Portfolio Management Final

***look at ford problem in ch.9 ppt**

**solution in ppt**

** study problems at end of ch.12 ppt**

**solutions in ppt**

Active Management

-Actively pursues opportunities in the market to add return -Objective to produce sufficient return to overcome additional transaction costs while controlling risk -Takes deliberate and sometimes sizeable mismatches to risk factors including credit spreads, yield curve, and (to a lesser extent) duration

Concerns of Alternative Assets w/Private Wealth clients

Tax issues Suitability (liquidity and multiple time horizons) Communication with client regarding complex investments and strategies Decision risk - changing strategies at point of maximum loss Client ownership of a concentrated equity position in a closely held company (suitability of private equity)

Advantages of Direct Real Estate Investment

Tax subsidies for some expenses Ability to leverage using mortgages Control premium due to ability to take needed action related to properties Low geographic correlation between investments (east Vs West etc). Low volatility compared to equities

Characteristics of Commodity Investments

Unusually low correlations to stocks and bonds Determinants of return include: -Sensitivity to business cycle (supply and demand) -Convenience yield (ability to time consumption - when crop is ripe, how are the economic conditions?) -Real options (ability of producers to increase or reduce production based on prices) Hedge against inflation (particularly for storable commodities such as oil and metals) Risk diversifier

Empirical Evidence of Factors & Behavioral Biases

Value, Momentum (form of growth) Quality & Size all outperform over the long term due to behavioral biases: Value: risk premia: Expectations turned too low, reversion to the mean. Pitfall: Value trap. Momentum: Investors underappreciate the initial good news. Earnings drift upward: Pitfall: High expectations can not be met and when momentum doesn't work, it crashes hard. Quality: Continuing compounding (5% eps growth per year). Pitfall is Anchoring: (will it always grow @5% or will an inflection hit). Size: Small stocks outperform due to risk premia (compensated for higher risk). Pitfall: Need long term.

Passive or Full Indexing

Exposure to entire market, cheaper, lower turnover (also tax advantage). Negatives: buying last years winners, exposure to entire market, no ability to take active overweights or underweights. Difficult to implement in Fixed income.

Immunization Strategies

-Changes in interest rates affect both reinvestment income and portfolio value -Immunization strategies "lock in" total return over a given time horizon by finding the portfolio in which the two total return factors exactly cancel each other out -To immunize a single period, the portfolio must have: >duration equal to the investment horizon >Initial present value of cash flows equal to the present value of the future liability

Role of Alternative Assets in a Portfolio

-Diversification & Uncorrelated to traditional assets. -Exposure to risk factors not easily accessible through stock and bond investments (real estate and long-only commodities) -Exposure to specialized investment strategies (hedge funds and managed futures) -A combination of the above (private equity and distressed securities)

Pure Bond Indexing

-Goal is to produce a portfolio that perfectly matches the benchmark portfolio -Owns all bonds in same proportion as index -Difficult and expensive to implement due to illiquidity and infrequent trading of many bonds -Rarely attempted due to difficulty, inefficiency, and high cost to implement. Lehman Agg has 10,300 securities.

Portfolio Leverage

-Leverage magnifies the return on a portfolio -If earn less than cost of borrowing, returns are harmed -Repurchase agreements (repos) are arrangements to sell a set of securities and buy them back at a pre-specified date and price -Repos offer lower-cost borrowing for issuers and higher returns for lenders compared to Treasuries

Equitizing a Long-Short Portfolio

-Market neutral long-short portfolio can be given equity market exposure (equitized) by holding a stock index futures position and rolling over futures contracts -May establish a long futures position with notional value equal to cash position resulting from short sales -Appropriate when want to achieve market exposure while maximizing alpha due to manager skill -Over periods longer than a single futures contract, ETFs may represent a more efficient way to equitize

Hamilton Lane Presentation Takeaways

-Private Equity: investments in assets or financial instruments that are not listed on an exchange > purchases of family owned/private companies, take-privates, growth capital for early stage companies -Investors/limited partners provide capital for the fund -PE firm/general partners manage the fund -Process 1. Capital Commitment 2. Investment period 3. Harvesting period-cash or stock disbursed to the investors -PE strategies: • Create/develop new companies or new technologies • Acquire growth companies in fragmented industries • Restructure, refocus or revitalize inefficient operating companies • Lend to companies unable to borrow from banks -buyout, venture/growth equity, credit, real assets, secondaries, co-investments Primaries: • Represent the core of a private markets portfolio • Diversification across time, geography, and strategy, not an "indexed approach" • Access to top-tier managers as the foundation of the portfolio • Use managers and strategies as building blocks • Target sub-strategies to refine portfolio to meet investment objectives Secondaries • Effective portfolio management tool • Mitigate J-curve by purchasing at a discount • Mature assets with strong liquidity profiles • Shorter fund life reduces portfolio duration • Existing investments eliminate blind pool risk Co-Investments • Investing alongside core managers in their area of expertise • Deal flow driven by primary fund allocation • Potential for enhanced returns • Cost effective way to invest in private markets- no fees to GP • Add targeted exposure to specific industry, geography, and vintage year In the U.S. there are over 20,000 private companies with annual revenues over $100 million vs. approximately 3,000 public companies with the same annual revenues • Fundraising reached peak levels in 2017 for the third consecutive year • Despite record levels, private markets fundraising has only averaged 1.7% of MSCI World market cap since 2006. All of the private markets capital raised in 2017 wouldn't be enough to buy all of Apple's stock Keys to Private Equity Manager Success: -Low Purchase Price/Higher Sale Price • Structure/Financing • Earnings Improvement • Strategic Reorientation How to exit an investment -IPO • Strategic/Financial Sale • Merger • Refinancing why invest in private equity • Historical out-performance vs. public markets • Access to private, less efficient market • Portfolio diversification Considerations • Illiquidity • Blind pool investment • Transparency/Valuations • Fees A longer-term asset class, private equity may be suitable for investors who are able to make capital commitments over a multiyear period. Embracing Data & Technology> Data advantage adds real value and drives benefits for our clients > enhancing transparency, providing industry insights to clients, partnering with cutting edge tech providers.

Factors Determining Repo Rate

-Quality of collateral - higher quality, lower rate -Term of the repo - longer term, higher rate -Delivery requirement - physical delivery reduces default risk, leads to lower rate -Availability of collateral - buyer of securities (lender of funds) may accept a lower rate if the underlying securities are hard to get -Prevailing interest rates - repo rates are typically tied to Fed Funds rate -Seasonal factors - some institutions have seasonal factors that affect their supply of and demand for funds

Common Features of Alternative Investments

-Relative illiquidity, which requires a corresponding return premium -Improved diversification relative to stocks and bonds (lower correlation) -High due diligence costs due to complex investment structures, specific expertise, and lack of reporting transparency -Difficulty appraising performance due to complexity of establishing benchmarks

Enhanced Indexing by Matching Primary Risk Factors

-Uses a sampling approach with the objective of matching primary index risk factors and earning a higher return -Primary risk factors include changes in interest rate levels, twists in the yield curve and changes in credit spreads -Sampling reduces construction and maintenance costs, typically more than offsetting the higher tracking error compared to full replication -Reaction to macro events will be similar to the benchmark, but manager can add value by finding undervalued bonds

The Role of Equities

-represent a significant source of wealth and percentage of total investable assets worldwide -Domestic and international ____ markets offer diversification benefits -Common _____ offer better inflation protection than conventional bonds -Comparatively high long-term real rates of return. Ave is 10% (extremely LT average)

Alternative Asset Due Diligence

1) Market opportunity - what is it and why is it there? 2) Investment process - who is best and why? 3)Organization - Are all the pieces in place and stable? 4) People - are they trustworthy? 5) Terms and structure - are they fair? Are interests aligned properly? 6) Service providers - who (auditors, attorneys) supports them? 7) Documents - understand the prospectus 8) Write-up - formal recommendation

S&P 500 index weights

10 largest holdings =21.8% of total net assets Microsoft, apple, alphabet, amazon, berkshire hathaway, facebook, j&j, jpmorgan, exxon, bank of america

sector/quality effect

Ability to select the right issuing sector and quality group Estimated by repricing each security using average yield premium in each category to calculate gross return Sector/quality effect is difference between external effect and interest rate management effect from this return

Types of Benchmarks

Absolute return: -Can be an objective, but is not investable and therefore does not satisfy benchmark critieria Manager Universes: -Performance of average manager fails all benchmark criteria other than measurability Broad market indexes (S&P 500, R1000, R2000, EAFE): -Meet many criteria for benchmark and are suitable for core approaches -May not be appropriate if manager does not pursue a broad style Style indexes: -Well known, easy to understand and widely available (Russell 1000 Value, Russell 1000 Growth) -Some weight securities or sectors more highly than managers would consider prudent -Style definition may be ambiguous or inconsistent with the manager's investment process Custom security based (ex ecommerce tech names - not tech sector or all companies based in Houston): Manager's research universe weighted in a particular fashion that reflects manager's weighting style Meets all benchmark criteria Is useful for performance evaluation Can be expensive to construct and maintain Since not composed of published indexes, lack of transparency can be a concern

Popular Trends & Fads Constantly Emerge

Active Management Can Get out in Front look at what has been successful and then underweight them going forward bc it'll change

Components of Portfolio Return

Active return - the difference between the portfolio and its benchmark (alpha) Style - the difference between the benchmark portfolio and the market index Market return - the return on the market index (beta)

Equity Manager Fee Structures

Ad valorem - percentage of value of assets under management (also called assets under management or AUM fees) Performance based - shared percentage of the return in excess of benchmark Performance based fees often include: -High water mark requiring cumulative outperformance since previous fee paid -Fee cap limiting total fee paid to limit incentive to take undue risk Ad valorem fees are more predictable for investor, but performance fees better align manager interests (though poor performance and loss of incentives could also cause staff turnover or other practical obstacles)

Real Estate Investment Characteristics

Asset with intrinsic value Rental income increases stability of returns Lack of liquidity High transaction costs Heterogeneity Immobility Low information transparency Driven by population growth and interest rates Generally a good inflation hedge.

Hedge Fund Due Diligence

Authenticity of reported performance is doubtful and risk monitoring is difficult Due diligence includes learning: -Structure (legal entity, manager, domicile, regulatory registrations, personnel, support providers) -Strategy (style, instruments, benchmark, niche, holdings) -Performance data (all funds since inception) -Risk (measurement, controls, use of leverage) -Research (changes due to past findings, efforts, budget and personnel) -Administration (lawsuits, turnover, disaster recovery) -Legal (fee structure, lock-up, subscription amounts, drawback) -References (professional, other investors)

Growth Investing Style

Believe future earnings growth justifies higher current P/E ratio. Requires market to continue paying a premium for the greater growth prospects Risk / Pitfalls: that expected growth fails to materialize. Can high expectations be met? Traditional Growth metrics: EPS growth, Sales G, price Momentum, Earnings revisions.

Differences Between VC and Buyout Funds

Buyout funds are usually highly leveraged Buyout cash flows to investors come quicker and are often more stable Returns to VC investors are subject to greater measurement error VC is generally earlier in the investment cycle of a company

Limitations of VaR

Can be difficult to estimate, and estimation methods can lead to significant differences Can create false sense of security Often underestimates severity of worst-case returns Fails to incorporate positive results (incomplete picture)

Direct Investments in Commodities

Cash purchase of physical commodities (agricultural products, metals, oil) Exposure to markets via derivatives (futures) Can require possession, storage, financing, insurance and transportation of commodities

Enterprise Risk Management

Centralized risk management at senior management level Takes a firm-wide perspective Considers risks both in isolation and interplay Should control sensitivity of earnings to stock market fluctuations, interest rates, exchange rates and commodity prices Should also control exposures to credit and default risk, asset/liability management, operational systems, fraud and other factors

Risk Adjusted Performance: The Sharpe Ratio

Compares excess returns to total portfolio risk, measured as standard deviation of portfolio returns Numerator is difference between portfolio return and risk-free rate Denominator is standard deviation of portfolio returns May identify manager as not-skillful when Treynor measure/alpha suggests skill if manager accepts large amounts of non-systematic risk

Hedge Fund Structure

Compensation based on management fee (1-2%) and incentive fee (15-20% of excess returns) High water mark represents level that must be exceeded before next incentive fee can be paid. Ie. 15% is HWM so anything > 15% hedge funds get 20% of profit > than this. High fee structure criticized when providing beta exposure, but possibly justified as an insurance premium if adds diversification benefit May include a lock-up period before investment can be withdrawn

Flows to Passive, Especially into ETFs, Will Create Active Opportunity

Cumulative flows: US Domestic Equity Mutual Funds and ETFs. We believe passive trend is unsustainable.

Types of Real Estate Investments

Direct investment in residences, business real estate and land Indirect investment: -Companies engaged in development, ownership or management (homebuilders, real estate operating companies) -Real estate investment trusts (REITs) - public equities representing pooled investments -Commingled real estate funds (CREFs) - professionally managed vehicles for substantial pooled accounts -Separately managed accounts -Infrastructure funds - make private investments in public infrastructure projects (airports, schools, etc)

Dislocated markets

Dislocations occur when financial markets, operating under stressful conditions, experience large, widespread asset mispricings Barclays Aggregate and 30 yr UST had positive Q4 returns when other indexes were all negative > benefits of diversification

Stages of Private Company Financing

Early-stage financing Seed capital - small amounts to form company and prove idea Start-up - commercialization of product pre-revenue First stage - additional funds if needed (and merited) Later-stage financing Financing promising companies needing funds to expand sales Exit Merger, acquisition or IPO Give Google Example from the book

Fixed Income Returns

Effect of Interest Rate Environment -Fixed income prices inversely related to interest rates Effect of Active Management - Factors that affect the nominal spreads to the yield curve -Sector weighting -Credit quality -Individual security differentials

Trading activity

Effect of sales and purchases over a given period Total portfolio return less all other components

Indirect Investments in Commodities

Equity in commodity producers Does not effectively provide exposure to commodity price movements Companies may hedge exposure

Types of Hedge Fund Investments

Equity market neutral - offsets long positions in stocks with equal short positions to eliminate systematic risk exposure (beta) Convertible arbitrage - attempts to exploit anomalies between stock prices and the prices of instruments convertible into stock Fixed income arbitrage - predict changes in term structure or credit ratings (typically market-neutral through short positions) Distressed securities - Exploit inability or lack of desire of most investors to participate in bankruptcy dealings Merger arbitrage - captures price spread between market price and price offered by an acquirer Hedged equity - holds long and short positions while remaining net long Global macro - exploits major systematic moves in markets through currencies, futures and option contracts Emerging markets - focus on less mature investment markets Fund of funds - invests in a number of other hedge funds

Private Equity Benchmarks

Events indicating change in market value occur infrequently (financing, IPO, acquisition or failure) Cambridge Associates and Thomson Venture Economics provide overall indices for VC and buyout funds Typically calculate IRR based on cash flows since inception Appraisals are estimates by the venture capitalist, and can be stale Often compare firms by vintage year (the year in which the first influx of investment capital is delivered to a project or company) to assure comparability across financing stages and macroeconomic influences

Value at Risk (VaR)

Financial industry's premier risk management technique besides Standard Deviation. Probability based measure of loss potential from the level of a transaction up to the total enterprise Estimated loss (in money terms) that could be exceeded (minimum loss) at a given level of probability Lower probability will equate to higher potential loss, all else equal $1 million daily VaR at 5% means 5% chance of losing at least $1 million in one day (or 95% chance that one day's losses will be lower than $1 million

Types of Private Equity Investments / VC

Financing private businesses Leveraged buyouts of public companies Distressed debt investments Financing of public infrastructure projects

Bottoms-up Approach to Security Selection

Focuses on company-specific fundamentals or factors Identify factors by which to screen the investment universe Collect further information on companies passing the screen Identify those that constitute potential investments based on other company-specific criteria

Top-Down Approach to Security Selection

Focuses primarily on macroeconomic factors or investment themes What themes are affecting the global economy How do the themes affect various sectors and industries Are there any special country or currency considerations Which stocks within the industries or sectors will most likely benefit

Importance of Performance Evaluation

For Fund Sponsor -Provides exhaustive quality control check -Enhances effectiveness of investment policy by acting as feedback and control mechanism -Identifies an investment program's strengths and weaknesses -Helps focus attention on poorly performing operations -Provides evidence to trustees that program is conducted in an appropriate and effective manner For Investment Manager -Helps monitor the efficiency of various aspects of the portfolio construction process

Credit Risk of Forward Contracts

Forward contracts require commitments from each counterparty, from which the party owing the larger amount could potentially renege Prior to expiration, credit risk is only potential since no money is due Risk borne by party that will benefit from the contract (the one with a positive claim)

Active Indexing

Fundamental research, specific exposure and active weightings, potential to generate alpha, PMs respond to changing capital market expectations. Generally more expensive option, can have negative alpha

Equity Index Futures

Futures contracts available that can be exchanged for physicals, with the physical being the basket of stocks represented by an index Equity index futures are often purchased by portfolio managers who want to hedge against potential losses. If a portfolio manager has positions in a large number of stocks, index futures can help hedge the risk of declining stock prices by selling equity index futures. Since many stocks tend to move in the same general direction, the portfolio manager could sell or short an index futures contract in case stocks prices decline. In the event of a market downturn, the stocks within the portfolio would fall in value, but the sold index futures contracts would gain in value offsetting the losses from the stocks. The fund manager could offset all of the downside risks of the portfolio, or only partially offset it. Exchanging futures for physicals sharply reduces transaction costs Facilitates risk management for many market participants S&P 500, Russell 2000, etc

Risk Adjusted Return: The Information Ratio

Generalized form of the Sharpe ratio with active return in the numerator and active risk in the denominator Active return is difference between portfolio return and benchmark return Active risk is the standard deviation of active return Measures reward earned by manager for each unit f risk created by deviation from benchmark holdings

Estimating VaR Using the Historical Method

Graphs actual daily returns from user-specified past period in a histogram If have 1,000 observations, the 1% and 5% probabilities would be of a loss greater than the 10th or 50th-worst, respectively Reflects historical results, not future Should adjust for moving investment horizon Advantage is that it is nonparametric (doesn't need probability distribution assumptions) Disadvantage is that future could differ greatly from past

Modern types of alternative investments

Hedge funds (macro, hedged, AA, leveraged). Managed futures (we are not covering this but know names) Distressed equities (not covering, know name)

Limitations of Hedge Fund Benchmarks

Hedge funds often promoted as absolute return vehicles, which have no direct benchmark but alpha estimates must be made in relation to a benchmark -Is alpha generated benchmark-specific? -Does alpha take into consideration all systematic risks faced by the portfolio? Most databases are self-reported - are they neutral/accurate? Survivorship bias due to poorly performing managers exiting the database Stale prices may distort correlation measures Backfill bias (A variation of the survivorship bias that results from inclusion of a new hedge fund into a given index and its past performance is 'backfilled' into the index's database. In other words, this bias occurs when the performance of a fund is added to database listings months or even years after inception. new managers usually are entered into a database after a period of good performance, when entry seems particularly alluring. During periods of bad performance, fewer managers join databases, and therefore bad performance is rarely backfilled into the averages.)

Risks of Investing in Emerging Market Debt

High volatility Negative skewness of returns Lack of transparency Lack of legal and regulatory structure Tendency to over-borrow with little help in event of default

Historical High Yield Spreads & Default Rates (BBB- and >)

Highest default rate in financial crisis was 15% - so if you owned bonds BBB- and less you would expect 15% of those to default current high yield default rate = 2.82% In December, the U.S. speculative grade default rate was 2.82% which was the ninth consecutive month below 4%. The average since 1980 is 4.41%. The market is forecasting a decline during the first half of 2019 and then slowly rising to 3.43% by December 2019. The volume of upcoming maturities appears to be manageable based on recent new issue figures from the past few years.

Interest Rate management

How well the manager predicts interest rate changes Calculated by subtracting aggregate return of Treasury universe from aggregate return of portfolio repriced to risk free rate Can be further broken down into duration, convexity and yield-curve shape change components

Characteristics of Private Equity Investments

Illiquid - no secondary market Long-term commitments required Higher risk relative to public equities High expected IRR required (25-30% target) can be nice benefit to stock & bond portfolio Limited information (especially for venture capital funding of novel ideas) Low correlation with stocks and bonds and less correlated

Disadvantages of Direct Real Estate Investment

Indivisibility (each property can be a large portion of total portfolio) High information costs due to property uniqueness High brokerage commissions High operating and maintenance costs, need for expertise Risk of neighborhood deterioration Political risk surrounding tax advantages

Measuring Risk Adjusted Return Using the Sharpe Ratio

Industry standard measure Sharpe ratio = (Mean portfolio return - risk free rate)/Standard deviation of portfolio return) Mean excess return for unit of volatility Can be inaccurate when applied to portfolios with nonlinear risk (such as option exposure)

Socially Responsible Investing > ESG (environmental, Social, Governmental)

Integrates ethical or societal concerns with investment decisions Typically uses stock screens Negative screens to exclude undesirable characteristics (such as gambling, tobacco, etc) Positive screens to include desirable characteristics (such as high labor standards or good corporate governance) Particular screens employed reflect client concerns Can introduce unintended consequences, as excluding polluters (energy and utilities) may introduce a growth bias Should choose a benchmark that reflects the exclusions

Structure of Private Equity Funds

Limited partnerships or LLCs -Expected life of 7-10 years with options for additional 1-5 -Objective is to realize full value by liquidation date -LP or LLC taxable at shareholder level (no corporate double-taxation) -No liability beyond initial investment -Do not usually maintain pools of uninvested capital but receive commitments that they "take down" to make investments or pay expenses -Manager fee is 1.5-2.5% per year, plus carried interest

Alpha and Beta Separation

Long only active portfolio has exposure to beta (market return) and alpha (manager skill) Long-short market neutral portfolio designed not to have beta exposure Can get beta inexpensively from an indexed portfolio and explicitly pay for alpha generated from a long-short portfolio Allows mixing of alpha and beta - if benchmark is efficient and offers little alpha opportunities it can be gained from long-short managers using another benchmark (portable alpha-portable alpha is a strategy that involves investing in areas that have little to no correlation with the market.) Broadens opportunities to gain alpha Separates fees for (cheap) beta and (expensive) alpha

The Role of Real Estate in a Portfolio

Low correlation (high diversification) relative to stocks and bonds Income enhancements through rentals Increased Sharpe ratio for REITs Improve diversification relative to stocks and bonds but may be redundant to portfolios also containing hedge funds and commodities Low correlation within real estate (geographic diversification or sector diversification such as apartments versus office)

Advantages of Investing in Emerging Market Debt

Low correlation = favorable diversification Increasingly earning investment grade ratings Has been resilient to multiple financial crises Can react quickly to negative economic events by cutting spending and raising taxes Access to lenders such as IMF and World Bank Large foreign currency reserves

Time Weighted versus Money-Weighted Return

MWR represents average growth rate of all money invested, while TWR represents growth of a single unit invested MWR is sensitive to timing of external cash flows, TWR is not affected Time weighted return is preferable for evaluating a manager who does not have control over the size or timing of cash flows, and is generally required by GIPS MWR may be more appropriate in circumstances where manager can influence cash flow size and timing, such as private equity funds that take down commitments for specific investments Money manager prefers time weighted

Long-Short Investing

Many portfolios prohibited from short sales Value added by manager is called alpha If short sales are permitted, manager can effectively contribute two alphas Market neutral strategy designed to have no beta, and alpha uncorrelated with market returns can be combined with various sources of beta (portable alpha) Can have twice the negative alpha when stock selections go the wrong way Leverage can magnify alpha but increases risk that short-term movements force manager to unwind positions

Identifying Financial Risk Exposures

Market risk Interest rates, exchange rates, stock and commodity prices How will these affect asset/liability management Credit risk Loss caused by missed payment from debtor or counterparty Can be managed using credit derivatives or traditional credit analysis Liquidity risk Inability to efficiently buy and sell Can change during investment horizon

Money-Weighted Rate of Return (MWR)

Measures compound growth rate in the value of all funds invested in the account over the evaluation period Equivalent to internal rate of return (IRR) MWR is the growth rate that solves: -MV1 = MV0(1+R)m + CF(1+R)m-L(1) + ... + CFn(1+R)m-L(n) where: M = number of time units in the subperiod L(i) is the number of time units by which the ith cash flow is separated from the beginning of the evaluation period

Value Investing Style

More concerned about stock's relative cheapness than about its growth prospects Look for low price relative to earnings or book value Traditional Metrics: PE, P/BV, EV/EBITDA, Div Yield, P/S, P/NAV Rationales: -Earnings tend to revert to mean, presenting opportunities when earnings are temporarily depressed -Investors overpay for "glamour" stocks, presenting opportunities elsewhere Risks / Pitfalls -Stocks may be cheap for a good reason the investor does not appreciate (sears, Kroger, Macy's). Is there a secular or cyclical impairment. Value TRAP???? -Correction of mispricing may require longer time than investment horizon

Buyout Funds (Blackstone, KKR etc)

Much larger market segment than venture capital Mega-cap funds take public companies private (levis public, private now public again). Mid-market funds purchase private companies or divisions of public companies (GE) Can add value by restructuring, opportunistically buying below intrinsic value or capturing gains from adding or restructuring debt. - take costs out and leverage up the balance sheet Can realize gains through IPO, sale or dividend recapitalization (borrowing to pay a special dividend). Buy low, restructure and sell high.

Predictive Power of Past Performance

Must include disclaimer that "past performance is no guarantee of future results" Studies indicate that few managers consistently remain in top quartile Consistency of performance is important - same level of performance more highly valued if comes from consistent people and process Past Performance is No Guide > Forward Looking Assessment and Insight Required

US Fixed Income Demand

Mutual funds and pension funds used to be the largest buyers but now there's broad based demand from domestic and foreign investors. overall demand has shifted to domestic investors 1/3 is corporate bonds

Real Estate Benchmarks

National Council of Real Estate Investment Fiduciaries (NCREIF) Property Index for direct investments -Value-weighted, quarterly reported -Nonlevered return, more representative of private real estate funds -Appraisal method leads to stale valuations and appearance of smoother performance NAREIT (National Ass. of RE Investment Trusts) Index for indirect investments -Real-time cap weighted -Levered, higher standard deviation than NCREIF

Identifying Nonfinancial Risk Exposures

Operational risk - loss from failures in systems and procedures or external events (JPM London Whale ex). Model risk - incorrect or misspecified valuation models (option models that don't pick up the volatility changes). Settlement risk - one counterparty in process of settling account while other is declaring bankruptcy. Counterparty Risk Regulatory risk - uncertainty regarding regulation of transactions Legal/Contract risk - Potential loss from legal system failing to enforce a contract Tax risk - uncertainty associated with tax laws Accounting risk - uncertainty regarding how to record transactions and potential rule changes Sovereign and Political Risks - regime changes or risk that sovereign borrower defaults

Calculating Portfolio Return

Percentage change in market value over a period of time, after accounting for external cash flows (contributions and withdrawals) If no external cash flows, return = difference between ending and beginning value, divided by beginning value With cash flow at beginning of measurement period: r= MV1-(MV0+CF)/MV0+CF With cash flow at end of measurement period: r=(MV1-CF) -MV0/MV0

Components of Performance Evaluation

Performance measurement - what was the performance Performance attribution - why did the performance occur Performance appraisal - was the performance due to luck or skill

The Equity Style Box

Popular way of looking at style Separates universe into nine cells in a matrix according to: -Capitalization (small, mid, large) -Style (value, core, growth)

Managing Credit Risk

Position limits - limit exposure to a given party Marking to market - periodically marking forward contracts to market can reduce credit risk by making smaller interim payments Collateral - margin requirements to cover expected losses Netting - only one party (with larger obligation) pays (the difference) Credit standards - Dealing only with qualified counterparties Credit derivatives - transfer risk to another party

Treasury yield curve

Positive Slope = term premium, negative Slope is a possible recession indicator. Yield curve is generally upward sloping Right now flat yield curve Inverted yield curve- 30 yr is earning less than 2-5 year > indicator of a recession

Steve's Insights

Preservation of capital is key: -50% means +100% to get it back, -70% means +230% Trees don't grow to the moon. Law of large numbers (Apple Example). Show spaghetti chart. 4 most dangerous words in investing are: "This time its different" i.e. tech bubble. Timing is everything: Right idea but wrong timing means you are toast. MSFT in 2000 different than in 1997 or 2002. Set aside some risk chips to have fun with. Have some cash ready (dry powder to be ready to take advantage of opportunities. 80%-90% of the time, go for singles maybe doubles. 10-15% go for the HR if the opportunity presents itself. Markets can stay more irrational than investors can stay solvent. (timing Again).

Emerging Market Debt Appears Attractive

Russia, Indonesia yields are 5% Us yields are 0% Some are negative yields

Estimating VaR Using the Monte Carlo Method

Produces random outcomes to examine effects of particular set of risks Uses a probability distribution for each variable of interest Can use normal or nonnormal distributions Often the only practical means of generating needed risk management information Can require extensive commitments of computer resources with large portfolios

Advantages of VaR

Quantifies potential loss in simple terms Widely accepted by regulators Versatile

Traditional types of alternative investments

Real estate Private equity Commodities

Time Weighted Rate of Return (TWR)

Reflects the compound rate of growth over a stated evaluation period of one unit of money invested in the account Interim external cash flows result in subperiods that begin with each cash flow, and TWR must link the subperiods together (chain-linking) such that: R(twr) = (1+r(1)) X (1+r(2) X ... X (1+r(n)) -1 For example, during a year there are subsequent subperiods of 1%, 8% and -3% returns. The time weighted return for the year is 1.01 X 1.08 X 0.097 - 1 = 0.058 = 5.8%

Risk Adjusted Performance: The Treynor Measure

Relates excess returns to systematic risk assumed by the manager Numerator is difference between portfolio return and risk-free rate Denominator is manager beta Provides same assessment of manager skill as alpha *Don't have to calculate - just have to know concepts - 1 or 2 questions

Security Selection Effect

Return of specific securities relative to their sector Security's total return less all other factors Selection effect for portfolio is market weighted average of individual effects

The Risk Management Process

Risk management subject to continuous evaluation and revision by: -Identifying risk exposures (sometimes harder to identify than you would think). Ex of Southwest or Bayer). -Establishing appropriate ranges of exposure (+/- 5% sector bets, country bets etc.). -Continually measuring the exposures -Executing appropriate adjustments when exposures fall outside target ranges (rebalancing, watch list etc). -May require alterations to reflect new policies, preferences and information

Stress Testing

Seeks to identify unusual circumstances that could lead to larger than expected losses Scenario analysis -Stylized scenarios from modest to extreme -Standard sets can facilitate comparisons -Does not account for correlation of exposures (scenarios performed sequentially) Actual or hypothetical extreme events -Simulate portfolio under extreme conditions -Useful if extreme breaks considered more likely than given by the model in use

Bond Index as a Benchmark

Some investors (for example, a fixed income mutual fund) have no specific liabilities to meet Not having a cash flow constraint, these managers have more freedom to invest Their objective will be to either meet or exceed the return on the ______

Liabilities as a Benchmark

Some investors have specific liabilities that must be met -Asset / liability matching -Portfolio leverage -Legal promises such as retirement benefits -Ongoing cash flow needs / Liability Matching In such cases, investment success is determined by whether the liabilities are met Liabilities are both an objective and the portfolio benchmark

Components of Commodity Return

Spot return (80/90% of return) -Change in spot price during futures contract (The spot price is the current price in the marketplace at which a commodity can be bought or sold for immediate delivery) -Commodities often have positive exposure to event risk Collateral return (collateral yield) -Treasury yield earned if 100% margin is invested in treasuries during contract Roll return (roll yield) - know this. -(if you own the march it will expire on 3/31/19, so if you want to keep holding you have to roll over and buy June) -Arises from rolling contracts forward in time as spot and futures prices converge -Downward sloping term structure (backwardation) results in positive roll yield >backwardation-prices are lower in the future than now -Upward sloping term structure (contango) results in negative roll yield >Contango-prices are higher in the future than now March > 3/31/19 sell $2900, buy June $2850 (backwardation-prices are lower in the future than now) June > 6/30/19 sell $2900, buy Sept $3100 (contango)

Tests of Benchmark Quality

Systematic biases - historical beta of account relative to benchmark should be close to 1.0, and correlation between active and style return should be statistically insignificant Tracking error - volatility of active returns should be closer to the benchmark than to a market index or alternative benchmarks Risk characteristics - exposure to systematic sources of risk should be similar to those of the benchmark over time Coverage - a high percentage of the securities in the portfolio should be in the benchmark Turnover - percentage of benchmark's market value allocated to purchases during a rebalancing has bearing on whether the benchmark is investable Positive active positions - too many securities the manager does not want to own indicates a poorly constructed benchmark

Market Value > EPS Vs. PE Multiples

The value of the stock market's two most important factors are the earnings and the multiple that people will pay for it. 57% of calendar year returns have come from changes in stock multiples > PE from 1 month > 12 months PE is majority, from 12 months>12 years EPS is majority

Equity Style Indices

Typically distinguish between growth, value and blend according to multiple variables such as price, earnings, dividends, book value and growth Typically employ holdings-based analysis to classify index components into styles Style indices may be mutually exclusive or have overlap Buffering rules maintain previous style classification until stock clearly moves into new style

Comparing yields

USD 10 yr bonds are yielding more than most other developed countries except for Italy

Properties of a Valid Benchmark

Unambiguous - clearly defined identities and weights of securities or factor exposures Investable - can be held without active decisions Measurable - readily calculable return Appropriate - consistent with manager's investment style or expertise Reflective of current investment opinions - manager has knowledge of the components and opinions of some sort Specified in advance - specified prior to the evaluation period and known to all interested parties Owned - manager accepts accountability for performance relative to the benchmark

Supply and Demand for Venture Capital

Venture capital is financing that investors provide to startup companies and small businesses that are believed to have long-term growth potential Issuers of venture capital include: Formative-stage companies (startups) Expansion stage companies (young, mid-market or pre-IPO Suppliers of venture capital include: Angel investors - accredited investors at seed and early stages Venture capital - pooled capital, management support Large companies - strategic partners

Price Weighted Equity Indices

Weight each stock in the index according to its share price Simple to construct Index value is the sum of the share prices of each stock in the index, so historical data may be available further back than the index was actually available Requires adjustments for stock splits, additions and deletions Index performance skewed by the performance of the highest-priced stocks Performance represents performance of buying and holding one share of each stock in the index Best known price weighted index is the Dow Jones Industrial Average Boeing stock price = $378 Pfizer = $41 When Boeing drops 5%, it's a bigger impact than Pfizer dropping 5%

Value Weighted / Mkt Cap Equity Indices

Weighted according to market cap of component stocks (also called cap weighted) Market cap uses the total market value of a firm's outstanding shares by multiplying those shares by the current price of a single share The components with a higher market cap carry a higher weighting percentage in the index. Conversely, the components with smaller market caps have lower weightings in the index Subcategory is float-weighted, which weights only according to the publicly traded shares Performance represents performance of a portfolio that buys and holds all the available shares of all the component stocks in the index Biased toward performance of the largest companies by market capitalization - which tend to be either mature or overvalued The S&P 500 and most major indices are _____

Equal Weighted Equity Indices

Weights each stock in the index equally Performance represents investing an equal amount of money in each component stock Must be rebalanced periodically because performance differences will cause weights to drift from equality Smaller stocks may not be sufficiently liquid to index in this manner Generally better performance than Mkt cap

Risk Budgeting

Where should risks be taken and how can they be allocated efficiently? Establishes objectives for individuals, groups and divisions to allocate risk Limits should be carefully monitored and managed Allows comparison of unit profits according to the capital and risk employed Sum of individual risk budgets typically exceeds organization budget due to diversification benefits Can also be used to allocate funds among managers

Price Inefficiency and Short Sales

______ may better exploit market inefficiencies because: Fewer investors search for overvalued stocks due to impediments to short selling Short sale opportunities due to fraud, window-dressing or negligence do not have parallel long-side opportunities Sell-side analysts issue more buy than sell ratings

Exchange Traded Index Funds (ETFs)

a basket of securities such as stocks that tracks an underlying index. An exchange-traded fund is a marketable security meaning it can be bought and sold since the ETF has a price associated with it. ETFs can contain all types of investments including stocks, commodities, or bonds. Shareholders buy and sell amongst themselves throughout the day Dealers can create and redeem shares with in-kind deposits and withdrawals once daily at market close Do not need to account for individual shareholders In-kind deposits and withdrawals are more tax-efficient Do not need to buy or sell securities based on investor cash flows SPY, QQQ, sector or country ETS are very popular. ETFs 25% of market turnover.

Manager Universes as Benchmarks

a peer group of investment managers who have the same investment style. Manager universe data is often used to compare and evaluate the performances of money managers. Fund sponsors want to know how the managers they hired performed relative to the managers they could have hired instead Cannot be specified in advance Median manager is not investable because can only be determined ex-post Ambiguous Style of median manager may not be appropriate Subject to survivor bias, which overstates peer group return

Germany 10 year government bond

bad investment because very small return but some people want it because it's a safehaven

Enhanced Indexing

broad exposure, tight risk control, cheaper than active but not huge alpha, limited active exposure, in between active and passive but closer to passive.

Spreads wider after market dislocation: Security selection matters

corporate bonds are generally 138 bps or 1.38% over treasuries High yield is 5.12% over treasuries Emerging market debt is 3.55% over treasuries

Call Option

gives buyer the right to buy one fixed income futures contract at the strike price. Buy a call if you think rates are going to decrease (price goes up).

Put option

gives buyer the right to sell one fixed income futures contract at the strike price. Buy a put if you think rates are going to increase (price goes down).

downgrade risk

risk that a rating agency will lower its rating on the issuer Binary credit options pay off only if a specified negative event occurs. They can be used to hedge _______

Default risk

risk that the issuer may fail to meet its obligations Binary credit options pay off only if a specified negative event occurs. They can be used to hedge _____

credit spread risk

risk that the spread between the risky bond and risk-free securities will vary after purchase (30 yr bond will move more than 2 yr bond) Credit spread options pay off based on the spread over a benchmark rate and may be used to hedge ________

Style Drift in Equity Portfolios

the term used to describe inconsistency in management style Presents an obstacle to investment planning and risk control If hire a manager because want value exposure, you don't want the style to drift to growth Manager may not have as much expertise in selecting stocks of a different style and won't benefit if things come back.