CFA 2017 Level II

Portfolio Management
Study Session 16
Readings 47, 48, 49

Study Session 17
Readings 50, 51, 52

Created and developed by Michael Cao

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About Study Sessions 16 & 17

• 5‐10% of level II exam = 1‐2 item sets
• Core topics
– Multifactor models & applications
– Active return decomposition
– Information ratio
– Fundamental Law of Active Management
– Portfolio management process & IPS
• Exam focus
– Intuitive understanding of results, formulas, and models
– Application of theory and heuristics to specific examples

Reading 47

The Portfolio Management Process

and Investment Policy Statement

Created and developed by Michael Cao

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 Overview
• Portfolio perspective
– Portfolio risk‐return analysis as a whole
– Only systematic risk priced
– Non‐systematic (idiosyncratic) risk diversified away
• Portfolio management process
– Planning
• Evaluating investor and market characteristics
• Developing investment policy statement
• Determining asset allocation strategy
– Execution
– Feedback
LOS 47.a/b 3

Investment Policy Statement (IPS)

• Role of IPS:
– Easily adopted by current/future managers (transportable)
– Long‐term discipline for investment decisions
• Elements of IPS:
– Client description
– Duties/responsibilities of parties
– Investment objectives
– Constraints
– Schedule for rebalancing and review/adjustment

LOS 47.c 4

Investment Objectives
• Risk objectives:
– Risk tolerance determined by investor’s willingness and
ability to take risk, whichever is lower
• Education recommended if willingness < ability
– Willingness (behavioural) more relevant for individuals
– Ability (constraints) more important for institutions
• Return objectives:
– Desired return – what the investor wishes to achieve
– Required return – what the portfolio must generate
– Total return perspective important: income + capital gains

LOS 47.e 5

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 Investment Constraints
• Time horizon
– Related to acceptable level of risk and liquidity in portfolio
• Tax considerations
– Consider after‐tax return, tax‐exempt/deferred accounts
• Liquidity needs
– Ability to quickly convert invested assets into cash
• Legal/regulatory constraints
– Legal restrictions, percentage allocations allowed
• Unique circumstances
– Ethical concerns, religious preferences, specific needs
LOS 47.e 6

Reading 48

An Introduction to Multifactor
Models

Arbitrage Pricing Theory (APT)

• Assumptions:
– Unsystematic risk diversified away in a portfolio
– Asset returns generated from a (multi‐)factor model
– No arbitrage opportunities
• Equilibrium expected return (of portfolio ):
E , ⋯ ,
– : risk‐free rate of return
– : th factor’s risk premium (pure factor portfolio return)
• Pure factor portfolio: sensitivity = 1 to th factor and = 0 to others
– , : portfolio’s factor loading/sensitivity to th factor

LOS 48.a 8

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 Arbitrage Opportunity: Example
Expected Factor
• Given a single‐factor model, Portfolio return sensitivity
determine whether an A 6% 0.8
arbitrage opportunity exists B 8% 1.1
and arbitrage return, if any C 9% 1.2
• Answer: use two portfolios to replicate the third
• Construct portfolio D = 25% × A + 75% × C
– So, for D, factor sensitivity = 25% × 0.8 + 75% × 1.2 = 1.1
and expected return = 25% × 6% + 75% × 9% = 8.25%
– Portfolio B: 1.1 factor sensitivity, but 8% expected return
• Long D and short B  0.25% risk‐free return

LOS 48.b 9

Macroeconomic Factor Models

E , ⋯ ,
–E : expected return of asset A
– : surprise in th factor (e.g. unexpected interest rates)
• Factors represent “priced” risks, i.e. rewarded if exposed to factors
– , : asset’s factor loading/sensitivity to th factor
• Loadings/sensitivities found by regression on historical data
• Loadings/sensitivities higher for cyclical stocks and lower for non‐
cyclical stocks given different exposures to economy
– : asset‐specific return not explained by the factors

LOS 48.d 10

Fundamental Factor Models

int , ⋯ ,
– int : intercept term – average of all assets (no meaning)
– : factor return of th factor
• Return of factor‐mimicking portfolio estimated from cross‐
sectional regression of factor loadings vs. asset returns
– , : asset’s standardized factor loading to th factor
• Cross‐sectionally standardized asset‐specific attributes (e.g. ROE)
attribute , attribute
,
attribute
• Standardization makes no economic difference
– : asset‐specific return not explained by the factors

LOS 48.d 11

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 Active Return & Risk
• Active return = portfolio return – benchmark return

• Active risk = standard deviation of active return

1
, ,
1

• Active weight = portfolio weight – benchmark weight

Δ , , for th asset
– Note: ∑ Δ 0

LOS 48.e 12

Applications of Multifactor Models

• Return attribution
– Active return = factor return + security selection return
– Active factor return = ∑ , , ∙
• , : benchmark’s factor loading/sensitivity to th factor
– Security return (residual) = total – factor
• Risk attribution (active risk squared)
– = factor risk squared + specific risk squared
– Active specific risk = ∑ Δ ∙ ,
– Factor risk squared (residual) = total – specific

LOS 48.f 13

Applications of Multifactor Models

• Passive management
– Identifying and tracking index’s factor exposures
• Active management
– Predicting active return (alpha) using factors
– Managing risk in portfolios using (risk) factors
– Benefits of using factor‐based approach:
• Focusing on risks where the manager has comparative advantage
• Avoid risks that the manager is not able to bear
• Rules‐based algorithm active management
– Systematically applying factor‐based active management

LOS 48.f/g 14

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 Reading 49

Measuring and Managing Market

Risk

15

Value at Risk (VaR)

• VaR: best scenario among the worst scenarios
– at a given probability
– over a given period of time
• Methods of estimating VaR: 5%
– Parametric method: VaR5%
based on (co)variances, easier if assuming normality
– Historical simulation:
relying on a historical sample for possible outcomes
– Monte Carlo simulation:
creating scenarios repeatedly from an assumed probability
distribution of possible outcomes

LOS 49.a/b/c 16

Value at Risk (VaR)

• Example: calculate the 5% VaR if the distribution is
normal with mean $40k and
standard deviation $30k
– At 5% one‐tailed probability,
5%
critical z‐value = ±1.65 VaR5%
– VaR5% = $40k – 1.65 × $30k = –$9.5k
– This is parametric method
• Conditional VaR: expected loss given that loss
exceeds the VaR threshold
– Average across all the worst case scenarios specified by a
probability (over a given period of time)
LOS 49.c 17

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 Risk Assessment Methods
• Sensitivity analysis:
– Analyzing effects of changes in a variable
– Relevant for understanding individual risk factors
• Scenario analysis
– Analyzing effects due to simultaneous changes in multiple
variables
– Relevant for studying market conditions
– Either actual (historical) or hypothetical scenarios

LOS 49.f/h 18

Measuring Risk Exposures

• Beta – sensitivity to overall stock market (equity)
• Duration – sensitivity to interest rates (fixed income)
• Greeks (options):
– Delta – sensitivity of value to underlying price
– Gamma – sensitivity of delta to underlying price
– Vega – sensitivity of value to volatility of underlying
– Rho – sensitivity of value to risk‐free rate

LOS 49.g 19

Risk Measures
• Banks:
– Asset‐liability mismatches (and leverage)
– Market risk of investments (e.g. duration, convexity)
• Asset managers:
– Volatility of investment performance (and losses)
• Pension funds:
– Asset‐liability mismatches (and deficits)
• Insurers:
– Asset‐liability mismatches (and deficits)
– Sensitivity of investment portfolio to risk factors

LOS 49.j 20

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 Reading 50

Economics and Investment Markets

21

Asset Valuation
• Value = PV (expected cash flows) at discount rate
• Discount rate (required return) =
R+π+θ+γ+κ+φ
– R: real risk‐free return
– π: expected inflation
– θ: uncertainty in inflation
– γ: credit risk premium
– κ: equity risk premium
– φ: illiquidity premium
• Changes in expectations  changes in valuation

LOS 50.a/b 22

Short Rates & Economic Growth

• Inter‐temporal rate of substitution:
marginal utility of consuming 1 unit next year
marginal utility of consuming 1 unit now
– Zero‐coupon inflation‐indexed risk‐free bond, E

• Real risk‐free interest rate, 1

• Higher (lower) expected economic growth
– Higher (lower) expected future income
• Increased (decreased) consumption; decreased (increased) savings
– Lower (higher) vs. , or lower (higher)
– Higher (lower) real risk‐free rate, R

LOS 50.c 23

Created and developed by Michael Cao

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 Short Rates & Economic Growth
• cov ,
– cov , : risk premium due to sale price uncertainty
• cov , 0 for risk‐averse investors
– Higher (lower) expected future asset prices  lower
(higher) inter‐temporal rate of substitution
– Negative covariance  reduction on  risk premium

LOS 50.c 24

Term Structure of Interest Rates

• Yield curve & business cycle:
– Recession (expansion)
 Scarce (abundant) opportunities
 Low (high) short‐term interest rates
 Improving (deteriorating) future economic expectations
 High (low) long‐term interest rates
 Positively (negatively) sloped yield curve
• Term spread usually positive
– Attributed to uncertainty in inflation (risk premium θ)
• Break‐even inflation (BEI) rate = π + θ
– Yield spread between inflation‐indexed and non‐indexed

LOS 50.d/e 25

Credit Risk
• Credit spread (credit risk premium γ):
– Difference in yield between credit‐risky bonds vs. default‐
free bonds
• In economic downturn (expansion),
– Credit‐risky bonds increase (decrease) in yield by more
– Credit spread widens (narrows)
– Credit‐risky bonds underperform (outperform) default‐free
bonds
– Also, spreads for issuers in cyclical industries increase
(decrease) compared to non‐cyclical industries

LOS 50.f/g 26

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 Equity & Commercial Real Estate
• Equity and commercial real estate: both poor hedges
against bad consumption outcomes
– In worse state of economy, lower personal income amidst
lower investment returns
– Hence, risk premiums positive for equity and real estate
• Commercial real estate:
– Bond‐like characteristics: rental income stream
– Equity‐like characteristics: uncertainty in terminal value
– Illiquidity (i.e. exit timing/cost): risk premium φ

LOS 50.i/m 27

Reading 51

Analysis of Active Portfolio

Management

28

Active Return (Value Added)

• Two ways to measure (equivalent):
– Definition: ∑ , ∑ ,

– Based on active weights: ∑ Δ ∙

• Active return positive if Δ and positively related
• Decomposition (asset allocation + security selection):
Δ ∙ , , ∙ ,

– : number of asset classes

– Δ : active weight of th asset class, = , ,
– , : active return within th asset class, = , ,

LOS 51.a 29

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 Active Return: Example
• Measure value added (active return) and decompose
it into asset allocation and security selection returns
, , , ,
Fundamental equity 30% 45% 14.2% 12.9%
Quantitative equity 30% 35% 10.6% 16.8%
Fixed income 40% 20% 5.8% 6.1%
Total 100% 100%

• Value added: RA = RP – RB = 12.9% – 9.8% = 3.1%

– RP = 0.45 × 12.9% + 0.35 × 16.8% + 0.20 × 6.1% = 12.9%
– RB = 0.30 × 14.2% + 0.30 × 10.6% + 0.40 × 5.8% = 9.8%

LOS 51.a 30

Active Return: Example

• Measure value added (active return) and decompose
it into asset allocation and security selection returns
, , , , ∆ ,
Fundamental equity 30% 45% 14.2% 12.9% 15% –1.3%
Quantitative equity 30% 35% 10.6% 16.8% 5% 6.2%
Fixed income 40% 20% 5.8% 6.1% –20% 0.3%
Total 100% 100% 12.9% 9.8%

• Asset allocation (AA) + security selection (SS):

– AA = 0.15 × 14.2% + 0.05 × 10.6% + (–0.20) × 5.8% = 1.5%
– SS = 0.45 × (–1.3%) + 0.35 × 6.2% + 0.20 × 0.3% = 1.6%
– Total = 1.5% + 1.6% = 3.1%, as calculated via definition
LOS 51.a 31

Information Ratio
• Information ratio (IR) =

– Risk‐adjusted measure of value added (i.e. consistency)

• Altering aggressiveness of active weights (i.e.
expanding or shrinking active weights by a multiple):
– Active return multiplied by constant multiple
– Active risk multiplied by constant multiple
– IR unaffected
• Given active risk, IR determines active return
–E ∙
LOS 51.b/d 32

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 Optimal Combination
• Combine benchmark (total risk , Sharpe ratio )
and an active portfolio (active risk , information
ratio ) by maximizing combined Sharpe ratio
– Optimal active risk (aggressiveness):
∗
∙

– Total portfolio risk of combined portfolio:

– Maximized Sharpe ratio of combined portfolio:

LOS 51.b 33

Fundamental Law of Active Mgmt.

• Fundamental Law: ∙ ∙
– Equivalent: E ∙ ∙ ∙
– Information coefficient (IC)
• Correlation between forecast returns and realized returns
• Higher IC  better skill
• Market timing: IC = % correct – % incorrect (= 2 × % correct – 1)
– Transfer coefficient (TC)
• Correlation between optimal active weights (decision) and actual
active weights (portfolio)
• TC = 1 for unconstrained portfolios; TC < 1 with constraints
– Breadth (Br)
• Number of independent active bets per year
LOS 51.c/e 34

Fundamental Law: Example

• Max analyzes each quarterly financial report to make
a decision for each of the 20 stocks he covers with an
IC of 0.06. He is considering changing his strategy to
market timing 8 times per year. Given changes in
portfolio constraints, his transfer coefficient will
increase from 0.70 to 0.82. What is the accuracy rate
he would need to achieve to preserve his current IR?
• His current IR = 0.70 0.06 20 4 0.376
.
• Required new IC = 0.162
.
• 0.162 = 2 × % correct – 1  % correct = 58.1%
LOS 51.c/e 35

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 Reading 52

Algorithm Trading and

High‐Frequency Trading

36

Algorithmic Trading
• Algorithmic trading: automated trading strategy
• Execution algorithms: to minimize price impact of a
large order and to match benchmark price
– VWAP: based on trading volume distribution
– Implementation shortfall: considering slippage costs
– Market participation: segmented on pro‐rata basis
– Broker algorithms – two alternatives:
• Parent order transmitted via execution management system (EMS)
• Child orders by buy side sent through direct market access (DMA)

LOS 52.a/b/c 37

Algorithmic Trading
• Algorithmic trading: automated trading strategy
• High‐frequency trading (HFT) algorithms: to generate
profit from tracking high‐frequency streams of data
– Statistical arbitrage – taking advantage of spreads resulting
from breaks in correlated relationships between assets
• Examples: pairs trading, index arbitrage, spread trading
– Low end‐to‐end latency (lapse from stimulus to response)
• Speed of data, algorithm and order execution
• Physical connection and co‐location

LOS 52.a/b/c 38

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 Market Fragmentation
• Trading split across multiple venues
• Techniques to capitalize on market fragmentation:
– Liquidity aggregation: “super book” offering global‐
ordered view over all venues
– Smart order routing: sending order to relevant market(s)
with displayed quote

LOS 52.d 39

Impact on Markets
• Positive impacts:
– Lower market impact (and cost of execution)
– Improved market efficiency (less security mispricing)
– More competitive and more efficient trading venues
• Concerns:
– Unfair advantage via “front running” or unique data access
– Potentially exacerbating market dislocations
– Increased risk due to bad logic in unanticipated scenarios
– Increased load on systems of trading venues

LOS 52.f 40

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