Portfolio Management Final Exam

Type I Error

• hiring or retaining a manager who subsequently underperforms expectations

• are more transparent to investors, so they entail not only the regret of an incorrect decision but the pain of having to explain it to the investor

Type II Error

• not hiring or firing a manger who subsequently outperforms, or performs in line with, expectations

• may come from choosing investment managers based on too short-sighted a view (i.e. not investing based on underperformance in the short-term)

Top-Down Approach

• returns-based style analysis (RBSA)

• estimates a portfolio’s sensitivities to security market indexes

• imprecise tool due to lacking flexibility with dynamic portfolios

• begins at the macro level, focusing on the macroeconomic environment, demographic trends, and government policies

  • country and geographic allocation to equities

  • sector and industry rotation

    • using sector and industry prospects

  • volatility-based strategies

    • long straddle strategy

  • thematic investment strategies

    • finding new themes/ideas that will drive the market in the future

Bottom-Up Approach

• holdings-based style analysis (HBSA)

• estimates risk exposures from actual securities held in the portfolio at a point in time

• may only reflect the portfolio at one point in time

• begin at the individual asset and company level (i.e. price momentum and profitability)

• fundamental investors often focus on the following in relation to industries and peers:

  • business model and branding

  • competitive advantages

  • company management and corporate governance

Efficient Markets Hypothesis

• securities markets ARE weak-form efficient, and therefore, investors cannot earn abnormal returns by trading on the basis of past trends in price

• securities markets ARE semi-strong efficient, and therefore, analysts who collect and analyze info must consider whether that info is already reflected in security prices and how any new info affects a security’s value

• securities markets are NOT strong-form efficient because securities laws are intended to prevent exploitation of private info

Weak Form

• prices reflect:

  • past market data

• returns over short horizons

  • tendency of poorly performing stocks and well-performing stocks in one period to continue that abnormal performance in following periods is the momentum effect

• returns over long horizons

  • reversal effect is the tendency of poorly performing stocks and well-performing stocks in one period to experience reversals in following periods

• January effect

• IF weak form EMH holds, these previous returns should not inform how we trade profitably moving forward

Semi-Strong Form

• prices reflect:

  • past market data

  • public info

• small firms typically outperform large firms

• high BTM firms typically outperform low BTM firms

• Post-Earnings Announcement Drift (PEAD)

  • the drift of prices in the direction of earnings new indicates a lack of immediate price discovery from public info

• low P/E stocks typically outperform high P/E stocks

• neglected firm effect

  • investments in stock of less well-known firms have generated abnormal returns

• illiquid stocks have a strong tendency to exhibit abnormally high returns

• IF true semi-strong form holds, then you should not be able to trade profitably and consistently with these anomalies

Strong Form

• prices reflect:

  • past market data

  • public info

  • private info

• stock prices should follow a random walk → prices are random and unpredictable

• the ability of insiders to trade profitability in their own stock indicates whether true strong-form EMH is present

  • IF insiders can trade profitably on a consistent basis, then true strong-form CANNOT exist, since all price info about the stock is obviously NOT priced in

Behavioral Finance

• examines investor behavior to understand how people make decisions, individually and collectively

  • does NOT assume that people consider all available info in decision-making and act rationally by maximizing utility within budget constraints

  • attempts to explain why individuals make the decisions they do, whether rational or irrational

Behavioral Biases

• loss aversion

• herding

• overconfidence

Loss Aversion

• most models assume RISK aversion, meaning that people require a higher expected returns to compensate for exposure to additional risk

• LOSS aversion is the tendency of people to dislike losses more than they live comparable gains

• may explain some market overreactions

Herding

• this is when investors trade on the same side of the market in the same securities, or when investors ignore their own private info or analysis and act as other investors do

• this clustered trading may or may not be based on info

Overconfidence

• overconfident investors overestimate their ability to process and interpret info about a security and may not process info appropriately, thus stocks will be misplace (may be temporary mispricing)

Asset Allocation

• is the primary determinant of long-run portfolio performance

• is a strategic - and often a first or early decision in portfolio construction

• considered the most important decision in the investment process

• 3 broad approaches:

  • asset only, liability-relative, goals-based

• should take into account both what is ACTUALLY on an investor’s balance sheet AS WELL AS other potential inclusions that can impact how their money is to optimally be invested

Asset Only

• focus only on investor assets

• i.e. Mean Variance Optimization (MVO) which considers only expected returns, risks, and correlations of asset classes in the opportunity set

• objective is to maximize Sharpe ratio for acceptable volatility level

• focuses on asset class risk and effective combinations of asset classes (simulation results help mitigate potential risks)

Liability-Relative

• fund the investor’s liabilities

• i.e. surplus optimization which is MVO applied to surplus assets

• objective is to fund liabilities and invest excess assets for growth

• focuses on the risk of having insufficient assets to pay obligations when they are due (shortfall risk)

  • the volatility of CF that fund liabilities can also be an issue

Goals-based

• primarily for individuals as and families

• each goal is associated with CFs, a distinct time horizon, and a risk tolerance level

• objective is to achieve investor goals with specified required probabilities of success

• focuses on the risk of failing to achieve goals

  • overall portfolio risk is the weighted average of the risks associated with each goal

5 criteria that help in effectively specifying asset classes for the purpose of asset allocation

• assets within an asset class should be relatively homogenous

  • “equity” should not include real estate

• asset classes should be mutually exclusive

  • global vs. world Ex-US

• asset classes should be diversifying

  • low correlations

• the asset classes as a group should make up a preponderance of world investable wealth

  • increase risk-adjusted returns

• asset classes selected for investment should have the capacity to absorb a meaningful proportion on an investor’s portfolio

  • liquidity and transaction costs

3 Super classes of assets

• capital assets

• consumable / transformable assets

• store of value assets

Capital Assets

an ongoing source of something of value (interest or dividends); can be valued by NPV

Consumable/Transformable Assets

assets, such as commodities, that can be consumed or transformed, as part of the production process, into something else of economic value, but which do not yield an ongoing stream of value

Store of Value Assets

neither income generating nor valuable as a consumable or an economic input; examples include currencies and art, whose economic value is realized through sale or exchange

Tactical Asset Allocation (TAA)

• involved deliberate short-term deviations from the strategic asset allocation

• this is active management at the asset class level

• decisions may be in response to price momentum, perceived valuation, or the business cycle

ETFs

• allow investors to trade index portfolios just as they do shares of stock

• trade continuously like stocks

• can be sold short or purchased on margin

• cheaper than mutual funds

• tax efficient

• prices can depart from NAV

• must be purchased from a broker (for a fee)

Mutual Funds

• dominant investment company today

• accounts for 87% of investment company assets

• are sold…

  • directly by the fund underwriter (i.e. direct-marketed funds)

  • indirectly through brokers acting on behalf of the underwriter (i.e. sales force distributed)

  • financial supermarkets

Performance Measurement

• typically returns relative to benchmark

• can be in both absolute and relative terms

• also considers the risks associated with these returns

Performance Attribution

• how was the performance achieved?

• what portion of returns is driven by active manager decisions?

• macro attribution

• micro attribution

• returns based attribution

• holdings-based attribution

• transactions-based attribution

• return attribution

  • time weighted average

  • dollar weighted rate of return

  • factor based returns

• fixed-income return attribution

  • exposure decomposition

  • yield curve decomposition (duration based)

  • yield curve decomposition (full repricing based)

• risk attribution

Risk Attribution

should reflect the investment decision-making process

Yield Curve Decomposition (full repricing based)

bottom-up approach that reprices all bonds as zero-coupons

Yield Curve Decomposition (Duration Based)

estimates the returns of securities, sector buckets, or YTM buckets using the relationship between YTM and duration

Exposure Decomposition (Duration based)

top-down approach explaining active performance relative to benchmark

Factor-based Returns

• Fama-French

Dollar-Weighted rate of return

• is the internal rate of return on an investment

• returns are weighted by the amount invested in each period

Time-Weighted Average

• geometric average is a time-weighted average

• each period’s return has equal weight

Transactions-Based Attribution

• calc. by using both the holdings of the portfolio and the transactions (purchases and sales) that occurred during the evaluation period

  • need the most detailed date

Holdings-Based Attribution

• calc. by reference to the underlying beginning-period holdings of the portfolio only

  • does not account for within-period transactions

Returns Based Attribution

• uses only the total portfolio returns over a period to identify the components of the investment process that have generated the returns

  • vulnerable to data manipulation

Macro Attribution

evaluated the asset owner’s tactical asset allocation and manager selection decisions

Micro Attribution

evaluates the impact of the portfolio manager’s’s decisions on the performance of the asset owner’s total fund

Performance Appraisal

• captures most aspects of the quantitative analysis piece

• was the performance skill or luck?

• key feedback loop in investment process

• Appraisal Measures

  • Sharpe ratio

  • Treynor ratio

  • Info ratio

  • appraisal ratio (annualized alpha over annualized residual risk)

    • measures reward of active management relative to its risk

  • Sortino ratio

    • penalizes only those returns that are lower than a user-specified return

    • requires a target rate of return and target semi deviation

    • penalizes managers for “harmful volatility”

  • capture ratios

Private vs. Institutional Constraints

• time horizon

• taxes

• scale

Private Taxes

• income tax

• capital gains tax

• wealth/property tax

• stamp duties

• wealth transfer tax

Time Horizons

• retirement planning

  • assessing savings needed and determining at what age they will be financially prepared for retirement

  • analyzing retirement goals via mortality tables and Monte Carlo simulations

Income Tax

wages, rents, dividends, and interest earned

Capital Gains Tax

profits based on price appreciation of assets

Wealth/property Tax

taxation of real property, but may apply to financial assets

Stamp Duties

tax on the purchase price of shares or real estate

Wealth Transfer Tax

when assets are transferred to another owner without outright sale/purchase (estate/inheritance/gift taxes)

Hedge Fund Strategies

• equity related

• event driven

• relative value

• opportunistic

• specialist

• multi-manager

Equity-Related

focus on equity markets, and the majority of their risk profiles involve equity-oriented risk

Event-Driven

focus on corporate events like management changes, M&As, bankruptcy, etc.

Relative Value

focus on the relative value between two or more securities

Opportunistic

take a top-down approach, focusing on a multi-asset opportunity set

Specialist

focus on niche opportunities that often require a specialized skill or knowledge of a specific market

Multi-Manager

focus on building a portfolio of diversified hedge fund strategies

Management Fees

• good performance is only good NET of all fees

• AUM fees are based on the amount of money a firm manages, regardless of performance, but performance-based fees are based on the returns an investment manager creates

Psychological Biases

• may undermine the analyst’s ability to make accurate and unbiased forecasts

  • anchoring bias: weighing the first info you get disproportionately

  • status quo bias: reflects the tendency to perpetuate recent observations

  • confirmation bias

  • overconfidence bias

  • prudence bias: the tendency to temper forecasts so that they do not seem extreme

  • availability bias

Macroeconomic effects on returns

• policy changes

• new products/technologies

• geopolitics

• natural disasters

• natural resources/critical inputs

• financial crises

• higher economic growth trend, greater expected returns, all else equal

Policy Changes

• any significant, unexpected change to taxes, regulation, infrastructure, human capital, or intrusion on the private sector will change the trend of growth

• i.e. tax cuts & jobs act, China tariffs, etc

New Products/Technologies

• innovation drives economic growth

• i.e. AI, the internet, the computer, the railroad, etc

Geopolitics

• conflicts can hinder growth

• MANY examples, but WWII would be the strongest

Natural Disasters

• destroy productive capacity via workers and facilities

• hurricanes, wildfires, floods, etc.

Natural resources/critical inputs

• new resources or ways to recover them can enhance potential growth

• fracking

Financial Crises

the financial system makes for the efficient use of resources in an economy, thus crises cause capital to be harder to come by and people to lose their willingness to participate in the economic system

CAPM

• expresses the expected return on a risky asset as the sum of the risk-free rate and one or more risk premiums that compensate investors for taking on risk

• risk premium model

• the base equilibrium approach to equity returns

• has 2 underlying assumptions that are used in the Singer-Terhaar model:

  • all global markets and asset classes are fully integrated (use one global equities index portfolio)

  • complete segmentation of markets such that each asset class in each country is priced without regard to any other country/asset class (extreme assumption)

Market Efficiency

• an informationally efficient market is one in which asset prices reflect new info quickly and rationally

  • asset prices reflect ALL past and present info

• investment managers care about efficiency because it helps determine how many profitable trading opportunities exist

• consistent, superior, risk adjusted returns are unachievable in an efficient market

• PASSIVE investing is superior to ACTIVE investing in an efficient market

  • it a very inefficient market, opportunities may exist for effective active management

• what is “quick info reflection in prices?

  • as long as the shortest time a trader needs to execute a transaction in the asset

    • in liquid markets, this won’t be long AT ALL

    • this means market efficiency falls on a continuum

• if markets are highly efficient, then we expect market prices to reflect intrinsic values

  • discrepancies between these two values are the basis for profitable active investment

Technical Analysis

• is the attempt to profit by looking at patterns of priced and trading volume

• some price patterns persist, but exploiting these may be too costly to produce consistent abnormal returns