Ethical and Professional Standards 6.

Presentation and Reporting

7. Real Estate
I (A) Knowledge of the law: comply with the strictest law;
8. Private Equity
disassociate from violations.
9. Wrap Fee/Separately Managed Account (SMA) Portfolios
I (B) Independence and objectivity: do not offer, solicit, or accept
Know the requirements and recommendations for each provision.
gifts that might compromise independence and objectivity.
Review the study notes.
I (C) Misrepresentation: do not guarantee performance; avoid
plagiarism.
Important formulas from this section:
I (D) Misconduct: do not behave in a manner that affects your
professional reputation or integrity. Time weighted return: rtwr = (1 + rt,1) × (1 + rt,2) × ... × (1 + rt,n) − 1
II (A) Material nonpublic information: do not act or cause others
to act on this information; to act on a mosaic of information is not a Original Dietz method
violation. 𝑉1 − 𝑉0 − 𝐶𝐹
𝑟𝐷𝑖𝑒𝑡𝑧 =
II (B) Market manipulation: do not manipulate prices/trading 𝑉0 + (𝐶𝐹 × 0.5)
volumes to mislead others; do not spread misleading information.
III (A) Loyalty, prudence, and care: act with reasonable care and Modified Dietz method
exercise prudent judgment; place client’s interest before 𝑉1 − 𝑉0 − 𝐶𝐹
𝑟𝑀𝑜𝑑𝐷𝑖𝑒𝑡𝑧 =
employer’s or your own interests. 𝑉0 + ∑𝑛𝑖=1(𝐶𝐹𝑖 × 𝑤𝑖 )
III (B) Fair dealing: treat all clients fairly; disseminate investment
𝐶𝐷 − 𝐷𝑖
recommendations or take investment action without 𝑤𝑖 =
discrimination. 𝐶𝐷
III (C) Suitability: in advisory relationships, understand client’s
risk profile, develop and update an IPS periodically; in fund/index Composite returns
management, ensure investments are consistent with stated Sum of beginning assets and weighted external cash flows =
𝑛
mandate.
𝑉𝑝 = 𝑉0 + ∑(𝐶𝐹𝑖 × 𝑤𝑖 )
III (D) Performance presentation: do not misstate performance;
make detailed information available on request. 𝑖=1
Beginning assets weighting method composite return =
III (E) Preservation of confidentiality: maintain confidentiality of 𝑉0,𝑝𝑖
clients: unless disclosure is required by law; information concerns 𝑟𝐶 = ∑ [𝑟𝑝𝑖 × 𝑛 ]
illegal activities; client permits disclosure. ∑𝑝𝑖=1 𝑉0,𝑝𝑖
IV (A) Loyalty: do not cause harm to your employer; obtain Beginning assets plus weighted cash flows method composite
written consent before starting an independent practice; do not return =
take confidential information when leaving. 𝑉𝑝𝑖
𝑟𝑐 = ∑ (𝑟𝑝𝑖 × )
IV (B) Additional compensation arrangements: do not accept ∑ 𝑉𝑝𝑖
compensation arrangements that will create a conflict of interest MIRR: Modified IRR = value of r that satisfies the following
with your employer; unless written consent is obtained from all equation: EV =
parties involved. 𝑛
IV (C) Responsibilities of supervisors: prevent employees under ∑[𝐶𝐹𝑖 × (1 + 𝑟)𝑤𝑖 ] + BV (1 + r)
your supervision from violating applicable laws. 𝑖=1
V (A) Diligence and reasonable basis: have a reasonable and
adequate basis for any analysis, recommendation, or action. Behavioral Finance
V (B) Communication with clients and prospective clients:
distinguish between fact and opinion; make appropriate Traditional finance assumes that individuals are perfectly
disclosures. rational, risk-averse, and self-interested; they have perfect
V (C) Record retention: maintain records to support your information; markets are efficient; price is right; there is no free
analysis. lunch.
VI (A) Disclosure of conflicts: disclose conflict of interest in plain
language. Behavioral finance assumes investors are not consistently risk
VI (B) Priority of transactions: client transactions come before averse; markets are not necessarily efficient; anomalies do exist.
employer transactions that come before personal transactions.
VI (C) Referral fees: disclose referral arrangements to clients and Bounded rationality theory.
employers. ▪ Decisions are based on a limited set of important factors and/or
VII (A) Conduct as participants in CFA Institute programs: do heuristics: mental shortcuts, also called “rules of thumb.”
not compromise the integrity of the CFA institute; keep exam ▪ People satisfice (satisfy + suffice).
information confidential.
VII (B) Reference to CFA Institute, the CFA designation, and the Traditional and behavioral perspective on portfolio
CFA program: do not state that the holders of CFA charter are construction
better than others; references to partial designation not allowed. Traditional portfolio theory: Investor uses the MVO framework;
considers different sources of money/wealth to be fungible.
Overview of the Global Investment Performance Behavioral portfolio theory: A BPT investor maximizes expected
Standards (GIPS) wealth subject to a safety constraint. BPT investor exhibits mental
accounting bias and self-control bias.
The nine provisions of the GIPS standards are:
1. Fundamentals of Compliance Behavioral bias categories
2. Input Data Cognitive
3. Calculation Methodology Conservatism bias: Maintain prior views by inadequately
4. Composite Construction incorporating new information.
5. Disclosure Confirmation bias: Look for and notice what confirms beliefs.

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Representativeness bias: Classify new information based on past ▪ Bubbles: Overconfidence bias (illusion of knowledge and self-
experiences. attribution)
Illusion of control bias: False belief that we can influence or control Crashes: Disposition effect in the context of loss aversion bias.
outcomes. Value stocks outperform growth stocks in the long run.
Hindsight bias: See past events as having been predictable.
Anchoring & adjustment bias: Incorrect use of psychological Capital Market Expectations
heuristics.
Mental accounting bias: Treat one sum of money (or source of Capital Market Expectations, Part 1 : Framework and
return) as different from another. Macro Considerations
Framing bias: Answer question differently based on how it is asked. Application of Growth Analysis to Capital Market Expectations
Availability bias: Heuristic approach influenced by how easily Aggregate value of equity: V𝑒=GDP×E/GDP×P/E
outcome comes to mind. In the long run, total value of equity depends on the growth rate of
Emotional GDP.
Loss-aversion: Prefer avoiding losses overachieving gains. Approaches to Economic Forecasting
Overconfidence: Unwarranted faith in one's abilities. Econometric models – Output variable is predicted based on input
Self-control: Fail to act in pursuit of long-term goals. variables.
Endowment: People value assets more when they hold rights to it. ▪ Structural models specify functional relationships among
Regret aversion: Avoid pain of regret associated with bad decisions. variables based on economic theory.
Status quo: Do nothing rather than make a change. ▪ Reduced form models more compact versions of the underlying
structural models.
Moderate biases versus adapt portfolio to biases
Econometric indicators – Economic statistics published by official
1) Client’s level of wealth
agencies and/or private organizations. Types include lagging,
▪ high wealth → low SLR → adapt to biases
coincident, and leading indicators. Multiple individual indicators
▪ low wealth → high SLR → try to moderate biases
combined ⟶ diffusion index.
2) Type of behavioral biases the client exhibits
Checklist approach - subjective and involves putting together
▪ emotional → adapt to biases
information that is considered relevant by the analyst.
▪ cognitive → try to moderate biases
Effects of Monetary and Fiscal Policy on Business Cycles
BB&K (Bailard, Biehl, and Kieser) model: Aspects of fiscal policy can counteract cyclical fluctuations in the
economy
Adviser
Personality Methodology Monetary policy is used as a mechanism for intervention in the
Investor type relationship
axis axis business cycle
notes
▪ Maintain price stability and/or growth consistent with potential.
Reluctant to take
Adventurer Confident Impetuous ▪ Suffers from “Long and variable lags.”
advice
▪ Ability to fine-tune the economy is limited.
May be willing to
Celebrity Anxious Impetuous The Taylor rule is a useful tool for assessing a central bank’s stance
take advice
and for predicting how it will evolve
Will listen to ̂e − Y
̂trend ) + 0.5(πe − πtarget )
Individualist Confident Careful i∗ = rneutral + πe + 0.5(Y
advice
Guardian Anxious Careful May seek advice
Fiscal Policy
Straight arrow Mid-point Mid-point Rational
Loose Tight
Behavioral investor types Monetary Loose High Real Rates + Low Real Rates +
Policy High Expected High Expected
Risk Biases
Investor type Active/Passive Inflation = High Inflation = Mid
tolerance (primarily)
Nominal Rates Nominal Rates
Passive
Passive Low Emotional Tight High Real Rates + Low Real Rates +
preserver
Low Expected Low Expected
Friendly Low-
Passive Cognitive Inflation = Mid Inflation = Low
follower moderate
Nominal Rates Nominal Rates
Independent Moderate-
Active Cognitive Macroeconomic, Interest Rate, and Exchange Rate Linkages
individualist high
Between Economies
Active Macroeconomic Linkages
Active High Emotional
accumulator Macroeconomic linkages between countries are expressed through
Impact of behavioral factors on portfolio construction their respective current and capital accounts.
▪ Status quo bias → Maintaining default portfolio allocation. Four primary mechanisms to keep current and capital accounts in
▪ Regret aversion and framing biases →Naïve diversification or balance:
1/n strategy. ▪ Changes in income (GDP)
▪ Overconfidence, naïve extrapolation of past returns, status-quo, ▪ Interest rates and asset prices
framing, loyalty biases → Investing in the familiar. ▪ Relative prices
▪ Regret aversion, overconfidence, and disposition effect (loss ▪ Exchange rates
aversion) biases →Excessive trading. In the short run, interest rates, exchange rates, and financial asset
▪ Availability, illusion of control, endowment, familiarity, and prices must adjust to keep the capital account in balance with the
status quo biases→ Home bias, investing in one’s home country. more slowly evolving current account.
Investor behavior and markets Interest Rate/Exchange Rate Linkages
Momentum or trending effects ▪ Interest rates and currency exchange rates are linked
▪ Herding behavior Two countries will share a default-free yield curve if (and only if)
▪ Availability bias: more recent events easily recalled and given there is perfect capital mobility, and the exchange rate is credibly
relatively high weight (recency effect) fixed forever.
▪ Hindsight bias → regret → trend-chasing effect

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If there is lack of credibly fixed exchange rates, yield curves will not
have perfect correlation.
With floating exchange rates, the link between interest rates and
exchange rates is based on expectations.
▪ Interest rates should be higher in a currency that is expected to
depreciate.
▪ Interest rates should be lower in a currency that is expected to
appreciate.
Capital Market Expectations - Part 2: Forecasting Asset Class
Returns
Capital flows
▪ Capital seeks the highest risk-adjusted expected return.
▪ Exchange rate will be driven to the point at which expected
percentage change equals the “excess” risk-adjusted expected
return on the portfolio of assets denominated in the domestic
currency over that of the portfolio of assets denominated in the
foreign currency.
▪ E(%ΔSd/f) = (rd – rf) + (Termd – Termf) + (Creditd – Creditf) +
(Equityd – Equityf) + (Liquidd – Liquidf)
▪ Three phases in response to relative movements in investment
opportunities.

Forecasting Equity Returns Portfolio balance, portfolio composition, and sustainability

Historical statistics approach ▪ Each country/currency has a unique portfolio of assets that
▪ Equity returns are extremely volatile makes up part of the global “market portfolio.”
▪ Fluctuations in P/E and E/GDP ▪ Exchange rates provide an across-the-board mechanism for
▪ Forecasts are not reliable adjusting the relative sizes of these portfolios to match
investors’ desire to hold them.
DCF approach ▪ In the long run, the relative size of each currency portfolio
D
▪ Gordon growth model: r = 1 + g depends mainly on relative trend growth rates and current
P
▪ Grinold-Kroner model: account balances.
D ▪ Exchange rates adjust in response to changes in relative sizes
E(R𝑒 ) ≈ + (%∆E − %∆S) + %∆P/E and compositions of the aggregate portfolios denominated in
P
Risk premium approaches each currency.
The Singer-Terhaar model combines two underlying CAPM models
The first assumes complete global integration of markets and asset Forecasting Volatility: VCV Matrices from Multi-Factor Models
classes. ▪ To forecast variance-covariance (VCV) matrix linear factor
The second assumes complete segmentation of markets and asset models used ⟶impose structure on the VCV matrix - can handle
classes. very large numbers of asset classes; covariances are fully
RPi = φRPiG + (1 - φ)RPiS determined by exposures to a small number of common factors;
RPGM each variance includes an asset-specific component.
RPiG = ρi,GM σi ▪ Return on asset i with K common factors: 𝑟𝑖 = 𝛼𝑖 +
σGM
RP𝑖𝑆 ∑𝐾
𝑘=1 𝛽𝑖𝑘 𝐹𝑘 + 𝜀𝑖
S
RPi = σi ▪ Variance of asset i: 𝜎𝑖2 = ∑𝐾 𝐾
𝑚=1 ∑𝑛=1 𝛽𝑖𝑚 𝛽𝑖𝑛 𝜌𝑚𝑛 + 𝜈𝑖
2
σi
▪ Covariance between the ith and jth assets: 𝜎𝑖𝑗 =
Forecasting Real Estate Returns
Historical real estate returns ∑𝐾 𝐾
𝑚=1 ∑𝑛=1 𝛽𝑖𝑚 𝛽𝑗𝑛 𝜌𝑚𝑛
▪ Real estate valuation relies heavily on appraisals rather than ▪ Imposing structure with a factor model ⟶ VCV matrix simpler
transactions. • With N assets, [N(N – 1)/2] distinct covariance elements.
▪ Historical return data is subject to smoothing • Factor model: estimates [N × K] factor sensitivities plus [K(K
▪ Volatility and correlations are understated + 1)/2] elements of the factor VCV matrix, Ω.
▪ Real estate cycles
▪ Real estate is subject to boom–bust cycles that both drive and Time-Varying Volatility: ARCH Models
are driven by the business cycle ▪ Financial asset returns tend to exhibit volatility clustering -
Capitalization rates ARCH models help address time-varying volatilities.
Cap rate = net operating income in the current period divided by ▪ One of the simplest and most used ARCH models represents
the property value today’s variance as a linear combination of yesterday’s variance
▪ Standard valuation metric for commercial real estate and a new “shock” to volatility.
E(Rre) = Cap rate + NOI growth rate – %ΔCap rate ▪ 𝜎𝑡2 = 𝛾 + 𝛼𝜎𝑡−1
2
+ 𝛽𝜂𝑡2 = 𝛾 + (𝛼 + 𝛽)𝜎𝑡−1
2
+ 𝛽(𝜂𝑡2 − 𝜎𝑡−12
)
Cap rates are higher for riskier property types, lower-quality
properties, and less attractive locations Asset Allocation and Related Decisions in Portfolio
Management (1)
Risk premium perspective on real estate expected return
Term premium: As a very long-lived asset with relatively stable Overview of Asset Allocation
cash flows, income-producing real estate has a high duration. A common governance structure in an institutional investor
Credit premium: A fixed-term lease is like a corporate bond issued context will have three levels
by the leaseholder (tenant) and secured by the property. 1) governing investment committee 2) investment staff and 3)
Equity premium: Owners bear the risk of property value third-party resources
fluctuations, as well as risk associated with rent growth, lease
renewal, and vacancies. An economic balance sheet includes:
Liquidity premium: Real estate trades infrequently and is costly to ▪ Conventional (financial) assets and liabilities
transact. ▪ Extended portfolio assets and liabilities

Forecasting exchange rates Investment objectives of asset-only, liability-relative and

Goods and services, trade, and the current account goals-based asset allocation approaches
Trade in goods and services can influence the exchange rate in 3 Asset only
ways: 1) directly through trade flows, 2) through quasi-arbitrage of ▪ Relation to economic balance sheet: Does not explicitly model
prices, and 3) through competitiveness and sustainability of the liabilities or goals.
current account. ▪ Typical objective: Maximize Sharpe ratio for acceptable level of
volatility.

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Liability relative
▪ Relation to economic balance sheet: Models legal and quasi-
liabilities.
▪ Typical objective: Fund liabilities and invest excess assets for
growth.
Goals based
▪ Relation to economic balance sheet: Models goals.
▪ Typical objective: Achieve goals with specified required
probabilities of success.
Criteria for asset class specification
1. Assets within an asset class should be relatively homogeneous.
2. Asset classes should be mutually exclusive.
3. Asset classes should be diversifying.
4. The asset classes as a group should make up a preponderance
of world investable wealth.
5. Asset classes selected for investment should have the capacity
to absorb a meaningful proportion of an investor’s portfolio.
Use of risk factors in asset allocation
Examples of how risk factor exposures can be achieved:
▪ Inflation. Going long nominal Treasuries and short inflation-
linked bonds isolate the inflation component.
▪ Real interest rates. Inflation-linked bonds provide a proxy for
real interest rates.
▪ Credit spread. Going long, high-quality credit and short
Treasuries/government bonds isolate credit exposure.
Global market-value weighted portfolio should be the baseline
asset allocation.
▪ Represents all investable assets → minimizes non-diversifiable
risk
▪ Investing in the global market portfolio helps mitigate
investment biases such as home country bias
▪ Most portfolios exist to pay for a liability or consumption series,
and MVO allocations are not directly connected to what
influences the value of the liability or the consumption series.
▪ MVO is a single-period framework that does not take account of
trading/rebalancing costs and taxes.
Some techniques for addressing the limitations of MVO:
▪ Reverse optimization.
▪ Reverse optimization tilted toward an investor’s views on asset
returns (Black–Litterman).
▪ Constraints on asset class weights to prevent extremely
concentrated portfolios.
▪ Resampled efficient frontier.
Liquidity considerations
Less liquid asset classes include direct real estate, infrastructure
and private equity; offer illiquidity return premium.
Two major problems associated with less liquid asset classes:
▪ Lack of accurate indexes → challenging to make capital market
assumptions
▪ Difficult to diversify and no low-cost passive investment
vehicles.
Risk budgeting:
▪ Marginal contribution to total risk (MCTR) = rate at which risk
changes with a small change in the current weights = (Beta of
asset class i with respect to portfolio) x (Portfolio return
volatility)
▪ Absolute contribution to total risk (ACTR) = amount asset class
contributes to portfolio return volatility = (Weighti)(MCTRi)
▪ Asset allocation is optimal from a risk-budgeting perspective
when the ratio of excess return (over the risk-free rate) to MCTR
is the same for all assets and matches the Sharpe ratio of the
tangency portfolio.

Rebalancing strategies: Two major strategies: calendar Approaches to liability-relative asset allocation
rebalancing and percent-range rebalancing. Surplus Hedging/return- Integrated asset–
▪ Calendar rebalancing rebalances the portfolio to target weights optimization seeking liability portfolios
periodically. portfolios
▪ Percent-range rebalancing sets a range with thresholds or Simplicity Simplicity Increased complexity
trigger points around target weights. A more disciplined tighter Linear Linear or non- Linear or non-linear
asset mix control than calendar rebalancing. correlation linear correlation correlation
All levels of Conservative All levels of risk
Strategic Considerations: risk level of risk
▪ Higher transaction costs for an asset class ⟶ wider rebalancing Any funded Positive funded Any funded ratio
ranges. ratio ratio for basic
▪ More risk-averse investors will have tighter rebalancing ranges approach
▪ Less correlated assets ⟶ tighter rebalancing ranges Single period Single period Multiple periods
▪ Beliefs in momentum favor wider rebalancing ranges, whereas
mean reversion encourages tighter ranges
▪ Illiquid investments complicate rebalancing. Percent-range rebalancing - Factors affecting the corridor
▪ Derivatives create the possibility of synthetic rebalancing. width of an asset class
Transaction The higher the High transaction costs set a
▪ Taxes discourage rebalancing and encourage asymmetric and costs transaction costs, the high hurdle for rebalancing
wider rebalancing ranges. wider the optimal benefits to overcome.
corridor.
Principles of Asset Allocation Risk The higher the risk Higher risk tolerance
tolerance tolerance, the wider the means less sensitivity to
Utility adjusted return: U = E(R) − 0.005λ σ2 optimal corridor. divergences from the target
allocation.
Criticisms of mean–variance optimization Correlation The higher the When asset classes move in
▪ The outputs (asset allocations) are highly sensitive to small with the rest correlation, the wider sync, further divergence
changes in the inputs. of the the optimal corridor. from target weights is less
▪ The asset allocations tend to be highly concentrated in a subset portfolio likely.
Volatility of The higher the Containing transaction
of the available asset classes.
an illiquid volatility, the wider the costs is more important
▪ Many investors are concerned about more than the mean and asset class optimal corridor. than expected utility losses.
variance of returns, the focus of MVO. Volatility of The higher the Higher volatility makes
▪ Although the asset allocations may appear diversified across the rest of volatility, the narrower large divergences from the
assets, the sources of risk may not be diversified. the portfolio the optimal corridor. strategic asset allocation
more likely.

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 Asset Allocation with Real-World Constraints Investment objectives
▪ Loss protection
Constraints in asset allocation
▪ Upside preservation
Asset size: a portfolio could be:
▪ too large for some asset classes and certain active strategies.
▪ too small for complex asset classes like hedge funds and private Profit and loss at expiration
equity and where there is a minimum investment requirement. Maximum profit = ST – S0 – p0
Maximum loss = S0 – X + p0
Time horizon. Two major aspects: Breakeven point = S0 + p0
▪ Changes in human capital. Expiration value = Max(ST , X)
▪ Changing character of liabilities. Profit at expiration = Max(ST , X) – S0 – p0
Liquidity constraint has two dimensions:
▪ Liquidity characteristics of asset classes. Bull spread
▪ Liquidity needs of asset owner. ▪ To benefit from an increase in price of the underlying while
keeping cost low.
Regulatory and other external constraints Structure: Buy a call option with low exercise price and sell a call
▪ Allocations to certain asset classes might be constrained by option with high exercise price.
regulator. Cost = cL – cH
▪ Tax incentives. Maximum profit = XH – XL – cost
▪ Need to maintain certain financial ratios. Breakeven price for a call bull spread = XL + cost
After-tax portfolio optimization Maximum loss = cost
Portfolio optimization should be based on after-tax return and risk
▪ rat = rpt(1 – t) or rat = pdrpt(1 – td) + parpt(1 – tcg) Bear spread
▪ σat = σpt(1 – t) ▪ To benefit from a decrease in price of the underlying while
▪ Correlations are not impacted by taxes. keeping cost low.
After-tax volatility < before-tax volatility → larger asset class Structure: Buy a put option with a high exercise price and sell a put
movements to materially alter risk profile of taxable portfolio → option with a low exercise price.
wider rebalancing ranges for taxable portfolios relative to tax Cost = pH – pL
exempt portfolios. Maximum profit = XH – XL – cost
Breakeven price for a put bear spread = XH – cost
Strategic asset location: place less tax-efficient assets in tax-exempt Maximum loss = cost
or tax-deferred accounts; place tax-efficient assets (low tax rates
and/or deferred capital gains) in taxable account. Straddle
Short-term shifts in asset allocation ▪ To take advantage of volatility.
Tactical asset allocation (TAA) allows short-term deviations from Structure: A long straddle is buying a call and buying a put on the
SAA based on cyclical variations within a secular trend or same underlying asset. The exercise price of the call and put should
temporary price dislocations in capital markets. be the same.
Discretionary TAA is based on manager skill in predicting short- ▪ Profitable if there are increased volatility and large price
term market movements and considers, large number of data movement of underlying stock.
points such as valuations, credit spreads, monetary and fiscal Cost = c0 + p0
policy, GDP growth, economic sentiment indicators, market Max profit = unlimited
sentiment indicators, etc. Breakeven = X + cost, X – cost (a straddle has two breakeven
Systematic TAA seeks to exploit asset class level return anomalies points)
that have been shown to have some predictability and persistence, Max loss = cost
such as value factor and momentum factor.
Collar
Derivatives and Currency Management ▪ To limit downside risk at low cost.
Structure: Long stock + Long put with an exercise price (X1) below
Options Strategies the current stock price + Short call with an exercise price above the
Covered call current stock price (X2).
▪ short call + stock Cost = S0 + p0 – c0
Max profit = X2 – cost
Investment objectives Min profit = X1 – cost
▪ Yield enhancement
▪ Reducing position at favorable price
Calendar Spread
▪ Target price realization
▪ To take advantage of time decay.
Structure: Sell an option and buy the same type of option with
Profit and loss at expiration
Maximum gain = (X – S0) + c0 different expiration dates but the same strike price.
Maximum loss = S0 – c0 Two types of calendar spreads:
Breakeven point = S0 – c0 ▪ Short calendar spread: selling a longer-dated call, buying a near-
Expiration value = ST – Max[(ST – X), 0] term call. Profitable when greater price movements are
Profit at expiration = ST – Max[(ST – X), 0] + c0 – S0 expected in the near-term relative to price movements expected
in the future.
Protective put ▪ Long calendar spread: selling a near-dated call, buying a long-
▪ stock + long put dated call. Profitable when investment outlook is flat in the near
term, but greater price movements are expected in the future.

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 Swaps, Forwards, and Futures Strategies ▪ An equity swap converts the returns from an equity investment
into another series of returns.
Interest Rate Swaps
▪ An interest rate swap is an OTC contract in which two parties ▪ Three main types of equity swaps:
agree to exchange cash flows on specified dates, one based on a • Receive-equity return, pay-fixed.
floating interest rate and the other based on a fixed rate (swap • Receive-equity return, pay-floating.
rate), determined at swap initiation. • Receive-equity return, pay-another equity return.
▪ Interest rate swaps can be used to change a portfolio’s modified
duration. ▪ The equity leg of the swap can be based on the returns of a
• To reduce the modified duration, we can combine the single stock, a portfolio of stocks, or an equity index.
portfolio with a negative duration swap i.e., a pay-fixed
receive-floating swap. Equity forwards and futures
• To increase the modified duration, we can combine the ▪ Equity risk in a portfolio can also be managed using equity
portfolio with a positive duration swap i.e., a receive-fixed futures and forwards.
pay-floating swap
If the portfolio beta S is different from f the futures contract beta,
The notional amount of the swap NS: the number of equity futures contracts to buy or sell (to hedge the
MDUR T − MDURP
NS = ( ) (MVP ) portfolio) is:
MDUR S βT − βS S
Nf = ( )( )
βf F
Interest Rate Forwards and Futures To completely hedge the equity risk, βT = 0,
▪ An FRA is an OTC derivative instrument used mainly to hedge a −βS S
loan expected to be taken out in the near future or to hedge Nf = ( )
βf F
against changes in the level of interest rates in the future.
▪ An FRA will settle the discounted difference between the If the portfolio beta S = f the futures contract beta,
interest rate agreed on in the contract and the actual rate −S
Nf =
prevailing at the time of settlement applied on the notional F
amount of the contract.
▪ Interest rate risk can be hedged using interest rate futures Cash Equitization
contracts. ▪ Cash equitization is a strategy designed to boost returns by
finding ways to “equitize” unintended cash holdings.
Fixed-Income Futures
▪ Longer-dated compared to interest rate future; a preferred In this case, βS = 0, the number of futures to be purchased is:
instrument to hedge bond positions. βT S
Nf = ( )
▪ CTD bond is determined by comparing purchase price with βf F
amount received on delivery.
Principal invoice amount = (futures settlement Volatility Derivatives and Variance Swaps
price/100) x CF x Contract size ▪ VIX option prices are determined from VIX futures. They provide
asymmetrical exposure to potential increases or decreases in
The number of bond futures to buy or sell to reach the target basis anticipated volatility.
point value is the basis point value hedge ratio (BPVHR). Variance swaps allow directional bets on implied versus realized
BPVT − BPVP volatility. The payoff for a variance swap at expiration is:
BPVHR = ( ) × CF Settlement amount = (Variance notional)(Realized variance –
BPVCTD T

𝐵𝑃𝑉𝑃 = 𝑀𝐷𝑈𝑅𝑃 × 0.01% × 𝑀𝑉𝑃 Variance strike)

Vega notional
Variance notional (Nvariance ) =
To completely hedge a bond portfolio BPVT = 0: 2 × Strike price
Settlement amount T = Nvariance (σ2 − X 2 )
−BPVP σ2 − X 2
BPVHR = × CF = Nvega ( )
BPVCTD 2 × Strike price

Managing Currency Exposure Use of Derivatives in Portfolio Management

Currency Swaps reduce borrowing costs of companies that need Use Cases/Applications Derivative Type
cash in foreign currency.
Cross-currency basis swaps help parties in the swap to hedge 1. Inferring expectations for Fed funds futures
against the risk of exchange rate fluctuations and to achieve better FOMC moves
rate outcomes. 2. Inferring expectations for CPI (inflation)
▪ “Basis” is the difference between interest rates in the cross- inflation rates swaps
currency basis swap and interest rates used to determine 3. Inferring expectations for VIX futures
forward rates. market volatility
▪ Currency swaps can use used to earn extra yield
▪ Fed funds futures can be used to infer expectations of changes in
Currency Forwards and Futures hedge against undesired moves in the federal funds rate.
the exchange rate by buying or selling a specified amount of foreign Fed funds futures contract price = 100 – Expected FFE rate
currency, at a defined time in the future and an agreed-on price at ▪ To determine the probability of a change in the federal funds
contract initiation. rate, where the current federal funds rate is the midpoint of the
current target range:
Managing Equity Risk
Equity swaps

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 Effective federal funds rate implied by futures contract Hedging multiple foreign currencies
− Current federal funds rate A cross hedge (proxy hedge) occurs when a position in one asset
Federal funds rate assuming a rate hike (or a derivative based on the asset) is used to hedge the risk
− Current federal funds rate exposures of a different asset.
▪ Hedge ratio = Nominal value of hedging instrument/market
Currency Management: An Introduction value of hedged asset
▪ Minimum or optimal hedge ratio = Correlation (R DC; R FX )
Return decomposition S.D. (RDC)
× [ ]
Domestic-currency return = RDC = (1+RFC)(1+RFX) – 1 S.D. (RFX)
▪ Long position in a risk reversal = Long position in a call option +
Volatility decomposition Short position in a put option
Total risk of the domestic-currency returns: ▪ Short position in a risk reversal = Long position in a put option +
2
𝜎𝐷𝐶 = 𝜎𝐹𝐶2
+ 𝜎𝐹𝑋2
+ 2𝜌𝜎𝐹𝐶 𝜎𝐹𝑋 Short position in a call option
▪ Short seagull position = Long protective put + Short deep-OTM
Currency hedging strategies call option + Short deep-OTM put option
Passive hedging: To keep the portfolio’s currency exposures close, ▪ Long seagull position = write ATM call + Long deep-OTM call
option + Long deep-OTM put option
if not equal to, those of a benchmark portfolio used to evaluate
performance, a rules-based approach, and removes almost all Currency management for emerging market currencies
discretion from the portfolio manager. ▪ Higher trading costs than the major currencies under “normal”
Discretionary hedging: Measures performance against a “neutral” market conditions.
benchmark portfolio. The portfolio manager has some limited ▪ Increased likelihood of extreme market events and severe
discretion on how far to allow actual portfolio risk exposures to illiquidity under stressed market conditions.
vary from the neutral position. ▪ Where capital controls exist, use non-deliverable forwards.
Active currency management: Portfolio manager is allowed to
express directional opinions on exchange rates, but is nonetheless Fixed-Income Portfolio Management (1)
kept within mandated risk limits.
Currency overlay: involves active currency management conducted Overview of Fixed-Income Portfolio Management
by external, FX-specialized sub-advisors to the portfolio. Fixed-income mandates: liability-based and total return
Liability-based: match or cover expected liability payments with
Currency trading strategies future projected cash flows.
Active currency management based on the carry trade: The carry Immunization: process of structuring and managing a fixed-income
trade is a trading strategy of borrowing in low-yield currencies and portfolio to minimize the variance in the realized rate of return
investing in high-yield currencies. over a known time horizon.
▪ Cash flow matching
Buy/invest Sell/borrow
▪ Duration matching
Implementing carry High-yield
Low-yield currency ▪ Contingent immunization
trade currency
▪ Horizon matching
Trading forward Forward discount Forward premium
rate bias currency currency Duration matching Cash flow matching
Yield curve Parallel yield curve None
Volatility trading: Trade based on a view about future volatility of assumptions shifts
exchange rates, not the direction of exchange rates. Rebalancing Frequent rebalancing Not required but
Use delta hedging to hedge away the exposure to changes in FX required often desirable
rates. Complexity High Low
Trader has exposure to other Greeks, the most significant of which
is vega (sensitivity of option price to volatility underlying FX rate).
One simple option strategy that implements a volatility trade is a Total return mandates:
straddle, which is a combination of both an at-the-money (ATM) Pure indexing
put and an ATM call. ▪ Match benchmark return and risk as closely as possible.
A similar option structure is a strangle position for which a long ▪ Risk factors are matched exactly.
position is buying out-of-the-money (OTM) puts and calls with the Enhanced indexing
same expiry date and the same degree of being out of the money. ▪ Modest outperformance (generally 20 bps to 30 bps) of
benchmark while active risk is kept low (typically around 50 bps
Strategies to reduce hedging costs and modify a portfolio’s or lower).
risk profile ▪ Most primary risk factors are closely matched (in particular,
Forward Over/under- Profit from market view duration).
contracts hedging
Option OTM options Cheaper than ATM Active management
contracts ▪ Higher outperformance (generally around 50 bps or more) of
Risk reversal Write options to earn premiums
benchmark and higher active risk levels.
Put/call Write options to earn premiums ▪ Large risk factor deviations from benchmark (in particular,
spreads duration)
Seagull spreads Write options to earn premiums ▪ Considerably higher turnover than the underlying benchmark.
Exotic Knock-in/out Reduce upside/downside
options features exposure
Digital options Extreme payoff strategies A model for fixed-income returns
E(R) ≈ Yield income + Rolldown return + E(Change in price based
on investor’s views) - E(Credit losses) + E(Currency gains or
losses)

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Leveraged portfolio return rp PBO = Projected benefit obligation
rp = Portfolio return/Portfolio equity or m = multiplier
𝑉 (𝑟 −𝑟 )
rp = 𝑟𝐼 + 𝐵 𝐼 𝐵 G = years worked
𝑉𝐸
W0 = current wage
where: w = annual wage growth rate = constant fraction x r
VE = value of the portfolio’s equity T = remaining work life/ pre-retirement life in years
VB = borrowed funds Z = post-retirement lifetime in years
rB = borrowing rate (cost of borrowing) r = yield on high-quality corporate bonds
rI = return on the invested funds (investment returns) Plan PBO = PBO per employee x no. of employees covered
rp = return on the levered portfolio (𝑃𝑉− )−(𝑃𝑉+ )
Effective duration for liabilities (or assets) = 2×∆𝐶𝑢𝑟𝑣𝑒×(𝑃𝑉 )0
Repurchase Agreement PBO BPV = Plan PBO x effective duration x 0.0001
Dollar interest = Principal x repo rate x (terms of repo in days/360)
Laddered bond portfolios
Liability-Driven and Index-Based Strategies ▪ Laddered portfolios offer diversification over the yield curve.
▪ Balance between reinvestment and price risk.
Liability-driven investing
▪ Attractive in stable, upward sloping yield curve environment.
Liability Amount of Timing of Example
▪ Offer liquidity even if underlying bonds are not liquid.
type cash outlay cash outlay ▪ High convexity.
I Known Known Traditional fixed Macaulay Duration2+ Macaulay duration+Dispersion
income bonds Convexity = (1+cash flow yield)2
II Known Uncertain Callable and ▪ Laddered portfolios can be created using fixed maturity
putable bonds corporate bond ETFs.
III Uncertain Known Floating rate notes ▪ Decision to build a laddered portfolio should be evaluated
IV Uncertain Uncertain Defined benefit against buying shares in a fixed-income mutual fund.
plan obligations
Fixed-Income Portfolio Management (2)
Managing the interest rate risk of a single liability
Immunization achieved if change in cash flow yield on the bond Yield Curve Strategies
portfolio is equal to the change in the yield to maturity on the zero- Major types of yield curve strategies
coupon bond being replicated. Active strategies under assumption of a stable yield curve
Key characteristics: 0. Buy and hold.
▪ Market value ≥ present value of liability 1. Roll down (ride) yield curve: Works with upward sloping yield
▪ Macaulay duration = liability’s due date curve. As bond ages → yield down → price up. Target steep
▪ Minimize portfolio convexity portion of yield curve → significant price appreciation.
Structural risk: yield curve changes such that immunization is not 2. Sell convexity: If yields are stable then convexity does not help
achieved. This risk can be minimized by minimizing the convexity → sell convexity. Sell options or buy callable bonds and MBS.
statistic. 3. Carry trade: Buy securities with high yield and finance with
low-yield securities.
Managing the Interest Rate Risk of Multiple Liabilities
Active strategies for yield curve movement of level, slope, and
Duration matching
▪ Market value of assets ≥ market value of liabilities curvature
1. Duration management: % P change ≈ –D × ∆Y (in percentage
▪ Match money duration: asset basis point value = liability basis
points)
point value
Duration management methods:
▪ Dispersion of cash flow and convexity of assets greater than
▪ Number of futures contracts = Required additional PVBP / PVBP
those of liabilities
of the futures contract
Derivatives overlay strategy: derivatives such as interest rate
▪ MV of bonds to be purchased = (Additional PVBP / Duration of
futures contracts are used to immunize single or multiple liabilities
bonds to be purchased ) x 10,000
by maintaining its target duration as the yield curve shifts and
▪ Effective portfolio duration ≈ (Notional portfolio value /
twists.
portfolio equity ) x duration
Contingent immunization: hedge liabilities and actively manage
▪ Notional value of swaps = Additional PVBP / PVBP of swap
surplus.
▪ How the duration is changed does matter
Accounting defeasance: Both assets and liabilities can be 2. Bullet and barbell structures: Bullets target a single segment of
removed from the balance sheet. the yield curve; barbells target short and long yields; Bullet
Basis point value = Money duration x 1 bp structures do well when yield curve steepens; Barbell
Money duration = Modified duration x market value structures do well when yield curve flattens
Modified duration = Macaulay duration / (1 + CFY) 3. Buy convexity: If yield is expected to change → add convexity;
Liability portfolio BPV − Asset portfolio BPV Higher convexity bonds are more expensive (lower yield);
Nf = Convexity can be bought by 1) altering portfolio structure or 2)
Futures BPV
Futures contracts can be used buying call options
▪ Over-hedge if yields are expected to decline.
▪ Under-hedge if yields are expected to increase. Intra-market carry trades can be implemented in three ways:
1. Buy a bond and finance it in the repo market.
LDI – An Example of a Defined Benefit Pension Plan 2. Enter into a receive fixed and pay floating on an interest rate
For an ongoing independent institution that preserves its current swap.
pension plan PBO is the appropriate measure for pension plan 3. Take a long position in a bond futures contract.
liabilities.
𝑚×𝐺×𝑊0×(1+𝑤)𝑇 1 1
PBO (per employee) = (1+𝑟)𝑇
×[ − ]
𝑟 𝑟×(1+𝑟)𝑍
where:

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Inter-market carry trades can be implemented in three ways: ▪ More valuable when interest rates are stable.
1. Borrow lower rate currency, convert to higher rate currency Condor: 4 positions. Examples:
and invest. Long 2s Short 5s and Short 10s Long 30s.
2. Enter into a currency swap to receive payments in high rate Short 2s Long 5s and Long 10s Short 30s.
currency and make payments in low rate currency.
3. Borrow higher rate currency and invest; In the FX market buy Framework for evaluating yield curve trades
higher rate currency using lower rate currency. E(R) ≈ Yield income + Rolldown return + E(Change in price based
on investor’s views of yields and spreads) - E(Credit losses) +
Altering portfolio convexity E(Currency gains or losses)
Adding convexity ▪ If forecasted ending yield < forward rate → expected return >
▪ Make structure more barbelled one-period rate
▪ Buy options ▪ If forecasted ending yield > forward rate → expected return <
Reducing convexity one-period rate
▪ Make structure more bulleted ▪ Expected gain/loss from change in yield ≈ [-MD × ∆Yield] + [½ ×
▪ Sell options Convexity × (∆Yield)2]
▪ Buy callable bonds
▪ Buy mortgage backed securities Fixed-Income Active Management: Credit Strategies

Portfolio positioning strategy given forward rates and interest Risk considerations in investment-grade and high-yield bonds
rate view ▪ High-yield bonds have relatively high credit loss rates → credit
▪ Upward sloping yield curve which will remain stable→ Roll risk.
down the yield curve ▪ Investment-grade bonds have relatively low credit loss rates →
▪ Parallel shift up→ Lower duration credit migration risk and spread risk.
▪ Parallel shift down→ Higher duration
▪ High interest rate volatility→ Add convexity→Buy options, more Credit spreads
barbelled structure. If yield change does not materialize the ▪ Benchmark spread: Yield on credit security – yield on
higher convexity will cause a yield drag. benchmark bond.
▪ Low interest rate volatility→ Sell convexity→Sell options, More ▪ G-spread: Yield on credit security – yield on government bond
bulleted structure ▪ I-spread: Yield on credit security – swap rate
▪ Flatter yield curve→ Barbell ▪ Z-spread: Constant spread that must be added to each point of
▪ Steeper yield curve→ Bullet the implied spot yield curve to make the present value of a
bond’s cash flows equal its current market price; Works for
Use of derivatives to implement yield curve strategies bonds without embedded options.
Altering duration ▪ OAS: Constant spread that, when added to all the one-period
▪ Number of futures contracts = Required additional PVBP / PVBP forward rates on the interest rate tree, makes the arbitrage-free
of the futures contract value of the bond equal to its market price.
▪ Notional value of swaps = Additional PVBP / PVBP of swap Credit spread is equal to excess return if there is no change in the
Altering convexity security’s yield or in interest rates, and if the security does not
To add convexity of portfolio: Sell bonds and buy options default during the holding period
Par value of option needed = Par value of bonds being sold x XR ≈ (s × t) – (∆s × SD) assuming no default losses
(bond’s PVBP / option’s PVBP) EXR ≈ (s × t) – (∆s × SD) – (t × p × L)  
To reduce convexity of portfolio: Sell options, buy callable bonds or
MBS. Spread curve: fitted curve of credit spread for each bond of an
issuer versus spread duration or maturity of each of those bonds.
Evaluating sensitivity to changes in slope using KRDs ▪ At a given spread duration, pick the bond with higher spread if
Key rate durations (KRD, partial durations) measure duration at credit worthiness is the same.
key points on the yield curve ▪ Evaluate bonds that are significantly above or below the fitted
▪ Used to identify bullets and barbells spread curves.
▪ Sum of KRDs ≈ effective duration
Predicted change = Portfolio par amount × Partial PVBP × (–Curve Tail risk: Tail risk is the risk that there are more actual events in
shift in bps) / 100 the tail of a probability distribution than probability models would
predict.
Inter-market curve strategies try to exploit the yield curve Comparing the bottom-up and top-down approaches
differences as well as the expected changes in the yield curve. Bottom-up approach Top-down approach
While engaging in inter-market strategies we should consider Advantage: Advantage:
several aspects such as: Easier to gain informational Sizable portion of credit
▪ Carry advantage in individual returns can be attributed
▪ Returns based on riding the curve companies or bonds to macro factors
▪ Returns based on anticipated spread changes Challenge: Challenge:
Difficult to earn substantial Difficult to gain
Constructing duration neutral portfolios to benefit from returns from bottom-up security informational advantage
change in curvature selection without exposing the
Long barbell and a short bullet portfolio to macro factors
▪ Benefit from flattening yield curve.
▪ Benefit from increase in curvature. Structured financial instruments
▪ More valuable when interest rate volatility is high. Advantages of using structured financial instruments in credit
portfolios
Short barbell and a long bullet ▪ Multiple tranches with different risk and return profiles
▪ Benefit from steepening yield curve. (potential for high returns).
▪ Benefit from decrease in curvature. ▪ Potential for relative value opportunities.

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▪ Possibility of more-targeted exposure to a certain market or Attribution analysis refers to the analysis of sources of return of
sector. the portfolio and the underlying index and identifying the reasons
Improved portfolio diversification. for the differences. The sources of return include: company-
specific, sector, country, currency etc.
Equity Portfolio Management (1)
Equity Portfolio Management (2)
Overview of Equity Portfolio Management
Equity Investment Universe Active Equity Investing: Strategies
▪ Segmentation by Size and Style
Fundamental Quantitative
▪ Segmentation by Geography
Style Subjective Objective
▪ Segmentation by Economic Activity
Decision- Discretionary Systematic,
▪ Segmentation of Equity Indexes and Benchmarks
making non-
process discretionary
Income and Costs in an Equity Portfolio
Primary Human skill, experience, Expertise in
▪ Dividend Income
resources judgment statistical
▪ Securities Lending Income
modeling
▪ Ancillary Investment Strategies – additional income through
Information Research Data and
dividend recapture, selling options
used (company/industry/economy) statistics
▪ Management Fees (ad valorem fees) – percentage of funds under
Analysis Conviction (high depth) in A selection of
management – fees include: direct costs of research/investment
focus stock-, sector-, or region- variables,
analysts/portfolio managers, direct costs of portfolio
based selection subsequently
management
applied
▪ Performance fees (incentive fees) features may include:
broadly over a
upwards only, high-water mark, threshold
large number
▪ Administration fees – fees include: processing of corporate
of securities
actions, performance and risk measurement, voting at company
meetings, third party services fees Orientation Forecast future corporate Attempt to
▪ Marketing and Distribution costs to data parameters and establish draw
▪ Trading Costs include explicit costs, implicit costs, total trading views on companies conclusions
costs not generally revealed to investor from a variety
▪ Investment Approaches and Effects on Costs – portfolio costs of historical
depend upon approach used data
Portfolio Use judgment and conviction Use optimizers
construction within permissible risk
Equity Investment Across the Passive-Active Spectrum
parameters
The decision of where to position a portfolio on a passive-active
spectrum depends on: A factor-based strategy involves identifying favorable factors and
▪ Confidence to outperform tilting the portfolio towards these factors. The commonly used
▪ Client preference factors are: size, value, growth, quality, and price momentum.
▪ Suitable benchmark
▪ Client- specific mandates Statistical arbitrage strategies use statistical and technical
▪ Risks/costs of active management analysis to exploit pricing anomalies. A popular example of a stat
▪ Taxes arb strategy is ‘Pairs trading’.

Passive Equity Investing Two main approaches to style classification are:

▪ Herfindahl–Hirschman Index (HHI) - a valid measure of stock-
concentration risk in a portfolio = ∑𝑛𝑖=1 𝑤𝑖 2
where wi = weight of stock i in the portfolio, n = no. of securities
HHI of 1/n ⟶an equally weighted portfolio, HHI of 1.0 ⟶
portfolio concentration in a single security
▪ Effective no. of stocks = 1/HHI
In factor-based strategies we try to replicate the performance of a
benchmark by creating a portfolio that has the same exposure to
risk-factors as the benchmark. Some risk factors include: growth,
value, size, yield, momentum, quality, volatility etc.
In market-capitalization-weighted indexing, we create
portfolios with the same weights of constituent securities as the
benchmark index.
In the full replication approach, all securities represented by the
index are purchased.
In the stratified sampling approach, we split the population into
strata (or sub-groups) and then sample from each strata.
In the optimization approach, we try to maximize desirable
characteristics or minimize undesirable characteristics subject to
one or more constraints.
▪ Holdings-based approaches: aggregate the style scores of
individual holdings
▪ Returns-based approaches: Compare the returns of the strategy
to those of style indexes.
Active Equity Investing: Portfolio Construction
The four major building blocks used in portfolio construction
are:
▪ Factor weighting: This involves overweighting, underweighting
or neutralizing rewarded factors.
▪ Alpha skills: This involves using expertise, experience and
superior analysis to identify assets that are
overpriced/underpriced. It also involves timing exposures to
factors, securities and markets.
▪ Position sizing: This refers to the choice between large positions
in a few stocks versus small position in many stocks.
▪ Breadth of expertise: It involves integrating the three building
blocks mentioned above. The breadth of expertise is high when
the number of independent decisions are high.
Active share measures the extent to which the number and sizing
of positions in benchmark differ from the portfolio. It is not

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impacted by the correlation between securities, hence a portfolio 3. Relative Value Strategies earn good returns (credit, liquidity,
manager has complete control on this measure. or volatility premiums) during normal conditions. In a financial
It is calculated as: crisis, these strategies can result in losses. Equity market-neutral
n
1 investing is a relative value strategy.
Active Share = ∑|Weight portfolio,i − Weight benchmark,i | Fixed-Income Arbitrage
2
i=1 Convertible Bond Arbitrage
Active risk is a more complicated measure. Active risk is affected ▪ Convertible bond = straight bond + equity call option.
by the degree of cross correlation. A portfolio manager does not ▪ Conversion ratio = number of shares to exchange bond.
have complete control on this measure, because it is impacted by ▪ Stock’s conversion price = bond price / conversion ratio
the correlation & variances of securities. ▪ Bond’s current conversion price = current stock price x
conversion ratio
Measure of Absolute Risk
Total portfolio variance (Vp) = ∑𝑛𝑖=1 ∑𝑛𝑗=1 𝑥𝑖𝑥𝑗𝐶𝑖𝑗 where: 4. Opportunistic Strategies seek to profit from investment
xj = asset’s weight in the portfolio opportunities across a range of markets and securities
Cij = the covariance of returns between asset i and asset j using a variety of techniques.
Global Macro Strategies
Contribution of each asset to portfolio variance (CVi) =
Managed Futures Strategies
∑𝑛𝑗=1 𝑥𝑖𝑥𝑗𝐶𝑖𝑗 = 𝑥𝑖𝐶𝑖𝑝 where:
Cip = the covariance of returns between asset i and the portfolio
5. Specialist Strategies require highly specialized skill sets, focus
Measure of Relative/Active Risk on niche markets, and the objective is to generate uncorrelated and
Variance of portfolio’s active return (AVp) = attractive risk-adjusted returns.
∑𝑛𝑖=1 ∑𝑛𝑗=1(𝑥𝑖 − 𝑏𝑖)(𝑥𝑗 − 𝑏𝑗)𝑅𝐶𝑖𝑗 where: Volatility Trading
Reinsurance/Life Settlements
xi = asset’s weight in the portfolio
bi = benchmark weight in asset i 6. Multi-Manager Strategies Most investors invest in a range of
RCij = covariance of relative returns between asset i and asset j hedge fund strategies
Three main approaches
Contribution of each asset to the portfolio active variance (CAVi): ▪ Creating one’s mix of managers
CAVi = (𝑥𝑖 − 𝑏𝑖)𝑅𝐶𝑖𝑝 where: ▪ Fund-of-funds
RCip = covariance of relative returns between asset i and the ▪ Multi-strategy funds
portfolio
Conditional Factor Risk Model applied to a hedge fund strategy’s
Long-only approaches rely on long positions only and no short returns is:
positions are taken. (𝑅𝑒𝑡𝑢𝑟𝑛 𝑜𝑛 𝐻𝐹𝑖)𝑡 = 𝛼𝑖 + 𝛽𝑖,1 (𝐹𝑎𝑐𝑡𝑜𝑟 1)𝑡 + 𝛽𝑖,2 (𝐹𝑎𝑐𝑡𝑜𝑟2)𝑡 + ⋯
Long/short positions have both long and short positions. The + 𝛽𝑖,𝐾 (𝐹𝑎𝑐𝑡𝑜𝑟 𝐾)𝑡 + 𝐷𝑡 𝛽𝑖,1 (𝐹𝑎𝑐𝑡𝑜𝑟1)𝑡
positions can be negative and are not constrained to sum 1. + 𝐷𝑡 𝛽𝑖,2 (𝐹𝑎𝑐𝑡𝑜𝑟 2)𝑡 + ⋯ + 𝐷𝑡 𝛽𝑖,𝐾 (𝐹𝑎𝑐𝑡𝑜𝑟 𝐾)𝑡
+ (𝑒𝑟𝑟𝑜𝑟)𝑖,𝑡
A long extension portfolio can be considered as a hybrid of long-
only and long/short strategies. It is also called ‘enhanced active Performance Contribution to a 60/40 Portfolio - Adding a 20%
equity’ strategy. A popular example is the 130/30 strategy. allocation of a hedge fund strategy group to a traditional 60%/40%
portfolio typically results in:
A market-neutral portfolio is another specialized form of
▪ Lower total portfolio standard deviation
long/short portfolio construction. In dollar-neutral portfolios the
▪ Higher Sharpe and Sortino ratios
dollars invested in long positions are equal to the dollars invested ▪ Lower maximum drawdown.
in short positions. In true market-neutral portfolio, the exposure
to the market is cancelled out. Asset Allocation to Alternative Investments
Alternative Investments Portfolio Management The Role of Alternative Investments in a Multi-Asset Portfolio
▪ Higher risk-adjusted returns
Hedge Fund Strategies
▪ Achieve: capital growth, income generation, risk diversification,
and/or safety
1. Equity Strategies: Invest in equity and equity-related ▪ Private equity
instruments. ▪ Return enhancer
Equity L/S Strategies ▪ Illiquidity risk
Dedicated Short Selling and Short Biased Hedge funds
Equity Market Neutral ▪ Spectrum: risk reducers to return enhancers.
Long/short equity strategies provide equity-like returns but with
2. Event-Driven Strategies take positions in corporate securities lower exposure to equity premium.
and derivatives to profit from events such as mergers and Short-biased equity strategies try to generate alpha by going
acquisitions, bankruptcies, share issuances, buybacks, capital short on overvalued securities.
restructuring, reorganization, etc. Arbitrage and event-driven strategies deliver equity-like returns
Merger Arbitrage with little to no correlation with traditional asset classes.
Distressed Securities Real assets
▪ Generally perceived to provide a hedge against inflation.

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 ▪ Timber investments provide both growth and inflation-hedging Monitoring the Investment Program
properties. Performance Evaluation Two common benchmarking approaches:
▪ Commodities serve as a hedge against inflation and provide a ▪ Custom index proxies
differentiated source of alpha. ▪ Peer group comparisons
▪ Farmland investing can have a commodity-like profile or a Some funds report IRR, which is sensitive to timing of cash flows.
commercial real estate-like profile. Pricing issues can distort reported risk and return measures.
▪ Energy investments → the investor owns the mineral rights to
the commodities which are correlated with inflation. Monitoring the Firm and the Investment Process Some areas to
▪ Infrastructure investments usually generate stable/modestly monitor: Key person risk, alignment of interests, style drift, risk
growing income and also tend to have a high correlation with management, client/asset turnover, client profile, and service
overall inflation. providers.
Commercial real estate
▪ Commercial real estate provides protection against
Private Wealth Management (1)
unanticipated inflation.
Strategies range from core to opportunistic. Overview of Private Wealth Management
▪ Core strategies focus on income generation.
▪ Opportunistic strategies focus on capital appreciation. Private Clients versus Institutional Clients
Private credit Investment Objectives
Private credit includes direct lending and distressed investments. Private Clients Institutional Clients
▪ Direct lending assets are income-producing; asset owner Investment objectives Relatively well defined
assumes default and recovery risks. are diverse Typically related to a
▪ Distressed investments have an equity-like profile. Idiosyncratic May not be clearly specific liability stream
risk dominates all other risks. defined or quantified Not likely to change
Might compete with materially over time
Traditional Approaches to Asset Classification each other
Two approaches to classify assets: Likely to change over
▪ A liquidity-based approach to defining the opportunity set. time
▪ An approach based on expected performance under distinct
macroeconomic regimes. Constraints
Private Clients Institutional
Risk-Based Approaches to Asset Classification Clients
Under risk-based approaches, the typical risk factors applied to Time Relatively short → more Relatively long
alternative investments include equity, size, value, liquidity, horizon constrained with respect to Generally a
duration, inflation, credit spread, and currency. risk-taking and liquidity single time
Different time horizons for horizon and a
Asset Allocation Approaches different objectives single
After making the initial asset allocation decision using only the investment
broad, liquid asset classes, a second iteration of the asset allocation objective
exercise is incorporating alternative assets. Three approaches: Scale Relatively small → asset Relatively
1. Monte Carlo simulation class limitations large
2. Portfolio optimization Taxes Taxable private clients will Tax-exempt
Mean-variance optimization without and with constraints favor tax-efficient institutions
Mean-CVaR Optimization can improve the asset allocation decision. investments will favor
investments
3. Risk factor-based optimization
with high
Liquidity Planning
taxable income
Three primary considerations associated with private investment
liquidity planning:
1. How to achieve and maintain the desired allocation. Information Needed in Advising Private Clients includes
To determine the annual commitments for reaching and personal information, financial information, and tax considerations.
maintaining the long-term target asset allocation - cash flow, and
commitment pacing models are used. Private Client Tax Considerations
Capital Contribution = Rate of Contribution × (Capital Commitment ▪ Basic tax strategies that can help reduce the tax outflow of
– Paid-in-Capital) individuals - tax avoidance, tax reduction, and tax deferral.
Distributions = Rate of Distribution at time t × [NAV × (1 + Growth
Rate)] Client Goals Two types - planned goals and unplanned goals.
NAV at time 1 = prior NAV × (1 + Growth Rate) + Capital Planned Goals: can be estimated or quantified within an expected
Contribution – Distributions time horizon.
Cash flow and commitment-pacing models enable investors to Unplanned Goals: related to unforeseen financial needs.
▪ Manage portfolio liquidity Wealth Manager’s Role: relevant considerations that help clients in
▪ Set realistic annual commitment targets to reach desired asset their goal creation are goal quantification, goal prioritization, and
allocation. goal changes due to circumstances.

2. How to handle capital calls. Technical and Soft Skills for Wealth Managers
3. How to plan for the unexpected. Technical skills - capital markets proficiency, portfolio construction
ability, financial planning knowledge, quantitative skills,
technology skills, and language fluency.

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 n
Soft skills - communication skills, social skills, education/coaching FVGift [1 + rg (1 − t ig )] (1 − Tg )
skills, and business development and sales skills. RVTaxableGift = =
FVBequest [1 + re (1 − t ie ]n (1 − Te )

Investment Planning If the tax is paid by the donor:

Capital sufficiency analysis, retirement planning, and the client’s FVGift
n
[1 + rg (1 − t ig )] [1 − Tg+ (Tg Te )]
investment policy statement. =
FVBequest [1 + re (1 − t ie ]n (1 − Te )
Capital sufficiency (needs) analysis: process to determine whether
a client has, or is likely to accumulate, sufficient financial resources Relative value of generation skipping =
to meet his or her objectives. 1
▪ Two methods: (1 - tax rate of capital transferred from 1st to 2nd generation)
1. Deterministic forecasting
2. Monte Carlo simulation Double Taxation: Three forms of tax conflicts in double taxation:
▪ Residence-residence conflict
Retirement planning ▪ Source-source conflict
▪ Analyzing Retirement Goals – Three commonly used tools for ▪ Residence-source
retirement planning are:
Methods used to provide double taxation relief
▪ Mortality tables
▪ Credit method: Tax liability = Max [TResidence, TSource]
▪ Annuities
▪ Exemption method: Tax liability = TSource
• Immediate annuity
▪ Deduction method: Tax liability = TResidence + TSource – (TResidence ×
• Deferred annuity
TSource)
▪ Monte Carlo simulations
▪ Behavioral Considerations in Retirement Planning
▪ Heightened loss aversion Private Wealth Management (2)
▪ Consumption gaps
▪ The “annuity puzzle.” Concentrated Single-Asset Positions
▪ Preference for investment income over capital appreciation.
A holding is generally considered “concentrated” if it represents of
≥25% of an investor’s wealth.
Portfolio Construction and Monitoring
Portfolio Allocation and Investments for Private Wealth Clients: Investment risks of concentrated positions:
Two primary approaches to constructing a client portfolio: a ▪ systematic risk
traditional approach and a goals-based investing approach. ▪ company-specific risk
▪ property-specific risk
Taxes and Private Wealth Management
Objectives in managing concentrated positions:
▪ to reduce concentration risk.
▪ Returns-based taxes: accrual taxes on interest and dividends: ▪ to generate liquidity to satisfy spending needs.
FVIFi = [1 + r (1 – ti)]n ▪ to achieve objectives 1 & 2 in a tax-efficient manner.
▪ Returns-based taxes: deferred capital gains:
FVIFcgb = (1 + r)n(1 – tcg) + tcgB Strategies for managing concentrated positions in publicly
▪ Wealth-based taxes: traded common shares
FVIFw = [(1 + r)(1 – tw)]n Equity monetization: Hedge risk and borrow against equity
When investment returns are subject to accrued taxes on annual position. Loan proceeds can be reinvested. Use when there are
basis: selling restrictions and/or when investor wants to retain control.
▪ Tax drag > nominal tax rate Equity monetization tools:
▪ All else equal, as investment horizon increases → tax drag 1. Short sale against the box: creates risk-less position → high LTV
increases. ratio. It is the least expensive method.
▪ All else equal, as investment return increases → tax drag 2. Total return equity swap: due to dealer spread, money market
increases. return < short sale against the box.
▪ Given investment returns, the longer the time horizon, the 3. Forward conversion with options: long put + short call. Riskless
greater the tax drag. asset is created → investor can earn money market return and can
▪ Given investment time horizon, the higher the investment have high LTV ratio.
returns, the greater the tax drag. 4. Equity forward sale contract: Riskless asset is created →
investor can earn money market return and have high LTV ratio
Estate Planning in a Global Context but limited upside potential.
Two principal forms of wealth transfer: Hedging tools:
1. Protective put
1. Gifts: lifetime gratuitous transfers or inter vivos transfers
2. Cashless (zero-premium) collar
2. Bequests: testamentary gratuitous transfers
Core capital = 3. Prepaid variable forwards: combination of hedge and margin
𝑵 loan
𝐩 (𝐒𝐮𝐫𝐯𝐢𝐯𝐚𝐥) × 𝐒𝐩𝐞𝐧𝐝𝐢𝐧𝐠 𝐣
∑ Other tools for managing concentrated positions in publicly
(𝟏 + 𝐫)𝐣
𝒋=𝟏 traded common:
A. Index-tracking strategy with active tax management.
Tax free gift: B. Completeness portfolio.
n
FVGift [1 + rg (1 − t ig )] C. Cross/indirect hedge.
RVTaxFreeGift = =
FVBequest [1 + re (1 − t ie ]n (1 − Te ) D. Exchange fund.

If tax is paid by the recipient: Strategies for managing concentrated positions in privately
held businesses:

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1) Sale to strategic buyers. Portfolio Management for Institutional Investors
2) Recapitalization: Sell a large portion of business equity while
retaining a minority ownership interest. This is considered as Overview of Investment Policy
“staged” exit strategy. Common investment approaches used by institutional investors
3) Sale to financial buyers. are:
4) Sale to management or key employees. Investment Description
5) Sale or disposition of non-core assets. Approach
6) Personal line of credit secured against company shares. Norway Traditional style characterized by 60%/40%
7) Going public through an IPO Model equity/fixed-income allocation, few alternatives,
8) Employee stock ownership plan largely passive investments, tight tracking error
limits, and benchmark as a starting position.
Strategies for managing concentrated positions in real estate: Endowment Characterized by high alternatives exposure,
1) Outright sale Model active management and outsourcing.
2) Mortgage financing
3) Donate Canada Characterized by high alternatives exposure,
4) Sale and leaseback Model active management, and insourcing.
Liability Characterized by focus on hedging liabilities and
Risk Management for Individuals
Driven interest rate risk including via duration-matched,
There is an inverse relationship between financial capital and Investing fixed-income exposure. A growth component in
human capital. At a young age, human capital is high while financial (LDI) Model the return-generating portfolio is also typical
capital low. At retirement, human capital is low and financial (exceptions being bank and insurance company
capital is high. portfolios).
The economic (holistic) balance sheet includes:
▪ Traditional assets. Evaluating Investment Portfolios
▪ Traditional liabilities. Pension Plans: Usually, similar goals, but asset allocations vary due
▪ Present value of all available marketable and non-marketable to differences in:
assets (e.g. human capital and pensions). ▪ Legal, regulatory, accounting, and tax constraints, investment
▪ All liabilities (e.g. consumption needs and bequests) besides objectives, risk appetites, and investment views of the
traditional assets and liabilities. stakeholders, liabilities to and demographics of the ultimate
beneficiaries, availability of suitable investment opportunities,
Life Insurance Policy: and the expected cost of living in retirement.
Permanent: provides lifetime coverage; non-cancelable; fixed Sovereign Wealth Funds
premiums ▪ Budget stabilization funds are generally risk-averse and invest
▪ Whole life: fixed, annual premiums and non-cancelable; cash mainly in bonds and cash.
value ▪ Reserve funds invest in equities and alternatives but maintain a
▪ Universal life: more flexible than whole life; variable premium significant allocation of bonds for liquidity.
payments ▪ Savings funds and pension reserve funds hold relatively higher
Temporary/term: for a certain period of time; non-cancelable; allocations of equities and alternatives because of their longer-
policy specific premium; less costly. term liabilities.
Annuities hedge the risk of living longer than expected and University Endowments
outliving assets. Immediate annuities provide an immediate
▪ Most large endowments follow the endowment investment
income stream and cost more. Whereas, deferred annuities cost
model and allocate a significant portion to alternative
less. Annuities can be either fixed or variable.
investments.
Fixed Annuities Variable Annuities ▪ Larger endowments have a higher allocation to alternatives and
Volatility of Constant income Variable income a relatively smaller portion to fixed income.
Benefit stream; suitable for stream; suitable for ▪ “Home bias” is more prominent in smaller endowments.
Amount investors with low investors with Foundations
risk tolerance relatively high risk ▪ Investment approach is similar to endowments in spite of
tolerance differences in liability structure.
Flexibility Low; generally High; access to ▪ Larger foundations have higher allocation to alternatives.
irrevocable funds but at a cost ▪ Private foundations have higher allocation to alternatives
Future Market Bond-like returns Variation in compared to community foundations.
Expectations Interest rate risk payments but Banks and Insurers
higher expected ▪ Portfolio decisions depend heavily on the underlying liabilities.
value of payments ▪ Undertake asset-liability management (ALM) and focus on
Fees Low High liability-driven investing (LDI).
Inflation Major concern Less of a concern ▪ Proper implementation of the investment policy is difficult - a
Concerns variety of factors to consider.
▪ Key portfolio decisions -at the highest levels of the institution’s
management.

University Endowments—Liabilities and Investment Horizon

Three types of endowment spending policies:
1. Constant growth rule - a fixed amount annually adjusted for
inflation (the growth rate).
2. Market value rule - spending rate is a pre-specified percentage
of the moving average of asset values, typically between 4% -
6%.

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3. Hybrid rule - spending is a weighted average of the constant (∑ 𝑠𝑗 )𝑝0−(∑ 𝑠𝑗 )𝑝𝑑 ∑ 𝑠𝑗 𝑝𝑗 −(∑ 𝑠𝑗 )𝑝0 (𝑆−∑ 𝑠𝑗 )(𝑃𝑛 −𝑃𝑑 )
IS = + + + 𝐹𝑒𝑒𝑠
growth and market value rules. 𝐷𝑒𝑙𝑎𝑦 𝑐𝑜𝑠𝑡 𝑇𝑟𝑎𝑑𝑖𝑛𝑔 𝑐𝑜𝑠𝑡 𝑂𝑝𝑝𝑜𝑟𝑡𝑢𝑛𝑖𝑡𝑦 𝑐𝑜𝑠𝑡

All three spending rules: SA = w × [SA × (1 + Inflation Rate)] + Evaluating Trade Execution
t+ 1 t
▪ Trade evaluation measures the execution quality of the trade
(1 – w) × Spending Rate × Average AUM and the performance of the trader, broker, and/or algorithm.
Banks and Insurers—Balance Sheet Management and ▪ Various techniques measure trade cost execution using different
Investment Considerations benchmarks (pre-trade, intraday, and post-trade).
The interest rate sensitivity of shareholder’s capital
𝐴 𝐴 ∆𝑖 ▪ Cost($) = Side × (𝑃̅ − 𝑃 ∗ ) × Shares
𝐷𝐸∗ = ( ) 𝐷𝐴∗ − ( − 1)𝐷𝐿∗ ( ) Cost($/share) = Side × (𝑃̅ − 𝑃 ∗ )
𝐸 𝐸 ∆𝑦
where 𝑃̅ = Average execution price; 𝑃 ∗ = Reference price →
Arrival price, or VWAP, or TWAP, or MOC;
Volatility of Shareholder’s Equity
𝐴 𝐴 𝐴 𝐴 Shares = Shares executed
2 2 2
𝜎∆𝐸 = ( )2 𝜎∆𝐴 + ( − 1)2 𝜎∆𝐿 − 2 ( ) ( − 1) 𝜌𝜎∆𝐴 𝜎∆𝐿
𝐸 𝐸 𝐴 𝐸 𝐿 𝐸 𝐸 𝐴 𝐿 𝑃̅−𝑃∗
Cost(bps) = Side × × 10,000 bps
𝑃∗
Trading, Performance Evaluation, and Manager Side = {+1 Buy order, −1 Sell order}
Selection
▪ Market-adjusted cost (bps) = Arrival cost (bps) -  x Index cost
Trade Strategy and Execution (bps)
Commonly used benchmarks for trade execution include: • Index cost (bps) = Side x [(Index VWAP – Index arrival
▪ Pre-trade benchmarks - decision price, previous close, opening price)/Index arrival price] x 10^4
price, arrival price
▪ Intraday benchmarks - volume-weighted average price, time- ▪ Added value (bps) = Arrival cost (bps) – Est. pre-trade cost (bps)
weighted average price
Post-trade benchmarks – closing price Portfolio Performance Evaluation
▪ Price target benchmarks – fair value
The Components of Performance Evaluation: Performance
Trade Strategies measurement; Performance attribution; Performance appraisal.
▪ Short-term alpha trade, long-term alpha trade, risk rebalance
trade, client redemption trade, new mandate trade. Performance Attribution - includes return attribution and risk
attribution
Trade Implementation Choices
Quote-driven, over-the-counter, off-exchange markets Approaches to Return Attribution
▪ Large blocks of securities require a high touch approach Return attribution: a set of techniques used to identify the sources
▪ Principal trades or broker risk trades of excess return of a portfolio against its benchmark.
▪ Dealer or market maker becomes the counterparty Equity Return Attribution – The Brinson Model
▪ Request for quote is a variation of quote-driven markets Portfolio return R = ∑𝑖=𝑛
𝑖=1 𝑤𝑖 𝑅𝑖 Benchmark return B = ∑𝑖=1 𝑊𝑖 𝐵𝑖
𝑖=𝑛

The Brinson Model: a portfolio’s

Order-driven markets outperformance/underperformance can be attributed to three
▪ Buyers and sellers display prices and quantities at which they sources:
are willing to transact ▪ Allocation effect: The allocation effect refers to the value the
▪ Order matching systems use rules to arrange trades portfolio manager adds (or subtracts) by having portfolio sector
▪ Works for liquid, standardized securities weights that are different from the benchmark sector weights.
▪ Selection effect: The selection effect refers to the value the
Algorithmic Trading portfolio manager adds by holding individual securities or
▪ Computerized execution of investment decisions based on a set instruments within the sector in different-from-benchmark
of trading instructions weights.
▪ Slice large orders into smaller pieces to minimize market impact ▪ Interaction effect: The interaction effect is the effect resulting
▪ Used for trade execution and profit-seeking. from the interaction of the allocation and selection decisions
Execution Algorithm Classification combined.
▪ Scheduled (POV, VWAP, TWAP) ▪ Individual sector allocation effect - ith sector: Ai = (wi – Wi)Bi;
▪ Liquidity seeking ▪ Individual sector selection effect - ith sector: Si = Wi(Ri – Bi);
▪ Arrival price ▪ Interaction effect - interaction of the allocation and selection
▪ Dark strategies/Liquidity aggregators decisions – Ii = (wi – Wi)(Ri – Bi);
▪ Smart order routers
Equity Return Attribution – Factor-Based Attribution: One of the
Trade Cost Measurement factor models used is – Carhart model
▪ Implementation shortfall - ex post trade cost measurement IS ▪ Rp – Rf = ap + bp1RMRF + bp2SMB + bp3HML + bp4WML + Ep
= Paper return – Actual return
IS = Execution cost + Opportunity cost + Fees Fixed-income attribution
IS = ∑ 𝑠𝑗 𝑝𝑗 − ∑ 𝑠𝑗 𝑝𝑑 + (𝑆 − ∑ 𝑠𝑗 )(𝑃𝑛 − 𝑃𝑑 ) + 𝐹𝑒𝑒𝑠 Exposure Decomposition – Duration Based
▪ Expanded implementation shortfall ▪ Top-down attribution approach
IS = Delay cost + Trading cost + Opportunity cost + Fees ▪ Active decisions: duration, yield curve positioning, sectors
where Delay cost + Trading cost = Execution cost.
Yield Curve Decomposition – Duration Based

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 ▪ Can be executed as a top-down or bottom-up approach • Drawdown duration is the total time from the start of the
▪ % total return = % income return + % price return where price drawdown until the cumulative drawdown recovers to zero.
return = - duration x change in YTM
▪ Compare differences between benchmark’s return drivers and Investment Manager Selection
portfolio’s return drivers
▪ Quantify the effect of active portfolio management decisions A Framework for Investment Manager Search and Selection -
three broad components: the universe, a quantitative analysis of
Yield Curve Decomposition – Full Repricing
the manager’s performance track record, and qualitative analysis of
▪ Provides more precise pricing the manager’s investment process.
▪ Allows for broader range of instrument types and yield changes
Type I and Type II Errors in Manager Selection
Risk Attribution
Realization
Type of Attribution Analysis
Null hypothesis: manager is Below At or above
Investment Relative(vs. Absolute
not skillful expectations expectations
Decision-Making Benchmark)
(no skill) (skill)
Process
Decision Hire/Retain Type I Correct
Bottom-up Position’s marginal Position’s marginal
contribution to contribution to Not Hire/Fire Correct Type II
tracking risk total risk
Top-down Attribute tracking Factor’s marginal Type I Errors Type 2 Errors
risk to relative contribution to Errors of commission Errors of omission
allocation and total risk and Explicit costs Opportunity costs
selection decisions specific risk Easily measurable Less likely to be measured
Factor-based Factor’s marginal
contribution to More transparent to investors Less transparent to investors
tracking risk and More psychological pain Less psychological pain
active specific risk
Style Analysis - Managers can be evaluated using returns-based
Return Attribution Analysis at Multiple Levels analysis style analysis (RBSA) and holdings-based style analysis
▪ Macro attribution: attribution analysis to determine impact of (HBSA).
fund sponsor decisions: allocation, selection.
▪ Micro attribution: attribution of individual portfolio
management decisions. Capture Ratios
▪ Return attribution effects using the Brinson–Fachler approach Upside capture ratio (UC) measures capture when the benchmark
• Allocation = (wi – Wi)(Bi – B) return is positive
• Selection + Interaction = Wi(Ri – Bi) + (wi – Wi)(Ri – Bi) Downside capture ratio (DC) measures capture when the
benchmark return is negative
Benchmarking Investments and Managers Capture ratio (CR) is the upside capture divided by downside
▪ Liability-Based Benchmarks: Used when the assets are required capture
to pay a specific future liability; focus on the cash flows that the
assets are required to generate. Investment Decision-Making Process: There are four elements:
▪ Asset-based benchmarks contain a collection of assets to signal creation, signal capture, portfolio construction, portfolio
compare against the portfolio’s assets monitoring.

▪ Properties of a Valid Benchmark - unambiguous, investable, Evaluation of Investment’s Terms (Management Fees)
measurable, appropriate, reflective of current investment ▪ Assets under management fees and performance fees
opinions, specified in advance, accountable. ▪ Performance-based fees can be structured in three ways
1. Fully exposed to upside and downside – symmetric structure
Evaluating Benchmark Quality: Analysis Based on a ⟶ Fee = Base + Sharing of performance.
Decomposition of Portfolio Holdings and Returns 2. Not fully exposed to downside but fully exposed to upside –
P = M + S + A; where A = P – B and S = B – M, S = style return, M = bonus structure⟶ Fee = Higher of either (1) Base or (2) Base
market index return plus sharing of positive performance]
If benchmark is broad market index, S = 0. 3. Not fully exposed to either the downside or the upside – bonus
structure ⟶ fee = Higher of (1) Base or (2) Base plus sharing of
Appraisal Measures performance, to a limit.
𝑅̅𝐴 − 𝑟̅𝑓 𝑅̅𝐴 − 𝑟̅𝑓
▪ The Sharpe Ratio 𝑆𝐴 = 𝜎
̂𝐴
; The Treynor Ratio 𝑇𝐴 = 𝛽𝐴
; ▪ Bonus-style fees are like a call option for the manager with base
𝐸(𝑟𝑃) – 𝐸(𝑟𝐵) fee ⟶ the strike price.
The Information Ratio IR = ;
𝜎(𝑟𝑃 −𝑟𝐵 )
𝛼 𝐸(𝑟𝑃 )− 𝑟𝑇
The Appraisal ratio AR = ; The Sortino Ratio SRD = ; Case Study in Portfolio Management: Institutional
𝜎𝜀 𝜎𝐷
∑𝑁 𝑚𝑖𝑛(𝑟𝑡 −𝑟𝑇)2 1/2
𝜎𝐷 = [ 𝑡=1 ] Institutional investors use several tools to manage a portfolio’s
𝑁
▪ Capture ratios: UC(m,B,t) = upside capture for manager m liquidity risk, such as:
relative to benchmark B for time t; DC(m,B,t) = downside ▪ Liquidity profiling and time-to-cash tables
capture for manager m relative to benchmark B for timet; ▪ Rebalancing and commitment strategies
CR(mB,t) = UC(m,B,t)/DC(m,B,t) ▪ Stress testing analyses
▪ Drawdown: cumulative peak-to-trough loss during a continuous ▪ Derivatives
period

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▪ Liquidity Classification Schedule (Time-to-Cash Table) and
Liquidity Budget - The liquidity classification schedule defines
portfolio categories (or “buckets”) based on the estimated time
it would take to convert assets into cash in that particular
category. The liquidity budget assigns portfolio weights in the
time-to-cash table and establishes a liquidity benchmark.
▪ Liquidity profiling for a portfolio identifies – asset classes,
allocations as a percent of portfolio, investment vehicles, and
liquidity classification (highly liquid, liquid, semi-liquid, illiquid)
for each asset and investment vehicle.
Amount of coverage that the life insurance policy should
provide can be calculated using two methods.
▪ the human life value method ⟶ estimates the amount of future
earnings that must be replaced,
▪ the needs analysis method ⟶ estimates the amount needed to
cover a survivor’s living expenses.

Rebalancing, Commitments
Rebalancing mechanisms:
▪ Systematic rebalancing policies
• Calendar rebalancing
• Percent-range rebalancing
▪ Automatic adjustment mechanisms
Cash flow and commitment-pacing strategies/models enable
investors to
▪ Manage portfolio liquidity
▪ Reach desired asset class exposure
Stress Testing – seek to understand how a portfolio’s liquidity
profile and an institution’s liquidity needs may be impacted during
periods of stress.
Derivatives - can be used to manage cash flow needs and change
risk exposure, such as:
▪ futures overlay program can be used to rebalance exposures to
public asset classes and
▪ using leverage to modify the portfolio’s liquidity profile.

QUINCO Case:
This case covers important aspects of institutional portfolio
management, such as:
▪ Capturing illiquidity premium
▪ Liquidity management
▪ Asset allocation
▪ Use of derivatives versus the cash market for tactical asset
allocation and portfolio rebalancing. The case also covers
potential ethical violations in manager selection.

Case Study in Risk Management: Private Wealth

The case is based on the different life stages – from early career
phase to retirement of a married couple, the Schmitts.
In this case study:
▪ We identify and analyze the Schmitts’ risk exposures and
observe how the types of risk exposure change across their
different life stages. The analysis is conducted holistically
starting from the economic balance sheet, including human
capital.
▪ We recommend and justify methods to manage the Schmitt
family’s risk exposures at different stages of their professional
life. We use insurance, self-insurance, and adjustments to their
investment portfolio.
▪ We recommend and justify modifications to the Schmitts’ life
and disability insurance at different stages of the income
earners’ lives.
▪ Finally, we recommend and justify a plan to manage risk to the
Schmitts’ retirement lifestyle goals.

Human capital ⟶present value (PV) at a wage-risk adjusted

discount rate of the expected stream of income from employment
𝑝(𝑠𝑡)𝑤𝑡−1(1+𝑔𝑡 )
 𝐻𝐶0 = ∑𝑡=𝑁
𝑡=1 (1+𝑟𝑓 +𝑦)𝑡

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