CFA 2022 Portfolio Management

Defined contribution plan

A pension plan in which employer will contribute to the pension fund but does not promise future value of the plan; employees take investment risks

Modern portfolio theory

A theory on how risk-averse investors can construct portfolios to optimize or maximize expected return based on a given level of market risk, emphasizing that risk is an inherent part of higher reward.

Investment policy statement (IPS)

A written planning document that describes a client's investment objectives and risk tolerance over a relevant time horizon, along with constraints that apply to the client's portfolio

Jensen's alpha

Actual Rp - E(Rp) at portfolio beta = Treynor measure * portfolio beta + Rf - E(Rp)

Fama and French model

B(Market) + B(Size)+ B(book to market Value)

Belief perseverance biases

Conservatism, confirmation, representativeness, illusion of control, and hindsight biases

The expected return of the leverage portfolio

Ep = Wb Rb + (1-Wb) * E(Rm); Rb is the borrowing rate and Wb is the borrowing weight in -VE; points on CML below market portfolio is lending portfolio; above is borrowing

Return-generating models: single index model (aka CAPM: capital asset pricing model)

Expected return = Rf + Beta * (market risk premium)

Market model

Expected return = alpha + beta(Rm) + specific return; alpha = Rf (1-beta); when specific return is not zero, the security has abnormal return

Carhart

Fama and French model + B(momentum)

Tactical asset allocation

Form of active management; the decision to deliberately deviate from the strategic asset allocation in an attempt to add value based on forecasts of the near-term relative performance of asset classes

Type of returns

Gross: total return without any deduction Net: return with manager/admin fees deducted Nominal: return with manager/admin, taxes, interests, and dividends deducted Real: = nominal/inflation

Capital market theory

Investors have homogeneous expectations for all RISKY assets in an efficient market, including the same 1) efficient frontier of risky assets; 2) an optimal risky portfolio (aka market portfolio) represented by local stock index; 3) same capital market line

M-squared

M2 = portfolio return = sharpe ratio * market risk + Rf; represent the market-rate adjusted return at market risk; alpha is M2 - Rm; alpha > 0 means portfolio outperform at market risk

Mental-accounting bias

Money is treated differently depending on how it is categorized >> neglecting opportunities to reduce risk by combining assets with low correlations

Factors to consider during portfolio planning

RRTTLLU 1) Risk tolerance: conform to the lower of the client's ability/willingness to bear risk; resolution is needed when ability/willingness contradict; 2) Return objectives: absolute or relative to benchmark (bearing tracking risk/error; 3) Time horizon; 4) Tax exposure; 5) Liquidity needs (note that PE has low liquidity high risk); 6) Legal constraints; 7) Uncertainties and preferences: ethical/religious preferences, diversification needs

Measures to use when portfolio is exposed to both systematic and non-systematic risks...

Sharp ratio and M-squared alpha

Regression analysis for beta

The regression of Security return over market return; security beta is the slope

Strategic asset allocation

The set of exposures to IPS-permissible asset classes that is expected to achieve the client's long-term objectives given the client's investment constraints; the optimal investor portfolio with highest utility on the client's capital allocation line

Security characteristic line (SCL)

a plot of a security's expected excess return over excess market return; slope is beta

Execution stage in PM

after client accepts IPS, set asset allocation and purchase assets in the most cost-efficient way

Two-fund separation theorem

all investors regardless of taste, risk, preferences, and initial wealth will hold a combination of two portfolios or funds: one risk-free and one optimal risky portfolio

Load of the fund

annual fees, transaction fees, upfront fees...etc. no-load funds only charge for annual fee

Framing bias

answer a question differently based on the way it is framed/presented

Pairwise correlations within asset classes...

are generally higher than correlations among asset classes; high in the same class and low among different classes

Emotional biases

based on feelings or emotions; harder to manage than cognitive errors; includes loss aversion, overconfidence, self-control, status quo, endowment, and regret aversion biases

Illusion of control bias

believe can control outcome but actually not; infer non-existing causal connections and have certainty in prediction; lead to poor diversification and very detailed financial models to control uncertainties

Beta calculation

beta = correlation * security risk over market risk = covariance over market variance

Open-ended MF

can invest/withdraw by issue/retire shares at NAV at the time of action; shares outstanding can change; trades at NAV; easy to grow but hard to manage in/out CFs so not fully invested to keep cash for redemptions not covered by new investments; trade once a day, no short/margin; dividend reinvested; higher entry than ETF

Close-ended MF

cannot invest/withdraw to/from the fund; buy/sell existing shares to other investors; trades at premium/discount of NAV depending on demand; shares outstanding will not change

Endowment bias

consciously inactive; asset is perceived as special and more valuable just because its already owned; "Would you buy the same asset at its current price?"

Regret aversion bias

consciously inactive; inaction due to fear that actions might lead to regret >> causes herding/fomo and go with consensus or popular opinion

Planning stage in PM

consider RRTTLLU in IPS: risk tolerance, return objectives, time horizon, tax exposure, liquidity needs, legal constraints, unique circumstances/preferences

The market...

consists of all risky assets; not all assets are tradable, and not all tradable assets are investable

Markowitz efficient frontier

contains all portfolios of risky assets that rational, risk-averse investors will choose; decreasing rise in return when investor take more risks

For large asset numbers with equal weights and average variance/covariance...

contribution of variance gradually decrease as N gets larger; covariance among assets accounts for all the portfolio risk when N gets larger >> approaching mean COV

When comparing returns of different time frame...

convert to annualized return

Lower correlation between holdings in portfolio...

equals better diversification; correlation increases during market crash

Kurtosis

fat tails or higher than normal probabilities for extreme observation to occur; higher/wider curve than that of normal distribution

Cognitive errors

faulty cognitive reasoning; include belief perseverance biases and processing errors

Loss aversion bias

feeling more pain in loss than pleasure in gains at the same level >> excessive trading, early exit, or keep holding losing positions in hope of bouceback

Passive management

follow SAA and rebalance

Security Market Line (SML)

graphical representation of the expected return-beta relationship of the CAPM; slope is equal to market risk premium

Processing errors

illogical or irrationally process information; flaws in how information is processed

Appendices in IPS

include 1) strategic asset allocation to explain weights and hedging risk; 2) rebalancing policy

Statement of duties and responsibilities in IPS

include duties and responsibilities of the client, the custodian of the client's assets, the investment managers...

Investment guidelines in IPS

information about how policy should be executed (ex: use of leverage/derivatives; existing constraints; asset classes to exclude)

Banks

institutional investor with the highest liquidity needs

Bond MF

invest in LT bonds (>1yr) and sometimes preferred shares

Money market MF

invest in ST (<90d) treasury bills, certificates of deposit, commercial papers; high liquidity with return in money market rates

Core-satellite approach

invest in both passively and actively managed portfolios to minimize offsetting active positions and unnecessary trading

Client's distinctive needs are most linked to...

investment objectives section and constraints in the investment guideline section in IPS

IPS

investment policy statement, documented in planning stage of PM; specifies benchmarks for portfolio

Mutual funds

investment pool in which each investor has claim on the income and value of the fund; NAV is computed daily based on the closing price of the securities in the fund

Capital market expectations

investor's expectations concerning the risk and return prospects of asset classes; form a correlation matrix among asset classes

Self-control bias

lacking disciplines and focus on ST satisfaction over LT goals

Hedge funds

loosely regulated and not required to report as common companies; private investment vehicles using leverage, derivatives, long/short strategies; not readily available to common investors; high entry with restricted liquidity (quarterly withdrawals) and fixed-term commitments; low correlation with traditional asset classes; management fees, performance incentive (portion of capital gains)

Feedback stage in PM

maintenance, review/update IPS and target allocation, rebalance portfolio; evaluate performance against benchmark return

PE

make a few large investments to take company private; reorganize firm to increase CF and reduce debt to increase equity; sell the firm / IPO

VC

make many small investments (startups) and expect few with large returns while most other fails; grow company to increase value; sell the firm / IPO

Representativeness bias

make premature conclusions based on flawed assumptions; base-rate neglect (rate in larger population is neglected in favor or specific information); sample-size neglect (use small sample size to represent large population)

Utility

measure of relative satisfaction of the investor to a portfolio; +ve A = risk aversion; -ve A = risk seeking

Time-weighted return

neutralize the effect of CF on return to evaluate fund performance

Systematic risk

non-diversifiable risk an investor must bear to earn return; in reverse the investor will not take risk if not compensated

Confirmation bias

only notice new information that supports prior beliefs and avoiding conflicting views; closely related to overconfidence

Conservatism bias

overweight prior beliefs and underreact to new information >> hold assets for too long or reluctant to update portfolio

Defined benefit plan

pension plan that guarantees a specified level of retirement income; employer takes investment risk with high income needs

Risk-aversion is best illustrated by...

positive relationship between risk and return

Endowments and foundations

provide ongoing and perpetual financial support to programs (endowment) or charity (foundation)

Availability bias

put emphasis on readily available information

Holding period return

rate of return over a given investment period

Anchoring and adjustment bias

related to conservatism; rely on initial information to make subsequent estimates and decisions

Capital allocation line

represents the portfolios available to investor considering utility and risk appetite

Arithmetic return

return earned in an average period over multiple periods

Minimum-variance portfolio

risk-averse investor only invest in portfolio on the minimum-variance frontier for the minimum risk at the given expected return

Money-weighted return

same as IRR; for CF-sensitive return calculation

Risk budgeting

sets overall risk limit for portfolio; for portfolio, passive management is systematic risk and tactical asset allocation and security selection both add risk to portfolio

Diversification ratio

standard deviation of equally weighted investments / standard deviation of a randomly chosen security; lower is better

Total variance is the sum of

systematic and non-systematic variances

indifference curve

the combinations of risk-return pairs that an investor would accept to maintain a given level of utility; the trade-off between the expected rate of return and variance of the rate of return

Covariance and correlation

the extent to which the returns of the two assets move together over time; covariance shows no magnitude >> use correlation ranging from -1 to 1

Geometric mean return

the mean return computed by finding the equivalent return that is compounded for N periods

Optimal risky portfolio

the portfolio at the tangential point between the capital allocation line and the efficient frontier of. risky assets

Optimal investor portfolio

the portfolio at the tangential point between the capital allocation line and the indifference curve

global minimum-variance portfolio

the portfolio with the least variance among all risky assets; investor cannot hold portfolio with risky assets that has less risk than the global minimum-variance portfolio

Within CAPM, the returns of assets vary only by...

their systematic risk represented by beta; assets with the same beta will have the same expected return

Hindsight bias

think past events are predictable and reasonable to expect >> overconfident in prediction; unfairly assess performance of managers

Status quo bias

too lazy to change even when change is warranted; inaction due to inertia

ETF

trades like a stock; intraday transaction, can short/margin; dividend paid as cash; low entry; trade at premium/discount to NAV

Overconfidence bias

underestimate risk and overestimate return; lead to poor diversification; self-attribution; prediction and certainty overconfidence

The dominant capital allocation line is the...

use of leverage and the combination of risk-free asset and the optimal risky portfolio

Treynor measure

(Rp - Rf) over portfolio beta; the slope of the SML for the portfolio; steeper than market SML >> outperform at given level of systematic risk

Sharpe ratio

(Rp-Rf) over portfolio risk; the slope of the capital allocation line for the portfolio/security; steeper than CML >> outperform at given level of total risk

Portfolio beta

weighted sum of the individual holding's beta in portfolio

CAPM assumptions

1) investors are risk averse, rational, and wants the highest utility; 2) frictionless market with not transaction costs/tax/restrictions; 3) investors plan for the same single holding period; 4) homogenous expectations; 5) infinitely divisible investments; 6) investors are price taker as trades do not alter price

Issues with active management

1) managers benchmark against the same index leads to offsetting positions that cancel out active returns; 2) excessive and unnecessary trading leads to higher taxes/expenses

Limitation of CAPM

1) single factor/period only; 2) do not consider assets that are not investible such as human capital, closed economies etc >> true market unobservable; 3) use of proxy for market portfolio such as S&P500; 4) beta is historical >> limited representation for present/future economic conditions; 5) beta is time-period sensitive; 6) weak empirical support for CAPM >> systematic risk is not the only factor; 7) in real life investors have different optimal risky portfolios

Non-systematic risk

Diversifiable risk; infinite demand in an efficient market leads to zero return

Measures to use when portfolio is exposed to systematic risk only (well-diversified)...

Treynor measure and Jensen's alpha