Volume 2 & 6 - Portfolio Management Flashcards
Portfolio Risk and Return: Part 1
describe characteristics of the major asset classes that investors consider in forming portfolios
explain risk aversion and its implications for portfolio selection
explain the selection of an optimal portfolio, given an investor’s utility (or risk aversion) and the capital allocation line
calculate and interpret the mean, variance, and covariance (or correlation) of asset returns based on historical data
calculate and interpret portfolio standard deviation
describe the effect on a portfolio’s risk of investing in assets that are less than perfectly correlated
describe and interpret the minimum-variance and efficient frontiers of risky assets and the global minimum-variance portfolio
Historical returns document past performance, while expected returns reflect anticipated future performance. An asset’s expected return is a function of the real risk-free rate, expected inflation, and any risk premiums that investors require as compensation.
Using a mean and variance approach assumes that returns are normally distributed and that markets are informationally and operationally efficient.
However, these assumptions do not necessarily hold.
A normal distributions has three characteristics:
Its mean and median are equal.
It is completely defined by its mean and variance
It is symmetric around its mean.
Most equity return distributions are not normally distributed. They are often asymmetric (or skewed). Stock returns are usually negatively skewed
Distributions also usually have fatter tails than normally distributed variables, which means extreme returns are more likely. This is referred to as kurtosis
The presence of skewness and/or kurtosis is contrary to the assumption that returns are normally distributed. The assumption that markets are operationally efficient is limited by market frictions, such as trading costs. These frictions impact both actual and expected returns.
Risk-seeking investors enjoy the thrill of gambling and will take risks even with a negative expected return.
Risk-neutral investors only care about the expected return. They will prefer an investment that offers a higher return, regardless of its level of risk.
Risk-averse investors will choose the investment that offers the highest return for their desired level of risk (or the least risk for their desired level of return). It is reasonable to assume that most investors are risk-averse.
The key conclusions from utility functions are:
1- Utility has no maximum or minimum
2- A higher return contributes to higher utility
3- Higher variance reduces utility (for risk-averse investors)
4- Utility is only useful in ranking investment options
Utility measures the relative satisfaction gained from a particular portfolio. The utility that investors derive from an asset or portfolio is a function of their degree of risk aversion (A), which is the marginal reward that they require as compensation for taking an additional unit of risk.
The value of A will be positive for risk-averse investors and higher for investors with lower levels of risk tolerance.
A = 0 for risk neutral
A < 0 for risk seeking (ignorant)
Indifference curves plot the risk-return pairs that have the same utility.
The capital allocation line (CAL) represents the investment options for this portfolio of two securities. It is the plot of different risk-return combinations derived by changing the weights of the two securities.
The CAL represents all the investment options. An investor must be somewhere on the line.
The slope represents the additional return required for every increment in risk, which is the market price of risk. The slope is equivalent to the Sharpe ratio.
Indifference curves can be used to determine the optimal investment point on the CAL. The goal is to maximize utility, which is the same as getting on the highest indifference curve. This optimal investment corresponds to the point of tangency between the indifference curve and the capital allocation line.
With respect to risk-averse investors, a risk-free asset will generate a numerical utility that is:
A
the same for all individuals.
B
positive for risk-averse investors.
C
equal to zero for risk seeking investors.
A
When p12 = 1 , the two assets are perfectly positively correlated. An asset is always perfectly positively correlated with itself. If a portfolio is composed of two assets are perfectly positively correlated with each other, its standard deviation is a simple weighted average of the standard deviations of the individual assets.
The lower correlation between two assets in a portfolio, the higher the expected return for a given level of portfolio risk.
If p12 = 0 , the two assets are uncorrelated. The return on the risk-free asset is known in advance with certainty, meaning that it has zero volatility. It follows that the correlation between the risk-free asset and any risky asset is zero. Adding the risk-free asset to a portfolio of risky assets will lower the portfolio’s riskiness as measured by standard deviation.
The power of diversification is its ability to reduce portfolio volatility. There are many ways to diversify a portfolio, notably by making allocations across asset classes (e.g., large-cap stocks, small-cap stocks, corporate bonds, government bonds). Other ways to achieve diversification include:
- Holding international assets, which provides the additional benefit of diversifying currency risk exposure
- Using index funds as a relatively inexpensive and more efficient means of diversification
- Avoiding ownership of your employer’s stock to limit dependence on the source of your employment income to provide investment income as well
- Protecting risky assets by purchasing insurance, which has a negative expected return but is also perfectly negatively correlated with the protected asset
As more assets are added to a portfolio of risky assets, its variance approaches the average covariance of its components.
Each asset that is being considered for inclusion in a portfolio should be evaluated in the portfolio context. Specifically, an asset should only be added to a portfolio if its Sharpe ratios is greater than the Sharpe ratio of the existing portfolio multiplied by the portfolio’s correlation with the new asset
As the number of assets in an equally-weighted portfolio increases, the contribution of each new asset’s variance to the portfolio’s overall variance most likely:
A
increases.
B
approaches zero.
C
remains unchanged.
B
Efficient frontier:
Adding less-correlated asset classes (e.g., international assets) will improve the risk-return trade-off, pushing the curve up and to the left.
The minimum-variance frontier is the left edge of the possibilities in the graph below. It represents the least portfolio risk that can be obtained for a given expected return. The global minimum-variance portfolio, located on the far left of the curve, is the least risky of the minimum variance portfolios.
The section of the minimum-variance frontier that lies above the global minimum-variance portfolio is the Markowitz efficient frontier. Risk-averse investors will not consider portfolios on the lower half of the minimum-variance frontier because, for any portfolio that plots in this section, there is a Markowitz efficient frontier that offers a higher expected return for the same level of risk.
According to the two-fund separation theorem, all investors will use the risky portfolio P to a greater or lesser extent depending on their level of risk aversion. Investors will have different allocations to the risk-free asset, but they will all create portfolios that use the optimal portfolio,
P , and plot on the CAL according to their risk tolerance. Note that CAL portfolios offer better risk-return profiles than efficient frontier portfolios of equivalent risk that have not been combined with the risk-free asset.
The portfolio, P , is the optimal risky portfolio.
Tangent of CAL with Efficient frontier
The location of an investor’s optimal portfolio on the CAL will be at its point of tangency with their indifference curve.
A less risk-averse investor could create a portfolio that plots above P by borrowing at the risk-free rate and investing the proceeds in the optimal risky portfolio (e.g., allocations of -20% to the risk-free asset and 120% to portfolio P ).
Portfolio Risk and Return: Part 2
describe the implications of combining a risk-free asset with a portfolio of risky assets
explain the capital allocation line (CAL) and the capital market line (CML)
explain systematic and nonsystematic risk, including why an investor should not expect to receive additional return for bearing nonsystematic risk
explain return generating models (including the market model) and their uses
calculate and interpret beta
explain the capital asset pricing model (CAPM), including its assumptions, and the security market line (SML)
calculate and interpret the expected return of an asset using the CAPM
describe and demonstrate applications of the CAPM and the SML
calculate and interpret the Sharpe ratio, Treynor ratio, M2, and Jensen’s alpha
Each individual investor will make portfolio decisions that are consistent with their own willingness and ability to tolerate risk. Investors with higher levels of risk aversion will build portfolios with greater allocations to less risky assets, notably the risk-free asset.
However, capital market theory also stipulates that even investors who are willing to accept the highest levels of risk should use the risk-free asset in their portfolios. The risk-free asset’s value in a portfolio stems from the fact that its returns are completely uncorrelated with those of risky assets.
Capital market theory further shows that the capital allocation line created by combining the risk-free asset with a portfolio of risky assets allows for portfolios that dominate those on efficient frontier for all levels of risk tolerance. An investor’s optimal portfolio of risky assets is the one on the CAL that intersects with their indifference curve. All else equal, investors prefer a steeper CAL for a given risk-free rate because this maximizes their expected return for their level of risk tolerance.
Capital market theory assumes homogeneity of expectations, meaning that all investor have the same economic expectations about investment characteristics such as prices, cash flows, and discount rates for all assets. If this assumption holds, all investors will conduct the same analysis, which should produce the same optimal portfolios of risky assets.
In reality, this assumption does not hold. However, if we accept market prices as proxies for the valuations that would exist under homogenous expectations, it is possible to use these as the basis for asset weights in a market portfolio that is the optimal portfolio of risky assets for all investors.
Active investors believe that various market inefficiencies cause assets to trade at prices that do not reflect their true value.
Overweighted the undervalued and sold short the overvalued.
The “market” portfolio includes all risky assets. In theory, this can includes anything that has value, such as traditional assets (e.g., stocks), alternative assets (e.g., real estate), and even intangible assets (e.g., human capital). In practice, investors limit their definition of the market portfolio to include assets that are valuable, tradable, and investable. For example, a stock that is listed on a local exchange with prohibitions on trading by foreigners would be considered valuable and tradable, but not investable.
Commonly used: S&P 500
The capital market line (CML) is simply a capital allocation line with the risky portfolio being the market portfolio. Graphically, it is the line tangent to the efficient frontier constructed from all available risky assets.
Investors can leverage positions by borrowing at the risk-free rate Rf and investing the proceeds in the market portfolio M
However, while investors can easily lend as the risk-free rate by purchasing short-term government bills, they cannot borrow at the same rate. Because investors must pay a higher borrowing rate Rb , the CML will become kinked at M with a change in slope to reflect the different rates at which investors can borrow and lend.
Which of the following statements most accurately defines the market portfolio in capital market theory? The market portfolio consists of all:
A
risky assets.
B
tradable assets.
C
investable assets.
A
Systematic risk is also called non-diversifiable risk or market risk. It includes risks like interest rates and economic cycles that cannot be avoided. Nonsystematic risk is also called company-specific, industry-specific, or diversifiable risk. Diversification can reduce or even eliminate nonsystematic risk.
Since nonsystematic risk can be eliminated with a diversified portfolio, investors should not receive compensation for it. Investors are only compensated for systematic risk.
A return-generating model estimates the expected return of a given security. Multi-factor models allow for more than one variable. The factors could be macroeconomic, fundamental, or statistical, although statistical variables that have no macroeconomic or fundamental meaning are usually discarded.
A single-index model generated return expectations using an asset’s sensitivity to a market index as the only factor. Because of its simplicity, the single-index model can be used to create the capital market line (CML).
The market model is the most common implementation of the single-index model. It is similar to the single-index model, but it allows for an easier estimation of beta.
Beta measures the sensitivity of an asset’s return to the market return. It is the covariance between the security return and the market return divided by the market variance.
Beta can be estimated by using the market model with historical regression. Beta represents the slope of the best-fit line when plotting the market return on the horizontal axis and the security return on the vertical axis
The historical beta may not accurately represent future systematic risk.
Assumptions of the CAPM
1- Investors are risk-averse, utility-maximizing, and rational individuals :
Investors expect compensation for taking risk and always seek more wealth. Investors correctly evaluate available information.
2- Markets are frictionless – no taxes or transaction costs :
This also includes being able to borrow and lend at the same risk-free rate. There are no extra costs or restrictions on short-selling.
3- All investors plan for same single holding period
4- Investors have homogeneous expectations :
Rational investors will arrive at the same conclusions regarding valuations since the inputs are the same. This leads to the same optimal risky portfolio for all investors.
5- Investments are infinitely divisible
6- Investors are price takers :
No investor is large enough to influence the prices.
The security market line (SML) is constructed with beta on the horizontal axis and expected return on the vertical axis. The slope is the market risk premium,
Rm - Rf. The SML applies to any security, not just efficient portfolios.
The security market line also applies to a portfolio of securities. The portfolio beta is simply the weighted average of the individual betas.
CAPM can be used to estimate the expected return or cost of capital. These rates can then be used to calculate the present value of expected cash flows.
With respect to the capital asset pricing model, the market risk premium is:
A
less than the excess market return.
B
equal to the excess market return.
C
greater than the excess market return.
B
With respect to the security market line (SML), which of the following is most accurate?
A
The SML only applies to efficient portfolios
B
The slope of the SML is the market risk premium
C
The SML is a graphical illustration of the efficient frontier
B
Theoretical Limitations of the CAPM
1- It is a single-factor model that only includes beta risk.
2- It is a single-period model that does not consider multi-period implications of decisions.
Practical Limitations of the CAPM
1- The true market portfolio includes all assets, some of which are not investable.
2- Proxies for the market portfolio can generate different return estimates.
3- Beta risk estimates require a long history but may not be applicable for future risk estimates.
4- CAPM is a poor predictor of returns.
5- Homogeneity of investor expectation is assumed to generate a single optimal risky portfolio.
Treynor Ratio:
This is like the Sharpe ratio, but it substitutes beta risk for total risk. Like the Sharpe ratio, it is only meaningful if both the numerator and denominator are positive.
Sharpe Ratio :
This reward-to-variability ratio is the slope of the capital allocation line. It is an easy measure to use, but it suffers from two shortcomings:
The Sharpe ratio uses total risk rather than systematic risk.
The ratio is meaningless but for comparisons with other Sharpe ratios.
M-Squared :
M-squared was created by Franco Modigliani and his granddaughter, Leah. It is based on total risk like the Sharpe ratio. The portfolio return is adjusted to what it would be at the same risk level as the market. If M2 is greater than the market return, then the portfolio outperformed the market on a risk-adjusted basis.
Jensen’s Alpha :
As with the Treynor ratio, this measure is based on systematic risk. It is the difference between the actual return and risk-adjusted return using beta. Portfolios that outperform the market will have a positive
Both Sharpe and Treynor ratios are commonly used to rank portfolios. On the other hand, M-squared and Jensen’s alpha provide direct information on whether the portfolio has outperformed the market.
The security characteristic line (SCL) is a plot of the excess return of the security to the excess return of the market. The slope is beta and the intercept is alpha.
Individual price calculations could differ from the CAPM-calculated price (heterogeneous beliefs). If the investor-calculated price is higher, the asset is considered undervalued. A positive Jensen’s alpha indicates a good buy. Undervalued securities are candidates for investments and will plot above the security market line.
Based on CAPM, investors should hold a combination of the risk-free asset and the risky market portfolio. It is not practical or necessary to own every existing risky security. Non-systematic risk can be effectively eliminated with about 30 individual securities.
An investor could start with an index such as the S&P 500. Other securities with positive a could be included. Also, securities in the S&P 500 with negative a could be dropped and ones with positive could be increased in weight. A security with a larger information ratio (i.e., alpha divided by the nonsystematic risk) is more valuable.
Portfolio Management: An Overview
describe the portfolio approach to investing
describe the steps in the portfolio management process
describe types of investors and distinctive characteristics and needs of each
describe defined contribution and defined benefit pension plans describe aspects of the asset management industry
describe mutual funds and compare them with other pooled investment products
If the portfolio standard deviation is only 14% rather than the 20% average, the portfolio’s diversification ratio is 70% (14%/20%).
The optimal portfolio will maximize the return for a given amount of risk or minimize the risk for a given level of return.
However, severe market turmoil often leads to many assets moving down in value together. This phenomenon, known as contagion, reduces the benefits of diversification that are achieved under normal market conditions.
No downside protection
All else equal, adding a security with returns that are negatively correlated with those of an equally-weighted portfolio will most likely:
A
decrease the diversification ratio.
B
increase the diversification ratio.
C
not impact the diversification ratio.
A
The diversification ratio of an equally-weighted portfolio is the ratio of the portfolio’s standard deviation to the average standard deviation of its components.
MPT emphasizes focus on the portfolio rather than individual securities in isolation. The implication is that investors should focus only on systematic, or non-diversifiable, risk. There is no reward to be earned for accepting risk that can be eliminated by diversifying a portfolio’s assets. This perspective on risk is the basis for the capital asset pricing model (CAPM).
The portfolio management process has three steps:
- The Planning Step
Understanding the client’s needs
Preparing the Investment Policy Statement (IPS) - The Execution Step
Asset allocation
Security analysis
Portfolio construction - The Feedback Step
Monitoring and rebalancing
Performance measurement and reporting
The IPS may specify a benchmark, such as a market index, that can be used to measure and evaluate the manager’s performance.
The portfolio that emerges from the execution step should reflect target weights for asset classes, any individual assets that were identified in the security analysis process, and the client’s level of risk tolerance. Investment decisions should be made based on consideration of the entire portfolio rather than an isolated focus on individual assets. Managers may rely on the services of outside specialists, such as buy-side traders, to execute the necessary transactions.
Any analysis of a portfolio’s performance should be done relative to a relevant benchmark that has been specified in the IPS.
University endowments and charitable foundations provide ongoing financial support to their affiliated organizations. Usually, their investment objective is to earn sufficient returns to maintain the real (inflation-adjusted) value of their assets after meeting their annual spending commitments. As a general rule, endowments and foundations expect to operate indefinitely, which gives them very long investment horizons and high risk tolerance. Liquidity needs are usually relatively low as a share of assets.
Banks : Risk tolerance is low and liquidity needs are high because deposits can be redeemed on demand. Note that deposits made by customers are assets that belong to the customers and are therefore liabilities for the banks. Because customers could withdraw their funds, banks must maintain a portfolio of liquid assets to offset this liability. These assets are known as reserves, which are typically invested in low-risk, short-term fixed-income securities.
Often, DB pension plans hold long-term bonds to offset their liabilities and generate income (which is particularly important for more mature plans). Long investment horizons and low liquidity needs contribute to a relatively high level of risk tolerance.
The time horizon is effectively indefinite if new members are continually being admitted into the pension plan. Because a steady inflow of new participants is accompanied by a corresponding inflow of contributions, current income needs are low in these circumstances.
If the plan was closed, the time horizon would still be relatively long but finite.
Life insistance companies typically have longer horizons than non-life companies, but liquidity needs are still relatively high and risk tolerance is relatively low. Income needs are low compared to, for example, a mature-stage DB pension plan.
Non-life (property and casualty) insurance companies need to be able to pay liabilities for claims on an ongoing basis. In order to be able to meet these obligations, their investments tend to be relatively short-term, liquid, and conservative.
Investment companie : liquidity needs are generally high in order to be able to meet redemption requests, all else may vary
Sovereign wealth funds (SWFs) are government-owned investment funds. Risk tolerance, time horizons, income needs, and liquidity constraints vary by fund.
Which of the following types of institutional investors most likely have the lowest risk tolerance?
A
Foundations
B
Non-life insurance companies
C
Defined benefit pension plans
B : pay liabilities for claims on an ongoing basis
A university endowment begins the year with net assets of $375 million. If it has a 5.5% spending rule based on beginning-of-year value and inflation is 3.2%, the target year-end value is closest to:
A
$387.0 million.
B
$407.6 million.
C
$408.3 million.
A
To maintain the real (inflation-adjusted) value of assets, the endowment must end the year with a value of:
The endowment will seek to generate returns of approximately 8.7%, but the spending rule dictates that 5.5% of beginning-of-year value must be spent during the year.
Asset management companies are called buy-side firms to distinguish them from the sell-side broker/dealer firms that make investment recommendations and trade securities.
The multi-boutique model seeks to achieve the operational benefits of centralization while allowing individual business units to retain some independence.
Buy-side firms are offering more smart beta strategies, which provide passive exposure to factors such as size, style, and momentum. Trading decisions for smart beta portfolios are rules-based, but costs are still higher compared to pure passive investing due to higher portfolio turnover.
As alternative strategies have grown in popularity, traditional asset managers have started offering alternative products and alternative managers have created “liquid alternatives” that seek to make alternative strategies available to a wider pool of investors. Compared to standard alternative investment vehicles, liquid alternatives use less leverage and hold more liquid assets. They are regulated like mutual funds and do not charge performance fees.
One of the implications for asset managers has been the incorporation of non-traditional data in the investment analysis process. Examples include social media data, which can be used as indicators of market sentiment, or imagery data, which can provide a real-time indication of economic activity (e.g., cargo ship traffic).
Asset managers have made substantial investments in human capital and information technology as they attempt to harness big data as a source of excess returns.
The rapid growth of robo-advisors can be attributed to several factors, including:
Underserviced customers: Younger investors and the “mass affluent” often do not require the customized advice offered by traditional asset management firms.
Lower fees: Robo-advisor platforms require significant upfront investments, but operating costs are relatively low. This scalability allows robo-advisors to charge significantly lower fees compared to traditional asset management firms. The emergence of low-fee ETFs has made robo-advisory services even more attractive to cost-conscious investors.
New entrants: Relatively low barriers to entry have allowed large, traditional investment firms and firms from outside the asset management industry (e.g., insurance companies) to enter the robo-advisor market. Technology firms may enter the market as they attempt to further monetize their user data.
Some robo-advisory firms supplement their online platforms with access to human advisors.
Mutual funds are commingled pools of assets. Investors have pro-rata claims to these assets based on the amount of their investment.
Open-end funds will accept new investments after they have been launched. Funds with this structure can easily accommodate growth by creating new shares. The number of new shares to be created is determined by dividing the amount of the new investment by the fund’s net asset value (NAV) per share.
Closed-end funds do not accept new money investments after they have been launched. No new shares are created and no existing shares are retired. However, closed-end fund shares can be sold to other investors. Because of this structure, closed-end fund shares can trade at a premium or discount relative to NAV.
No-load funds do not have investing or redemption fees, but they do take a percentage of NAV as an annual fee. Load funds charge an annual fee based on NAV as well as fees on inflows (new investments) and outflows (redemptions). The number of load funds has steadily decreased.
The major advantage of closed-end funds is that managers can be fully invested because there is no need to hold cash in anticipation of redemptions. However, open-end funds are easier to grow because they are always accepting new capital.
Money market funds are similar to bank savings accounts but they are not insured like bank deposits. Taxable money market funds hold high-quality, short-term corporate and sovereign debt, while tax-free money market funds hold municipal debt. Most money market funds maintain a share price of 1 US dollar (or another unit of currency). This is called a constant net asset value (CNAV) basis. There are also variable net asset value (VNAV) money market funds with fluctuating share prices.
Bond mutual funds : there is no assurance that bond mutual funds allow investors to earn higher yields than could be achieved by holding individual bonds.
Different funds allow investors to select their preferred exposures with respect to duration, sectors, credit risk, etc.
Separately managed accounts are managed exclusively for an individual or institution. SMAs tend to be used by investors with very large portfolios (e.g., large institutions) because there is a very high minimum investment requirement compared to other vehicles.
SMAs allow investors to own assets directly. (Customized strategies) Investors who own shares in mutual funds have no such authority.
Hybrid funds invest in both bonds and stocks. Lifecycle funds automatically adjust based on a target retirement date. For example, a 40-year-old investor who wants to retire in 25 years can make regular contributions to a lifecycle fund that will gradually increase its allocation to fixed-income and decrease its allocation to equities over time.
PE: Funds often have a lifespan of 7 - 10 years
Private equity funds are almost always structured as limited partnerships with a manager acting as the general partner (GP) and investors as limited partners (LPs). The GP earns management fees based on a percentage of committed capital. GPs also earn carried interest, which is a percentage of capital gains. Typically, no carried interest is earned until LPs have recovered the amount of their original investment.
Portfolio companies pay transaction fees to the fund in exchange for corporate and structuring services. Funds also receive investment income from the profits of portfolio companies.
Exchange Traded Funds (ETFs) : They are structured like open-end mutual funds
1- Unlike mutual funds, which can only be traded at the end of each day, ETFs can be traded throughout the day like stocks.
2- Investors can sell ETF shares short and buy on margin, which is not possible with mutual fund shares.
3- Unlike closed-end mutual funds, ETF prices do not deviate significantly from NAV.
4- ETFs distribute dividends to investors, while mutual funds typically reinvest dividends.
5- ETFs have lower minimum investment requirements.
The key features of hedge funds include:
Short positions are common, either directly through short sales or indirectly with derivatives.
Managers pursue high absolute returns that have a low correlation with returns on other asset classes.
High leverage (either from borrowing or derivatives) is used to enhance returns.
The manager’s fee structure includes a management fee based on a percentage of assets and a performance-based incentive fee, which may be subject to a high-water mark provision.
The pool of hedge fund investors is relatively small due to high minimum investment levels, liquidity constraints, and long-term investment commitments.
Which of the following investment products is most likely to trade at their net asset value per share?
A
Exchange traded funds.
B
Open-end mutual funds.
C
Closed-end mutual funds.
B is correct. Open-end funds trade at their net asset value per share, whereas closed-end funds and exchange traded funds can trade at a premium or a discount.
Stock Mutual funds are the largest in AUM
Basics of Portfolio Planning and Construction
describe the reasons for a written investment policy statement (IPS)
describe the major components of an IPS
describe risk and return objectives and how they may be developed for a client
explain the difference between the willingness and the ability (capacity) to take risk in analyzing an investor’s financial risk tolerance
describe the investment constraints of liquidity, time horizon, tax concerns, legal and regulatory factors, and unique circumstances and their implications for the choice of portfolio assets
explain the specification of asset classes in relation to asset allocation
describe the principles of portfolio construction and the role of asset allocation in relation to the IPS
describe how environmental, social, and governance (ESG) considerations may be integrated into portfolio planning and construction
The investment policy statement (IPS) is the written document that governs this process. It serves as a reference manual for helping clients achieve their investment objectives. An IPS should be reviewed regularly to ensure that it remains consistent with the client’s current circumstances.
A general framework for an IPS includes the following components:
Introduction
Statement of purpose
Statement of duties
Procedures
Investment objectives
Investment constraints
Investment guidelines
Evaluation and review
Information about the strategic asset allocation and rebalancing policy may be included as appendices.
The most relevant components of the IPS are investment objectives (i.e., risks and returns) and investment constraints (e.g., liquidity, time horizon, taxes).
The major components of an IPS are listed in Section 2 of the reading. Investment Guidelines are described as the section that provides information about how policy may be executed, including restrictions on the permissible use of leverage and derivatives and on specific types of assets excluded from investment, if any.
A quantitative risk objective may be stated in absolute or relative terms.
An absolute risk objective may be to require a 95% probability of not experiencing negative returns in a given year.
A relative risk objective references a benchmark. An example is a 3% maximum tracking error relative to a market index.
An assessment of a client’s risk tolerance should consider both ability and willingness to accept risk.
The determination of ability to take risk is based on largely objective criteria, such as time horizon and level of wealth. In general, longer time horizons and higher levels of wealth (relative to liquidity needs) indicate a greater ability to accept risk.
A client’s willingness to take risk is based on much more subjective analysis.
When there is a conflict between ability and willingness to take risk, a resolution is required. In the case of a client with high ability and low willingness, the manager may attempt to educate the client
The overall assessment of risk tolerance should be based on the lower of ability or willingness.
IPS Constraints
1- Liquidity : Liquidity needs are withdrawals from the investment portfolio. Expected withdrawals should be documented in the IPS and the portfolio should be managed to ensure that there are sufficient liquid assets to meet these needs.
2- Time Horizon : Could be the period before withdrawals or before the client’s circumstances are likely to change (short horizon –> avoid illiquid assets).
3- Tax Concerns : Portfolio management decisions should account for the client’s taxable status (income/interest and dividends gains).
4- Legal and Regulatory Factors: Institutional investors are often subject to minimum or maximum allocations to certain asset classes.
5-Unique Circumstances : Clients may have self-imposed constraints based on, for example, ethical or religious beliefs. Investors may choose to avoid certain stocks or sectors by applying negative screening (a.k.a. exclusionary screening). Alternatively, positive screening (a.k.a. best-in-class approach) seeks to identify top-performing companies according to environmental, social, and governance (ESG) metrics.
Individual investors who are corporate insiders may be subject to restrictions on trading their company’s shares during quiet periods before material information has been made public. Any such restrictions should be documented in the IPS.
Active ownership and shareholder engagement rely on shareholder voting power to influence the corporation to achieve ESG objectives.
Thematic investing attempts to profit from important trends and structural changes, such as the transition to alternative sources of power generation. Impact investing is similar, but managers primarily consider the expected environmental or social benefits when selecting investments.
ESG integration, which involves adding an ESG perspective to the traditional process of investment analysis, is increasingly popular.
clients may want to exclude securities of their employers to limit the concentration of human and financial capital.
Investment advisors should know their clients. This is true even in advisory relationships. Good record keeping is also essential.
Which of the following best describes the underlying rationale for a written investment policy statement (IPS)?
A
A written IPS communicates a plan for trying to achieve investment success.
B
A written IPS provides investment managers with a ready defense against client lawsuits.
C
A written IPS allows investment managers to instruct clients about the proper use and purpose of investments.
A is correct. A written IPS is best seen as a communication instrument allowing clients and portfolio managers to mutually establish investment objectives and constraints.
The objectives section of an IPS includes two categories - risk tolerance and return objectives.
Capital market expectations are the risk and return prospects of asset classes. It usually includes expected returns, standard deviations, and correlations.
The strategic asset allocation combines the constraints and objectives of the IPS with long-term capital market expectations. The risk-return profile is improved by adding asset classes with low correlations.
focus should be on systematic risk to make sure it is consistent with the client’s risk and return objectives.
The risk can be subdivided into strategic asset allocation, tactical asset allocation, and security selection.
- Strategic asset allocation defines exposure to systematic risk.
- Tactical asset allocation seeks to add return by varying the weights between asset classes based on forecasts. Tactical asset allocation involves overweighting or underweighting specific asset classes, securities, or sectors based on short-term capital market expectations. Such deviations from the systematic risk exposure implied by a portfolio’s policy weights create non-systematic risk exposure that would not be present if the optimal portfolio weights had been maintained.
- Security selection can add return by picking securities with higher returns.
The formal definition of the rebalancing policy is the set of rules that guide the process of restoring a portfolio’s original exposures to systematic risk factors. This may be done periodically according to a schedule or whenever asset class weights move outside of specified corridors.
The core-satellite approach involves allocating the majority of a portfolio’s assets to passive or low active investments (the “core”) and placing the remaining funds in actively managed “satellite” accounts.
Growth in the offering of exchange traded funds (ETFs) with robo-advice :
The proliferation of exchange-traded funds (ETFs) and algorithm-based robo-advisors have made it easier for investors to build portfolios with low-cost, liquid exposure to a broad range of asset classes.
Risk-parity investing :
Advocates of risk-parity investing call for asset classes to be weighted based on their contribution to a portfolio’s overall risk.
Although advocates argue that portfolios benefit from screening out companies with significant exposure to ESG risks, empirical evidence on this topic is mixed.
Investors may choose to screen out companies that do not meet specific ESG criteria or seek out best-in-class companies.
In defining asset classes as part of the strategic asset allocation decision, pairwise correlations within asset classes should generally be:
A
equal to correlations among asset classes.
B
lower than correlations among asset classes.
C
higher than correlations among asset classes.
C is correct. As the reading states, “an asset class should contain homogeneous assets… paired correlations of securities would be high within an asset class, but should be lower versus securities in other asset classes.”
Based on a thorough analysis of macroeconomic data, a manager forecasts that interest rates will fall sharply over the next quarter and temporarily increases her portfolio’s allocation to fixed-income securities above the policy weight for this asset class. As a result of this tactical asset allocation decision, the portfolio’s risk of meeting the investor’s objectives is most likely:
A
lower.
B
unaffected.
C
higher.
C) Tactical asset allocation involves over- or underweighting specific asset classes, securities, or sectors based on short-term capital market expectations. Such deviations from the systematic risk exposure implied by a portfolio’s policy weights create non-systematic risk exposure that would not be present if the optimal portfolio weights had been maintained.
A strategic asset allocation is the optimal combination of asset class weights for an investor’s particular objectives and constraints. Any tactical deviations from these weights increase the risk of failing to achieve the investor’s objectives.
The Behavioral Biases of Individuals
compare and contrast cognitive errors and emotional biases
discuss commonly recognized behavioral biases and their implications for financial decision making
describe how behavioral biases of investors can lead to market characteristics that may not be explained by traditional finance
The field of behavioral finance seeks to understand the behavioral biases that arise when people make investment decisions and design strategies to mitigate them.
There are two types of behavioral biases:
1- Cognitive errors: Due to faulty cognitive reasoning
2- Emotional biases: Due to feelings or emotions
Cognitive errors can be corrected through better information and education. However, emotional biases are harder to detect and correct because they normally arise from intuitions on a subconscious level.
Cognitive Errors :
- Belief perseverance biases
Conservatism bias
Confirmation bias
Representativeness bias
Illusion of control bias
Hindsight bias - Processing errors
Anchoring and adjustment bias
Mental accounting bias
Framing bias
Availability bias
Emotional Biases :
Loss-aversion bias
Overconfidence bias
Self-control bias
Status quo bias
Endowment bias
Regret-aversion bias
Cognitive errors can be divided into two categories: belief perseverance and processing errors.
1- Belief perseverance: An individual may cling to their initially held beliefs and refuse to accept new information. The mental discomfort that arises when new information conflicts with the initial beliefs is known as cognitive dissonance.
2- Processing errors: Information may not be processed rationally when making financial decisions.
Conservatism bias occurs when people fail to incorporate new information that conflicts with their prior opinions. From the Bayesian perspective, these people tend to overweight their prior probability of an event and do not react adequately to the new information.
Confirmation bias occurs when people seek “evidence” that confirms their prior beliefs and ignore those that contradict them. An investor who is subject to confirmation bias may insist on holding a certain investment and only use research that supports their decision.
Base-rate neglect refers to the scenario where the base rate (i.e., the rate of incidence in the large population) is neglected when new information arises. For example, rising jet fuel costs will reduce the profitability of the entire airline industry, especially for companies with limited power to pass on the higher costs to consumers. An analyst who conducts diligent research on an individual airline stock may overlook this general information.
Sample-size neglect refers to the scenario where a small sample is incorrectly assumed to be representative of the population. For example, a portfolio manager may achieve 20% annual returns for two consecutive years.
Representativeness bias occurs when people inappropriately classify new information based on past similar situations. This will produce a misleading impression about the information especially when each event is inherently unique.
Illusion of control bias occurs when people overestimate their ability to control events and outcomes. They tend to believe they can predict the outcomes when the results are in fact completely random.
Hindsight bias occurs when people look back at past events and believe they would have been predictable. For instance, most investors today think there were many red flags in 2008 that indicated a financial crisis was approaching.
Mental accounting bias occurs when people put money in separate mental buckets and treat them differently although money is fungible. These arbitrary classifications are based on the source or use. For example, people tend to spend their lottery money a lot faster than their monthly salary. They treat the lottery winnings as “free money” that can be spent on discretionary items, although the money from both sources should be fungible.
Framing bias occurs when people answer the same question differently just based on how the question is framed. This may lead to different decisions.
Anchoring and adjustment bias occurs when people rely too much on the initial piece of information (i.e., the “anchor”) in estimating an unknown value. This is closely related to conservatism bias because people tend to adjust their anchors insufficiently when new information emerges. For example, an analyst may predict a recession and adjust the current stock price of a company by -20%. In this case, the initial price is set as an anchor.
Availability bias occurs when people use mental shortcuts when making decisions. People assume outcomes that are easier to remember are more likely. There are four common availability biases:
1- Retrievability – An idea will more likely be chosen if it comes to mind more quickly.
2- Categorization – People may not be familiar with certain topics, so the search set will be smaller.
3- Narrow range of experience – People often extrapolate from narrow personal experience.
4- Resonance – People often assume most other people think like they do.
Jun Park, CFA, works at a hedge fund. Most of Park’s colleagues are also CFA charterholders. At an event with recent university graduates, Park comments, “Most CFA charterholders work at hedge funds.” Park’s remark exhibits which behavioral bias?
A
Availability
B
Conservatism
C
Framing
A is correct. Park is extrapolating his observation based on a narrow range of experience (working at a hedge fund that employs many CFA charterholders) to the entire population of CFA charterholders. Using a narrow range of experience is a form of availability bias.
The disposition effect, which is the situation of holding investments in a loss position and selling investments in a gain position. Many investors do not want to experience the pain of locking in a loss, and they tend to sell their winners too quickly as they do not want to see their gains “evaporate.”
Loss-aversion bias occurs when people strongly prefer avoiding losses more than achieving gains. This can sometimes cause them to accept more risks to avoid losses than to achieve gains.
Overconfidence bias occurs when people overestimate their own abilities. This bias normally arises with self-attribution bias where people consistently attribute success to their own skill and failure to external factors.
Prediction overconfidence results in narrow prediction ranges. For example, an analyst may estimate the future stock price using a very narrow range of expected returns with a low standard deviation.
Certainty overconfidence results in excessively great probabilities being assigned to uncertain outcomes. For example, an investor may believe strongly that an investment has no downside risks and refuse to hedge or diversify the risks.
Self-control bias occurs when people fail to make decisions that are best for their long-term goals due to a lack of self-discipline. Short-term satisfaction often conflicts with long-term goals. People prefer immediate small payoffs to large delayed ones.
Status quo bias occurs when people are more inclined to do nothing rather than make changes. Inertia keeps them in the same position. For example, when a client meets the portfolio manager for the first time, an IPS is created to capture the client’s investment goal and risk appetite. Although the IPS should be reviewed regularly and updated if necessary, most clients tend to stick to the original IPS (i.e., the “default”) even when their circumstances have changed.
Endowment bias occurs when people value an asset more when they hold the rights to it. According to economic theory, a person should be willing to buy and sell at the same price. However, with this bias, people’s selling price will be greater than the purchase price.
Regret-aversion bias occurs when people avoid making decisions that could potentially turn out badly. The regret that arises due to an action that was taken is more painful than the regret that arises due to an action that was not taken.
Market anomalies refer to return distortions that deviate from the efficient market hypothesis. Investors get persistent positive abnormal returns and the trend is predictable in direction.
Factors that result in the misclassification of anomalies:
1- Choice of asset pricing model
2- Statistical issues
3- Temporary disequilibria : They typically last for a period and disappear when investors discover these arbitrage opportunities and take advantage of them. Examples include the small company January effect and the weekend effect.
Momentum (a.k.a. trending effects) causes the stock price to be positively correlated with its recent past. In other words, outperformers from the last year continue to outperform this year, and underperformers continue to underperform.
Based on the following biases:
1- Availability bias: This is related to the recency effect, where people assign more weight and credibility to recent events.
2- Hindsight bias: Investors do not like to face the regret of not owning a stock when it performed well in the previous year. They are likely to feel they could have predicted the significant upward movement of the stock because the signs were “obvious.”
3- Loss aversion bias
Bubbles can be linked to confirmation bias, self-attribution bias, and hindsight bias. In a bull market, most investments will be profitable. Investors may believe they made a good decision in selling their stocks at a profit, although this decision is not financially sound if the stocks are being sold too soon. Regret-aversion bias can trigger the investor’s “fear of missing out,” encouraging them to participate in a bubble.
When an asset bubble unwinds, investors may first underreact due to anchoring and adjustment bias. Many of them will also exhibit cognitive dissonance as they refuse to accept the loss and attempt to justify their flawed decisions.
Many studies have shown value stocks outperform growth stocks. Value stocks have low price-to-earnings ratios, high book-to-market equity, and low price-to-dividend ratios.
Emotional factors play a big role in stock appraisal :
Halo effect: Investors may assume a favorable characteristic of a company is representative of the entire company.
Home bias: Investors prefer to invest in domestic securities rather than global portfolios due to proximity of the former.
Introduction to Risk Management
define risk management
describe features of a risk management framework
define risk governance and describe elements of effective risk governance
explain how risk tolerance affects risk management
describe risk budgeting and its role in risk governance
identify financial and non-financial sources of risk and describe how they may interact
describe methods for measuring and modifying risk exposures and factors to consider in choosing among the methods
Individuals and companies should accept risks in the areas in which they have the expertise and manage their exposure to risks in other areas.
The risk management process involves setting an optimal level of risk exposure, measuring the actual level of risk exposure, and making any necessary adjustments to reach the target level. The objective of risk management is to minimize the uncertainty of the impact of unpredictable events.
A risk management framework is the infrastructure, process, and analytics needed to effectively manage an organization’s risk exposures. It should include the following key factors:
Risk governance: This is the top-level system of structures, rights, and obligations. It is normally done at the board level, led by a risk management committee that is tasked with overseeing the company’s risk exposures and providing an enterprise-wide perspective on risk management.
Risk identification and measurement: This makes up the main quantitative core elements of risk management. All of an organization’s potential risk exposures should be assessed qualitatively and quantified as accurately as possible.
Risk infrastructure: This includes the people and systems needed to assess and quantify risk exposures. (vary among companies depending on their size and the nature of their activities)
Policies and processes: The overall vision for risk management is established by the risk management committee.( govern day-to-day operations, and integrated into business activities)
Risk monitoring, mitigation, and management: This is the most important part of the risk framework and also the most difficult. It is an active process that must be continuously reviewed.
Communications: Relevant information about risk management must be clearly communicated throughout an organization.
Strategic analysis or integration: Good risk management is key to increasing a company’s value. A well-integrated risk management strategy can help identify activities that add value as well as those that may be destroying value.
Benefits from good risk management :
1- Fewer surprises and a better understanding of the impact of unpredictable events
2- More disciplined decision-making based on a better understanding of risk-return tradeoffs
3- Better monitoring to allow for faster responses
4- Policies and procedures that increase transparency and minimize operational errors
5- More trust between the risk management committee and company management
6- Better reputation with analysts and investors
The risk governance sets the broad direction Management creates executable strategies in sync with the board goals. Feedback loops are needed to measure and adjust risks so they stay in line with the risk tolerance and budget.
Which of the following statements is least accurate? Good risk management:
A
is a continuous process.
B
leads to less delegation of responsibilities.
C
provides a full top-to-bottom framework that assists in the decision making process.
B) Good risk management provides a full top-to-bottom framework that assists in the decision-making process – before, during, and after a risk event. It is a continuous process because risk exposures are dynamic in nature and are always changing.
If properly implemented, the risk management process should improve trust and lead to more effective delegation of responsibilities.
Risk management is not eliminating risk. It is the process by which a firm defines the appropriate level of risk, with the eventual goal of maximizing the company’s value.
An effective risk management framework should address the following key factors:
Risk governance
Risk identification and measurement
Risk infrastructure
Definition of policies and processes
Risk monitoring, mitigation, and management
Communications
Strategic analysis
Responsibilities of governing body (i.e., risk management committee) include:
Providing risk oversight
Determining organizational goals, direction, and priorities
Specifying risk appetite or tolerance (i.e., which risks and levels of exposure are acceptable)
Risk governance : This identifies the risk appetite or risk tolerance abilities of a company, meaning which risks are acceptable, and which risks are to be mitigated. It also provides guidance on the worst losses that could be tolerated in various scenarios.
Enterprise-focused risk management (ERM), which takes a holistic view of the firm, is more likely to add value than narrower, less integrated approaches to risk management. ERM can be applied to individuals as well.
Wise to appoint a chief risk officer (CRO) who is responsible for developing and implementing an enterprise-wide risk management framework.( involved in decisions about the company’s strategic direction)
An analysis of risk tolerance should seek to identify the following:
1- Internal shortfalls that would result in failure to achieve critically important objectives. Specific metrics may include the percentage drop in revenue that would trigger debt covenants or the amount of cash flow needed to fund key capital projects.
2- Risk drivers, or external uncertainties to which the organization is exposed (e.g., exchange rates, commodity prices, interest rates).
Risk budgeting is an effort to quantify and allocate allowable risk for both business and portfolio management. It is the process of implementing risk tolerance in the everyday decisions that affect a company’s actual risk exposures.
Risk budgeting can be multi-dimensional and complex or single-dimensional and simple. Single-dimension measures include standard deviation, beta, value at risk, and scenario loss. More complex risk budgeting practices include factor approaches that implement tilts toward certain types of stocks (e.g., value vs. growth) while maintaining a target level of overall equity market risk.
Risk budgeting –> maximizing returns per unit of overall risk or excess risk relative to a benchmark.
Which of the following is the correct sequence of events for risk governance and management that focuses on the entire enterprise? Establishing:
A
risk tolerance, then risk budgeting, and then risk exposures.
B
risk exposures, then risk tolerance, and then risk budgeting.
C
risk budgeting, then risk exposures, and then risk tolerance.
A is correct. In establishing a risk management system, determining risk tolerance must happen before specific risks can be accepted or reduced. Risk tolerance defines the appetite for risk. Risk budgeting determine how or where the risk is taken and quantifies the tolerable risk by specific metrics. Risk exposures can then be measured and compared against the acceptable risk.
A benefit of risk budgeting is that it:
A
considers risk tradeoffs.
B
establishes a firm’s risk tolerance.
C
reduces uncertainty facing the firm.
A is correct. The process of risk budgeting forces the firm to consider risk tradeoffs. As a result, the firm should choose to invest where the return per unit of risk is the highest.
Financial Risks:
1- Market Risk : Fundamental factors such as economic conditions, world events, or company-specific developments.
2- Credit Risk : Default risk or counterparty risk
3- Liquidity Risk : risk of a downward adjustment when selling a financial asset. While all securities have bid-ask spreads, liquidity risk relates to the possibility that spreads will widen significantly for certain types of assets during periods of market stress.
Non-Financial Risks :
1- Settlement risk : risk of settling payments right before a default. For example, the long party of a forward contract could transfer funds but the short party may not transfer the asset.
2- Legal risk
3- Compliance risk : includes regulatory, accounting, and tax risk.
4- Model risk
5- Tail risk : Often the distribution tail is fatter than implied by the probability distribution used to model the process.
6- Operational risk: people and processes used by companies to produce the output. This includes both external risks (e.g., hackers) and internal risk (e.g., employee theft). Another example is rogue employees such as traders who execute unauthorized or illegal transactions that result in significant losses.
7- Solvency risk : lacks the cash needed to fund day-to-day operations.
8- Risks unique to individuals : property (e.g., theft, damage) and their health. Financial planning should account for the risk of dying relatively young (mortality risk) as well as the possibility of outliving one’s assets (longevity risk), which is an increasing concern with an aging population.
There is a considerable amount of interaction between risks. For example, credit risk and legal risk are closely linked for lenders because the recovery rate in the event of a bankruptcy will be determined by court proceedings.
Adverse risk interaction occurs when losses caused by one type of risk exacerbate losses caused by another type of risk.
Often the risk of individual companies is thought to be unsystematic. However, seemingly unsystematic risk can turn into systematic risk. For example, poor credit risk management by one large bank can lead to a major crisis with widespread effects throughout the financial system.
Metrics refers to the quantitative measure of risk exposure. Probability is the most basic metric. For example, a model may indicate a 5% likelihood of a company defaulting on its debt obligations.
Value at risk (VaR) specifies the minimum loss over a given time period at a given probability. VaR measure includes three elements: a probability, a time period, and a minimum possible loss stated in units of currency.
VaR does not tell the maximum loss. It only provides the loss estimate.
Conditional VaR is the average loss that exceeds the VaR, which is a better measure of the tail risk.
The following metrics are used to measure the risks of derivatives:
Delta (sensitivity of the derivative price to the underlying asset)
Gamma (sensitivity of delta to the underlying asset)
Vega (sensitivity of the derivative price to the volatility of the underlying asset)
Rho (sensitivity of the derivative price to changes in interest rates)
Avoiding a risk altogether is certainly a safe option, but some risks may be unavoidable. Most risk avoidance has trade-offs
Risk Acceptance: Self-Insurance and Diversification
If it is too expensive to eliminate certain risks, individuals can effectively insure themselves by setting aside sufficient capital that can be accessed later if necessary. Self-insurance should be a conscious decision to accept certain risks that are consistent with a company’s (or individual’s) risk tolerance. (ignoring –> denial).
Risk Transfer : Insurance (derivatives)
These financial intermediaries can be profitable if the correlations between the risks that they have insured are low. If correlations are too high, insurers can transfer some of their risk to a reinsurer or issue catastrophe bonds that require investors to cover claims over a certain level.
Deductibles are used to encourage caution from the insured by ensuring the policyholder has a financial stake in the risk (certain ammount in case).
Surety bonds are contracts in which the insurer accepts the risk of non-performance. For example, if a company orders a custom-built machine, it can use a surety bond to protect itself against the risk that the manufacturer will not meet its obligations.
Fidelity bonds are similar contracts that companies use to protect themselves against losses due to employee dishonesty.
How to Choose A Method for Modifying Risk
There is no single “correct” method of risk modification. All of the methods covered here have trade-offs.
Risk avoidance and prevention are recommended methods for managing risks that offer relatively little upside and potentially extreme losses. Self-insurance is a more feasible option for companies with significant free cash flows.
The risk management infrastructure identifies, measures, and monitors risks (among other things).
Both availability bias and overconfidence bias result in portfolio under-diversification.
Availability bias – Investors assume that outcomes which are easier to remember are more likely. This results in limited investment opportunity sets and in turn causes their portfolios to be under-diversified.
Overconfidence bias - Investors underestimate risks and overestimate returns. As a result, they do not sufficiently diversify their portfolios.
Self-control bias occurs when people fail to make decisions that are best for their long-term goals due to a lack of self-discipline. While it causes investors to sacrifice long-term goals in favor of short-term satisfaction, it does not directly result in portfolio under-diversification.
Which of the following statements is least likely correct? The risk management committee:
A
plans and executes value-maximizing strategies consistent with the governance guidance.
B
reviews risk policies at the operational level.
C
provides a forum for the top decision-makers to discuss risk management issues.
A
