pm 3: diversification and risk reduction

what is the portfolio approach and goal?

• evaluate securities based on contribution to total portfolio risk/return

• want to reduce risk without lowering return

why does diversification matter?

• avoids concentrated exposure

• reduces imapce of poor impacts from any single investment

what is the diversification ratio

• portfolio sd/individual sd

• lower = better

what are the limits of diversification

diversification offers little portection furing severe wide spread market downturns

what is modern portfolio theory?

• portfolio selection must consider covariances not just individual characteristics

• only systemic risk should be priced

• forms basis of market hteory and CAPM

what are the three steps of the portfolio management process?

1. planning

2. execution

3. feedback

what happens in the planning stage

1. understanding clients investment objectives and contraints

2. IPS - investment policy statement

• formal document with objectives, constraints, benchmarks, responsibilities

• reviewed periodically or when circumstances change

what happens in the execution stage?

1. asset allocation

• decide weightings across asset classes (equities, fixed income, cash, alternatives)

• top-down - macro →market→security

• bottom-up - focus on company specific requirements regardless of macro

2. security analysis

• expected cash flows, risks, and valuations of individual securities

• combine top down view and bottom up insights

3. portfolio construction

• apply diversification to reduce risk

• allocate across asset classes, sectors, securities,

• incorporate IPS

• recognise asset allocation often drives a long term performance

what happens in the feedback stage?

1. monitoring and rebalancing

• rebalance when weights drift from targets due to market movers

• adjust porfolio when client needs/market conditions change

2. perfomance evaluation

• compare returns vs. erquired return

• assess success in IPS goals

what are the two types of investors?

1. individual

2. insitutional

for an individual investor what are goals and focuses

goals: retirement, education, house etc

focuses:

1. growth focused: seek capital gains → favour equities

2. income focused: need regular income → favour fixed income and dividend stock

• many invest thorugh defined contribution (DC)

• employee bears all investment and inflation risk

• risk tolerance varies based on age an income

what do insitutional investors include?

1. defined benefit pension plans

2. endowments and foundations

3. banks

4. insurance companies

5. sovereign funds

what is a defined benefit pension plan and its characteristics (length, risk, funding)?

• employer promises fixed retirement income to employees

• employer bears investment risk and is responsible for funding the plan

• plan managers must ensure there is sufficient assets to pay pension benefits

• may have indefinite time horizon if new members allowed, or finite if the scheme has been shut down

• may match assets to liabilities (buy bonds that match pension cash flows)

• mature plans require more income and lower volatility

what are endowments and foundations and their characteristics

endowments: funds supporting non profit institutions (unis)

foundations: grant making entities

• want to preserve real inflation adjusted capital while generating income to fund insitituion

• perpetual time horizon

• high risk tolerance

• heavy allocation to alternatives

what are banks goals and characteristics?

• aim to earn return above interest owed to depositors

• need high liquidity to meet withdrawals

• invest mainly in short duration in high quality fixed income

what are insurance companies goals and characteristics?

• invest premiums to meet future claims

• life insurers: long term liabilities → longer investment duration

• P&C insurers: shorter term liabilities → shorter duration

• general account to pay claims: conservatively investde in fixed income

• surpluse account: targets higher returns

what are sovereign wealth funds , their goals and characteristics

• state owned fudns investing in financial and real assets

• goals: budget stabilisation, future development, resource revenue

• large and growing presence globally

investor type, time horizon, risk tolerance, income needs, liquidity needs

Client	Time Horizon	Risk Tolerance	Income Needs	Liquidity Needs
Individual investors	Varies by individual	Varies by individual	Varies by individual	Varies by individual
Defined benefit pension plans	Typically long term	Typically quite high	High for mature funds; low for growing funds	Varies by maturity of the plan
Endowments and foundations	Very long term	Typically high	To meet spending commitments	Typically quite low
Banks	Short term	Quite low	To pay interest on deposits and operational expenses	High to meet repayment of deposits
Insurance companies	Short term for property and casualty; long term for life insurance companies	Typically quite low	Typically low	High to meet claims
Investment companies	Varies by fund	Varies by fund	Varies by fund	High to meet redemptions
Sovereign wealth funds	Varies by fund	Varies by fund	Varies by fund	Varies by fund

what are buy side and sell side firms?

buy side: asset managers buy research/services from sell-side firms (brokers/dealers)

what are the two types of asset manager

1. active

• aim to out perform a benchmark through fundamental/quantative research

2. passive

• aims to replicate a market index

• much lower fees

passive is 20% of global AUM but only 6% of revenue

what are the two types of asset type?

traditional

• long only equity, fixed income, multi asset

• fees are asset based

alternative

• hedge funds, private equity, venture capital

• fees are for management and performance fees

what are the key industry trends

1. growth of passive investing

• 20% of global AUM

2. big data in investing

• machine learning and advanced anlytics

3. robo advisors

• algorithm driven platforms

what is a mutual fund?

• investment pool - combine capital and hold a proportion of a fund

• managed by professional portfolio manager

• value: Net asset value

what are open ended funds?

• accept new investors at any time - new shares issued at NAV

• investors can sell at NAV at any time

• fund may have to liquidate fund at any time to meet redemptions

• easy to grow but cerates cash flow management pressure

what are closed ended funds?

• fixed number of shares

• investors buy/sell shares on open market

• can trade at a premium/discount to NAV

no load vs load fund

no load: annual fee as % of NAV

load: upfront and redemption sales fee in addition to annual fe

what are the four types of mutual funds?

1. money market funds

2. bond mutual funds

3. stock mutual funds

4. hybrid/balanced funds

what are money market funds and characteristics?

• invest in short term instruments

• goals: high liquidiity, capital preservation, money market rate returns

• CNAV: (constant) - share price fixed

• VNAV (variable) - share price fluctuates

what are bond mutual funds and characteristics?

• portfolio of individual bonds

• much longer maturities (1-30 years)

• categroies: global, government, corporate, high yiels, inflation protected, tax-free

what are stock mutual funds and their characteristics?

• actively managed or passively managed

what are hybrid/balanced funds and characteristics?

• combination of stocks and bonds

• pick a target date and fund automatically shifts asset mix over time

• more equities when young, more bonds as retirement approaches

what are separately managed acounts?

• managed for single client

• assets owned directly

• higher minimum investment, customised for constraints and tax preference

what are ETFs

• structured like open end funds but traded on exchanges like stocks

• typically passive

• can be shorted or traded on margin

• prices track nav closely but may deviate slightly

what are hedge funds and characteristics?

• private pooled vehicles

• aim for absolute returns

• short selling, leverage, low coreelation to equities and bonds

• charge management and performance fees

• limited liquidity and high minimums

what are private equity and venture capital and characteristics?

• buy improve and exit private companies over 7-10 years

• structured as limited partnerships - General partner = fund manager, limited partner = investors