CFA Level 3 Trade, Performance, Eval.

contrast return attribution and risk attribution; contrast macro and micro return attribution; (Trade, Per., Eval.) 26c

- Return attribution - effect of active portfolio management on the fund's investment returns - Risk attribution - effect of portfolio manager's active investment decisions on portfolio risk - Micro attribution - analyzes investment decisions at the PM's level - Macro attribution - analyzes investment decision at the fund sponsors' level

describe uses of the upside capture ratio, downside capture ratio, maximum drawdown, drawdown duration, and up/down capture in evaluating managers; (Trade, Per., Eval.) 27d

- Upside capture of over 100% indicates outperformance; it measures capture when the benchmark is positive - Downside capture of less than 100% indicates outperformance; measures capture when the benchmark return in negative - Capture ratio = Upside Capture/ Downside Capture; capture ratio greater than 1 indicates positive asymmetry and a convex return profile - Drawdown - peak to trough loss for a given period - Drawdown duration - total time from start of the drawdown until cumulative recovers to zero

describe types of asset-based benchmarks; (Trade, Per., Eval.) 26j

Absolute - Generally a minimum target return that has to be exceeded - Advantage - simple to understand - Disadvantage - not investable, do not satisfy benchmark criteria Broad Market Indices (S&P 500, etc.) Advantages - - well organized and easy to understand - Unambiguous and investable - Appropriate if it reflects managers investing style Disadvantages - Not appropriate if manager's style may deviate Style Indices (LC Growth, LC Value etc.) - Advantages - Widely available and understood - Disadvantages- Differing definitions of investment style can produce widely different benchmark returns Factor based models (such as using CAPM) - Advantages - Provides insights into managers styles - Disadvantages - May be ambiguous because different factor models can produce different outputs, and are not specified in advance, not investable Returns Based Benchmarks (Uses an investment algorithm that most closely solves for the investment style) Advantages - Meets the criteria of a valid benchmark - Useful when all you have are account returns Disadvantages - Enough monthly returns would be needed to establish a statically reliable pattern Manager universes Advantage - Measurable Disadvantages - Subject to survivor bias as underperforming managers go out of business - Fund sponsors who choose to employ manager universes must rely on the compiler's representations Custom security based Advantage - Allow fund sponsors to effectively allocate risk across IM teams Disadvantages - Can be expensive and there can be a lack of transparency

describe attributes of an effective attribution process; (Trade, Per., Eval.) 26b

An effective performance attribution process must: - Account for all of the portfolio's return or risk exposure - Reflect the investment decision- making process - Quantify the active decisions of the PM - Provide a complete understanding of excess return/ risk of the portfolio Micro Attribution - understanding the drivers of a manager's returns and whether those drivers are consistent with the stated process Macro attribution - conducted to evaluate the asset owner's (sponsor's) tactical asset allocation and manager selection decisions - To use an example a DB plan decides to allocate a given percentage to certain asset classes - Macro attribution measures the effect of the sponsor's choice to deviate from the strategic asset allocation - Micro attribution measures the impact of the selected manager's allocation and selection decisions on fund performance Returns based attribution - uses on the total portfolio return over a period to identify the components of the investment process Holdings based attribution - references the beginning of period holdings of the portfolio - Because holdings based attribution fails to capture the impact of any transactions made during the measurement period, it may not reconcile to the actual return Transactions based - uses both the holdings and transactions that occurred during the evaluation period.

evaluate a firm's trading procedures, including processes, disclosures, and record keeping with respect to good governance. (Trade, Per., Eval.) 25i

Any trade policy needs to include several key aspects. These include the following: Meaning of best execution - Term used by regulators to describe the best possible result for clients when trading their assets - Generally best execution does not mean just the lowest possible cost but involves achieving the right tradeoff between objectives - Firms should consider the following: execution price, trading costs, sped of execution, order size, nature of the trade Factors that determine the optimal execution approach - Urgency of an order - does the order need to be aggressive or can it be at a slower pace - Characteristics of securities traded - how liquid are they, are they standard or customized? - Characteristics of available execution venues - i.e. lit or dark - Investment objectives - i.e. short term or long term - Rationale for a trade - is a trade intended to capture a manager's expected return? Is it a risk trade or liquidity? List of eligible brokers and venues - Quality of service - does a broker provide competitive execution compared with an execution benchmark? - Financial Stability - Good reputation for ethical behavior - Adequate settlement capabilities - Speed of execution - Cost competitiveness - Willingness to commit capital Process for monitoring execution agreements - Trade submission - has the trading/ strategy been implemented consistent with investment process? - Is there a balance between trading costs and opportunity costs? - Could better execution have been achieved using a different strategy?

describe the three basic forms of performance-based fees; (Trade, Per., Eval.) 27h

Assets Under Management (ad valorem) Fees - Result from applying stated percentage rates to assets under management - Downside could be there is less incentive to take risks after you have a large AUM in order to retain assets Performance based fees are determined by portfolio returns and are designed to reward managers with a share of return for their skill in creating value. Performance based fees are structured in one of three basic ways: - Symmetrical structure in which the manager is fully exposed to both upside and downside (computed fee = base + sharing of performance) - Bonus structure in which the manager is not fully exposed to the downside but is fully exposed to the upside (Fee = higher of either Base or base plus sharing of positive performance) - Bonus structure in which the manager is not fully exposed to the downside or the upside (fee = higher of base or base plus sharing of performance to a limit)

describe problems that arise in benchmarking alternative investments; (Trade, Per., Eval.) 26l

Benchmarking Hedge Fund Investments Broad Market indexes - Hedge Funds may have an unlimited investment universe, vary substantially from one to another, can use leverage, sell assets short, and vary asset allocation over time. They also typically lack transparency and are difficult to monitor Risk Free Rate - This could be used with something like an arbitrage strategy when the additional spread on top of the rfr could be used to represent active management - However even those that target market-neutral strategies are not completely free of systematic risk Hedge Fund Peer Universes - Hedge fund peer universes suffer from survivorship bias - The risk and return characteristics of a strategy peer group is unlikely to be representative of the approach taken by a single fund - Hedge Fund performance are often self-reported and not confirmed by the index provider Real Estate Real Estate benchmarks exist but they are not suitable for real estate investments - Benchmarks are based on a subset of the real estate opportunity set and therefore are not fully representative of the asset class - Index performance likely to be highly correlated with return of largest fund data contributors - Benchmark returns are self-reported and may be inherently biased - Benchmarks place disproportionate emphasis on most expensive cities and asset types - Use of appraisal data could lead to smoothing - Lack of comparability of benchmark returns given some benchmarks use leverage while others do not - Indices assume no transaction cost Private Equity The normal metric used to grade PE investments is IRR. Several limitations to be aware of when comparing returns among managers: - Valuation methodology used by managers may differ - A fund's IRR can be meaningfully influenced by an early loss or an early win in the portfolio - The data are from a specific point in time, and companies in a fund can be at different stages of development Commodities - Benchmarks are usually based on futures as opposed to actual assets; - Different funds will have different degrees of leverage, indexes are typically delevered - Discretionary weighting of exposures within the index Managed Derivatives - Benchmarks are hard to find and may be too specific - Other benchmarks are based on peer groups which suffer from known limitations of peer-group based benchmarks including survivorship bias Distressed Securities - Due to lack of marketability and the illiquidity of distressed assets it is almost impossible to determine an appropriate benchmark

discuss tests of benchmark quality; (Trade, Per., Eval.) 26k

Characteristics of a valid benchmark - Specified in advance - benchmark must be constructed prior to the evaluation period so that the manager is not judged against benchmarks created after the fact - Appropriate - consistent with manager's area of expertise - Measurable - must be possible to measure on a reasonable frequency - Unambiguousness - securities and their weights should be clearly identifiable - Reflective of the manager's current investment opinions - manager should be familiar with constituent securities - Accountable - manager should accept ownership and be willing to be held accountable - Investable - must be possible to replicate and hold benchmark Portfolio = Benchmark + active Benchmark = market + style returns Style = Benchmark - Market Portfolio return can be broken up into 3 components: market, style, and active management Portfolio return = Market + Style + Active management Active return is the difference between manager's overall portfolio return and the style benchmark Excess return to style, difference between managers style index return and the broad market return

describe the components of a manager selection process, including due. (Trade, Per., Eval.) 27a

Due Diligence - Analysis and investigation in support of investment decisions The manager search and selection process has three broad components: the universe, a quantitative analysis of the manager's performance track record, and a qualitative analysis of the manager's investment process Defining the Manager Universe - - The objective is to reduce the manager universe to a manageable size relative to the resources and time available to evaluate it. - At the manager universe stage there should not be any performance assessment, but instead whether it is a good fit - There are several approaches to assigning a manager to a benchmark: third party categorization (database or software providers typically assign managers to a strategy sector), Returns based, Holdings based, Manager experience - A hybrid strategy that combines elements of each approach is recommended Quantitative Analysis - - Through performance attribution and appraisal, one can distinguish between managerial skills versus luck Qualitative Analysis - - What is the likelihood that the returns will continue in the future, and does the manager's investment process account for all relevant risks

contrast key characteristics of the following markets in relation to trade implementation: equity, fixed income, options and futures, OTC derivatives, and spot currency; (Trade, Per., Eval.) 25f

Equities - are usually traded on stock exchanges and dark pools. - Equity markets are the most technologically advanced; algorithmic trading is common and most trades are electronic - Large & urgent trades are high touch, large and non-urgent - trading algorithm Fixed income - usually done at a dealer based, quote driven market - market transparency and price discovery for fixed-income markets are generally much lower - There is limited algorithmic trading in bond markets except for on the run (most recently issues) US treasuries - Small trades and large & urgent trades - principal trades - Non - urgent trades - agency trades Exchange traded derivatives - Electronic trading is widespread for exchange traded derivatives, however algo trading is not as evolved as in equity markets - Market transparency is high and trade price, size, quote, and depth of book data are publicly available OTC derivatives - Historically have been opaque with little public data about prices, trade sizes, and structure details - Trading OTC takes place through dealers - Trade size is generally large - Large non -urgent trades are generally implemented by a high touch approach, where you attempt to match buyers and sellers directly - Large urgent trades are generally implemented as broker risk where risk is transferred to the broker who takes the contract into his inventory - Small trades and large & urgent trades - principal trades - Non - urgent trades - agency trades Spot foreign exchange (currency) - No exchange or centralized clearing place for the majority of forex trades - For large urgent trades, RFQs are generally submitted to multiple dealers - Large, non-urgent trades are mostly executed using algorithms such as TWAP Broker risk trades -Large blocks of securities requires a higher-touch approach involving greater human engagement and the need for a dealer or market maker to act as counterparty and principal to trade transactions. For these transactions, also called principal trades or broker risk trades, market makers and dealers become a disclosed counterparty to their clients' orders and buy securities into or sell securities from their own inventory or book, assuming risk for the trade and absorbing temporary supply-demand imbalances Agency trades - dealers may be unable or unwilling to hold the securities in their inventories and take on position (principal) risk. In agency trades, dealers try to arrange trades by acting as agents, or brokers, on behalf of the client. Summary: High touch agency trades are used in executing large block trades that are non-urgent very illiquid. Dealers attempt to arrange trades as a broker. DMA allows buy-side portfolio managers/traders to access the order book of the exchange directly through a broker's technology infrastructure.

compare types of investment manager contracts, including their major provisions and advantages and disadvantages; (Trade, Per., Eval.) 27g

Evaluation of Investment's Terms Liquidity - Closed end funds and ETFs have the highest liquidity - PE and VC funds have the lowest liquidity (investors are contractually obligated to contribute committed and wait for distributions) - HFs have lockup periods and gates - Because SMA assets are held in the investor's name, the securities in the portfolio can be sold at any time. As a result, and SMA's liquidity will depend on the liquidity of the securities Management Fees - Meant to cover operating costs (Personnel, technology, etc.)

discuss motivations to trade and how they relate to trading strategy; (Trade, Per., Eval.) 25a

Four trading strategies Profit Seeking - Trading is based on information not fully reflected in prices - To prevent information leakage, or the disclosure of information about their trades, active managers take steps to hide their trades by using less transparent trade venues - Greater trade urgency is associated with executing over shorter execution horizons. - Portfolio managers may execute their orders at prices nearer to the market if they believe the info. is likely to be realized in the near term - Alpha decay - refers to the erosion or deterioration in short-term alpha once an investment decision is made. - Value managers may hold securities for months or years, in this case minimal trading is required, and can be carried out in a patient manner Risk Management/ Hedging Needs - As the market and the risk environment change, portfolios need to be traded or rebalanced to remain at targeted risk levels or risk exposures - May be simple rebalancing, or may involve using derivatives - Liquid derivatives are more cost efficient - Managers may also trade to hedge risks when they do not have a view on the specific risk Cash Flow Needs - Caused by flows into or out of a fund - Collateral/ margin calls could require close to immediate liquidation, whereas a fund redemption due to longer-term client asset allocation changes might not require immediate liquidation - Inflows can be monetized with etfs/ futures - In most cases, client redemptions are based on the fund's net asset value, where the NAV is calculated using the closing price of the listing market, so a fund manager would want to trade at closing price; this reduces redemption price risk Corporate Action/ Margin Call/ Index rebalance - Cash needs also arise from margin calls for leveraged positions as PMs are asked to increase cash collateral - Index tracking funds need to be rebalanced as the index changes, as do long only funds using a market- weighted index as a benchmark - Cash dividends/ coupons have to be reinvestedd

analyze and interpret a sample performance-based fee schedule. (Trade, Per., Eval.) 27i

In the event of underperformance, base fee is still paid - Negative for investor Low manager revenue as a result of only base fee - Increases operational risk When managers can control the timing of profit realization, may have incentive to hold on to assets when a profit is earned If HF managers are below high water mark, they may have an incentive to return many and start up a new fund

evaluate a manager's investment philosophy and investment decision-making process; (Trade, Per., Eval.) 27e

Investment Philosophy: The investment philosophy is the foundation of the investment process. Every investment strategy is based on a set of assumptions about the factors that drive performance and manager's beliefs. Generally speaking there are two types of inefficiencies: - Behavioral inefficiencies (perceived mispricings created by the actions of other market participants, usually associated with biases, these are usually temporary) - Structural inefficiencies (perceived mispricings created by external or internal rules and regulations, these can be long lived) Active strategies typically make assumptions about the dynamics and structures of the market. It is important to evaluate: - Can the manager clearly and consistently articulate their investment philosophy? - Are the assumptions credible and consistent? - How has the philosophy developed over time? (Ideally it is unchanged through time vs. reaction to performance) - Are the returns linked to credible and consistent inefficiencies? (is it repeatable? Is it sustainable?) If the source is linked to a credible inefficiency, there is the issue of capacity. Overall capacity is the level, repeatability and sustainability of returns Investment Personnel: - Does the investment team have sufficient expertise and experience to effectively execute the investment process? - What is the level of key person risk? - What is the turnover of personnel and are there agreements and incentives to maintain them? Investment Decision making Process - Signal Creation (Idea generation) - Is the idea timely? Does it rely on unique information? Does the manager have a unique way of interpreting information? - Signal Capture (Idea implementation) - translating the investment idea into an investment position - Portfolio Construction - What kind of securities are used to construct the portfolio? Are there stop losses? How much of the portfolio can be liquidated in 5 days or less? Average daily volume by position? - Portfolio Monitoring - Monitoring looks at how external factors such as the economy and financial markets and internal factors such as performance impact the manager Operational Due Diligence An important aspect of manager selection is assessing the level of business risk - What is the ownership structure of the firm - What are the total AUM by strategy and firm AUM - Are any of the firm's strategies closed to new capital? - How much capital would the firm like to raise? - What are the compensation arrangements? - Has the firm been involved in any lawsuits?

discuss uses of liability-based benchmarks; (Trade, Per., Eval.) 26i

Liability based benchmarks focus on the cash flows that the asset must generate. These are most often used when the assets are required to pay a specific future liability. - They allow the asset owner to track the fund's progress toward fully funded status - Or if fully funded, to track the performance of assets relative to changes in liabilities In investment practice we use benchmarks as: - Reference point for segments of the sponsors portfolio - Communication of instructions to the manager - Identification and evaluation of the current portfolio's risk exposures - Interpretations of past performance and performance attribution - Manager selection and appraisal - Marketing of investment products A liability - based benchmark focuses on the cash flows that the asset must generate. To best determine how a liability based benchmark should be constructed, the manager first needs to understand the features of the plan. The following features influence the structure of the liability - Average number of years to retirement - Percentage of workforce that is retired - Average participant life expectancy - Whether the benefits are indexed to inflation - Whether the plan offers an early retirement option - Whether the plan is a going concern (i.e. plans will eventually terminate if the sponsor has exited its business)

identify and interpret investment results attributable to the asset owner versus those attributable to the investment manager; (Trade, Per., Eval.) 26h

Macro Attribution - I.e. sponsor may select multiple PMs to manage against specific mandates within a given asset class - Attribution analysis that we use to determine the impact of these fund sponsor decisions is sometimes called macro attribution Micro attribution - Attribution of the individual PM decisions is sometimes called micro attribution - To evaluate the decision of the manager you can perform the Brinson analysis i.e. allocation, security selection, interaction.

contrast Type I and Type II errors in manager hiring and continuation decisions; (Trade, Per., Eval.) 27b

Null hypothesis is that the manager doesn't provide any value Type 1 is incorrectly rejecting the null hypothesis and hiring or retaining a manager who subsequently underperforms expectations - Type 1 is an error of commission, an active decision that turned out to be incorrect, creates explicit costs - Type 1 errors are more transparent to investors, since they entail the regret of an incorrect decision but the pain of having to explain to an investor Type 2 is an error of omission, or inaction; null hypothesis is not rejected where there was in fact value added; - not hiring or firing a manager who subsequently outperforms or performs in line with expectations - Type 2 errors are less transparent to investors, unless the investor tracks fired managers The smaller the difference in sample size and distribution mean between skilled and unskilled managers and the wider the dispersion of the distributions, the smaller the expected cost of Type 1 or Type 2 errors. More efficient markets are likely to exhibit smaller differences in distributions of managers indicating a lower opportunity cost.

discuss inputs to the selection of a trading strategy; (Trade, Per., Eval.) 25b

Order characteristics Order -related considerations include the following: - Side - whether you're buying/ selling; a list that contains only buys or sells has greater market risks than one with offsetting exposures - Size - number of securities traded; Larger order size creates greater market impact in trading and take longer to trade - Relative size - order size as a percentage of daily volume Security Characteristics - Security Type - Type of security being traded: ETFs/ ADRs, underlying securities - Short Term Alpha - The expected price movement in the security over the trading horizon; alpha decay is the erosion in ST alpha that takes place after the investment decision has been made. - Price Volatility - more volatile securities will have higher execution risk; Execution risk is the risk of an adverse price movement occurring over the trading horizon. - Security Liquidity - This affects how quickly the trade can be executed, in addition to the expected trading cost, and is a significant consideration in determining trade strategy; Greater liquidity decreases execution risk and trading costs Market Characteristics Inputs relating to market conditions include the following: - Liquidity crises: Deviations from expected liquidity patterns; During market events or crises, the volatility and liquidity of the market and the security will be critical to consider as conditions result in sudden deviations - Market volatility and liquidity are generally negatively related Trading Cost Risk Aversion - Risk aversion is specific to each individual and in a trading context, it refers to how much risk the PM or trader is willing to accept during trading - PMs with higher risk aversion will tend to trade more urgently Market Impact and Execution Risk - Market impact cost of trading an order is the often short-lived impact on security price from trading to meet the need to buy or sell - Execution risk - the risk of adverse price movement during the trading horizon due to a change in the fundamental value of the security arises as time passes - Trade too fast - increased market impact - Trade too slow - increased execution risk/ market risk - More liquid securities have lower levels of market impact and execution risk given that they can be transacted over shorter time horizons with greater certainty

evaluate the skill of an investment manager. (Trade, Per., Eval.) 26p

Performance attribution analysis - Tells us how the outperformance was achieved, distinguishing stock selection from country allocation Appraisal Measures Use techniques to review past periods of performance and risk.

explain the following components of portfolio evaluation and their interrelationships: performance measurement, performance attribution, and performance appraisal; (Trade, Per., Eval.) 26a

Performance evaluation includes three primary components: Performance measurement - Calculates both the return and risk of the portfolio over a specified time typically relative to a benchmark Performance attribution - determines the key drivers that generated the accounts performance. - What portion was driven by active manager decisions - Decompose risk and return Performance appraisal - determines whether the performance was affected primarily by investment decisions, by the market, or by chance; makes use of risk, return, and attribution analyses to draw conclusions regarding quality of a portfolio's performance These help to answer three questions - What performance did the fund achieve during the period? (performance measurement) - How did the manager achieve their performance or that risk was incurred? (attribution) - Did the fund manager achieve their performance via skill or luck? (appraisal)

compare benchmarks for trade execution; (Trade, Per., Eval.) 25c

Pretrade - a reference price that is known before the start of trading. These include: - Previous close - security's closing price on the previous trading day - Opening price - security's opening price for the day; often used as a proxy for decision price for fundamental PMs who are investing in a security for LT growth (opening price does not have overnight risk, all subsequent events are priced into the opening price) - Arrival price - price of the security at the time the order is entered into the market for execution; used by PMs buying or selling on the basis of alpha expectations or a current market mispricing as a benchmark - Decision Price - security price at the time the PM made the decision to buy or sell Intraday - based on a price that occurs during the trading period - VWAP - volume weighted average price of all trades executed over the day or the trading horizon; PMs who are rebalancing their portfolios over the day with both buy and sells may prefer VWAP - TWAP - equal weighted average price of all trades executed over the day or trading horizon, does not consider volume; PMs may choose TWAP when they wish to exclude potential trade outliers Posttrade benchmarks - is a reference price that is determined at the end of trading or sometime after trading has completed - Closing price - typically used by index managers and mutual funds that wish to execute transactions at the closing price for the day; An advantage is that it provides PMs with the price used for fund valuations and thus minimizes tracking error. Price target benchmarks - PMs seeking short-term alpha may select an alternative benchmark known as price target. - Good if a manager believe a stock is undervalued by .50 and will therefore attempt to purchase below the specified target price

describe factors that typically determine the selection of a trading algorithm class; (Trade, Per., Eval.) 25e

Principal trades - the executing broker assumes all or part of the risk related to trading the order, pricing it in her quoted spread; in general trading in larger blocks of securities requires a higher-touch approach - Crossing an order with a broker's own book is known as a broker risk trade or principal trade Large block trades and not urgent or very illiquid, agency trade is appropriate Agency trades - broker is engaged to find the other side of the trade but acts only as an agent - Tries to cross match with other clients orders Liquid, standardized trades with order driven markets - Trading done electronically with multiple venues - For trades other than large orders Algorithmic trading - computerized execution of the investment decision following a specified set of instructions, typically slices orders into pieces and trades across venues - Is well established in most equity, foreign exchange, and exchange traded derivative markets - In fixed income, algorithmic execution is mostly limited to highly liquid government securities - Trading algorithms are typically used for two purposes - trade execution and profit generation Profit seeking Algorithms - Determines what to buy and sell and then implements these decisions in the market as efficiently as possible Execution algorithm Classifications 1. Scheduled algorithms - Scheduled algorithms are appropriate for relatively small orders (5-10% of adv) in liquid markets for managers with less urgency and/or who are concerned with minimizing the market impact. - PM generally also has no expectation of momentum, and has a greater tolerance for longer execution when using scheduled algos POV - Sends orders following a volume participation schedule - As trading volume increases in the market these algorithms will trade more shares - Investors specify participation rate, i.e. if they only want 10% of the market volume until completion while POV algorithms incorporate real-time volume by following (or chasing) volumes, they may not complete the order within the time period specified. - POV relies on current market data, while VWAP is on historical trends VWAP - Slice order into smaller amounts to send to the market following a time slicing schedule based on historical intraday volume profiles - These typically are higher at the open and the close - Following a fixed schedule as VWAP algorithms do, however, may not be optimal for certain stocks because such algorithms may not complete the order in cases where volumes are low. - VWAP is unsuitable when: urgency is high, order size is a large percent of volume, large bid ask spread. - low spread, low % of adv, not urgent = VWAP - TWAP - TWAP will send the same number of shares and the same percentage of the order to be traded in each time period. - This helps ensure the specified number of shares are executed within the specified time period 2.Liquidity Seeking Algorithms - - Trade faster when liquidity exists at a favorable price - These algorithms may trade aggressively with offsetting orders when sufficient liquidity is posted on exchanges. - They may use dark pools and trade large quantities in dark venues when liquidity is present - Appropriate for large orders that the PM would like to execute quickly without substantial impact 3.Arrival Price - Seeks to trade close to current market prices at the time the order is received for execution - Will trade more aggressively at the opening, known as a front loaded strategy - Used for orders where the trader believes the prices are likely to be unfavorable during the trading horizon - Best when the security is relatively liquid and the order is not expected to have significant market impact 4.Dark Strategies - Execute shares away from lit markets, and instead execute in opaque, or less transparent, trade venues, such as dark pools - Used when PMs are concerned with information leakage and when order size is large/ VWAP or arrival price would lead to significant impact - Dark strategies are also appropriate for securities that are illiquid with wide bid ask spreads - PM does not require full execution Smart Order Routers - Determine how best to route an order given prevailing market conditions. SOR will determine the destination with the highest probability of executing the limit order and the venue with the best market price - Market orders - SOR are best used for orders that require immediate execution because of imminent price movement - Appropriate for securities traded on multiple markets (otherwise there wouldn't be any smart order routing) - Appropriate for small orders Small trades are usually implemented using DMA. DMA allows buy-side portfolio managers/traders to access the order book of the exchange directly through a broker's technology infrastructure.

evaluate the execution of a trade; (Trade, Per., Eval.) 25h

Proper trade cost evaluation enables PMs to better manage costs throughout the investment cycle and helps facilitate communication between the PM, traders and brokers Trade cost calculations are expressed such that a positive value indicates underperformance - Cost ($) = side x (average price - reference price) - Cost (bp) = side x ((price - reference price)/ Price ) x 10,000 bps - Side: buy order = +1, sell order = -1 VWAP/ TWAP / Arrival costs/ Market on Close - VWAP cost = side x (average price - vwap)/ vwap x 10^4 bps - TWAP cost = side x ((average price - twap)/ twap) x 10^4 bps - Arrival cost (bps) = side x ((average price - price when submitted)/ price when submitted ) x 10^4 bps - Market on close cost = side x ((average price - close/ close) x 10^4 bps For TWAP of VWAP for example, the average price is what your fund traded on that security. If it is lower than VWAP/ TWAP it indicates outperformance Index cost = side x ((Index VWAP - Index arrival price)/Index arrival price) x 10^4 Market adjusted cost = Arrival cost (bps) - Beta x Index cost (bps) arrival price = decision price = benchmark price; Arrival cost in bps is: ((average price paid - price when decision was made to place order)/ price when decision was made to place order) x 10^4 bps Added value (bps) = arrival costs (bps) - estimated pre-trade cost (bps) Allows traders to be evaluated against what costs were assumed to be

interpret the sources of portfolio returns using a specified attribution approach; (Trade, Per., Eval.) 26e

Return attribution - set of techniques used to identify the sources of excess return of a portfolio against its benchmark, quantifying the consequences of active investment decisions Geometric excess return = (portfolio return - benchmark return) / (1 + benchmark return) Brinson Model attribution effects Allocation effect - Refers to the value the portfolio manager adds (or subtracts) by having portfolio sector weights that are different from benchmark weights - Allocation effect (BB) = (W portfolio - W benchmark) * benchmark return for the sector - Allocation effect (BF) = (W portfolio - W benchmark) * (Benchmark sector return - benchmark return for the whole portfolio) - For BF when looking at allocation you can overweight to a negative, but still have a positive allocation if it is less negative than the benchmark. This isn't the case with BB Security Selection - Benchmark weight x ( Portfolio return - benchmark return) Interaction effect - This is the residual amount - Interaction effect = (weight of the investor's portfolio (sector) - benchmark weight(sector)) ( investors return (sector)- benchmark return (sector)) all summed. Carhart Model - Alpha + - beta * High minus low (difference between average return on high book to market portfolios - low book to market portfolios) + - sensitivity to factor * SMB (small minus big market cap) factor + - sensitivity to factor * WML (winner - losers), momentum factor equal to difference between last years winners and losers + - sensitivity to factor * RMRF - return on value weighted equity index above the 1 month t bill SMB (Small minus Big, -1 is large caps outperforming), RMRF ( return on a value weighted index in excess of the one month t bill), HML (High minus low, high book-to-market portfolios minus the return on low book-to-market portfolios, lower indicates growth, higher indicates value),

describe returns-based, holdings-based, and transactions-based performance attribution, including advantages and disadvantages of each; (Trade, Per., Eval.) 26d

Returns based attribution - regressions are used to analyze the performance over some period. No attempt is given to identify the holdings - Most appropriate when underlying portfolio information is not available - Easiest to implement - least accurate - Vulnerable to data manipulation - Returns-based attribution is the least accurate of the three attribution approaches. This technique does not use underlying holdings and is most vulnerable to data manipulation Holdings based attribution - Returns based won't take into account any changes in that were made after the initial period so could be good in identifying style drift - Good for strategies with low turnover (i.e. passive strategies) - Accuracy improves when data has shorter time intervals - Drawbacks: may not reconcile to portfolio return, fails to capture impact of transactions - All transactions are assumed to occur at end of day Transactions based - improves upon the holdings based returns by adding any subsequent trades. This is the most reliable of the trading measures - Difficult and time-consuming to implement - Most accurate

discuss considerations in selecting a risk attribution approach; (Trade, Per., Eval.) 26g

Risk attribution identifies the sources of risk in the investment process Bottom up - - Relative - security's marginal contribution to tracking risk - Absolute - position's marginal contribution to total risk Top down - Relative - attribute tracking error to relative allocation and selection - Absolute - Factor's marginal contribution total risk and specific risk Factor based - - Relative - Factor's marginal contribution to tracking error and active specific risk - Absolute - Factor's marginal contribution to total risk and specific risk

describe limitations of appraisal measures and related metrics; (Trade, Per., Eval.) 26o

Sharpe Ratio A key drawback with the ratio is that the denominator does not differentiate between volatility that is upside versus downside. Therefore, with the Sharpe ratio, there is a penalty for all volatility, even if it is "good" volatility. Treynor Ratio The Treynor ratio is only useful in evaluating portfolios that have systematic risk and do not have unsystematic risk; in other words, such portfolios are well diversified. Sortino Ratio for investments that have nonsymmetrical or skewed return distributions, such as hedge funds or options, the Sortino ratio appears to be a more appropriate performance metric. However, a comparability problem exists with the Sortino ratio because the determination of MAR is subjective and specific to each investor.

calculate and interpret the Sortino ratio, the appraisal ratio, upside/downside capture ratios, maximum drawdown, and drawdown duration; (Trade, Per., Eval.) 26n

Sharpe Ratio - - Excess return over the risk free rate divided by standard deviation - One of the weaknesses is that the use of standard deviation as a measure of risk assumes investors are indifferent between upside and downside volatility Treynor Ratio - - Portfolio return - risk free/ Beta - The usefulness of the Treynor ratio depends on whether systematic risk or total risk is most appropriate in evaluating performance Information ratio - - mean returns - benchmark/ variability of performance with the benchmark - Appraisal ratio - active return/ portfolio's tracking risk Appraisal Ratio (aka Treynor Black Appraisal Ratio) - It is the annualized alpha divided by the annualized residual risk (non-systematic risks). Both the alpha and the residual risk are computed from a factor regression - Alpha/ standard error of regression - Alpha can be calculated as the portfolio return - (rfr + Beta (Market return - risk free) Sortino - - only considers the standard deviation of the downside risk; Equation is portfolio return - minimum acceptable return/ downside deviation (semi-standard) - The Sortino ratio is arguably a better performance metric for such assets as hedge funds or commodity trading funds, whose distributions are purposely skewed from normal - Semi standard deviation is the sum of the difference between the target return and the actual return for every value below the target return. Each of these values is squared. You would then sum up everything and take the squared root Capture Ratios - - Measure the manager's participation in up an down markets - If a portfolio is up 10% and the Benchmark is up 5%, then the capture ratio is 10%/5% or up 200%, this was then be divided by the downside capture ratio - Upside/ downside capture ratio simply divides the two, looking for a value greater than 1 (positive asymmetry, concave return profile). Negative asymmetry is less than 1. Drawdown ratio - - Maximum drawdown is measured as the cumulative peak to trough loss during a continuous period. - Drawdown duration is the total time from start of the drawdown until the cumulative drawdown recovers to zero. - Recovery typically takes longer than drawdown

describe uses of returns-based and holdings-based style analysis in investment manager selection; (Trade, Per., Eval.) 27c

Style analysis based - uses key risk factors to estimate the portfolio's sensitivity to the security market indices. To be useful style analysis must be: - Meaningful (risk reported must represent the important sources of performance return and risk) - Accurate (reported values must reflect actual risk exposures) - Consistent (methodology must allow for comparison over time and across managers) - Timely (Report must be available in a timely manner so it can be used for investment decisions) Returns based style analysis - top-down approach that involves estimating a portfolio's sensitivities to security market indexes - This works best for publicly traded investments with frequent pricing data - Involves estimating the portfolio's sensitivities to security market indices representing a range of distinct factors - Drawback - it is an imprecise tool. This limits ability to identify impact of dynamic investment decisions. - The portfolio being analyzed might not reflect the current or future portfolio exposures especially those portfolios with illiquid holdings - Adv. - Doesn't require a large amount of data and is not subject to window dressing Holdings based style analysis- bottom up approach that estimates the risk exposures from the actual securities held in the portfolio at a point in time. - Drawback is the increased computational complexity and it is subject to windows dressing - The extra effort can be challenging for hedge fund, PE and VC managers that may be averse or unable to provide position level pricing

interpret the sources of portfolio returns using a specified attribution approach; (Trade, Per., Eval.) 26e (Brinson Fachler)

The Brinson-Fachler (BF) model differs from the BHB model only in how individual sector allocation effects are calculated. Clearly if the PM is overweight in a negative market that has outperformed the overall benchmark, the allocation effect should be positive. The BF model solves this problem by modifying the asset allocation factor to compare returns with the overall benchmark as follows: Allocation = (wi - Wi)(Bi - B) Security Selection = Wi(Ri - Bi) Interaction = (wi - Wi)(Ri - Bi) Ri is the performance for that individual segment Bi is the benchmark Return of the sector B is the benchmark return of the portfolio benchmark wi is the fund weight Wi is the benchmark weight Brinson Fachler rewards when: - Return of the sector > return of benchmark (when you overweight the sector) - Return of the sector < return of benchmark (when you underweight the sector) BHB rewards when: - Return of the sector > 0 (when you overweight the sector) - Return of the sector < 0 (when you underweight the sector) - BHB views allocation from an absolute positive or negative perspective

recommend and justify a trading strategy (given relevant facts); (Trade, Per., Eval.) 25d

The primary goal of any trading strategy is to balance the expected costs and risks associated with trading the order in the market consistent with PM's objectives, risk aversion and constraints. Short Term Alpha Trade - Given the possibility of short term price increases, the trader does not have the option of trading passively (i.e. TWAP, VWAP) - Can use an arrival price methodology that attempts to execute shares close to market prices at the time the order was received - Arrival price could be executed using a programmed strategy to electronically execute Long Term Alpha Trade (Fixed Income) - Scenario: You think a company whose bonds you own has a deteriorating credit position. - The trader may not want to execute quickly because it may leak information, or could result in unfavorable pricing - A reasonable trade approach would be to sell securities off gradually over the course of a few days or even weeks depending on the relative size of the bond holdings and their liquidity. Risk rebalance - Objective - rebalance hedge exposure - Execution method: TWAP algorithm Client Redemption Trade - Liquidate the holding to meet client redemptions - Execution - Following a strategy to receive a guaranteed closing price on all orders submitted eliminates risk to the fund since the client is receiving proceeds at NAV (from a fiduciary standpoint, however, trading in a manner that will lead to poorer execution is inappropriate) - Executing such a large sell at close may lead to significant price decline New Mandate Trade - When you are just given money to invest in a certain manner i.e. tracking the Russell 2000 - You can get immediate exposure by buying futures while beginning to build underlying stock positions over time and unwinding the futures. - Two considerations: futures may not have closing auctions, and the futures based strategy assumes the fund's investment mandate allows use of derivatives

evaluate the costs and benefits of pooled investment vehicles and separate accounts; (Trade, Per., Eval.) 27f

There are two broad options for implementing investment strategies: individual separate accounts and pooled (or commingled) vehicles) Pooled Investment Vehicles (Mutual Funds, ETFS) - Incremental costs of adding additional investors is relatively low - Trading costs are lower - Higher liquidity Separate Accounts - Disadv. Have higher transaction costs since trades can't be pooled, and higher costs to set up a new account - Disadv. Customization leads to tracking risk relative to a benchmark - Adv. Allow for customization, tax efficiency (no capital gains taxes as a result of liquidity events in other accounts)), greater transparency in reporting (real time position level data) - Adv. Investor owns the individual securities directly, this approach provides safety should a liquidity event occur

interpret the output from fixed-income attribution analyses; (Trade, Per., Eval.) 26f

Three common methods of fixed income attribution include Exposure decomposition (duration based) - seeks to explain active management of a portfolio relative to its benchmark, by working through a hierarchy of decisions. These decisions might include: - Duration bets (increase duration relative to benchmark in anticipation of falling rates) - Yield curve positioning (barbell for a flattening curve) - Sector bets(i.e. gov., corp., overweight credit in anticipation of spreads narrowing) Yield curve decomposition (duration based)- estimates the return of securities, sector buckets, or YTM buckets using the known relationships between duration and changes to YTM: % total return = % Income Return + % Price return Where % price return = - Duration x change in YTM - Estimates the returns based on duration, will have a residual for returns not accounted for - This requires more data points than exposure decomp. To calculate the separate absolute return attribution analysis. It exchanges better transparency for operational complexity. Yield curve decomposition (full re-pricing) - Instead of estimating price changes from changes in duration and YTM, bonds can be repriced from zero coupon curves (spot-rates) - The full repricing approach provides more precise pricing and allows for a broader range of instrument types and yield changes - Most complex of the three

explain how trade costs are measured and determine the cost of a trade; (Trade, Per., Eval.) 25g

Total costs of trading can be measured using implementation shortfall - Mathematically IS is calculated as = paper return - actual return Implementation Shortfall can be broken down into the following parts - Execution Costs - due to executing a trade at a less favorable cost than the reference amount - Fixed Fees - any explicit commissions or fees - Opportunity costs - Cost of not trading any unfulfilled portion More commonly, the IS is expressed as a fraction of the total cost of the paper portfolio trade in bps. Expanded Implementation Shortfall Decomposes execution cost further into two categories: - Delay Cost - arises when the order is not submitted to the market in a timely manner and the asset experiences adverse price movement, making it more expensive to transact - Trading Cost - Calculated as the ending price of the security minus the execution price paid on shares executed

describe the impact of benchmark misspecification on attribution and appraisal analysis; (Trade, Per., Eval.) 26m

True active return = P - normal portfolio benchmark Misfit active return = P - investor benchmark When benchmarks are mis specified, subsequent performance measures will be incorrect, both the attribution and appraisal analyses will be useless Sometimes, benchmarks are chosen for the wrong reasons. Underperforming managers have been known to change benchmarks to improve their measured excess return