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Concepts
Portfolio approach to investing

Types and characteristics of
investment management clients

Defined contribution pension /
Defined benefit pension

Description
Portfolio management
Portfolio perspective: evaluate individual investments by their contribution to the risk and return of a portfolio
Diversified portfolio → reduced risk @ given level of expected return
...
𝑠𝑡𝑎𝑛𝑑𝑎𝑟𝑑 𝑑𝑒𝑣𝑖𝑎𝑡𝑖𝑜𝑛 𝑜𝑓 𝑟𝑒𝑡𝑢𝑟𝑛𝑠 𝑓𝑜𝑟 𝑡ℎ𝑒 𝑁 𝑠𝑡𝑜𝑐𝑘𝑠

Investor type

Risk tolerance

Investment horizon

Liquidity needs

Income needs

Individuals

Depend on individual

Depend on individual

Depend on individual

Depend on individual

Banks

Low

Short

High

Pay interest

Endowments

High

Long

Low

Spending level

Insurance

Low

Life insurance - Long
Property & Casualty - Short

High

Low

Mutual funds

Depend on fund

Depend on fund

Depend on fund

Depend on fund

Defined benefit pension
Defined contribution pension plan

High

Long

Definition: Firm promises to contributes a sum each period to the employee's retirement
account
Investment decisions are left to the employee
Employee assumes all investment risk
Firm makes no promise to employee about the future value of the plan assets
Steps in portfolio management
process

Low
Defined benefit pension plan

Depend on age

Definition: Firms promises to make periodic payments to employees after retirement
Firm contributes to a fund established to provide the promised future benefits
Firm assumed all investment risk
Poor performance of fund → increase required contribu on from firm

Step 1 - Planning step: Analyse investor's risk tolerance, return objectives, time horizon, tax exposure, liquidity needs, income needs, etc
...
IPS should be reviewed / updated
periodically, or whenever there are significant changes in objectives and constraints
Step 2 - Execution step: Construct portfolio by determining suitable allocations to various asset classes based on IPS
- Top-down analysis : Examine and forecast macroeconomic conditions (GDP, inflation, interest rates) → iden fy most a rac ve asset classes
- Bottom-up seurity analysis: Use model valuations to identify undervalued securities
Step 3 - Feedback step: Monitor and rebalance the portfolio to adjust asset classes allocations and securities holding in respond to the market performance; evaluate portfolio's
performance against benchmark (IPS)

Mutual fund

Definition: a form of pooled investment
...
- Do not take new investments into the fund or redeem investor shares
...
Money market funds:
- Invest in ST debt securities
- Provide interest income
- Low risk of change in share value
- Differentiate by types and average maturities of money market securities purchased
2
...
Stock mutual funds:
a
...
Actively managed funds: individual securities are selected for greater returns than benchmark indexes
Actively managed funds have higher annual management fees as well as higher turnover than index funds

Other Pooled investments

1
...
Funds shares are traded in the market (with brokerage fee)
...

Management fee are low
...
Separately managed accounts: portfolio managed by individual investors
...
Hedge funds: Funds for limited qualified investors, with high minimum investment (often from $250k to $1M)
a
...

b
...
Event-driven funds: invest during one-time corporate events (M&A)
d
...
Convertible bond arbitrage funds: trading convertible bonds and equity that the convertible bonds could be converted into
...
Global macro funds: speculate on change in international interest rate, currency exchange rates
...
Buyout funds (private equity funds): Buy entire company, often funded by a significant increase in debt (leverage buyout) → reorganise the firm → ↑ CF, payout debt → resell
restructured company
5
...
Identify the risk tolerance
2
...
Modify and monitor these risks
→ Maintain bundle of risks that is expected to best achieve the goal of the organisa on

Risk management framework

- Establishng processes and policies for risk governance
- Determining risk tolerance
- Identifying and measurng existing risks
- Managing and mitigating risks to achieve optimal bundle of risks
- Monitoring exposure over time
- Communicating across organisation
- Performing strategic risk analysis

Risk governance

Definition: Determination of risk tolerance, element of its optimal risk's exposure strategy , and framework for oversight of risk management function
Purpose:
- Manage risks to support overall goal of the organisation → maximise expected return consistent with the risk tolerance
- Guide on which risk should be prsued / limit / reduced / avoided

Affect of risk tolerance on risk
management

Risk tolerance : setting the overall risk exposure the organisation takes, by identifyin risks that could take, and risk that should reduce or avoid
...
g
...
Differences in input and models used → significant change in value result
...
Calculated as the probability-weighted average loss for all loss exceeded the minimum account
Stress testing : Test the effect of a specific change in key variable (e
...
: interest rate, exchange rate)
Scenario analysis : what-if analysis of expected loss, incorporate changes in multiple inputs

Modifying risk exposure

Avoid risk: not engage the activity with uncertain outcome, typically when risks outweigh potential benefitt
Prevent risk (e
...
: prevent risk of data breach with greater security)
...
g
...
Real return = (1 + nominal return) / (1 + inflation rate)
- Leverage return : Gain/loss on investment as a % of investor's cash investment

Risk and return of major asset
classes

Assets class

Avg
...
7%
9
...
9%
5
...
7%
3
...
0%
20
...
4%
9
...
1%
4
...
Mean return are always propor onal in the same direc on
ρ = -1 → perfectly nega vely correlated
...
One the por olio ≈ 30 securi es → standard devia on remains constant

Return generating models

Return generating models : estimate the expected return on risky securities based on specific factors - Macroeconomic , Fundamental and Statistical factors
Multifactor models : Use macroeconomic factors (GDP growth, inflation, consumer confidence) and fundamental factors (earnings, earnings growth, firm size, research expenditure)
...

SML equation :

𝐸 𝑅 =𝑅 +

𝐸 𝑅 −𝑅
× 𝐶𝑜𝑣 ,
𝜎

=𝑅 +

𝐶𝑜𝑣 ,
× 𝐸 𝑅
𝜎

−𝑅

In which :
𝐶𝑜𝑣 ,
=𝛽
𝜎
Capital asset pricing model (CAPM) : relation between beta (systematic risk) an expected return
CAPM formula :

𝐸 𝑅

= 𝑅 + 𝛽 × [𝐸 𝑅

−𝑅 ]

Assumptions of CAPM:
- Risk aversion : ↑ expected return , in order to ↑ risk
- Utility maximising investors : Investors choose portfolio based on individial preferences, with risk and return combination that maximises their utilty
- Frictionless markets : no taxes, transaction costs or other impediments to tradings
- One-period horizon : all investors have same on-period horizon
- Homogeneous expectations : all investors have same expected returns, standard deviation of returns, and returns correlations between assets
- Divisible assets : all investments are infinitely dividible
- Competitive markets : No investor can influenc prices with their trades
SML vs
...
Higher Sharpe ratio → be er risk-adjusted por olio performance

𝑆ℎ𝑎𝑟𝑝𝑒 𝑟𝑎𝑡𝑖𝑜 =

𝑅 −𝑅
𝜎

M-squared : same portfolio raking with Sharpe ratio, but stated in %

𝑀 = 𝑅 −𝑅

×

𝜎
− (𝑅 − 𝑅 )
𝜎

Treynor measure : measure returns per unit of systematic risk

𝑇𝑟𝑒𝑦𝑛𝑜𝑟 𝑚𝑒𝑎𝑠𝑢𝑟𝑒 =

𝑅 −𝑅
𝛽

Jensen's alpha :

𝛼 = 𝑅 − [𝑅 + 𝛽 × 𝑅 − 𝑅 ]

Concepts

Description

Investment policy statement (IPS)

Basic of Portfolio planning and Construction
Objective: Understand client's needs, circumstances and constraints
Investment policy statement begin with the investor's risk and return, and must be compatible with investor's risk tolerance

Components of IPS

- Client description : circumstances, situations and investment objectives
- Statement of purpose
- Statement of Duties and Responsibilities of investment manager, custodian of assets and the client
- Procedures to update IPS and respond to possible situations
- Investment objectives
- Investment constraints
- Investment guidelines : how the policy is executed, asset types permitted, leverage to be used
- Evaluation of Performance : benchmark portfolio and other information for performance evaluation
- Appendices : Information on strategic asset allocation, permitted deviations from policy portfolio allocations, how and when portfolio allocations should be rebalanced

Risk objectives

Risk objectives include:
1
...
Relative risk objectives:
- Could relate to a specific benchmark : " return will not be less than 12-month euro LIBOR over any 12-month period"
- could relate to a benchmark portfolio return : "Exceed the return on S&P500 Index by 2% per annum"

Ability to bear risk /
Willingness to bear risk

Ability to bear risk : depends on financial circumstances (long investment horizons, more wealth, more insurance against unexpected occurences, secure job → greater ability to bear risk
Willingness to bear risk : based on investor's attitudes and beliefs about investments → subjec ve

Investor constraints
R-R-T-T-L-L-U
(Return - Risk - Time horizon - Tax
situation - Liquidity - Legal
restriction - Unique circumstances)

Liquidity : the need to draw cash from the portfolio for anticipated or unexpected future spending needs
...
Short time horizon → avoid risky or illiquidity investments
Tax consideration : Concern the tax treatments of investor's various acounts, relative tax treatment of capital gains and income, and investor's marginal tax bracket
Legal and regulatory : Constraints (e
...
: gov restrictions on portfolio contents or laws against insider trading)
Unique circumstances : restrictions due to investor preferences (religious, ethica;, etc
...
Main major asset classes include:
1
...
Fixed income
3
...
Real estate
5
...


Strategic asset allocation

Strategic asset allocation : allocations to various asset classes that is designed to meet investor's objectives

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