CFA 2022 Portfolio Management
Defined contribution plan
A pension plan in which employer will contribute to the pension fund but does not promise future value of the plan; employees take investment risks
Modern portfolio theory
A theory on how risk-averse investors can construct portfolios to optimize or maximize expected return based on a given level of market risk, emphasizing that risk is an inherent part of higher reward.
Investment policy statement (IPS)
A written planning document that describes a client's investment objectives and risk tolerance over a relevant time horizon, along with constraints that apply to the client's portfolio
Jensen's alpha
Actual Rp - E(Rp) at portfolio beta = Treynor measure * portfolio beta + Rf - E(Rp)
Fama and French model
B(Market) + B(Size)+ B(book to market Value)
Belief perseverance biases
Conservatism, confirmation, representativeness, illusion of control, and hindsight biases
The expected return of the leverage portfolio
Ep = Wb Rb + (1-Wb) * E(Rm); Rb is the borrowing rate and Wb is the borrowing weight in -VE; points on CML below market portfolio is lending portfolio; above is borrowing
Return-generating models: single index model (aka CAPM: capital asset pricing model)
Expected return = Rf + Beta * (market risk premium)
Market model
Expected return = alpha + beta(Rm) + specific return; alpha = Rf (1-beta); when specific return is not zero, the security has abnormal return
Carhart
Fama and French model + B(momentum)
Tactical asset allocation
Form of active management; the decision to deliberately deviate from the strategic asset allocation in an attempt to add value based on forecasts of the near-term relative performance of asset classes
Type of returns
Gross: total return without any deduction Net: return with manager/admin fees deducted Nominal: return with manager/admin, taxes, interests, and dividends deducted Real: = nominal/inflation
Capital market theory
Investors have homogeneous expectations for all RISKY assets in an efficient market, including the same 1) efficient frontier of risky assets; 2) an optimal risky portfolio (aka market portfolio) represented by local stock index; 3) same capital market line
M-squared
M2 = portfolio return = sharpe ratio * market risk + Rf; represent the market-rate adjusted return at market risk; alpha is M2 - Rm; alpha > 0 means portfolio outperform at market risk
Mental-accounting bias
Money is treated differently depending on how it is categorized >> neglecting opportunities to reduce risk by combining assets with low correlations
Factors to consider during portfolio planning
RRTTLLU 1) Risk tolerance: conform to the lower of the client's ability/willingness to bear risk; resolution is needed when ability/willingness contradict; 2) Return objectives: absolute or relative to benchmark (bearing tracking risk/error; 3) Time horizon; 4) Tax exposure; 5) Liquidity needs (note that PE has low liquidity high risk); 6) Legal constraints; 7) Uncertainties and preferences: ethical/religious preferences, diversification needs
Measures to use when portfolio is exposed to both systematic and non-systematic risks...
Sharp ratio and M-squared alpha
Regression analysis for beta
The regression of Security return over market return; security beta is the slope
Strategic asset allocation
The set of exposures to IPS-permissible asset classes that is expected to achieve the client's long-term objectives given the client's investment constraints; the optimal investor portfolio with highest utility on the client's capital allocation line
Security characteristic line (SCL)
a plot of a security's expected excess return over excess market return; slope is beta
Execution stage in PM
after client accepts IPS, set asset allocation and purchase assets in the most cost-efficient way
Two-fund separation theorem
all investors regardless of taste, risk, preferences, and initial wealth will hold a combination of two portfolios or funds: one risk-free and one optimal risky portfolio
Load of the fund
annual fees, transaction fees, upfront fees...etc. no-load funds only charge for annual fee
Framing bias
answer a question differently based on the way it is framed/presented
Pairwise correlations within asset classes...
are generally higher than correlations among asset classes; high in the same class and low among different classes
Emotional biases
based on feelings or emotions; harder to manage than cognitive errors; includes loss aversion, overconfidence, self-control, status quo, endowment, and regret aversion biases
Illusion of control bias
believe can control outcome but actually not; infer non-existing causal connections and have certainty in prediction; lead to poor diversification and very detailed financial models to control uncertainties
Beta calculation
beta = correlation * security risk over market risk = covariance over market variance
Open-ended MF
can invest/withdraw by issue/retire shares at NAV at the time of action; shares outstanding can change; trades at NAV; easy to grow but hard to manage in/out CFs so not fully invested to keep cash for redemptions not covered by new investments; trade once a day, no short/margin; dividend reinvested; higher entry than ETF
Close-ended MF
cannot invest/withdraw to/from the fund; buy/sell existing shares to other investors; trades at premium/discount of NAV depending on demand; shares outstanding will not change
Endowment bias
consciously inactive; asset is perceived as special and more valuable just because its already owned; "Would you buy the same asset at its current price?"
Regret aversion bias
consciously inactive; inaction due to fear that actions might lead to regret >> causes herding/fomo and go with consensus or popular opinion
Planning stage in PM
consider RRTTLLU in IPS: risk tolerance, return objectives, time horizon, tax exposure, liquidity needs, legal constraints, unique circumstances/preferences
The market...
consists of all risky assets; not all assets are tradable, and not all tradable assets are investable
Markowitz efficient frontier
contains all portfolios of risky assets that rational, risk-averse investors will choose; decreasing rise in return when investor take more risks
For large asset numbers with equal weights and average variance/covariance...
contribution of variance gradually decrease as N gets larger; covariance among assets accounts for all the portfolio risk when N gets larger >> approaching mean COV
When comparing returns of different time frame...
convert to annualized return
Lower correlation between holdings in portfolio...
equals better diversification; correlation increases during market crash
Kurtosis
fat tails or higher than normal probabilities for extreme observation to occur; higher/wider curve than that of normal distribution
Cognitive errors
faulty cognitive reasoning; include belief perseverance biases and processing errors
Loss aversion bias
feeling more pain in loss than pleasure in gains at the same level >> excessive trading, early exit, or keep holding losing positions in hope of bouceback
Passive management
follow SAA and rebalance
Security Market Line (SML)
graphical representation of the expected return-beta relationship of the CAPM; slope is equal to market risk premium
Processing errors
illogical or irrationally process information; flaws in how information is processed
Appendices in IPS
include 1) strategic asset allocation to explain weights and hedging risk; 2) rebalancing policy
Statement of duties and responsibilities in IPS
include duties and responsibilities of the client, the custodian of the client's assets, the investment managers...
Investment guidelines in IPS
information about how policy should be executed (ex: use of leverage/derivatives; existing constraints; asset classes to exclude)
Banks
institutional investor with the highest liquidity needs
Bond MF
invest in LT bonds (>1yr) and sometimes preferred shares
Money market MF
invest in ST (<90d) treasury bills, certificates of deposit, commercial papers; high liquidity with return in money market rates
Core-satellite approach
invest in both passively and actively managed portfolios to minimize offsetting active positions and unnecessary trading
Client's distinctive needs are most linked to...
investment objectives section and constraints in the investment guideline section in IPS
IPS
investment policy statement, documented in planning stage of PM; specifies benchmarks for portfolio
Mutual funds
investment pool in which each investor has claim on the income and value of the fund; NAV is computed daily based on the closing price of the securities in the fund
Capital market expectations
investor's expectations concerning the risk and return prospects of asset classes; form a correlation matrix among asset classes
Self-control bias
lacking disciplines and focus on ST satisfaction over LT goals
Hedge funds
loosely regulated and not required to report as common companies; private investment vehicles using leverage, derivatives, long/short strategies; not readily available to common investors; high entry with restricted liquidity (quarterly withdrawals) and fixed-term commitments; low correlation with traditional asset classes; management fees, performance incentive (portion of capital gains)
Feedback stage in PM
maintenance, review/update IPS and target allocation, rebalance portfolio; evaluate performance against benchmark return
PE
make a few large investments to take company private; reorganize firm to increase CF and reduce debt to increase equity; sell the firm / IPO
VC
make many small investments (startups) and expect few with large returns while most other fails; grow company to increase value; sell the firm / IPO
Representativeness bias
make premature conclusions based on flawed assumptions; base-rate neglect (rate in larger population is neglected in favor or specific information); sample-size neglect (use small sample size to represent large population)
Utility
measure of relative satisfaction of the investor to a portfolio; +ve A = risk aversion; -ve A = risk seeking
Time-weighted return
neutralize the effect of CF on return to evaluate fund performance
Systematic risk
non-diversifiable risk an investor must bear to earn return; in reverse the investor will not take risk if not compensated
Confirmation bias
only notice new information that supports prior beliefs and avoiding conflicting views; closely related to overconfidence
Conservatism bias
overweight prior beliefs and underreact to new information >> hold assets for too long or reluctant to update portfolio
Defined benefit plan
pension plan that guarantees a specified level of retirement income; employer takes investment risk with high income needs
Risk-aversion is best illustrated by...
positive relationship between risk and return
Endowments and foundations
provide ongoing and perpetual financial support to programs (endowment) or charity (foundation)
Availability bias
put emphasis on readily available information
Holding period return
rate of return over a given investment period
Anchoring and adjustment bias
related to conservatism; rely on initial information to make subsequent estimates and decisions
Capital allocation line
represents the portfolios available to investor considering utility and risk appetite
Arithmetic return
return earned in an average period over multiple periods
Minimum-variance portfolio
risk-averse investor only invest in portfolio on the minimum-variance frontier for the minimum risk at the given expected return
Money-weighted return
same as IRR; for CF-sensitive return calculation
Risk budgeting
sets overall risk limit for portfolio; for portfolio, passive management is systematic risk and tactical asset allocation and security selection both add risk to portfolio
Diversification ratio
standard deviation of equally weighted investments / standard deviation of a randomly chosen security; lower is better
Total variance is the sum of
systematic and non-systematic variances
indifference curve
the combinations of risk-return pairs that an investor would accept to maintain a given level of utility; the trade-off between the expected rate of return and variance of the rate of return
Covariance and correlation
the extent to which the returns of the two assets move together over time; covariance shows no magnitude >> use correlation ranging from -1 to 1
Geometric mean return
the mean return computed by finding the equivalent return that is compounded for N periods
Optimal risky portfolio
the portfolio at the tangential point between the capital allocation line and the efficient frontier of. risky assets
Optimal investor portfolio
the portfolio at the tangential point between the capital allocation line and the indifference curve
global minimum-variance portfolio
the portfolio with the least variance among all risky assets; investor cannot hold portfolio with risky assets that has less risk than the global minimum-variance portfolio
Within CAPM, the returns of assets vary only by...
their systematic risk represented by beta; assets with the same beta will have the same expected return
Hindsight bias
think past events are predictable and reasonable to expect >> overconfident in prediction; unfairly assess performance of managers
Status quo bias
too lazy to change even when change is warranted; inaction due to inertia
ETF
trades like a stock; intraday transaction, can short/margin; dividend paid as cash; low entry; trade at premium/discount to NAV
Overconfidence bias
underestimate risk and overestimate return; lead to poor diversification; self-attribution; prediction and certainty overconfidence
The dominant capital allocation line is the...
use of leverage and the combination of risk-free asset and the optimal risky portfolio
Treynor measure
(Rp - Rf) over portfolio beta; the slope of the SML for the portfolio; steeper than market SML >> outperform at given level of systematic risk
Sharpe ratio
(Rp-Rf) over portfolio risk; the slope of the capital allocation line for the portfolio/security; steeper than CML >> outperform at given level of total risk
Portfolio beta
weighted sum of the individual holding's beta in portfolio
CAPM assumptions
1) investors are risk averse, rational, and wants the highest utility; 2) frictionless market with not transaction costs/tax/restrictions; 3) investors plan for the same single holding period; 4) homogenous expectations; 5) infinitely divisible investments; 6) investors are price taker as trades do not alter price
Issues with active management
1) managers benchmark against the same index leads to offsetting positions that cancel out active returns; 2) excessive and unnecessary trading leads to higher taxes/expenses
Limitation of CAPM
1) single factor/period only; 2) do not consider assets that are not investible such as human capital, closed economies etc >> true market unobservable; 3) use of proxy for market portfolio such as S&P500; 4) beta is historical >> limited representation for present/future economic conditions; 5) beta is time-period sensitive; 6) weak empirical support for CAPM >> systematic risk is not the only factor; 7) in real life investors have different optimal risky portfolios
Non-systematic risk
Diversifiable risk; infinite demand in an efficient market leads to zero return
Measures to use when portfolio is exposed to systematic risk only (well-diversified)...
Treynor measure and Jensen's alpha