

Answer 23

Quantitative Analysis should be evaluated through performance ATTRIBUTION and APPRAISAL through capture ratios.

Qualitative analysis of manager selection includes investment and operational due diligence.

Performance attribution breaks down HOW performance was achieved by breaking it down into explanatory components. It shows quality of performance but not quality of a managers decisions.

Risk allocation based on sector allocations and security selection, which is TOP DOWN, would assess tracking risk relative to a benchmark.

Question 24

Qualitative Analysis? Investment due diligence. Two important issues

Operational due diligence

Answer 24

Qualitative analysis and Investment due diligence = philosophy, process, people and portfolio. 1) What is the likelihood that the same level of returns will continue in the future? 2) Does the manager’s investment process account for all the relevant risks?

Operational due diligence = process & procedures. Firm. Terms. Vehichle. Monitoring.

Question 25

Type 1 Errors
Type 2 Errors
Error of ommission or commission?

Non distinct distribution of skilled vs unskilled managers (opportunity cost?)

Difference in expected cost of type I and type II errors?

Answer 25

Type 1 Errors Reject the null which is correct - Cost of hiring/retaining weak managers. An error of commission for unskilled managers in large cap.

Type 2 Errors Fail to Reject the null which is false - Cost of not hiring/firing a strong manager. An error of ommission in small cap skilled managrs.

Non distinct distribution of skilled vs unskilled managers implies low opportunity cost.

The greater the difference in the distribution between skilled and unskilled managers, the greater the opportunity cost of retaining and cost of hiring an unskilled manager.

(Assuming two separate groups of managers (e.g., strong and weak), the greater the differences in sample size and mean, the greater the costs of Type I and II errors. The wider the dispersion of returns between strong and weak managers, the easier it is to distinguish between their relative skills. Therefore, it makes it less likely to have a Type I or II error which results in a lower expected cost of a Type I or II error.

Question 26

Style analysis must be:

returns-based style analysis (RBSA) TD

holdings-based style analysis (HBSA). BU
What causes a ‘residual term’?

Manager’s actual return uses?
Developing a manager universe?
Holdings based attribution

Answer 26

In sum useful style analysis must be meaningful, accurate, consistent, and timely.

RBSA estimates the portfolio’s sensitivities to security market indexes for a set of key risk factors. Top down using factor sensitivities and benchmark weights. Easy to obtain on a timely basis. Lacks precision. Difficult to ascertain multiperiod investment decisions. Risk factors are estimated. It uses objective risk exposures that are derived from the manager’s actual return series

HBSA looks at the actual securities THROUGH TIME included in the portfolio and manages illiquid stocks better. Using beginning of period market values. Holdings-based style analysis is often used to determine a benchmark to which managers can be assigned or used to develop a manager universe. That allows one to estimate the current risk exposures using a more security-specific (bottom-up) approach. More difficult to ascertain.
The residual term of HBSA may result from measuring a funds holdings less frequently than it trades.

Manager’s actual return uses? RBSA
Developing a manager universe? HBSA
Holdings based attribution used to assess passive funds.

Question 27

In geneneral how are inefficiencies categorised?

Behavioral inefficiencies

Structural inefficiencies

Long/short term?

Answer 27

Inefficiencies are categorised as either structural or behavioural

Behavioral inefficiencies are mispricings caused by other investors and their behavioral biases (e.g., trend-following). The mispricings are very short-term in nature.

Structural inefficiencies occur because of laws and regulations, which can make them long-term in nature

Question 28

Pooled Account

Separately Managed Account (SMA)

Answer 28

Pooled vehicles bring together the funds from all investors into one portfolio (e.g., mutual funds, ETFs, hedge funds) and there is no customization for any specific investor. Delayed times on positions. Better investor behaviour.

SMAs hold the funds of one investor in a separate account so a key analysis is the cost-benefit trade-off of holding investments in a SMA. Real time details on positions. Higher cost, better tax efficiency. More tailored. Direct legal ownership. Fixed costs borne entirely by one investor.

Question 29

Signal creation

Signal capture

Answer 29

Signal creation = A data point or fact which can be observed early enough to implement an investment position.

Signal Capture = translates the investment idea into an investment position.

Question 30

Hard lock redemptions
Soft lock redemptions

Answer 30

Hard lock redemptions not permitted
Soft lock redemptions permitted for a fee

Question 31

Base + Performance sharing fee

Fund X earns a –3% gross return for the year. The computed management fee is equal to a base fee of 2% plus a 20% sharing of both positive and negative performance. The sharing is based on return net of the base fee. What is Fund X’s total management fee for the year?

Greater of: Base or Base + performance sharing fee

Fund Y earns a gross return of 12% for the year, while the relevant benchmark earns 3%. The computed management fee is equal to the higher of either a base fee of 0.4%, or base plus a 20% sharing of positive performance, up to a maximum annual fee of 2.9%. The sharing is based on active return. What is Fund Y’s total management fee for the year?

Answer 31

2% + [20% × (-3% – 2%)] = 1%.

Higher of: (1) 0.4%, or (2) 0.4% + [20% × (12% – 3%)] = 2.2%

Question 32

Manager selection components - two considerations for qualitative and quantitative approaches

Answer 32

Qualitative is process and people and the four Ps —philosophy, process, people, and portfolio.
It is also operational due diligence of infrastructure and firm such as back office, monitoring and investment vehicle.

Quantitative is Attribution and Appraisal - such as capture ratios and drawdown.

Question 33

Four key methods to manage liquidity risk include
(1) liquidity profiling and time-to-cash tables,
(2) rebalancing and commitments, (Systematic rebalancing policies and Automatic adjustment mechanisms)
(3) stress testing, and
(4) derivatives.

Answer 33

(1) liquidity profiling and time-to-cash tables: three distinct colums: (1) amount of time needed to convert assets to cash ie < 1 week up to > 1 year (2) liquidity classification level ie highly liquid to lowly liquid and (3) liquidity budget ie at least 5% in highly liquid and and up to 10% in illiquid. (Plus everything inbetween).
Use of Liquidity profiles are used to look through commingled funds with various holdings

(2) rebalancing and commitments, -
Systematic rebalancing policies are designed to maintain the long-term (strategic) asset allocation as much as possible. Examples include calendar and percent-range rebalancing.
Automatic adjustment mechanisms assist in keeping the portfolio risk profile relatively constant if there is a change from the target.
Commitments - Private funds are hard to keep stable. A multi year strategy with the right level of commitments can be used to arrive at a long term optimal exposure.

(3) stress testing explicitly considers how the liquidity needs of a portfolio will change during a period of market stress. The idea is to conduct analysis to assume “worst case” or very extreme market conditions

(4) derivatives. require far less cash than investing in underlying assets, which makes derivatives an ideal method for rebalancing. In addition, a futures overlay allows for rebalancing of many (but not all) asset classes without altering any of the asset allocations determined by the external active managers.

Question 34

illiquid asset price =

illiquidity premium (%) =

Answer 34

illiquid asset price = marketable asset price – put price

illiquidity premium (%) = expected return on illiquid asset (%) – expected return on marketable asset (%)

Illiquidity premium is difficult to measure given it is teh premium earned by having ‘unknown’ delivery dates such as PE funds.

Question 35

Facts about the QU endowment fund

Answer 35

Long term horizon so greater ability to invest in illiquid assets and shift efficient frontier upwards.
The endowment has consistently earned positive returns from illiquid investments such as alternatives over the past 20 years.. They have good diversification and manager skill in selecting strong holdings in this area.
Compared to peers QU is under invested in illiquid investments so they could increase if they wish.
Allocation to illiquid assets (Real assets and PE) introduces more systematic risk. They choose to hold a small holding in larger number of strategies.

Question 36

Liability-based benchmarks

A broad market index

A factor model-based benchmark

Describe and Used by who?

Top down quantitative manager
government bond portfolio
DB pension

Answer 36

A Liability-based benchmarks focuses on the cash flows a benchmarked asset must generate. Used by pension funds looking to close the gap between assets and liabilities It would be used for an ENTIRE portfolio of a defined benefit pension (both equity and fixed income components)

A broad market index is suitable for a government bond portfolio where maturity and duration characteristics align with the benchmark

A factor model-based benchmark used by top down quantitative managers

Question 37

cash flow forecasting and commitment pacing models

Answer 37

Cash flow forecasting and commitment pacing models can be used to estimate the increased allocation to private equity and real assets. For example, cash outflows need to be estimated for future commitments in private equity; capital calls are legal obligations. Also, during market downturns, such cash outflows may become more onerous as inflows from prior investments could be curtailed or completely stopped due to a lack of cash as investments may not be liquidated due to low valuations.

Question 38

Describe the impact on QU’s liquidity resulting from the proposed asset allocation. Describe any follow-up actions Thompson needs to take with respect to the proposed asset allocation.

Answer 38

There will be a noticeable increase in more illiquid investments and a noticeable decrease in highly liquid investments. For example, in normal conditions, highly liquid assets will decrease by 5% (from 19% to 14%) and illiquid assets will increase by 6% (from 33% to 39%). In stressed conditions, highly liquid assets will decrease by 4% (from 15% to 11%) and illiquid assets will increase by 4% (from 39% to 43%). QU’s overall liquidity profile will become more illiquid due to the increased investment in private equity and real assets, both of which are the most illiquid asset classes.

Thompson must be certain that the endowment will be able to meet all its liquidity needs (e.g., distributions and rebalancing) for the proposed allocation and do so in stressed market conditions. Monitoring at key times when there is increased risk of not being able to meet its liquidity needs, as well as regular stress tests, would be suitable follow-up items to perform.

Question 39

Tracking error
ETFs
Futures
Total return swaps

Answer 39

ETFs - cash drag creates tracking error and mandatory diversification.
Futures - liquidity and interest rate differentials create tracking error for futures
Total return swaps - No tracking error since receipt is the index fund returns. Counteraparty risk does occur though.

Question 40

Liquidity budget percentage allocations for
Liquid allocations?
illiquid alloctions?

An illiquid asset price with put formula =

Answer 40

The liquidity budget provides minimum percentage allocations for highly liquid, liquid, and semi-liquid categories, and MAXIMUM percentage allocation for the iLLIQUID category only!.

illiquid asset price = marketable asset price - put price

Question 41

Unsmoothing effects of private equity

Answer 41

Unsmoothing better reflects the underlying risk of private equity.
Results in higher reported volatility.
Decreases serial correlation.

Question 42

the illiquidity premium in percentage terms can be calculated as
expected return on illiquid asset (%)
expected return on marketable asset (%).

Answer 42

expected return on illiquid asset (%) − expected return on marketable asset (%).

Question 43

How to best mitigate from unemployment?

In career development stage what is the most appropriate method to portfolio construction?

Answer 43

Increase your savings buffer.

a mix of pooled investment vehicles that are low cost and diversified across region, sector, and securities.

Question 44

Early career (Earnings risks?))
Career development
Peak Accumulation
Early Retirement (what risk is 20% drawdown limit?)

Answer 44

Early career - School leavers high human capital 20 - 28.
Risk EC, CD and PA is premature death risk mitigate by insuring, unemployment risk mitigate by savings and disability risk mitigate by insurance.
Career development - young kids 28 - 50 porfolios grow. Salary grows
Peak accumulation - age 55 (retirement age).
Early Retirement - age 65 - High financial capital - savings, low human capital. Lower spending. If a client cannot accept 20% drawdown then it’s a low risk portfolio.

Question 45

Which insurance coverage is appropriate for a) a young couple?
1. Human life value
2. Needs Analysis

When comparing which do you pick?

Answer 45

Human life value looks to replace future human capital.

A young couple would get insurance coverage based on a needs analysis as future earnings replacement is less certain.

You pick the lower of the two ie. If the human life says you need £2.5m and needs says you need £1.6m you pick the £1.6m value. If your assets are already £1.7m then you’d need £zero additional life insurance.

Question 46

Tech start up jobs
Investment Manager AUM jobs
Teachers/professors
EU citizen
government agency then 20 years later tech start up

Equity or bond like human capital?

Best way to mitigate equity risk in a pension?

Answer 46

Both tech start ups and Investment jobs have equity like human capital.
Teachors/professors possess bond like human capital
EU citizens have higher human capital due to mobility
Government agency is bond like and if starting at a tech start up 20 years later it would switch to be equity like.

Some allocations to equity markets may create too much human and financial capital risk. A bond allocation is warranted in some respect.

Question 47

headline risk.

Answer 47

adverse publicity and potential reputational damage from investing in companies with negative environmental, social, and governance impacts, sometimes referred to as headline risk.

Question 48

Five-step liquidity management process is as follows:

Answer 48

Step 1: Establish liquidity risk parameters (policy guidelines, escalation triggers).

Step 2: Assess the liquidity of the current portfolio (measure vs. guidelines; monitor).

Step 3: Develop a cash flow model (project future expected cash flows).

Step 4: Stress test liquidity needs (and cash flow projections).

Step 5: Plan for emergencies (a.k.a. a contingency funding plan; what to liquidate, other funding options).

Question 49

Advantage and disadvantage of direct investment in direct private equity vs indirect private equity.

Answer 49

direct private equity
- dedicated and experienced in house team is expensive to attract and retain high quality talent.
- Higher concentration risk increases idiosyncratic risk.
+ Control over individual investment assets. (easier to manage)
+ Increased portfolio liquidity due to control over the timing of exits.

indirect private equity.
- conversely it is less liquid as you have no control of the timing of exits.
- little control over choice of portfolio assets
- Payment of additional AMC fees and profit sharing.
+ increased diversification
+ Outsourced fund expertise means you don’t have troubles of attracting talent to internal teams.

Question 50

Enterprise risk management (ERM)

Answer 50

Enterprise risk management (ERM) is a top-down approach in which an organization decides which risks to take and which to avoid or transfer to achieve its purpose and objectives.
including major risks such as:

Credit risk.
Market risk.
Operational risk.
Liquidity risk.
Reputational risk.
Environmental, social, and governance risks.

Question 51

A typical ENTERPRISE risk management process involves the following steps:

Answer 51

A typical risk management process involves the following steps:

Step 1: Identify risks.

Step 2: Measure risks.

Step 3: Perform risk mitigation and management.

Step 4: Monitor risks.

Step 5: Report risks.

Step 6: Use analysis and strategic planning.

Question 52

VaR meaning? Difference between significance and confidence level?

Answer 52

The confidence level is 95%, meaning we assume that 95% of the time, the maximum loss will be $1 million.
The significance level is 5%, also known as the error rate, meaning that 5% of the time the loss will be larger than the $1 million estimate.

A common misconception is that VaR describes the maximum possible loss. In the example above, there is a 5% chance that the losses will exceed the VaR estimate of $1 million and fall into the catastrophic loss category.

Question 53

Appropriate benchmarks should reflect the manager’s style and fulfill the SAMURAI criteria. Richard’s and Tierney framework.

Answer 53

Specified in advance. Not created after the fact.
Appropriate and consistent with the manager’s investment style.
Measurable. Index returns are published daily.
Unambiguous, able to clearly identify the securities.
Reflective of current investment opinions. Representative of a managers investment process.
Accountable, accepted by the manager.
Investible, possible to replicate passively so freely tradeable.

Question 54

If VaR significance level is 5% what is the confidence level?
10% significance level?

Decreased holding period effect on VaR? estimate?

Increased confidence interval effect on conditional VaR?

Answer 54

Significance level 5% means that confidence level is 95%
10% significance level suggests 90% confidence level.

Decreased holding period will decrease the VaR amount it was increased after financial crisis as true figures weren’t reported.

Increased confidence interval will increase the VaR estimate.

Question 55

Maximum drawdown, value at risk, conditional value at risk and Monte Carlo simulation: long term or short term risk metrics?

Answer 55

Maximum drawdown, value at risk, and conditional value at risk are all short-term risk metrics. Monte Carlo simulation is a long-term risk methodology.

Question 56

Externalities

Headline risk.

Answer 56

Externalities are costs or benefits received resulting from the actions of third parties. For example, during the 2020-2021 COVID-19 pandemic, enforced lockdowns led to commercial winners and losers. Sectors such as hospitality and retail were negatively affected; however, the enforced switch to online business also brought new opportunities for growth and innovation.

The reputational damage from being associated with the exploitation of local workers is an important risk, sometimes termed headline risk.

Question 57

nationally determined contributions (NDCs),

Acute physical risks.
Chronic physical risks.

Transition climate risk

Answer 57

nationally determined contributions (NDCs), are country pledges toward reducing their national carbon emissions.

Acute physical risks are one-off weather events. Wildfires. Hurricanes. Storms. Droughts and heat waves.

Chronic physical risks are the gradual impacts of climate change. Rising sea levels. Rising temperatures from global warming.

Transition climate risk is failing to adapt or mitigate to the zero-carbon economy. Transition risk results in an outdated business model and possibly stranded assets (unable to monetize). Transition risk is driven by changes in carbon regulation (carbon taxes, carbon limits), new clean technologies, and shifts in consumer demand.

Question 58

Task Force on Climate-Related Financial Disclosures (TCFD)

Answer 58

voluntary disclosure framework that encourages organizations to make disclosures in the following areas:

Governance.
Strategy.
Risk management.
Metrics and targets.

Question 59

A “just transition”

Answer 59

A “just transition” relates to social risks. Fairness, justice, and equality are important principles for everyone. It ensures that support and communication is provided to assist people impacted and minimize the negative impacts of transitions.

Question 60

Enterprise Risk Management

Answer 60

A co-ordinated approach to risk management involving senior managers.
Strong independant risk functions. Use of Monte Carlo analysis to assess risks such as lower airport traffic in a new airport scenario.
Checks on envionmental risks such as global warming and rising sea levels.

Question 61

Investment philosophy

Capacity of an inefficiency.

Answer 61

Are the investment philisophy assumptions credible and consistent?
Can the manager clearly articulate their investment philosophy?

Capacity of an inefficiency
Does the inefficiency provide a repeatable source of return?
Does the inefficiency provide sufficient frequency of opportunity and level of return to cover transaction cost and fees.

Question 62

Explicit vs implicit costs

Answer 62

Commission, fees and taxes are described as explicit trading costs, while bid-ask spreads, market impact, delay cost, opportunity costs are examples of implicit costs.