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Title: CFA Level III Curriculum Notes
Description: CFA Level III exam notes from 2011 CFA Curriculum. 112 pages and extremely thorough
Description: CFA Level III exam notes from 2011 CFA Curriculum. 112 pages and extremely thorough
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CFA Level III Notes
Book 1
...
Several
circumstances can prompt an inquiry
1
...
2
...
3
...
4
...
- When an inquire is received, the Professional Conduct staff conducts an investigation resulting in no disciplinary
sanction, issue a cautionary letter, or continue proceedings to discipline the member or candidate
...
If rejected, it goes to a hearing
...
This claim has not been verified by CFA Institute”
The Code of Ethics
• Act with integrity, competence, diligence, respect, and in an ethical manner with the public, clients,
prospective clients, employers, employees, colleagues in the investment profession, and other
participants in the global capital markets
...
• Use reasonable care and exercise independent professional judgment when conducting investment
analysis, making investment recommendations, taking investment actions, and engaging in other
professional activities
...
• Maintain and improve their professional competence and strive to maintain and improve the
competence of other investment professionals
...
Professionalism
A
...
In the event of conflict, members
and candidates must comply with the more strict law, rule, or regulation
...
Members and Candidates must adhere to the following principles:
- Members and candidates must comply with applicable law or regulation related to their
professional activities
...
- In the absence of any applicable law or regulation or when the Code and Standards
impose a higher degree of responsibility than applicable laws and regulations,
members
and candidates must adhere to the Code and Standards
...
In extreme cases,
dissociation may require leaving firm
...
Stay informed – establish or encourage their employers to establish a procedure by which employees are
regularly informed about changes in applicable laws, rules, regulations and case law
...
Review Procedures – review or encourage their employers to review written compliance procedures on a
regular basis to ensure that they reflect current law and provide adequate guidance
...
Maintain Current files – maintain or encourage employers to maintain readily accessible current
reference copies or applicable statutes, rules, regulations and important cases
...
- when in doubt about appropriate action to take, seek advice of compliance or legal counsel
- when dissociating, document violation
Firms:
1
...
2
...
3
...
Independence and Objectivity – Members and candidates must use reasonable care and judgment
to achieve and maintain independence and objectivity in their professional activities
...
- Analysts must distinguish between fact and opinion in their reports
...
- when traveling, if commercial transportation is unavailable, analysts may accept modest accommodations
Recommended Procedures for Compliance:
1
...
Create a restricted list
3
...
Analysts are not expected to pay
for chartered flights or modest accommodations when a business is remote and there are not other options
...
Limit gifts and the acceptance of gratuities to token items only
5
...
Review Procedures
7
...
8
...
Misrepresentation – Members and candidates must not knowingly make any misrepresentations
relating to investment analysis, recommendations, actions, or other professional activities
...
Maintain Copies
2
...
3
...
D
...
Recommended Procedures for Compliance:
1
...
2
...
3
...
II
...
Material Nonpublic Information – Members and candidates who possess material nonpublic
information that could affect the value of an investment must not act or cause others to act on the
information
...
g
...
g
...
); orders for large trades before they are
executed
...
51) – An analyst gathers and interprets large quantities of information from many
sources
...
Under the “mosaic theory”, financial analysts are free to act on this
collection, or mosaic, of information without risking valuation
...
Try to achieve public dissemination if determined that information is material
2
...
Adopt disclosure procedures designed to ensure that information is disseminated to the marketplace in an
equitable manner
4
...
Companies should construct information “firewalls” including
- Substantial control of relevant interdepartmental communications
- Review of employee trading through the maintenance of watch or restricted and rumor lists
- Documentation of the procedures designed to limit the flow of information between departments and of
the enforcement actions taken pursuant to those procedures
- Heightened review or restriction of proprietary trading while a firm is in possession of material nonpublic
information
...
Appropriate Interdepartmental Communications
7
...
Prevention of Personnel Overlap between departments such as brokerage, sales, research, etc
...
Establish a reporting system in which authorized people review and approve communication between
departments
10
...
Record Maintenance
12
...
- firms that continue market making activity while in the possession of material nonpublic information
should instruct their market makers to remain passive to the market – to only take the contra side of
unsolicited customer trades
- the most prudent course for firms is to suspend arbitrage trading when a security is placed on the watch
list
13
...
Market Manipulation – Members and candidates must not engage in practices that distort prices or
artificially inflate trading volume with the intent to mislead market participants
...
- securing a controlling, dominant position in a financial instrument to exploit and manipulate the price
of a
related derivative and/or the underlying asset
NOTE: this standard is NOT meant to prohibit legitimate trading strategies that exploit a difference in
market power, information, or other market inefficiencies
...
The INTENT of the
is critical in determining whether it is a violation of the standard
...
III
...
Loyalty, Prudence, Care – Members and candidates have a duty of loyalty to their
clients and must act with reasonable care and exercise prudent judgment
...
- The duty of loyalty is owed to the ultimate beneficiaries and not just the client
...
Whenever the
manager uses client brokerage to purchase goods or services that do not benefit the client, the manager
should disclose to clients the method or policies followed by the manager in addressing the potential
conflict
...
Member or
candidate should disclose to client that the client may not be getting best execution from directed brokerage
Recommended Procedures for Compliance:
- submit at least quarterly account statements to clients if they control the assets
- seek client approval if uncertain about appropriate course of action with respect to a client
Firm Policies for Compliance:
1
...
Establish the investment objectives of the client
...
Consider all the information when taking actions
5
...
Deal fairly with all clients with respect to investments
...
7
...
Disclose compensation arrangements
9
...
Maintain confidentiality
11
...
Place client interests first
...
Fair Dealing – Members and candidates must deal fairly and objectively with all
clients when providing investment analysis, making investment recommendations,
taking investment action, or engaging in other professional activities
...
Member or
candidates duty of fairness and loyalty can NEVER be overridden by client consent
to patently unfair allocation procedures
...
- Oversubscriptions of IPOs or secondary financings: members and candidates should distribute the issues
to all customers for whom the investments are appropriate in a manner consistent with the block-allocation
policies of the firm
...
If the issue is oversubscribed, then the issue should be pro-rated to all subscribers
...
- A member’s or candidate’s duty of fairness and loyalty to clients can NEVER be overridden by client
consent to patently unfair allocation procedures
...
Limit number of people involved
2
...
Publish personnel guidelines for predissemination
4
...
Maintain a list of clients and their holdings
6
...
7
...
Establish systematic Account Review
9
...
Suitability –
1
...
Make a reasonable inquiry into a client’s or
prospective client’s investment experience,
risk and return objectives, and financial
constraints prior to making any investment
recommendation or taking investment action
and must reassess and update this
information regularly
...
Determine that an investment is suitable to the
client’s financial situation and consistent
with the client’s written objectives,
mandates, and constraints prior to making an
investment recommendation or taking
investment action
...
Judge the suitability of investments in the
context of the client’s total portfolio
...
When members and candidates are responsible for managing a portfolio to a specific
mandate, strategy, or style, they must only make investment recommendations or take investment actions
that are consistent with the stated objectives and constraints of the portfolio
Recommended Procedures for Compliance:
In formulating and IPS for a client, take the following into account:
1
...
Investor objectives – (a) return objectives (b) risk tolerance
3
...
Performance measurement benchmarks
D
...
Recommended Procedures for Compliance:
1
...
Compliance without Applying GIPS standards:
1
...
Presenting performance of the weighted composite of similar portfolios rather than using a single
representative account
3
...
Including disclosures that would fully explain the performance results being reported (if model used in
simulation, indicate if performance record is of prior entity, disclose whether gross of fees, net of fees, or
after tax)
5
...
Preservation of Confidentiality – Members and candidates must keep information
about current, former, and prospective clients confidential unless:
1
...
Disclosure is required buy law; or
3
...
IIII
...
Loyalty – In matters related to their employment, members and candidates must act
for the benefit of their employer and not deprive their employer of the advantage of
their skills and abilities, divulge confidential information, or otherwise cause harm to
their employer
...
Members and candidates should not render services until
receiving consent from their employer to all of the terms of the arrangement
...
Nature of Employment – duties with independent contractor relationship are governed by the oral or
written agreement between the member and client
...
Additional Compensation Arrangements – Members and candidates must not accept
gifts, benefits, compensation, or consideration that competes with, or might
reasonably be expected to create a conflict of interest with, their employers’ interest
unless they obtain written consent from all parties involved
...
Should
be a written report that states terms of any agreement under which a member or
candidate will receive additional compensation; terms include the nature of the
compensation, the approximate amount of compensation, and the duration of the
agreement
...
Responsibilities of Supervisors – Members and candidates must make reasonable
efforts to detect and prevent violations of applicable laws, rules, regulation, and the
Code of Standards by anyone subject to their supervision or authority
...
They may delegate supervisory duties, but
such delegation does not relieve them of their supervisory responsibility
...
They exercise supervision by establishing and
implementing written compliance procedures and ensuring that they’re followed through periodic review
...
Knowing the procedures designed to detect and prevent violations are not
being followed is a violation
...
V
...
Diligence and Reasonable Basis – Members and candidates must:
1
...
2
...
Secondary or Third-Party Research:
- must make reasonable and diligent efforts to determine whether such research is sound
...
e
...
Establish a policy requiring that research reports and recommendations have a basis that
can be sustained as reasonable and adequate
...
Develop detailed, written guidance for research analysts, supervisory analysts, and review
committees that establish due-diligence procedures for judging whether a particular
recommendation has a reasonable and adequate basis
...
Develop measurable criteria for assessing the quality of research, including the
reasonableness and adequacy of the basis for any recommendation and arrangements that
depend on these measurable criteria and that are applied consistently to all research
analysts
...
Develop detailed, written guidance that establishes minimum levels of scenario testing of
all computer-based models used in developing, rating, and evaluating financial
instruments
e
...
Adopt a standardized set of criteria for evaluating the adequacy of external advisers
B
...
Disclose to clients and prospective clients the basic format and general principles of the
investment processes used to analyze investments, select securities, and construct portfolios
and must promptly disclose any changes that might materially affect those processes
...
Use reasonable judgment in identifying which factors are important to their investment
analyses, recommendations, or actions and include those factors in communications with
clients and prospective clients
...
Distinguish
recommendations
...
Record Retention – Members and candidates must develop and maintain appropriate
records to support their investment analysis, recommendations, actions, and other
investment-related communications with clients and prospective clients
...
- In the absence of regulatory guidance, CFA Institute recommends maintaining records for at
least 7 (seven) years
...
However, members and candidates must retain research notes and other
documents supporting current investment-related communications to assist their firms in complying
with internal or external record preservation requirements
...
Conflicts of Interest
A
...
Members and candidates must ensure that such disclosures are
prominent, are delivered in plain language, and communicate the relevant
information effectively
...
Member or candidate may dissociate from activity if firm does
not permit such disclosure
...
If the firm does not permit disclosure, the member should document the request and may
consider dissociating from the activity
...
Priority of Transactions – Investment transaction for his clients and employers must
have priority over investment transactions in which a member or candidate is the
beneficial owner
...
If
the member or candidate has a beneficial ownership in the account, however, the member or candidate may still be
subject to preclearance or reporting requirements of their employer or applicable law
...
Disclosure of holdings in which the employee has a beneficial trust
b
...
Preclearance procedures
- Disclosure of Policies
C
...
- members and candidates must disclose when they pay a fee or provide compensation to others who have
referred prospective clients to the member or candidate
- Must advise the client or prospective client, before entering into any formal agreement for services, of any
benefit given or received for the recommendation of any services provided by the member or candidate
...
VII
...
Conduct as Members and Candidates in the CFA Program – Members and
candidates must not engage in any conduct that compromises the reputation or
integrity of CFA Institute or the CFA designation or the integrity, validity, or security
of the CFA examinations
...
Reference to CFA Institute, the CFA Designation, and the CFA Program - When
referring to CFA Institute, CFA Institute membership, the CFA designation, or
candidacy in the CFA Program, members and candidates must not misrepresent or
exaggerate the meaning or implications of membership in CFA Institute, holding the
CFA designation, or candidacy in the CFA program
...
- can state that the member passed each level on the first try, as it is a statement of fact
...
- “CFA” can never be used as a noun
...
Study Session 2: Ethical and Professional Standards in Practice
Reading 3: Ethics in Practice
2
...
e
...
Preamble to the Code of Ethics
- the preamble makes three points; it places the Code in the context of CFA Institute’s educational mission, specifies
who is bound by it, and mentions the sanctions to which violators are subject
- to remain in good standing, members of CFA Institute must submit an annual Professional Conduct Statement;
failure to do so can result in suspension
6
...
Standard III – Duties to Clients
- when providing advice, covered persons are first directed to inquire about the client’s investment experience,
objectives, and constraints before they make any recommendations or take any action
- the GIPS standards apply only to investment management firms, and the firms compliance is voluntary
...
11
...
Reading 5: Pearl Investment Management (A), (B), and (C)
- when trades are made in error or are misallocated, under no circumstance should client portfolios bear the risk of
an inappropriate transaction; nor should the firm shift the burden to another portfolio or client account
...
General Principles of Conduct
- managers have the following responsibilities to their clients
1
...
Act for the benefit of clients
3
...
Act with skill, competence, and diligence
5
...
Uphold the rules governing capital markets
A
...
Place client interests before their own
2
...
Create anti-money-laundering policy
3
...
Investment Process and Actions, Managers Must:
1
...
2
...
3
...
- this provision is not intended to prevent managers from engaging in secondary investment opportunities
as long as such opportunities are fairly allocated among similarly situated clients fro whom the opportunity
is suitable
4
...
5
...
Take only investment actions that are consistent with the stated objectives and constraints of that
portfolio or fund
...
Provide adequate disclosures and information so investors can consider whether any proposed changes in
the investment style or strategy meet their investment needs
...
When managing separate accounts and before providing investment advice or taking investment action on behalf
of the client:
a
...
) and any other relevant information that would affect investment policy
...
Determine that an investment is suitable to a client’s financial situation
...
Trading, Managers Must:
1
...
2
...
3
...
- if managers choose to use a soft commission or bundled brokerage arrangement, they should disclose their
use to clients
4
...
5
...
- where possible, managers should use block trades and allocates shares on a pro rata basis using an average
price or some other method that ensures fair and equitable allocations
D
...
Develop and maintain policies and procedures to ensure that their activities comply with the provisions of this
Code and all applicable legal and regulatory requirements
...
Appoint a compliance officer responsible for administering the policies and procedures and for investigating
complaints regarding the conduct of the Manager or its personnel
...
Ensure that portfolio information provided to clients by the Manager is accurate and complete and arrange for
independent third-party confirmation or review of such information
...
Maintain records for an appropriate period of time in an easily accessible format
...
Employ qualified staff and sufficient human and technological resources to thoroughly investigate, analyze,
implement, and monitor investment decisions and actions
...
Establish a business-continuity plan to address disaster recovery or periodic disruptions of the financial markets
...
Performance and Valuation, Managers Must:
1
...
Managers must not
misrepresent the performance of individual portfolios or of their firm
...
Use fair-market prices to value client holdings and apply, in good faith, methods to determine the fair value of any
securities for which no independent, third-party market quotation is readily available
...
Disclosures, Managers Must:
1
...
2
...
3
...
4
...
Conflicts of interests generated by any relationships with brokers or other entities, other client accounts,
fee structures, or other matters
...
Regulatory or disciplinary action taken against the Manager or its personnel related to professional
conduct
...
The investment process, including information regarding lock-up periods, strategies, risk factors, and use
of derivatives and leverage
...
Management fees and other investment costs charged to investors, including what costs are included in
the fees and the methodologies for determining fees and costs
...
The amount of any soft or bundled commissions, the goods and/or services received in return, and how
those goods and/or services benefit the client
...
The performance of clients’ investments on a regular and timely basis
...
Valuation methods used to make investment decisions and value client holdings
...
Shareholder voting policies
...
i
...
- managers must disclose to their trade allocation policy and disclose any changes
j
...
- results must be disclosed to clients if funds or accounts are submitted for annual review
k
...
- should be made aware in a timely manner
Book 1 Notes:
Book 2
...
people develop general principles as they find things out for themselves
b
...
People are susceptible to particular errors because the heuristics they use are imperfect
d
...
0 Representativeness
Representativeness – judgments based on stereoytypes
Winner-Loser Effect – De Bondt and Thaler found that stocks that have been extreme pat losers in the preceding
three years do much better than extreme past winners over the subsequent three years
Regression to the mean – suggests that future returns will be closer to their historical averages
Gambler’s Fallacy – arises because people misinterpret the law of averages, technically known as “the law of large
numbers”
3
...
0 Anchoring-and-Adjustment Conservatism
- the unexpected surprises in store for analysts are also a manifestation of overconfidence because overly narrow
confidence bands mean people get surprised more frequently than they anticipate
5
...
0 Emotion and Cognition
Cognitive Errors – errors that stem from the way people think
- phenomena involving the availability heuristic may reflect both cognitive and emotional elements
Reading 8: Frame Dependence: The Second Theme
- frame dependence deals with the distinction between form and substance
1
...
Some studies suggest
that losses are twice as powerful, psychologically, as gains
2
...
0 Hedonic Editing
- investors preferring some frames to others
- people are not uniform in their tolerance for risk; it depends on the situation
- according to Thaler and Johnson, the added attraction of experiencing gains separately inclines people to be more
willing to gamble
...
0 Cognitive and Emotional Aspects
- the cognitive aspects concern the way people organize their information, while the emotional aspects deal with the
way people feel as they register the information
“House Money” Effect – because of loss aversion, people who ignore having just won $X are much less prone to
accepting a new gamble involving a loss than those who see themselves as $X ahead
Frame Dependence – means that the way people behave depends on the way that their decision problems are framed
5
...
0 Regret
- regret us the emotion experienced for not having made the right decision; it is the pain associated with feeling
responsible for the loss
- regret minimization also leads some investors to use dividends, instead of selling stock, to finance consumer
expenditures
7
...
0 Cause and Effect
- investors’ errors are the cause of mispricing
2
...
0 Effects Stemming from Conservatism
- analysts who suffer from conservatism due to anchoring-and-adjustment do not adjust their earnings predictions
sufficiently in response to the new information contained in earnings announcements
4
...
0 Departure from Fundamental Value: Short-Term or Long-Term?
6
...
Implications of Overconfidence:
1
...
investors trade more frequently than is prudent, which leads to excessive trading volume
Summary:
- Heuristic-driven bias and frame dependence cause prices to stray from fundamental values, as evidenced by:
a
...
Conservatism as a cause of post-earnings-announcement drift
c
...
0 The Emotional Time Line
- emotions determine tolerance for risk
- fear induces an investor to focus on events that are especially unfavorable, while hope induces him or her to focus
on events that are favorable
- in Lopes’s terminology, the bottom-up perspective of fear emphasizes the desire for security, whereas the top-down
perspective of hope emphasizes the need for potential on the upside
2
...
0 Frame Dependence: Mental Accounts and Priorities – is Safety First?
- investors, like subsistence farms do think in terms of layers based on security and potential
4
...
0 Security Design
Cautiously Hopeful – investors who are driven by both security and fear
6
...
Why, because regret is counterfactual
...
Cognitive Dissonance – not wanting to judge themselves harshly, investors simply remember beating the market
7
...
display excessive optimism
b
...
discount diversification
d
...
0 Optimism
- excessive optimism is a well-studied phenomenon, especially in young people in their teens and twenties who
systematically think they are less likely to experience bad outcomes and more likely to experience good outcomes
9
...
0 The Online Revolution
- overconfidence and optimism appear to be particularly severe among day traders
11
...
0 Naive Diversification
Naïve Diversification = 1/n Rule; the rule that people will divide investment amounts equally between “n” number
of choices given to them
13
...
S
...
0 Introduction
Defined Benefit Plan – employer bears risk
Defined Contribution Plan – employee bears risk
- in recent years, there has been a significant shift in retirement income provision in the US from DB to DC; Bodie argues that
risk is being transferred “to those least able to manage it” with this shift
2
...
0 Portfolio Diversification and Investor Perceptions of Risk
Myopic Loss Aversion – investors seeking to avoid short term looses, despite the long time horizon usually involved in planning
for retirement
Endorsement Effect – employees taking the range of funds on offer as implicit guidance from the employer as the appropriate
asset allocation strategy
- company stock has consistently been rated less risky by employees than a diversified stock fund, though it is usually riskier than
the overall market
- studies show that the investment strategies employed in self-directed retirement plans are often at odds with standard investment
theory and suggest much of this can be explained by well-documented behavioral biases
4
...
0 U
...
Comparisons
- the U
...
, like the U
...
, is seeing a move from employer provision of DB pensions to a situation where DC is more common
- In an Occupational Money Purchase (OMP) scheme, the trustees have the responsibility for the investment choice offered
within the plan
- in a Group Personal Pension (GPP) scheme, the choice is determined by the product provider in consultation with the employer
6
...
S
...
K
...
0 The Folly of Forecasting
- inflation forecasts appear to be largely a function of past inflation rates, and are inaccurate
- acknowledgement of our own limitations is one of the reasons why we don’t even attempt to produce index
forecasts
A
...
Overconfidence and Experts
- experts are more overconfident than laypeople, as confirmed by Glaser, Langer and Weber survey
C
...
Unskilled and Unaware
- those who are amongst the worst performers actually are the most overconfident, as shown by David Dunning
- Dunning notes, “People fail to recognize their own incompetencies because that incompetence carries with it a
double curse…the skills needed to produce correct responses are virtually identical to those needed to evaluate the
accuracy of one’s responses…Thus, if people lack the skills to produce correct answers, they are also cursed with an
inability to known when their own answers, or anyone else’s are right or wrong”
- the evidence suggests that people’s impressions of their skills and abilities are at best moderately correlated and
frequently uncorrelated with their actual performance
...
Ego Defense Mechanism
- expertise thus may not translate into predictive accuracy but it does translate into the ability to generate
explanations for predictions that experts themselves find so compelling that the result is massive overconfidence
...
The “If Only” defense – experts claim they would have been correct “if only” their original advice or analysis was
followed
2
...
The “I was almost right” defense – although the predicted outcome did not occur, it “almost did”
4
...
The “Single Prediction” defense – although the conditions of the forecast were met, and the outcome never came
close to occurring and now never will
...
So Why Use Forecasts?
- the obsession of forecasts probably stems from the ingrained love of efficient markets
Anchoring – the tendency to grab onto the irrelevant when faced with uncertainty; this is why we keep forecasting
- when faced with the unknown, people will grasp onto almost anything
G
...
0 Truly Active Alphas
2
...
Process versus Outcome
- the ultimate issues is the soundness of the decision process itself
B
...
Bayesian Rigidity
- the “rigid Bayesians” will relentlessly try to retain their old views in the face of new information
D
...
The Ebullience Cycle
- in the ebullient atmosphere, both individual and institutional investors are inclined to hold on firmly to their
winning positions, which are shining examples of their brilliance
F
...
In essence, institutions act as “formulaic rebalancers”
Valuators – valuators take positions based on the belief that the market is either cheap (or rich) or that it will
continue (or reverse) its recent direction
Shifters – this category really represents a transient reaction rather than an ongoing style
...
0 Market Impact
- the aforementioned responses may either exacerbate or moderate market movements
Holders – have little effect on the market
Rebalancers – will tend to have a smoothing effect (buy more when it goes down, sell when it goes up)
- holders and rebalancers will usually invest their new funds congruently with their existing allocations
Valuators – contrarians and reversionists will act as moderators whereas those pursuing momentum strategies will
have an exacerbating effect
- make fresh decisions about where to apply new funds
Shifters – will exacerbate market moves
4
...
Risk as Risk to the Policy Portfolio
- the standard measure of risk, volatility, is an estimate of the range of returns at a given horizon
6
...
Study Session 4: Private Wealth Management
Reading 14: Managing Individual Investor Portfolios
1
...
- the IPS should serve as the fundamental point of reference
2
...
0 Investor Characteristics
- often unaccounted for in traditional models of “rational investor” behavior, such factors as personality, life
experiences, and personal circumstances can play an important role in determining the framework for addressing
financial decisions
3
...
1
...
1
...
1
...
2 Psychological Profiling
- a determinant of individual investing is the psychological process by which an individual establishes his or her
investment preferences
3
...
1 Traditional Finance
- in models of traditional, or standard, investment decision making, investors are assumed to:
- exhibit risk aversion, hold rational expectations, practice asset integration
Risk Aversion – Implies that investors with otherwise equivalent investment options will prefer the investment with
the lowest volatility
Rational Expectations – assume that investors are coherent, accurate, and unbiased forecasters
Asset Integration – refers to the process by which investors choose among risky investments, by comparing the
portfolio return/risk distributions that result from combining various investment opportunities with their existing
holdings
Traditional models of the portfolio building process have historically relied on the following tenets:
- asset pricing is driven by economic considerations such as production costs and prices of substitutes
- portfolios are constructed holistically, reflecting covariances between assets and overall objectives and
constraints
3
...
2 Behavioral Finance
- Behavioral finance decision making models attempt to incorporate the principles that investors:
- exhibit loss aversion, hold biased expectations, practice asset segregation
Exhibit Loss Aversion – demonstrated when investors evaluate opportunities in terms of gain or loss rather than in
terms of uncertainty with respect to terminal wealth
Hold Biased Expectations – result from cognitive errors and misplaced confidence in one’s ability to assess the
future
Practice Asset Segregation – the evaluation of investment choices individually, rather than in aggregate
Reference Dependence – behavior in which economic behavior is shaped by the frame of reference or the
context in which choices are presented, and mental accounting
According to behavioral finance models of individual decision making, portfolio construction takes place under a
more complex set of assumptions:
- Asset pricing reflects both economic consideration, such as production costs and prices of substitutes, and
subjective individual considerations such as tastes and fears
- portfolios are constructed as “pyramids” of assets, layer by layer, in which each layer reflects certain goals
and constraints
3
...
3 Personality Typing
- through personality typing, investment advisors can better understand the behavioral drivers that lead to an
individual’s goal setting, asset allocation, and risk-taking decisions, and thus advisors can better manage client
expectations and behavior
Stratified Random Sample – independent sample from subgroups that, when combined, represent a population’s
overall characteristics
Investment Personality Types:
1
...
Methodical Investors – methodical investors make decisions based on upon thinking and are
more risk averse
3
...
Individualist Investors – the group has a self-assured approach to investing
- see Exhibit 2 “Personality Types” pg
...
0 Investment Policy Statement
- the IPS is a client-specific summation of the circumstances, objectives, constraints, and policies that govern the
relationship between advisor and investor
...
1 Setting Return and Risk Objectives
4
...
1 Return Objective
- the process of setting the investor’s desired and required returns should take place concurrently with the discussion
of risk tolerance
Return Requirement – refers to a level necessary to achieve the investor’s primary or critical long-term financial
objectives
Return Desire – denotes a return level associated with the investor’s secondary goals
- a “total return” approach to setting the return requirements looks first at the individual’s investment goals and then
identifies the annual after-tax portfolio return necessary to meet those goals
- when dealing with a surplus, the investor must decide whether to protect that surplus by assuming less risk than she
is able and willing to accept or to use the surplus as the basis for assuming greater risk than needed to meet the
original return goals, with the expectation of achieving a higher return
- Needs ($) / Investable base ($) + Inflation (%) ~ Required After-tax Nominal Return
4
...
2 Risk Objective
- function of both ability to take risk and willingness to take risk
A
...
What are the investor’s financial needs and goals, both long term and short term?
2
...
How large an investment shortfall can the investor’s portfolio bear before jeopardizing its ability to meet major
short-term and long-term investment goals
- the limit of a portfolio’s ability to accept risk is reached when the probability of failing to meet a highpriority objective becomes unacceptably high
B
...
2 Constraints
- TTLLU
4
...
1 Liquidity
- refers to the investment portfolio’s ability to efficiently meet an investor’s anticipated and unanticipated demands
for cash distributions
- transaction costs and price volatility are two trading characteristics of its holdings that determine a
portfolio’s liquidity
- significant liquidity requirements constrain the investor’s ability to bear risk
...
Ongoing Expenses
b
...
Negative Liquidity Reserves
Illiquid Holdings – IPS should specifically identify significant holdings of illiquid assets and describe their role in
the investment portfolio
4
...
2 Time Horizon
- generally, time horizons greater than 15 to 20 years can be viewed as relatively long term, <3 years as relatively
short term, and 3
4
...
3 Taxes
1
...
Gains Tax – profits based on price appreciation
3
...
Property Tax – most often refers to the taxation of real property (real estate)
A
...
Tax Avoidance – ideal if can be done legally
- Tax exempt is attractive only when RTax-Free > [RTaxable*(1 – Tax Rate)]
C
...
Wealth Transfer Taxes – strategies for addressing wealth transfers focus on either the timing or the legal structure
of the transfer
- early gifting of higher-growth assets into the hands of a younger generation may shelter the subsequent growth of
those assets from transfer taxes when the investor ultimately dies
Additional issues to consider before making a permanent transfer include
- the amount of retained wealth needed to ensure the financial security of the primary investor
- possible unintended consequences of transferring large amounts of wealth to younger, possible less
mature beneficiaries
- the probable stability or volatility of the tax code
4
...
4 Legal and Regulatory Environment
- in the context of portfolio management for individual investors, legal and regulatory constraints most frequently
involve taxation and the transfer of personal property ownership
A
...
The Family Foundation – is an independent entity, often governed by family members
Gifting with Retained Interest – grantor’s give up legal ownership assets but retain ownership interest in any income
generated by the trust
C
...
2
...
It is also appropriate to list here any assets held outside the
investment portfolio and not otherwise discussed in the IPS
...
2
...
0 An Introduction to Asset Allocation
- the advisor’s challenge is to find a set of asset-class weights that produce a portfolio constraint consistent with the
individual investor’s return objective, risk tolerance, and constraints
...
5
...
5%
The process of selecting the most satisfactory from among several potential strategic asset allocations generally
consists of the following steps:
1
...
Eliminate asset allocations that fail to meet quantitative risk objectives or are otherwise inconsistent with
the investor’s risk tolerance
3
...
Evaluate the expected risk-adjusted performance and diversification attributed of the asset allocations
that remain after Steps 1 through 3 to select the allocation that is expected to be the most rewarding for the
investor
5
...
It is useful when trying to forecast future results that depend on multiple factors each with a unique
distribution of probable outcomes
- Monte Carlo analysis provides a probability estimate, as well as other detailed information, that allows the investor
to better asses risk
Benefits of Probabilistic Monte Carlo Approach
1
...
a probabilistic simulation can give information on the possible tradeoff between short-term risk and the risk of not
meeting a long-term goal
3
...
Monte Carlo analysis is well suited to model a stochastic process and its resulting alternative outcomes
Risks: be wary of a simulation tool that relies only on historical data and choose simulations that simulate the
performance of specific investments, not just asset classes and all simulations should take into account tax
consequences of investments
Summary Notes:
- an increasing need for liquidity will constrain the investment portfolio’s ability to accept risk
- for individual investors, investment decisions, including asset allocation, are made on an after-tax basis
Reading 15: Taxes and Private Wealth Management in a Global Context
2
...
1 International Comparisons of Income Taxation
2
...
3 General Income Tax Regimes
- each countries income tax structure can be classified as either progressive or flat
Tax Regimes
Common Progressive Regime – has progressive tax rates for ordinary income, but favorable treatment in all three
investment categories
Heavy Dividend Tax Regime – has a progressive tax system for ordinary income and favorable treatment for some
interest and capital gains, but taxes dividends at ordinary rates
Heavy Capital Gain Tax Regime – has a progressive tax system for ordinary inceom and favorable treatment for
interest and dividends, but taxes capital gains at ordinary rates
Heavy Interest Tax Regime – has a progressive tax system for ordinary income and favorable treatment for
dividends and capital gains, but taxes interest income at ordinary rates
Light Capital Gain Tax Regime – has a progressive tax system for ordinary income, interest, and dividends, but
favorable treatment of capital gains
Flat and Light Regime – flat tax system and treats interest, dividends, and capital gains favorably
Flat and Heavy Regime – flat tax system for ordinary income, dividends, and capital gains
...
4 Other Considerations
Tax deferred accounts:
- defers taxation on investment returns within the account
- may permit a deduction for contributions
- may occasionally permit tax free distributions
3
...
1 Returns-Based Taxes: Taxes on Interest and Dividends
- accrual taxes are levied and paid on a periodic basis, as opposed to deferred taxes that are postponed until some
future date
- the amount of money accumulated for each unit of currency invested after n years, assuming that returns (after
taxes at rate ti are paid) are reinvested at the same rate of return, r, is simply
FVIFi = [1 + r(1 – ti)]
n
- the tax drag on capital accumulation compounds over time when taxes are paid each year
- when investment returns are taxed annually, the effect of taxes on capital growth is greater than the nominal tax
rate
- the adverse effects of taxes on capital growth increase over time
- the tax drag increased as the investment return increases, all else equal
- return and investment horizon have a multiplicative effect on the tax drag associated with future accumulations
3
...
2 Returns-Based Taxes: Deferred Capital Gains
- if the tax on an investment’s return is deferred until the end of its investment horizon, n, and taxed as a capital gain
at the rate tcg, then the after-tax future accumulation for each unit of currency can be represented by:
n
n
n
FVIFcg = (1 + r) – [(1 + r) – 1)] tcg
FVIFcg = (1 + r) (1 - tcg) + tcg
- the after-tax investment gain = pretax investment gain * (1 – t)
- the tax drag from deferred capital gains is a fixed percentage regardless of the investment return or time horizon
- it is important to note that the advantages of tax deferral can be offset or even eliminated if securities taxed on an
accrual basis have great risk-adjusted returns
3
...
3 Cost Basis
- cost basis is generally the amount that was paid to acquire an asset, which serves as the foundation for calculating a
capital gain
- the after-tax cash flow from liquidation increases as cost basis increases, all else equal
- if the cost basis is expressed as a proportion, B, of the current market value of the investment, then the future aftertax accumulation can be expressed by simply subtracting this additional tax liability from these
expressions:
n
FVIFcgb = (1 + r) (1 - tcg) + tcg – (1 – B) tcg
- if cost basis is equal to initial investment, then B = 1 and the last term simply reduces to:
n
FVIFcgb = (1 + r) (1 - tcg) + tcgB
3
...
4 Wealth-Based Taxes
- if wealth is taxed annually at a rate of tw, then after n years each unit of currency accumulates to
FVIFw = [(1 + r) (1 – tw)]
n
- because wealth taxes apply to the capital base, the absolute magnitude of the liability they generate is less sensitive
to investment return than taxes based on returns; a wealth tax consumes a greater proportion of investment growth
when returns are low
3
...
- the future after-tax accumulation for each unit of currency in a taxable portfolio can be represented by
n
FVIFTaxable = (1 + r*) (1 – T*) + T* - (1 – B)tcg
3
...
3
...
Assuming $100k at 8%:
5
100,000(1 + RAE) = $138,662
- the accrual equivalent return is always less than the taxable return, r, but approaches the pre-tax return as the time
horizon increases
3
...
2 Calculating Accrual Equivalent Tax Rates
- the accrual equivalent tax rate is derived from the accrual equivalent return
...
it can be used to measure the tax efficiency of different asset classes or portfolio management styles
2
...
it can be used to asses the impact of future tax law changes
4
...
Taxable accounts – investments to these accounts are made on an after-tax basis and returns can be taxed in a
variety of ways
2
...
Tax-Exempt Accounts – contributions not deductible, earnings accumulate fee of taxation even as funds are
withdrawn (back-end tax benefit)
4
...
2 Tax-Exempt Accounts
- the future accumulation of a tax-exempt account is
FVIFTaxEx = (1 + r)
n
4
...
4 Choosing Among Account Types
n
- the future value of a pre-tax dollar invested in a tax-exempt account is (1-T0) (1 + r)
n
- the future value if a pre-tax dollar invested in a tax deferred account is (1 + r) (1-Tn)
- if the prevailing tax rate when funds are withdrawn is less than the tax rate when they are invested, the TDA will
accumulate more after-tax wealth than the tax-exempt account, and vice versa
5
...
0 Implications for Wealth Management
Tax Alpha – the value created by using investment techniques that effectively manage tax liabilities
6
...
Investors should borrow to weight their portfolios appropriately
6
...
3 Tax Loss Harvesting
Tax Loss Harvesting - the opportunity to recognize a loss that offsets some king of taxable gain in a given tax year
can create value
- the value in tax loss harvesting is largely in deferring the payment of tax liabilities
- a subtle benefit in tax loss harvesting is that recognizing an already incurred loss for tax purposes increases the
amount of net-of-tax money available for investment
- opportunities to create value through tax loss harvesting and HIFO (highest-in, first-out) are greater in jurisdictions
with high tax rates on capital gains
6
...
6
...
- an investor optimizing between two different asset classes (e
...
stocks and bonds) across two types of account (e
...
taxable and deferred accounts) has four different after-tax assets to allocate – stocks or bonds in each of the two
accounts
Reading 16: Estate Planning in a Global Context
2
...
1 Estates, Wills, Probate
Estate – is all of the property a person owns or controls
- may exclude assets transferred to an irrevocable trust inter vivos
Estate Planning – the process of preparing for the disposition of one’s estate upon death and during one’s lifetime
Will – outlines the rights others will have over one’s property after death
Probate – the legal process to confirm the validity of the will so that executors, heirs, and other interested parties can
rely on its authenticity
- avoid or limit impact of probate by holding assets in joint ownership, living trusts, retirement plans, or
with life insurance strategies as ownership transfers without need for a will
...
2 Legal Systems, Forced Heirship, and Marital Property Regimes
Testator – the person who makes a will
- under forced heirship rules, children have the right to a fixed share of a parent’s estate
- reduce or avoid forced heirship by moving assets into offshore trust governed by a different jurisdiction,
gifting or donating assets to others during lifetime, purchasing life insurance
- under common property regimes, each spouse has an indivisible one-half interest in income earned during marriage
- in separate property regimes, prevalent in civil law countries, each spouse is able to own land and control property
as an individual
2
...
Tax on income
2
...
Tax on wealth
4
...
0 Core Capital and Excessive Capital
Human Capital and/or Net Employment Capital – the present value of one’s employment capital
Core Capital – the amount of capital required to fund spending to maintain a given lifestyle, fund specific goals, and
provide adequate reserves for unexpected commitments
Excess Capital – an investor with more assets than liabilities that can be safely transferred to others
3
...
the probability that either the husband or wife survives
16
...
assuming their chances of survival are independent of each other, the PV of spending need is equal to:
16
...
1
...
It also helps augment increased spending
3
...
3 FV = (1 + RG) = ∏(1 + Rn)
n=1
= (1 + R1)(1 + R2)(1 + R3)…(1 + RN)
RG = the geometric average return over period N, the compounded return
- the geometric average return is related to the arithmetic average return and its volatility in the following way:
16
...
0 Transferring Excess Capital
- the first generation’s core capital implicitly determines their discretionary wealth
4
...
1
...
5 RVTaxFreeGift = FVGift =
n
[1 + rg(1 - tig)]
...
1
...
6 RVTaxableGift = FVGift =
FV
n
[1 + rg (1 - tig)] (1 – Tg)
n
Bequest
[1 + re (1 - tie)] (1 - Te)
- this model assumes the gift tax is paid by the recipient rather than the donor
4
...
3 Location of the Gift Tax Liability
- a cross border gift could result in both the donor and the recipient being taxed in their respective home countries
- the relative after-tax value of the gift when the donor pays gift tax and when the recipient’s estate will not be
taxable is:
16
...
2 Generation Skipping
- in general, the relative value of skipping generations to transfer capital that is excess for both the first and second
generations is 1 / (1 – T1) where T1 is the tax rate of capital transferred from the first generation to the second
4
...
4 Valuation Discounts
- the valuation of a privately held company is often discounted at a higher cost of capital to reflect the lack of
liquidity associated with their shares
- if shares being transferred represent a minority interest in the privately held company, an additional discount is
taken for lack of control
- liquidity and control discounts are not additive
4
...
6 Charitable Gratuitous Transfers
– the relative after-tax future value over n years of a charitable gift compared to a taxable bequest
n
n
16
...
0 Estate Planning Tools
5
...
1
...
1
...
1
...
2 Foundations
- foundations are typically set up to hold assets for a particular purpose; they survive the settlor
5
...
Premiums
paid for life insurance are generally outside the reach of creditors’ claims against the policy holder
5
...
0 Cross-Border Estate Planning
- passing ownership of overseas assets upon death may be difficult and may trigger multiple tax liabilities from both
the home country and country in which the asset is located
6
...
2 Tax System
Source Jurisdiction (aka territorial tax system) – a country that taxes income as a source within its borders imposes
this
Residence Jurisdiction – a tax imposed based on residency, whereby all income is subject to taxation
6
...
1 Taxation of Income
6
...
2 Taxation of Wealth and Wealth Transfers
- like income, wealth and wealth transfers may be subject to tax based on source or residence principles
6
...
3 Exit Taxation
- to offset the lost tax revenue from repatriation, some countries impose an “exit-tax” on individuals giving up their
citizenship or residency
Deemed Disposition – the exit tax amounts to a tax on unrealized gains accrued on assets leaving the taxing
jurisdiction
6
...
Some of the individual’s assets may be located in Country B, which exercises some
jurisdiction on those assets, creating this conflict
6
...
1 Foreign Tax Credit Provisions
- a residence country may choose to unilaterally provide its taxpayers relief from residence-source conflicts within
its own tax code using one or more of the following methods:
Credit Method – the residence country reduces its taxpayers’ domestic tax liability for taxes paid to a foreign
country exercising source jurisdiction; eliminates double taxation
- tax liability equals the greater of the tax liability due in either the residence or source country
16
...
10 TExemptionMethod = TSource
Deduction Method – the residence country allows taxpayers to reduce their taxable income by the amount of taxes
paid to foreign governments in respect to foreign-source income; the deduction method results in a higher tax
liability than either the credit or exemption method
16
...
3
...
permanent home
2
...
habitual dwelling
4
...
4 Transparency in Offshore Banking
Tax Avoidance – is developing strategies that conform to both the spirit and the letter of the tax codes of
jurisdictions with taxing authority
Tax Evasion – is the practice of circumventing tax obligations by illegal means such as misreporting or not reporting
relevant information to tax authorities
Reading 17: Low-Basis Stock
1
...
How Low-Basis Stock is Acquired
- principally acquired through entrepreneurial success, executive success, or investment success
B
...
0 Understanding Stock Risk
Market (Systemic) Risk – affects all securities in the same class, for instance all U
...
equities; non-diversifiable
Specific (Nonsystemic) Risk – relates to each security in particular; diversifiable
Residual Risk – what is left after any level of specific risk diversification has taken place
Counterparty Risk – exists for as long as your are still dependent upon a counterparty to complete a transaction
Regulatory Risk – exists for as long as the tax authorities can still query any transaction and reject the tax treatment
that you have chosen
A
...
page 272
B
...
Entrepreneurial Stage – specific risk very high
2
...
Investor Stage – moves use away from a single stock to a multi-security portfolio
a
...
Indexing Stage – investor aims to replicate the risk of the relevant index and thus holds a portfolio that
has virtually eliminated specific risk
3
...
The Entrepreneurial Stage
- no diversification is desired during the entrepreneurial stage
- entrepreneurs are not expected to want to diversify their exposure to their original great idea; rather they should
seek maximum profit from it and would only reluctantly share in it when the alternative reduces the profit potential
of the business
B
...
The Investor Stage
- the greatest diversification challenge concerns individuals who are no longer in either the entrepreneurial or the
executive stages; the fact that they no longer exercise significant control over the fortunes of the underlying
company requires them to start to think in terms of that investment being essentially a financial holding
4
...
financial strategies – outright sales, exchange funds, public exchange funds, private exchange fund, completion
portfolios
b
...
Outright Sale
- simplest and often most expensive strategy
B
...
Public Exchange Funds
- investors enter into a partnership for a minimum of seven years; at the end of the period each partner may receive a
proportional distribution of his or her share of the fund
- eliminates specific risk, but simply deferred capital gains tax liability
- exchange funds are expensive (management costs), investor lacks control (managed by someone else), and are
inflexible (can accept offer to join or deny, that’s it)
ii
...
Completion Portfolios
i
...
Multi-Asset Class Completion Portfolios
- completion portfolios do not have to be constrained to the asset class to which the low-basis holding belongs;
multi-asset completion portfolios incorporate more diversified sources of risk, and thus volatility
Shortcomings:
- this strategy is ill-suited to investors who do not have a substantial pool of other financial assets alongside the low-
basis holding
- the diversification process typically takes time unless the low-basis position was quite a small part of the investor’s
wealth at the outset
...
Hedging Strategies
- technique of choice for low diversification
Steps:
1
...
investor borrows against the value of his or her portfolio, in a transaction called monetization and reinvests the
proceeds
- hedge if you want to protect gains and let profits runs
- monetize if you want to get the money out without triggering a taxable event
- a pure monetization strategy involves borrowing against a position and reinvesting the proceeds in the
way you want
i
...
Monetization of the Position
- the collar sets the a minimum value for the underlying equity position and thus may increase the collateral value of
that equity from the point of view of a lender
iii
...
Relative Attractiveness of Hedging Transactions
- this relates to the deducibility of the interest paid on the borrowings associated with the collar
5
...
Three Case Studies
B
...
Making Diversification More Palatable
- diversifying a low-basis holding is a complex exercise, with investment, tax and estate planning, and psychological
dimensions
Reading 18: Goals-Based Investing: Integrating Traditional and Behavioral Finance
1
...
0 A Goals-Based Approach to Wealth Management
- the authors define a goals-based investing process that links investment strategy selection to client goals; most
commonly meeting current lifestyle expenses and investing for a fixed planning horizon
3
...
Risk Measurement
- traditionally relies on portfolio statistics
Skew – the degree of asymmetry in the probability distribution and is especially relevant when negative
Kurtosis – describes the degree to which the tail ends of the distribution are more concentrated, or fatter
than predicted by a normal distribution implying that extreme results are more likely
Heteroskedasticity – indicates that risk changes through time
- each property suggests that risks could be overlooked if relying on standard deviation alone
i
...
Loss Aversion
- the idea that investors are not risk-averse but loss-averse is on of the main tenets of behavioral finance
- loss aversion suggests that risk measurement should explicitly consider the risk of loss
iii
...
Risk Profiling
- risk profiling is used to establish the client’s risk tolerance, which is often the primary link between the client and
the investment recommendation
i
...
Mental Accounting
- investors who manage risk on a goal-by-goal basis exhibit mental accounting, referring to the practice of
maintaining separate investment accounts, either mentally or in practice and making decisions differently depending
on the nature of the account
Goal Based Investing – linking a particular strategy to a goal and managing it according to the risk measures and
risk tolerance that are most appropriate for that goal
C
...
Overconfidence
- overconfidence suggests that investors overestimate their ability to predict market events and investors often take
risks without receiving commensurate returns and it leads to overtrading
...
Hindsight Bias
- refers to evidence that people often believe they had predicted an event when in fact they had not
iii
...
Belief Perseverance
- indicates that people are unlikely to change their opinions even when new information becomes available
v
...
0 Implementing a Goals-Based Approach
- the process links client goals to risk management objectives and investment strategies
A
...
Measuring the Risk to Current Lifestyle Goals
Sustainable Spending Rate – the amount of spending that the investor can be confident of maintaining without
running out of capital
- investors are better equipped to select investments when decisions are framed in terms of their goals
ii
...
Lifestyle Protection Strategies
- these strategies align the investment process with spending goals; strategies are described by reward and risk
measures
- downside is that they underperform in bull markets as they are constructed with a beta < 1
...
iv
...
are spending targets likely to change
2
...
is the investor comfortable focusing on cash-flows without worrying about the market value of the
portfolio
B
...
Fixed Horizon Strategies
- to construct diversified portfolios that are efficient in the context of a fixed planning horizon, practitioners should
identify the risk free investment
Relative Return Strategies - the risk free investment is one that replicates the index against which returns
are compared
Absolute Return Strategies – the risk free investment is cash
Strategies Linked to Fixed Planning Horizon – risk free investment is a high-quality zero-coupon bond that
matures near the horizon date
- when testing suitability of a fixed horizon strategy, ask:
1
...
is the investor satisfied with the return on the zero coupon bond? If not, put more in sub-portfolio
3
...
0 Human Capital and Asset Allocation Advice
A
...
Role of Human Capital in Asset Allocation
i
...
Academic Literature
- investors with a high degree of labor flexibility should take more risk in their investment portfolios
Theoretical Implications:
- younger investors invest more in stocks that older investors
- investors with safe labor income (thus safe human capital) invest more of their financial portfolio in
stocks
- investors with labor income that is highly correlated with the stock markets invest their financial assets in
less risky assets
- the ability to adjust labor supply (ie higher flexibility) increases and investor’s allocation to stocks
iii
...
1 HC(x) =
(1 + r + v)
E[ht]
t-x
t = x+1
x = current age
HC(x) = human capital at age x
Ht = earnings for year t adjusted for inflation before retirement and after retirement, adjusted for Social
Security and pension payments
n = life expectancy
r = inflation-adjusted risk-free rate
v = discount rate
- we assume the investor follows the constant relative risk average (CRRA) function,
19
...
- in the model, labor income and the return of risk assets are correlated
C
...
Case #1
...
Case #2
...
Case #3
...
Case #4
...
Implications for Advisers
Advisors should know:
a
...
young investors with relatively safe human capital should invest more in stocks
c
...
Summary
Human Capital = present value of future labor income
2
...
Life Insurance and Asset Allocation Decisions
Mortality Risk – a loss of human capital in the unfortunate event of the investor’s premature death
- term life insurance and human capital have a -1 correlation
B
...
Description of the Model
- determination of the optimal asset allocation and prudent life insurance holdings
_
_
16
...
Case Studies
- when there are no special insights into a persons health, the subjective survival probability = objective probability
i
...
Human Capital, Financial Asset Allocation, and Life Insurance Demand over the Lifetime
- the primary driver of insurance demand is human capital; a decrease in human capital decreases insurance demand
ii
...
Strength of the Bequest Motive
- insurance demand increases as the bequest motive strengthens (i
...
as D gets larger)
...
Case #3
...
Case #4
...
Case #5
...
Summary
- investors need to make asset allocation decisions and life insurance decisions jointly
- the magnitude of human capital, its volatility, and its correlation with other assets significantly affect the two
decisions over the life cycle
- bequest preferences and a person’s subjective survival probability have significant effects on the person’s demand
for insurance but little influence on the person’s optimal asset allocation
- Conservative investors should invest relatively more in risk-free assets and buy more life insurance
3
...
Three Risk Factors in Retirement
i
...
Longevity Risk
- longevity risk is the risk of living longer than planned for and outliving one’s assets
- DB pension plans provide longevity insurance, especially those that adjust for inflation
iii
...
Controlling the Three Risks
- financial risk can be mitigated by using modern portfolio theory
- insurance products can hedge away longevity risk
- the risk of inadequate savings is primarily a behavioral issue
C
...
Social Security and DB Pension Plans
- traditionally SS and DB plans provided the bulk of retirement income
ii
...
Longevity Risk and Payout Annuities
- investors should be willing to pay an insurance premium to hedge away longevity risk; lifetime-payout annuities
provide investors with this type of longevity insurance
Lifetime Payout Annuity – an insurance product that converts an accumulated investment into income that the
insurance company pays out over the life of the investor
- when an investor buys a life annuity from an insurance company, the investor is transferring the longevity risk to
the insurance company
i
...
Variable Payout Annuities
- is an insurance product that exchanges accumulated investment value for annuity units that the insurance company
pays out over the lifetime of the investor
- payments fluctuate in accord with the performance of the fortunes of the underlying investments chosen by the
buyer of the annuity
E
...
Summary
- combining immediate fixed and variable life annuities with conventional investment instruments, such as mutual
funds, is the optimal solution to providing retirement income
- an immediate payout annuity is an effective way to manage longevity risk in retirement
- combining nonannuitized assets with annuitized assets can help investors manage financial market risk, longevity
risk, and bequest desires
Study Session 5: Portfolio Management for Institutional Investors
Reading 20: Managing Institutional Investor Portfolios
1
...
0 Pension Funds
- pension funds contain assets that are set aside to support a promise of retirement income
Defined Benefit Plan – is a pension plan that specifies the plan sponsor’s obligations in terms of the benefit to plan
participants
Cash Balance Plan – is a defined-benefit plan whose benefits are displayed in individual recordkeeping accounts
- a DB plan sponsor promises the organization’s employees or members a retirement income benefit based on certain
defined criteria
- all DB plans share one common characteristic: they are promises made by a plan sponsor that generate a future
financial obligation or “pension liability”
Defined Contribution Plan – specifies the sponsor’s obligations in terms of contributions to the pension fund rather
than benefits to plan participants
- DC plans encompass arrangements that are 1) pension plans, in which the contribution is promised and not the
benefit and 2) profit-sharing plans, in which contributions are based, at least in part, on the plan sponsor’s profits
Key Differences between DC and DB
- for DC, because the benefit is not promised, the plan sponsor recognizes no financial liability,
- DC plan participants bear the risk of investing, whereas in DB the plan sponsor bears the risk
- see page 358
2
...
1
...
360
2
...
2 Return Objectives
- a DB pension plan’s broad return objective is to achieve returns that adequately fund its pension liabilities on an
inflation-adjusted basis
2
...
3 Liquidity Requirement
- the greater the number of retired lives, the greater the liquidity requirement, all else equal
- the smaller the corporate contributions in relation to benefit disbursements, the greater the liquidity requirement
- plan features such as the option to take early retirement and/or the option of retirees to take lump-sum payments
create potentially higher liquidity needs
2
...
4 Time Horizon
- investment time horizon for a DB plan depends on whether the plan is a going concern or plan termination is
expected and the age of the workforce and the proportion of active lives
2
...
5 Tax Concerns
- investment income and realized capital gains within private defined-benefit pension plans are usually exempt from
taxation and investment planning decision at the level of the plan itself can generally be made without regard to
taxes
2
...
6 Legal and Regulatory Factors
- all retirement plans are governed by laws and regulations that affect investment policy
2
...
7 Unique Circumstances
- investment in alternative investments (i
...
PE, hedge funds, natural resources)
- some plans self impose constraints about investing in certain industries
2
...
8 Corporate Risk Management and the Investment of DB Pension Assets
Two important concerns:
- managing pension investments in relation to operating investments
- coordinating pension investments with pension liabilities
- a portfolio that diversifies sponsor operational risk increases the chance that, if the sponsor needs to increase
contributions to support the payment of plan pension benefits, the sponsor will be in a position to do so
- from an ALM perspective, the characterization of risk in the IPS needs to be stated in relative terms
2
...
2
...
3 Hybrid and Other Plans
- hybrid plans include cash balance plans, pension equity plans, target benefit plans, and floor plans which seek to
combine the most highly valued features of DC and DB plans
Cash Balance Plan – is a DB plan, in that the employer bears the investment risk however it looks like a DC plan
because they are provided a personalized statement showing their account balance, an annual contribution credit,
and an earnings credit
Contribution Credit - % of pay based on age
Earnings Credit - % increase in the account balance that is typically tied to long-term interest rates
ESOP – are DC plans that invest all or the majority of plan assets in employer stock
- ESOPs can be used to thwart takeover attempts by giving employees controlling stakes
3
...
1 Foundations: Background and Investment Setting
- foundations provide essential support of charitable activity; types:
a
...
Company Sponsored – tend to be short-term focused to facilitate philanthropic funding the corporate
guarantees
c
...
Community – draw upon board support for donations to fund a variety of grants
- see exhibit 2 pg
...
1
...
1
...
1
...
1
...
Those spent
down increase conservativeness as the X approaches
3
...
5 Tax Concerns
Unrelated Business Income – income that is not substantially related to a foundation’s charitable purposes
3
...
6 Legal and Regulatory Factors
- foundations may be subject to a variety of legal and regulator constraints, which vary by country and sometimes by
type of foundation
3
...
7 Unique Circumstances
- a special challenge faces foundations that are endowed with the stock of one particular company and that are then
restricted by the donor from diversifying; some foundations enter into swap or other derivatives to counter this
3
...
2
...
2
...
2
...
2
...
2
...
2
...
2
...
0 The Insurance Company
- life insurance, health insurance, and property and liability insurance
- insurance companies (whether life or casualty) are established either as stock companies (companies that have
issued common equity) or as mutual (companies with no stock that are owned by their policy holders)
...
1 Life Insurance Companies: Background and Investment Setting
- exposure to interest-rate-related risk is one major characteristic of life insurers’ investment setting
Disintermediation – occurs when individuals withdraw funds from financial intermediaries for deposit or investment
in other financial intermediaries or investments offering a higher return yield
- shorter liability durations have necessitated the shortening of the duration of life insurance company portfolios, or
at least those segments designed to fund these interest-rate sensitive product liabilities
4
...
1 Risk Objectives
- an insurance company’s primary investment objective is to fund future policy holder benefits and claims
- two important aspects of interest rate risk are valuation concerns and reinvestment risk:
Valuation Concerns – in a period of changing interest rates, a mismatch between the duration of an insurance
company’s assets and that of its liabilities can lead to erosion of surplus
Reinvestment Risk- defied as the risk of reinvesting coupon income or principal at a rate less than the original
coupon or purchase rate
- two other risk considerations are:
Credit Risk – represents another potential source of income loss for insurance companies
Cash Flow Volatility – loss of income or delays in collecting and reinvesting cash flow from investments
4
...
2 Return Objectives
- historically, a life insurance company’s return requirements have been specified primarily by the rates that
actuaries use to determine policyholder reserves, i
...
accumulation rates for the funds held by the company for future
disbursement
Net Interest Spread – is the difference between interest earned and interest credited to policyholders
- segmentation of insurance company portfolios has promoted the establishment of sub-portfolio return objectives to
promote competitive crediting rates for groups of contracts
4
...
3 Liquidity Requirements
- volatile interest rate environments and the ever-increasing importance of annuity products require that life
companies pay close attention to their liquidity requirements
- in assessing their liquidity needs, insurers must address disintermediation and asset marketability risk
- an asset liability mismatch can exacerbate the effects of disintermediation
Asset Marketability Risk – the marketability of investments is important to insure ample liquidity
4
...
4 Time Horizon
- life insurance companies have long been considered the classic long-term investor but asset/liability management
practices have tended to shorten the overall investment time horizon of the typical life insurance company
4
...
5 Tax Concerns
- unlike pension funds and endowments, insurance companies are tax-paying rather than wholly or partially taxexempt investors and taxes mean that insurance companies must focus on after-tax returns in their investment
activities
- only the corporate share of investment income is taxed
4
...
6 Legal and Regulatory Factors
- insurance is a heavily regulated industry
- important concepts related to regulator and legal considerations include eligible investments, the prudent investor
rule, and valuation methods
Eligible Investments – insurance laws determine the classes of assets eligible for investment and may specify the
quality standards for each asset class
Prudent Investor Rule – replacing traditional “laundry lists” of approved investments with prudent investor logic
simplifies the regulator process and allows life insurance companies much needed flexibility to keep up with the
ever-changing array of investments alternatives
Valuation Methods – in the EU, IAS specify a set of valuation procedures and in the US NAIC does
- regulation in the insurance industry has a profound effect on both the risk and return aspects of a life insurance
company portfolio because it constrains two critical aspects of portfolio management, asset allocation and the
universe of eligible investments
...
1
...
405 typical IPS for an insurance company
4
...
2
...
In setting risk
objectives, casualty companies must consider both cash flow characteristics and the common stock to surplus ratio
Cash Flow Characteristics – for the portion of investment portfolio relating to policyholder reserves, casualty
companies have low tolerance for loss of principal or diminishing investment income
Common Stock to Surplus Ratio – the amount of stock held by insurance companies in their investment portfolios
4
...
2 Return Objectives
- factors influencing return objectives include competitive pricing policy, profitability, growth of surplus, tax
considerations, and total return management
Competitive Policy Pricing – low insurance policy premiums rates, due to competition, provide an incentive for
insurance companies to set high desired investment return objectives
Profitability – investment income and the investment portfolio return are primary determinants of continuting
profitability for the typical casualty company and the industry
- casualty insurance portfolios are managed to maximize return on capital and surplus to the extent that
prudent/liability management, surplus adequacy considerations, and management preferences will
allow
Combined Ratio – the percentage of premiums that an insurance company spends on claims and expenses
Growth of Surplus – growth of surplus provides the opportunity to expand the volume of insurance the company can
write
Tax Considerations – insurance companies typically favor tax-exempt bonds, especially when underwriting is
profitable to achieve the highest after tax return
- for non-US insurance companies taxes are more of a constraint as US companies can benefit from NOLs
and using tax-exempt bonds
Total Return Management
– active management has become more common as GAAP mandates unrealized G/L flow through IS’
- the return of casualty companies differing is because of the latitude permitted by insurance regulations, differences
in product mix, a particular companies tax position, the emphasis placed on capital appreciation vs
...
2
...
They find it necessary to
increase tax-exempt portions of portfolios of periods of underwriting profits and non-tax exempt portions during
periods of losses
- T-Bills and CP are often maintained for short-term liquidity
4
...
4 Time Horizon
- time horizon function of durations of casualty liabilities and underwriting cycles
- because the tax-exempt yield curve in the US tends to be more positively sloped than taxable, casualty companies
find that they must invest in longer maturities
- differences in average maturity of bond portfolios between casualty and life insurance companies may reflect
companies’ willingness to accept interest rate risk via asset/liability duration mismatches
4
...
5 Tax Concerns
- 1986 tax law changes resulted in companies using computer models to determine the appropriate asset allocations
between tax-exempt and taxable securities
4
...
6 Legal and Regulatory Factors
- casualty company insurance regulation is relatively permissive, in contrast to life companies
- risk based capital regulations for casualty insurers specify the minimum amount of capital that an insurer must hold
as a function of the size and degree of the asset risk, credit risk, underwriting risk, and off-balance sheet risk that the
insurer takes
4
...
7 Determination of Portfolio Policies
- because of contractual liabilities and difficulty in forecasting the cash flow from insurance operations, casualty
companies seek some degree of safety from the assets offsetting insurance reserves
- the structure of a casualty companies bond portfolio between taxable and tax-exempt securities depends on the
company’s underwriting experience and current tax policy
5
...
To manage overall interest rate risk of the balance sheet
b
...
to produce income
d
...
1
...
1
...
1
...
1
...
1
...
1
...
1
...
2 Other Institutional Investors: Investment Intermediaries
- investment companies constitute another type of institutional investor that is important an include mutual funds,
closed-end funds, unit trusts, and ETFs; investment companies are pure investment vehicles in the sense that they
have no other corporate purpose besides investing
Reading 21: Linking Pension Liabilities to Assets
1
...
0 How to Define Risk
- in order to see the full picture of pension fund investment risk, one must also focus on the volatility of the
estimated benefit payments themselves and how they change over time
- for a relatively healthy company with an ongoing plan, risk is both the short-term volatility of plan costs and the
long-term risk of pension assets being insufficient to defease the liability
3
...
1 Value of Pension Liability
a
...
e
...
discount them
VL = ∑
Bt
t
...
Market Related Exposures
1
...
Active Participants – these are the estimated benefit payments associated with currently active employees
2
...
2 Future Benefits – benefits attributable to future wages to be earned, future service to be rendered, and future new
entrants into the plan
2
...
1 Future Wages – many plans bake in a wage increase component
2
...
1
...
2
...
2 Future Real Wage Growth – real wage growth is linked with economic growth through labor’s share of
productivity increases
2
...
2 Future Service Rendered –just like the volatility of future wage benefits, the volatility of future service benefits
is linked to wage growth; exclude this from the investment benchmark
3
...
Non-Market Related Exposures: Liability Noise
Liability Noise - the uncertainty in benefit payments attributable to non-market related exposures
...
g
...
Inactive Participants – for retirees, liability noise is attributable to one major source, mortality rates differing from
assumptions
- the uncertainty regarding the timing and amount of benefits coupled with mortality risk result in deferred liabilities
being noisier and less hedgeable than retirees’ liabilities
2
...
Linking Assets and Liabilities via Fundamental Factors
- the accrued benefit liability has primarily market related exposures to shifts in the discount rate, and thus the
relevant factors is the term structure which entails the real rate, inflation, and a nominal bond premium
- the real risk-free rate is proxied by the T-bill return minus the inflation proxy
A
...
Assets
- model to determine the sensitivities of bonds
21
...
(1 + rt)
t
- Gordon Growth Model
21
...
and
r = D
2
...
4 VL – AB = ∑ Bt
...
5VL – FW = B
s
d-s
* [ (( 1 + g) – 1)*((1 + r) -1) ]
(r – g)
[
(1 + r)
d
]
s = years until retirement
d = years till demise and subsequent termination of the obligation
- just like the future wage inflation, cash flows are not driven indefinitely by inflation; future wage growth only
applies until retirement
B
...
Designing Investment Policies Relative to Liabilities
- if the return on the fund’s assets beats the return on the liability mimicking asset portfolio, all stakeholders should
be satisfied since the pension promises will be paid
- finding the most efficient way to allocate more assets to “higher returning” asset classes such as equities while
minimizing the amount of unrewarded risks taken versus the liability can be approached in two steps:
1
...
focus the remaining capital on efficient return generation
5
...
a
s
VLs =
B * (1 + g) – 1
(r – g)
(1 + r)
s
- present value of the same eternal benefit obligation attributable to future wage growth for s years until retirement
21
...
0 The Apparent Issue – Funding Shortfall
Underfunded – when current marked-to-market value of the pension assets is less than the current marked-to-market
value of the pension liabilities
A
...
0 is fine and you do not need to be overfunded if you always hold assets
that precisely hedge the risk of the liabilities
- the risk mismatch is likely to be of greatest concern in cases where the ratio of pension assets to the market
capitalization of the companies equity is high
B
...
0 Accounting for Value Mismatch and Risk
Value Mismatch – the size of any pension surplus or shortfall
- the greater risk associated with equity-heavy pension plans seemed to show up in more volatile stock prices
2
...
2 Incorporating Pension Risk into WACC
- WACC sometimes fails to take account of the risk of other important assets that are not reflected on GAAP balance
sheets
- by failing to take account of their pension assets and pension liabilities when estimating their cost of capital,
companies are probably distorting their measures of operating, or project risk in two ways:
1
...
the standard analysis does not take account of the pension liabilities, it understates the firm’s leverage
ratio
- the two aforementioned distortions typically overstates WACC for an operating project
2
...
0 Strategic Analysis and Policy Development
- lowering the expected returns on assets (by switching pension assets from equities to bonds) also lowers the risk of
the entire firm and by lowering the risk you create the capacity for the firm to take other risk
3
...
2 Considering Alternative Pension Policies
- when a company alters the mix of its pension assets between fixed-income and equities, it changes its risk and the
risk of the overall firm
3
...
4 Cushioning Your Risks with Capital
- the analysis shows that a firm should understand how much risk their shareholders are bearing as a result of the
risk mismatch, how much capital they are using to support it, and how the cost of capital is affected by it
4
...
1 Underfunding
- if the firm were underfunded, one possibility is to issue debt to fund the plan
4
...
0 Moving from a DB to a DC Plan
- DC plans make a corporations life easier because the moment it pays its fraction of income into the plan, it has
seemingly carried out all of its obligations
Reading 22 Notes:
- decreasing equity holdings will lower risk associated with pension plan assets
- lowering equity holdings in the pension means higher fixed income, which will increase the D/E ratio of the
company
Book 3
...
0 Introduction
Capital Market Expectations: the investor’s expectations concerning the risk and return prospects of asset classes,
however broadly or narrowly the investor defines those asset classes
Macro Expectations – capital market expectations about classes of assets
Micro Expectations – expectations concerning individual assets
2
...
1 A Framework for Developing Capital Market Expectations
1
...
Research the historical record
3
...
Determine the best sources for information needs
5
...
Provide the set of expectations that are needed, documenting conclusions
7
...
Generally, good forecasts are:
- unbiased, objective, and well researched
- efficient, in the sense of reducing the magnitude of forecast errors to a minimum
- internally consistent
2
- if the number of asset classes is n, the analyst will need to estimate (n – n)/2 distinct correlations (or the same
number of distinct covariances)
2
...
2
...
2
...
Such errors are most serious if they reflect a bias
Survivorship Bias – arises when a data series reflects only entities that have survived to the end of the period
Appraisal (smoothed) data – tends to be less volatile than market-determined values for the idenctical assets would
be
...
The key is to model the risks of alternative investments as if they were frequently traded, focusing not
on statistical observations but on the underlying fundamental and economic drivers of return
2
...
3 The Limitations of Historical Estimates
Regime – changes in the technological, political, legal, and regulatory environments, as well as disruptions such as
wars and other calamities, can alter risk-return relationships
...
Data of high frequency are more sensitive to asynchronism (a discrepancy in the dating of observations that
occurs because stale data may be used in the absence of current data) across variables
...
2
...
2
...
2
...
2
...
2
...
Confirming Evidence Trap – is the bias that leads individuals to give greater weight to information that supports an
existing or preferred point of view than to evidence that contradicts it
Overconfidence Trap – is the tendency of individuals to overestimate the accuracy of their forecasts
Prudence Trap – is the tendency to temper forecasts so that they do not appear extreme, or the tendency to be overly
cautious in forecasting as to not damage the decision maker’s career
Recallability Trap – is the tendency of forecasts to be overly influenced by events that have left a strong impression
on a person’s memory
2
...
9 Model Uncertainty
Model Uncertainty – uncertainty concerning whether a selected model is correct
Input Uncertainty – uncertainty concerning whether the inputs are correct
Behavioral Finance – the theory that psychological variables affect and often distort individuals’ investment decision
making
3
...
1 Formal Tools
Formal Tools – are established research methods amenable to precise definition and independent replication of
results
3
...
1 Statistical Methods
Descriptive Statistics – methods for effectively summarizing data to describe important aspects of a dataset
Inferential Statistics – methods for making estimates or forecasts about a larger group from a smaller group actually
observed
3
...
1
...
1
...
2 Shrinkage Estimators
Shrinkage Estimation – involves taking a weighted average of a historical estimate of a parameter and some other
parameter estimate, where the weights reflect the analysts relative believe in the estimates
- a shrinkage estimator of the covariance matrix is a weighted average of the historical covariance matrix and
another, alternative estimator of the covariance matrix, where the analyst places the larger weight on the covariance
matrix he or she believes more strongly in
- superior approach for estimating the population covariance matrix for the medium and smaller-size
datasets typical in finance
Target Covariance Matrix – the selection of an alternative estimator of the covariance matrix
- a surprising fact concerning the shrinkage estimator approach is that any choice for the target covariance matrix
will lead to an increase in the efficiency of the covariance estimates versus the historical estimate
3
...
1
...
1 Model specifying that the volatility in period t, σ t, is a weighted average of the volatility in the previous
2
2
period, σ t-1, and the squared value of random “noise’ term, ε t
...
1 σ t = βσ t-1 + (1 – β) ε t
- the coefficient β measures the rate of decay of the influence of the value of volatility in one
period on future volatility, and the rate of decay is exponential; higher β, more volatility
3
...
1
...
2 Ri = ai + bi1F1 + bi2F2 + …+ binFn + εi
Ri = the return to asset i
ai = an intercept term in the equation for asset i
Fk = the return to factor k, k = 1, 2, …, K
Bik = the sensitivity of the return to asset i to the return factor k, k = 1, 2, …, K
εi = an error term with a zero mean that represents the portion of the return to asset i that is not explained by
the factor model
...
Factor Covariance Matrix – contains the covariances for the factors assumed to drive returns
...
3a Mii = b i1Var(F1) + b i2(F2) + 2bi1bi2Cov(F1,F2) + Var(εi), for i = 1 to 5
Where Mii is the variance of market i;
2
21
...
3
...
2 Discounted Cash Flow Models
- DCF models express the idea that an asset’s value is the present value of its (expected) cash flow
V0 = ∑ _CFt__
t=1
t
(1 + r)
- practitioners view them as appropriate for setting longer-term rather than shorter-term expectations
3
...
2
...
5 E(Re) = D0(1 + g) + g = D1 + g
P0
P0
- g can be estimated most simply as the growth rate in nominal GDP, where nominal GDP growth can be estimated
as the sum of the estimated real growth rate in GDP plus the expected long-run inflation rate
Earnings growth rate = GDP growth rate + Excess Corporate Growth
Grinold-Kroner Model – provides a restatement of the Gordon growth model that takes explicit account of
repurchases and also provides a means for analysts to incorporate expectations of valuation levels through the
familiar P/E ratiol; can alos be used as a tool to analyze sources of return
23
...
1
...
2 Fixed-Income Markets
YTM – yield that discounts all CFs to spot bond price
- YTM makes assumption that all interest payments are received, and that they can be reinvested at an
interest rate that always equals YTM
3
...
3 The Risk Premium Approach
Risk Premium Approach (aka build-up approach) – expresses the expected return on a risky asset as the sum of the
risk-free rate of interest and one or more risk premiums that compensate investors for the risky asset’s exposure to
sources of priced risk
3
...
3
...
7a E(Ri) = RF + (Risk Premium)1 + (Risk Premium)2 +…+ (Risk Premium)k
3
...
3
...
7b E(Rb) = Real risk-free interest rate + Inflation premium + Default risk premium + Illiquidity premium
+ Maturity Premium + Tax Premium
Real Risk-Free Interest Rate – single-period interest rate for a completely risk-free security if no inflation were
expected
Inflation Premium – compensates investors for expected inflation and reflects the average inflation rate expected
over the maturity of the debt plus a premium (or discount) for the probability attached to higher inflation than
expected (or greater disinflation)
Nominal Risk-Free Rate = Real Risk-Free Rate + Inflation Premium
- often represented by treasury YTM
Default Risk Premium – compensates investors for the possibility that the borrower will fail to make a promised
payment at the contracted time and in the contracted amount
= Expected Default Loss in Yield Terms + Premium for Nondiversifiable Risk of Default
Illiquidity Premium – compensates investors for the risk of loss relative to an investment’s fair value if the
investment needs to be converted to cash quickly
Maturity Premium – compensates investors for the increased sensitivity, in general, of the market value of debt to a
change in market interest rates as maturity is extended, holding all else equal
Tax Premium – may be applicable to certain classes of bonds in some tax jurisdictions
- the real risk-free rate is compensation for forgoing current consumption in exchange for certain future consumption
- the expected return to any asset or asset class has at least three components: the real risk-free rate, the inflation
premium, and the risk premium
- the inflation premium is the compensation for the depreciation of invested principal because of expected price
inflation
3
...
3
...
8 Bond Yield Plus Risk Premium Method
E(Re) = YTM on long-term government bond + Equity Risk Premium
3
...
4 Financial Market Equilibrium Models
- financial market equilibrium models describe relationships between expected return and risk in which supply and
demand are in balance
- assuming that the risk premium on any currency equals zero – as it would be if purchasing power parity
relationships hold – the ICAPM gives the expected return on any asset as the sum of:
- the (domestic) risk-free rate
- a risk premium based on the asset’s sensitivity to the world market portfolio and expected return on the
world market portfolio in excess of the risk-free rate
23
...
10 Asset Classes Risk Premium
RPi = σi ρi
...
11 the risk premium for the completely segmented markets case is higher than that for the perfectly integrated
markets case and equal to the amount shown in equation 11
RPi = σi (RPM)
σ
M
Singer-Terhaar Steps:
1
...
Add the applicable illiquidity premium, if any, to the estimates from the prior step
3
...
Take a weighted average of the perfectly integrated and the completely segmented premiums using the
estimate of market integration from the prior step
- the illiquidity premium for an alternative investment should be positively related to the length of the investment’s
lockup period or illiquidity horizon
...
The relevant MPSE is one calculated over a holding period equal to the investment’s lockup period
...
2 Survey and Panel Methods
Survey Method – for setting expectations involves asking a group of experts for their expectations and using the
responses in capital market formulation
...
3 Judgment
- in a disciplined expectations-setting process, the analyst should be able to factually explain the basis and rational
for forecasts; investment experience, the study of capital markets, and intelligence are requisites for the development
of judgment in setting capital market expectations
4
...
1 Business Cycle Analysis
- in business cycle analysis, two cycles are generally recognized: a short term inventory cycle (2 – 4 years) and a
longer term business cycle (9 – 11 years)
...
GDP – a calculation of the total value of final goods and services produced in the economy during a year,
consisting of consumption, investment, change in inventories, government spending, exports less imports
2
...
Output gap opens in recession, and
inflation tends to decline
3
...
1
...
1
...
Initial Recovery – short phase of a few months in which the economy picks up from its slowdown or
recession; confidence rising among businesses
Capital Market Effects: yields come down stocks rise strongly; cyclical assets perform well
2
...
healthiest
period of cycle
Capital Market Effects: short rates moving up, longer yields stable or rising, stocks trending up
3
...
Slowdown – economy slowing, usually under the impact of rising interest rates, especially vulnerable to
shocks at this point
...
Bonds yields top out
and prices rally sharply; curve inverts; utilities and financial services stocks usually perform best
5
...
Stock market rises before recovery
happens
- exhibit 15 pg
...
1
...
Central banks’ policy-making decisions must be independent of political influence
2
...
Central banks should use monetary policy (primarily interest rates) to control the economy and prevent it
from either overheating or languishing in a recession for too long
Deflation is a threat to the economy because it tends to undermine debt-financed investments and it undermines the
power of central banks
Gold Standard Currency System – currency could be freely converted intogold at established rates, so that the
money supply was constrained by the size of a government’s gold reserves
- inflation tends to accelerate in the later stages of the business cycle, when the output gap has been closed
- resistance to reduction in wages is a counterweight to deflationary pressures
- exhibit 18 pg
...
1
...
the upswing was relatively short or mild
2
...
Inflation is relatively low, so the central bank is willing to cut interest rates quickly
4
...
1
...
1
...
1 Taking the Pulse of Consumers
- principle sources of data on consumer spending are retail sales, miscellaneous store sales data, and consumer
consumption data
- consumer income after tax is by far the most important factor affecting consumption
4
...
5
...
1
...
3 Monetary Policy
- sometimes used as a mechanism for intervention in the business cycle
...
The Taylor Rule – this rule links a central bank’s target short-term interest rate to the rate of growth of the
economy and inflation
23
...
5 * (GDPgforecast – GDPgtrend) + 0
...
Money Supply Trends – trends in the money supply can be a good indicator of monetary conditions and of the
trend of the economy
- if money supply is particularly strong in relation to nominal GDP, chances are that growth will accelerate
in the near future and that inflation may eventually accelerate
C
...
1
...
4 Fiscal Policy – means manipulating the budget deficit to influence the economy
- governments increase spending or cut taxes to stimulate the economy and cut spending or raise taxes to slow it
4
...
5
...
2 Economic Growth Trends
- the economic growth trend is the long-term growth path of GDP, and reflects the average growth rate around which
the economy cycles
- economic trends exist independently of the cycle but are related to it
Shocks – wars, abrupt changes in government tax or trade policies, and the sudden collapse in an asset market or in
an exchange rate
4
...
1 Consumer Impacts: Consumption and Demand
- consumers can be counted upon as the largest source of aggregate economic growth in both developed and
developing countries
Permanent Income Hypothesis – asserts that consumers’ spending behavior is largely determined by their long-run
income expectations
- consumer trends are usually stable or even countercyclical over a business cycle
4
...
2 A Decomposition of GDP Growth and Its Use in Forecasting
The simplest way to analyze an economy’s aggregate trend growth is to split it into:
1
...
Growth from changes in labor productivity
...
- the trend growth in GDP is the sum of
- growth from labor inputs, comprising
- growth in potential labor force size and
- growth in actual labor force participation, plus
- growth from labor productivity, comprising
- growth from capital inputs and
- TFP growth (i
...
, growth from increase in the productivity in using capital inputs)
- potential sources of TFP growth include technological shocks and shifts in government policies
4
...
3 Government Structural Policies - refer to government policies that affect the limits of economic growth and
incentives within the private sector
The following are elements of a pro-growth government structural policy
1
...
The Public Sector Intrudes Minimally on the Private Sector – the thrust of economic theory is that the
marketplace usually provides the right incentives to individuals and businesses and leads to an efficient
allocation of scare resources
Structural Level of Unemployment – the level of unemployment resulting from scarcity of a factor
of production
3
...
Infrastructure and Human Capital Development are Supported
5
...
3 Exogenous Shocks – are events from outside the economic system that affect its course such as short-lived
political events, changes in government policy, or natural disasters and have short-lived effects
- shocks cannot be forecast in general
4
...
1 Oil Shocks – are important because a sharp rise in the price of oil reduces consumer purchasing power and also
threatens higher inflation
- low oil prices and low inflation boost economic growth that can contribute to overheating
4
...
2 Financial Crisis – periodic financial crises affect growth rates either directly through bank lending or indirectly
through their effect on consumer confidence
- financial crisis are potentially more dangerous in a low interest rate environment
4
...
4
...
4
...
domestic business has some reassurance that exchange rates are not going to fluctuate wildly
2
...
4
...
4
...
1 Essential Differences Between Emerging Markets and Major Economies
- since emerging countries are engaged in a catch-up process, they need higher rates of investment than developed
countries in physical capital and infrastructure and in human capital
- IMF and World Bank often place conditions on aid to manage risk crisis and promote growth
4
...
3
...
Six Country Risk Analysis Questions:
1
...
What are the economic and growth prospects for the economy?
- Economic Freedom Index best indicator of economic growth
3
...
Is external debt under control?
- external debt means foreign currency debt owed to foreigners by both the government and the
private sector
5
...
Is the political situation supportive of the required policies
- the analysis of emerging countries places a greater emphasis on the balance of payments, debt, liquidity, and
politics
4
...
5
...
Consumer Spending Growth = function of (Consumer Income Growth lagged one period and Interest
Rate*)
3
...
Consumer income growth lagged one period = Consumer Spending growth lagged one period
* = exogenous variable
- econometric models are widely regarded as very useful for simulating the effects of changes in certain variables
Econometric Model Limitations
- require user to find adequate measures for real-world activities and relationships to be modeleled
- variables may also be modeled with error
- relationships among the variables may change over time
4
...
2 Economic Indicators
Economic Indicators – are economic statistics provided by government and established by private organizations that
contain information on an economy’s recent past activity or its current or future position in the business cycle
Leading – variable that varies with the business cycle but at a fairly consistent time interval before a turn in
the cycle
Lagging and Coincident – are indicators of recent past and current economic activity
Diffusion Index – measures how many indicators are pointing up and how many down
Leading Indicator Indices for the World
a
...
Europe - Eurozone Harmonized Index of Consumer Prices (HICP) – developed by ECB for use in inflation targeting
- German Industrial Production – index of German industrial production relating to production data two months
prior
- German IFO Business Survey and French Monthly Business Survey are influential surveys of German and French
business executives
c
...
South America – Brazil Industrial Production index is a monthly release on data of industrial production 40 days
after end of the month surveyed
e
...
Average weekly hours, manufacturing
b
...
Manufacturers’ new orders, consumer goods and materials
d
...
Building permits, new private housing units
f
...
Money supply, M2
h
...
Index of consumer expectations
Coincident Indicators:
a
...
Personal income less transfer payments
c
...
Manufacturing and trade sales
Lagging Index
a
...
Inventory/Sales ratio, manufacturing and trade
c
...
Average prime rate
e
...
Consumer installment credit to personal income ratio
g
...
5
...
5
...
91
4
...
6
...
securities, which are settled using
reserves, to influence rates and the supply of credit by banks
...
6
...
bond reflects the expected short-term T-bill yields over the same horizon; or break down into
two components, real bond yield and forecast inflation
Real Bond Yield – determined by growth rate of GDP and the supply and demand for capital
- second, yields are affected by forecast inflation over the investment period
- for investors buying and selling long-term bonds over a shorter time period, the emphasis is on how bond yields
will respond to developments in the business cycle and changes in short-term interest rates
- strong growth makes yields rise (prices fall), and vice versa
4
...
3 Defaultable Debt
Defaultable Debt – is debt with some meaningful amount of credit-risk, i
...
most corporate debt
...
6
...
6
...
6
...
6
...
1 Economic Factors Affecting Earnings
- in the long term, the trend growth in aggregate company earnings is mainly determined by the trend rate of growth
of the economy; speed of growth positively correlated with earnings growth
- over the shorter term, the share of profits in GDP varies with the business cycle and is influenced by a variety of
factors, including final sales, wages, capacity utilization, and interest rates
Cyclical Stocks – companies with large fixed costs and a pronounced sales cycle that are more sensitive to the
business cycle than others
4
...
6
...
6
...
3 Emerging Market Equities
- empirical evidence points to ex post equity risk premiums for emerging markets that are on average higher and
more volatile than those in developed markets
- ex post, emerging market equity risk premiums in US dollar terms appear to be positively correlated with
expansion phases in G-7 economies as proxied by industrial economies
4
...
7 Real Estate
- interest rates are linked with a number of factors that affect the supply and demand for real estate, such as
construction financing costs and the costs of mortgage financing
...
4
...
8 Currencies
- the exchange rate between two countries reflects the balance of buyers and sellers; one major reason for buying
and selling foreign currencies is to facilitate trade in goods and services
- if a currency beings to import more, the currency will tend to depreciate, and vice versa
- the international flow of capital is another motive for purchases and sales of foreign currencies
- when interest rates are high, inflows are likely to be higher and the currency value rises
4
...
9 Approaches to Forecasting Exchange Rates
- four broad approaches are below
4
...
9
...
PPP reflects the idea that exchange rates should find a level that keeps different countries broadly
competitive with each other
4
...
9
...
It
suggests that a strong pace of economic growth in a country creates attractive investment opportunities, increasing
the demand for the country’s currency and causing it do appreciate
- the level of short-term interest rates influences the extent to which speculators are willing to be against a currency;
if rates especially high, they are less likely to short that currency
4
...
9
...
Inflows of FDI into a country increase the demand for the
country’s currency, all else equal
- note that long-term capital flows may have the effect of reversing the usual relationship between short-term interest
rates and the currency as a cut in short-term rates would be expected to boost economic growth and markets, making
long-term investments more attractive
4
...
9
...
6
...
7 Information Sources for Economic Data and Forecasts
- the main sources of leading indicators are the Conference Board and national sources such as central banks,
governmental statistical offices, Institute of Supply Management, OECD, IMF, and World Bank
- exhibit 33 pg
...
Lecture 6, pg
...
0 Introduction
- equity prices are negatively related to risk-free rates and risk premiums and positively related to earnings growth
2
...
1 Neoclassical Approach to Growth Accounting
- growth accounting is used in economics to measure the contribution of different factors, usually broadly defined as
capital and labor, to economic growth and indirectly, to compute the rate of an economy’s technological progress
24
...
2 Cobb-Douglas assuming constant returns to scale
ln(Y) = ln(A) + αln(K)+ (1- α) ln(L)
24
...
2 The China Economic Experience
- china economic growth has been largely driven by growth in the capital stock
2
...
4 Equity Market Valuation
- the growth rate of corporate earnings and dividend cash flow, adjusted for inflation, should bear a close
relationship with real GDP growth over the long term
H-Model – says that dividend growth rates are expected to decline in a linear fashion, over a finite horizon, towards
an ultimately sustainable rate from the end of that horizon into perpetuity
23
...
0 Top-Down and Bottom-Up Forecasting
- in top-down forecasting, analysts use macroeconomic projections to produce return expectations for large stock
market composites which can be further refined into return expectations for various market sectors and industry
groups within composites
- bottom-up forecasting begins with the microeconomic outlook for the fundamentals of individual companies
Top-Down Analysis
A
...
Industry Analysis: Evaluate domestic and global economic cycles to determine those industries expected to be top
performers in the best-performing equity markets
- Compare relative growth rates and expected profit margins across industries
- Identify those industries that will be favorably impacted by expected trends in interest rates, exchange
rates, and inflation
C
...
Company Analysis: Identify a rational for why certain stocks should be expected to outperform, without regard to
the prevailing macroeconomic conditions
- Identify reasons why a company’s products, technology, or services should be expected to be successful
- Evaluate the company’s management, history, business model, and growth prospects
- Use discounted cash flow models to determine expected returns for individual securities
B
...
Market Analysis: Aggregate expected industry returns to identify the expected returns for every equity market
3
...
2 Using Both Forecasting Types
- when each method produces different results, investigate assumptions to check for consistency
3
...
0 Relative Value Models
- as an investor, is it important to focus on the markets in a comparative fashion
4
...
S
...
5 Gordon Growth Model
...
6 Gordon Growth Model Estimate for Forward Earnings Yield, E1/P0
E1 = r – ROE(1 - p)
P0
p
p = payout ratio
24
...
8 Yardeni Model
=>
P0 = E1
r–g
E1 = r - g
P0
- the Yardeni model is a constant growth valuation model that values earnings
24
...
2 Asset-Based Models
Tobin’s q Ratio – asset-based valuation measure
Tobin’s Q = MVCompany
Replacement Cost of Assets
- is approximately = 1 in equilibrium
- if Tobin’s Q > 1, the marketplace values the company’s assets at more than their replacement costs, so additional
capital investment should be profitable
Tobin’s Q Market level = MVD+E
All Corporate Assets
Equity Q = Equity Market Capitalization
Net Worth at Replacement Cost
- equity Q differs from book value as BV uses value of equity reported on balance sheet, denominator of Equity Q
reflects difference between replacement cost of assets and the market value of liabilities
- pg
...
S
...
S
...
Increasing r would reduce justified P/E
- a bottom-up model is good for anticipating cyclical turning points while a top-down approach minimizes tracking
error risk because the forecast does not need to focus on individual securities
Reading 25: Dreaming with BRICs: The Path to 2050
1
...
0 A Dramatically Different World
- the big assumption underlying all assumptions presented is that BRICs maintain growth-supportive policy settings
- conclusions driven by economic size, economic growth, income and demographics, global demand
patterns, currency movements
3
...
developing countries have less capital than developed economies and returns on capital are higher given
and a given investment rate results in higher growth in the capital stock
b
...
0 Breaking Down Growth
- Growth accounting divides GDP growth into three components:
a
...
growth in the capital stock
c
...
0 A More Detailed Looked at the BRIC’s Potential
- in each economy, as development occurs, growth tends to slow and the exchange rate appreciates
- where labor force and population growth is rapid, income per captia tends to rise more slowly as higher investment
is needed just to keep up with population growth
6
...
0 A Look Back in Time – What Would We Have Said in 1960
- a good check is to go back in time and apply your model starting from a prior period and see where it would have
gotten you
Box 2: Conditions for Growth
1
...
Institutions – more efficient institutions allow an economy to produce the same output with fewer inputs
3
...
Education – more years of schooling are a prerequisite for the next stage of economic development
8
...
Main ingredients:
a
...
Strong and stable political institutions – political uncertainty and instability discourages investment and
damages growth
c
...
High levels of education – higher levels of education are generally helpful in contributing to more rapid
growth and catch-up
9
...
0 Implications of the BRICs’ Ascendancy
Appendix 25A
Cobb-Douglas Model
α
β
Y = AK L
Y = total real economic output
A = total factor productivity
K = capital stock
α = output elasticity of K
L = labor input
β = output elasticity of L
Study Session VIII: Asset Allocation
Reading 26: Asset Allocation
1
...
0 What is Asset Allocation
- in strategic asset allocation an investor’s return objectives, risk tolerance, and investment constraints are integrated
with long-run capital market expectations to establish exposures to IPS-permissible asset classes with the aim of
satisfying IPS objectives and constraints
- strategic asset allocation is the first element of the portfolio management process to focus on selecting investments
- tactical asset allocation involves making short-term adjustments to asset-class weights based on short-term
expected relative performance among asset classes
2
...
2 Strategic versus Tactical Asset Allocation
- strategic asset allocation sets an investors desired long-term exposures to systematic risk
- strategic asset allocations are reviewed periodically or when an investor’s needs and circumstances change
significantly
2
...
0 Asset Allocation and the Investor’s Risk and Return Objectives
3
...
When feasible, cash flow matching minimizes the risk relative to funding liabilities
Immunization – approach that structures investments in bonds to match (offset) the weighted-average duration of
liabilities
Dynamic Approach – recognizes that an investor’s asset allocation and actual asset returns and liabilities in a given
period affect the optimal decision that will be available next period
Static Approach – does not consider links between optimal decisions at different time periods
- ALM approach results in higher allocations to fixed-income instruments
- exhibit 2 pg
...
2 Return Objectives and Strategic Asset Allocation
Qualitative Return Objectives – describe the investor’s fundamental goals
- portfolio managers should prefer the multiplicative formulation for strategic asset allocation purposes
3
...
1 Asset Allocation Mix Evaluator
Um = E(RM) – 0
...
2 Roy’s Safety First
SF Ratio =
E(Rp) – RL
σp
- choose portfolio with highest SFRatio
3
...
0 The Selection of Asset Classes
- the selection must be from the set of asset classes permitted by the IPS
4
...
Criteria:
a
...
Asset classes should be mutually exclusive
c
...
The asset classes as a group should make up a preponderance of world investable wealth
e
...
Domestic Common Equity
b
...
Non-domestic (international) common equity
d
...
Real Estate
f
...
2 The Inclusion of International Assets (Developed and Emerging Markets)
- an objective criterion based on mean-variance analysis can help an investor decide whether he can improve on his
existing portfolio by adding a positive holding in nondomestic equities or bonds or any other asset class
...
3 Decision Formula
if
E(Rnew) – RF > [E(Rp) – RF] Corr(Rnew, Rp), then add new asset
σnew
[
σp
]
- for any portfolio, we can always effect a mean-variance improvement at the margin
- when investing in international assets, investors should consider the following special issues:
a
...
Increased correlations in times of stress – correlations across international markets tend to increase in
times of market breaks or crashes
c
...
3 Alternative Investments
- one concern for investors is the availability of resources to directly or indirectly research investment within AI
5
...
247
Risk Tolerance Function – can be used to portray the relationship between the investor’s circumstances and risk
tolerance
- from period to period some items in process may change, but the prediction procedure, investor’s risk tolerance
function, and optimizer should remain the same
6
...
1 The Mean-Variance Approach
6
...
1 The Efficient Frontier
- according to mean-variance theory, in determining a strategic asset allocation an investor should choose from
among the efficient portfolios consistent with that investor’s risk tolerance
- efficient portfolios offer the maximum expected return for their level of variance or standard deviation (risk)
Efficient Frontier – where efficient portfolios plot
Global Minimum Variance Portfolio – the portfolio with the smallest variance of all minimum variance portfolios
A
...
The Sign-Constrained MVF: The Case Most Relevant to Strategic Asset Allocation
Sign-Constrained Optimization – including constraints that the asset-class weights be non-negative and sum to 1
...
1
...
1
...
Cash Equivalents and Capital Market Theory
- from a multi-period perspective, T-bills exhibit a time series of returns with variability and can be included as a
risky asset class with positive standard deviation and nonzero correlations with other asset classes
- when we assume a nominally risk-free asset and take a single-period perspective, mean variance theory points to
choosing the asset allocation represented by the perceived tangency portfolio if the investor can borrow or lend at
the risk-free rate
- the tangency portfolio is the perceived highest-Sharpe-ratio efficient portfolio
Capital Allocation Line – describes the combinations of expected return and standard deviation of return available to
an investor from combining his or her optimal portfolio of risky assets with the risk-free asset
6
...
4 Extensions to the Mean-Variance Approach
- exhibit 18 pg
...
2 The Resampled Efficient Frontier
- MVO produces the portfolio weights of a specified number of mean-variance efficient portfolios (which may be
called simulated efficient portfolios
...
3 The Black-Litterman Approach
Unconstrained Black-Litterman Model – taking the weights of asset classes in a global benchmark such as MSCI
World as a natural starting point, the asset weights are adjusted to reflect the investor’s views on the expected returns
of asset classes according to a Bayesian procedure that considers the strength of the investor’s belief
Black-Litterman (BL) model – reverse engineers the expcted returns inmplictit in a diversified market portfolio and
combines them with the investor’s own views on expected returns in a systematic way taking into account investor
confidence
- desirable because the resulting asset allocation is well diversified and the resulting asset allocation
incorporates the investor’s views on asset-class returns, if any, as well as the strength of those views
- exhibit 19 pg
...
4 Monte Carlo Simulation
- Monte Carlo simulation involves the calculation and statistical description of the outcomes resulting in a particular
strategic asset allocation under random scenarios for investment returns, inflation, and other relevant variables
- the value of wealth at the terminal point of an investor’s time horizon is a criterion for choosing among asset
allocations
6
...
5
...
5
...
Determine the surplus efficient frontier and select a limited set of efficient portfolios, randing from the MSV
portfolio to higher-surplus-risk portfolios
26
...
05RAσ (SRm)
U
ALM
m
= surplus objective function’s expected value for a particular asset mix, m, for a
particular investor with the specified risk aversion
E(SRm) = expected surplus return for asset mix m, with the surplus return defined as
(change in asset value – change in liability value) / (initial asset value)
2
σ (SRm) = variance of the surplus return for asset mix m
RA = risk-aversion level
Step 2: Conduct a MC simulation for each proposed asset allocation and evaluate which allocations, if any, satisfy
the investor’s return and risk objectives
- must project pension payments and specify rule for making contributions first
Step 3
...
6 Experience-Based Approaches
- many independent advisors rely on tradition, experience, and rules of thumb in making strategic asset allocation
recommendations
...
A 60 / 40 stock/bond asset allocation is appropriate or at least a starting point for an average investor’s
asset allocation
2
...
Investors with longer time horizons should increase their allocation to stocks
4
...
0 Implementing the Strategic Asset Allocation
7
...
Passive investing – implemented through:
- a tracking portfolio of cash market securities
- a derivatives-based portfolio consisting of a cash position plus a long position in a swap in which the
returns to an index representing that asset class is received
- a derivatives-based portfolio consisting of a cash position plus a long position in index futures
b
...
Semi-active investing or enhanced indexing - implemented through:
- a tracking portfolio of cash market securities permitting some over-or-under weighting of a class
- derivatives-based position in asset-class plus controlled active risk in cash position
d
...
2 Currency Risk Management Decisions
- if money is allocated to a nondomestic asset class, the investor’s portfolio will be exposed to currency risk
7
...
0 Strategic Asset Allocation for Individual Investors
- individual investors are taxable and must focus on after-tax returns
...
1 Human Capital
Human Capital – the PV of expected future labor income; often an investors single largest asset; decreases to 0 at
retirement
Financial Capital – what an individual has in addition to human capital and consists of more readily tradable assets
26
...
(j – t)
(1 + r)
t = current age
Ij = expected earnings at age j
T = life expectancy
r = discount rate
A
...
- to effectively incorporate human capital in developing the appropriate asset allocation, an individual’s investment
advisor must determine whether the investor’s human capital is risk-free or risky and whether the human capital’s
risk is highly correlated with the stock market
8
...
0 Strategic Asset Allocation for Institutional Investors
9
...
2 Foundations and Endowments
- foundations and endowments generally must generate a high long-term rate of return in order to provide a
substantial spending flow as well as to compensate for inflation
9
...
4 Banks
- banks are financial intermediaries with a traditional focus on taking deposits and lending money
...
0 Tactical Asset Allocation
Tactical Asset Allocation – involves deliberately underweighting or over-weighting asset classes relative to their
target weights in the policy portfolio in an attempt to add value; it is active management at the asset-class level
- TAA is based on short-term expectations and perceived disequilibria
Based on following principles:
1
...
Relative expected returns reflect risk perceptions
- if relative expected returns reflect relative risk perceptions and those perceptions do not have a solid
economic basis, overweighting the out-of-favor asset class can be fruitful
3
...
0 The Traditional Case for International Diversification
- motivations for international investing include low international correlations allowing for reduction of volatility
and because it provides additional profit opportunities for an active investor
A
...
1 Expected Return on Portfolio
E(Rp) = wdE(Rd) + wfE(Rf)
26
...
Currency Considerations
- the return and risk of an asset depend on the currency used
Variance of Dollar Return
$
var(r ) = var(r + s) = var(r) + var(s) + 2cov(r,s)
or
2
2
2
σ f = σ + σ s + ρσσs
2
...
Equity
- the degree of independence of a stock market is directly linked to the independence of a nation’s economy and
government policies
4
...
Leads and Lags
- If markets are efficient, international news should affect all markets around the globe simultaneously, with markets
closed at that hour reflecting the news immediately on opening
B
...
An Ex-Post Example
- the benefits of global investing can hold from all national viewpoints simultaneously
...
Different Market Environments
- the return on a diversified portfolio is exactly equal to the average return of its components
3
...
Currency Risk Not a Barrier to International Investment
- currency fluctuations affect both the total return and the volatility of any foreign currency-denominated investment
- market and currency risks are not additive and would only be true if the two were perfectly correlated
- the exchange risk of an investment may be hedged for major currencies by selling futures or forward currency
contracts, buying put currency options, or even borrowing foreign currency contracts to finance the investment
- the contribution of currency risk should be measured for the total portfolio rather than for individual markets or
securities because part of that risk gets diversified away by the mix of currencies represented in the portfolio
- the contribution of currency risk decreases with the length of the investment horizon
2
...
Increase in Correlations
- it is often argued that the benefits of international diversification are overstated because markets tend to be more
synchronized than suggested previously
1
...
Correlation Increases When Markets Are Volatile
- correlation seems to increase dramatically in periods of crisis, so that the benefits of international risk
diversification disappear when they are needed most, this is referred to as correlation breakdown
- if they occur, correlation breakdowns would render very inefficient any hedging operations based on correlations,
or betas, estimated over long-term historical data
B
...
Barriers to International Investments
- international investment although growing is still not widespread in several countries and this behavior may be
explained by the prevalence of potential barriers to foreign investment
1
...
Political Risk
- some countries run the risk of being politically unstable
3
...
Regulations
- in some countries, regulations constrain the amount of foreign investment that can be undertaken by local
investors; some countries limit the amount of foreign ownership in their national corporations
5
...
Taxes
- withholding taxes exist on most stock markets
7
...
Conclusions
3
...
Pitfalls in Estimating Correlation During Volatile Periods
Conditioning Correlation on High Volatility – the conclusion of a correlation breakdown is derived by estimating the
correlation in periods of high volatility returns
2
...
Global Investing Rather than International Diversification
4
...
Regional and Country Factors
6
...
Global Investing
- to some extent, analysis should be country specific: country factors are still significant and many firms are still
primarily domestic in their activities
...
0 The Case for Emerging Markets
A
...
Volatility, Correlations, and Currency Risk
1
...
2
...
Currency Risk
- developing markets sometimes exhibit a negative correlation with the value of their currencies, but this is not
necessarily the case for emerging stock markets
C
...
Investability of Emerging Markets
Restrictions faced by foreign investors:
a
...
Free float is often small because the local government is often the primary owner of many companies
c
...
Discriminatory Taxes are sometimes applied to foreign investors
e
...
Authorized Investors are the only investors allowed to invest in some emerging countries
- lack of liquidity can also be a major problem with investing in emerging markets as any sizeable transaction could
have a significant price impact
E
...
In
segmented markets, the expected returns on similar assets from different countries should not be related
- segmented asset pricing is attractive to the global investor, as it implies that assets are mispriced relative to their
“international” value
- in a segmented market, expected asset returns should be proportional to local risks
Book 4
...
Alternative Investments, Risk Management, and the Application of Derivatives
Study Session XIII: Alternative Investments for Portfolio Management
Reading 36:
Reading 37:
Reading 38:
Study Session XIV: Risk Management
Reading 39:
Reading 40:
Study Session XV: Risk Management Applications of Derivatives
Reading 41:
Reading 42:
Reading 43:
Book 6
...
Why were the GIPS Standards Created?
- practitioner-driven set of ethical principles that establish a standardized, industry-wide approach for
investment firms to follow in calculating and reporting their historical investment results to prospective
clients
...
II
...
Compliance is a firm-wide process that
cannot be achieved on a single product or composite
...
III
...
Composites
- Must include all actual, fee-paying, discretionary portfolios managed in accordance with the same
investment objective or strategy
...
Verification – must be performed by independent third party
- Firms self-regulate their claim of compliance and may voluntarily hire an independent third party to
verify their claim of compliance to increase confidence in the validity of the firm’s claim of compliance
...
whether the investment firm has complied with all the composite construction requirements of GIPS on a
firm-wide basis
b
...
VI
...
Fundamentals of Compliance
2
...
Calculation Methodology
4
...
Disclosures
6
...
Real Estate
8
...
Introduction
A
...
- Requiring investment management firms to adhere to performance presentation standards will help assure
investors that the performance information is fairly presented
...
B
...
C
...
Overview
- Clearly define FIRM
- require FIRMS to include all actual fee-paying, discretionary portfolios in composites, shows GIPS compliant
history for minimum of 5 years (or since inception)
...
- requires firms use certain calculation and presentation methods
- Firms encouraged to adopt the recommended provisions to achieve best practice in performance presentation
- GIPS standards must be applied with goal of full disclosure and fair representation of investment performance
- Where local or country-specific laws or regulation conflicts with GIPS, firms are to comply with local law or
regulation and make full disclosure of conflict
- Within GIPS standards are supplemental PE and RE provisions that must be applied
E
...
- firms may link non-GIPS compliant performance record to their company history so long as no noncompliant
performance is presented after Jan 1, 2000 and firm discloses periods of noncompliance and explains how
reporting is not in compliance with GIPS
...
Compliance
- Effective date of revised GIPS standards is January 1, 2006
...
Encouraged to perform internal, periodic compliance checks
...
Fundamentals of Compliance
- GIPS standards must be applied on a FIRM-wide basis
...
If it has given a
compliant presentation to a client within the last 12 months, it has met this requirement
...
Encouraged to add disclosure to
composite presentations
Title: CFA Level III Curriculum Notes
Description: CFA Level III exam notes from 2011 CFA Curriculum. 112 pages and extremely thorough
Description: CFA Level III exam notes from 2011 CFA Curriculum. 112 pages and extremely thorough