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International Finance
Question 1 :  
Assume a Saudi Multinational Corporation decided to do a project in Germany one year ago (December 1st, 2021), which would be completed on November 30th, 2022. Suppose the project costs 100 million euros and is expected to generate income of 150 million euros on November 30th, 2022.  The exchange rate at the beginning of the project is 0.23 Euro/SAR, and it is 0.27 Euro/SAR at the end of the project.  There is no derivative bearing SAR currency, but there is a way for a Saudi firm to engage in the forward/options market.
a-    Calculate the initial investment in SAR.
b-     Show the choices for financing this project by the Saudi firm.  Just show without calculation.
c-    Calculate the profit from this investment in Euro and SAR also show whether the Saudi firm was hurt or benefited from changes in the exchange rate movement.
d-    How would the Saudi firm hedge against the exchange rate risk?
Question 2 : 
The US is considered a country that borrows at a lower cost of capital than the rest of the world; briefly explain why.
Question : According to Vision 2030, Saudi Arabia planned to diversify its production, and one of the production divisions is Small & Medium Enterprises (SME).  The goal by 2030 is to make 35 percent of GDP from SMEs.  Briefly explain whether Saudi Arabia can achieve this goal within this time frame and how the Saudi private equity market would attract foreign SMEs.  You might do a little research about this. 
Question 4 :
 There are two theories related to where Foreign Direct Investment (FDI) would be invested; one of them is the behavioral approach, which is that firms first invest in closer countries considered synch.  Explain how this would relate to Saudi firms invested in other countries.  Do you think this theory applies to Saudi firms, or do they usually invest in western countries?
Question 5 : 
If one of the Saudi banks (i.e., Al Bilad Bank) merges with another international bank (i.e., First Abu Dhabi Bank) to have a higher market share in the banking industry. Would you think a local firm’s action of merging with an international firm justifiable to increase its concentration on the industry globally? Discuss. 

Portfolio Management

(Case Study & Problem solving) Question(s):
Abdullah follows the automotive industry, including XYZ Motor Company. Based on XYZ’s 2021 annual report, Abdullah writes the following summary: XYZ Motor Company has businesses in several countries around the world. XYZ frequently has expenditures and receipts denominated in non-U.S. currencies, including purchases and sales of finished vehicles and production parts, subsidiary dividends, investments in non-U.S. operations, etc. XYZ uses a variety of commodities in the production of motor vehicles, such as nonferrous metals, precious metals, ferrous alloys, energy, and plastics/resins. XYZ typically purchases these commodities from outside suppliers. To finance its operations, XYZ uses a variety of funding sources, such as commercial paper, term debt, and lines of credit from major commercial banks. The company invests any surplus cash in securities of various types and maturities, the value of which are subject to fluctuations in interest rates. XYZ has a credit division, which provides financing to customers wanting to purchase XYZ’s vehicles on credit. Overall, XYZ faces several risks. To manage some of its risks, XYZ invests in fixed-income instruments and derivative contracts. Some of these investments do not rely on a clearing house and instead effect settlement through the execution of bilateral agreements. 
Based on the above summary, recommend and justify the risk exposures that should be reported as part of an Enterprise Risk Management System for XYZ Motor Company. 

An investment manager placed a limit order to buy 500,000 shares of Ahmad Corporation at SAR 21.35 limit at the opening of trading on February 8. The closing market price of Ahmad Corporation on February 7 was also SAR 21.35. The limit order filled 40,000 shares, and the remaining 460,000 shares were never filled. Some good news came out about Ahmad Corporation on February 8, and its price increased to SAR 23.60 by the end of that day. However, by the close of trading on February 14, the price had declined to SAR 21.74. The investment manager is analyzing the missed trade opportunity cost using the closing price on February 8 as the benchmark price.
A. What is the estimate of the missed trade opportunity cost if it is measured at a one-day interval after the decision to trade? 
B. What is the estimate of the missed trade opportunity cost if it is measured at a one-week interval after the decision to trade? 
Consider some stocks that trade in two markets, with a trader being able to trade in these stocks in either market. Suppose that the two markets are identical in all respects except that bid–ask spreads are lower and depths (the number of shares being offered at the bid and ask prices) are greater in one of the two markets. State in which market liquidity-motivated and information-motivated traders would prefer to transact. Justify your answer. 
Zaid retired from his firm. He has continued to hold his private retirement investments in a portfolio of common stocks and bonds. At the beginning of 2019, when he retired, his account was valued at SAR 453,000.By the end of 2019, the value of his account was SAR 523,500. Zaid made no contributions to or withdrawals from the portfolio during 2019. What rate of return did Zaid earn on his portfolio during 2019?The Portfolio
Management Process
by John L. Maginn, CFA
Donald L. Tuttle, CFA
PowerPoint Slides by
William A. Trent, CFA
Copyright 2007 John Wiley & Sons, Inc. All rights reserved. Reproduction or translation of this work beyond that
permitted in Section 117 of the 1976 United States Copyright Act without the express permission of the copyright
owner is unlawful. Request for futher information should be addressed to the Permissions Department, John Wiley &
Sons, Inc. The purchaser may make back-up copies for his/her own use only and not for distribution or resale. The
Publisher assumes no responsibility for errors, omissions, or damages caused by the use of these programs or from
the use of the information contained herein.
Chapter 1
The Portfolio Management Process
• Major learning outcomes:
– Justify the importance of the portfolio
– Formulate the steps of the portfolio
management process and the components of
those steps
– Compare and contrast the types of investment
– Contrast the types of investment constraints
Key Learning Outcomes

Justify the central role of the investment policy statement in the portfolio management

Review the elements of an investment policy statement and distinguish among the
components within

The risk objective
The return objective
The time horizon constraint

Compare and contrast passive, active and semiactive approaches to investing.

Discuss the role of capital market expectations in the portfolio management process.

Discuss the role of strategic asset allocation in the portfolio management process.

Discuss the roles of portfolio selection/composition and portfolio implementation in
the portfolio management process.

Contrast the elements of performance evaluation.

Explain the purpose of monitoring and rebalancing.
Key Learning Outcomes

Formulate the elements of portfolio management as an ongoing process.

Formulate and justify a risk objective for an investor.

Formulate and justify a return objective for an investor.

Determine the liquidity requirement of an investor and evaluate the effects
of a liquidity requirement on portfolio choice.

Contrast the types of time horizons, determine the time horizon for an
investor, and evaluate the effects of the investor’s time horizon on portfolio

Determine the tax concerns, legal and regulatory factors, and unique
circumstances for an investor and evaluate their effects on portfolio choice.

Justify ethical conduct as a requirement for managing investment portfolios.
The Importance of the Portfolio
• Economic factors influence the average
returns of many assets, resulting in
correlations between risk and return for
multiple assets.
• Analyzing assets in isolation ignores the
interrelationships between assets, and can
lead to misunderstanding the risk and
return prospects for the investor’s total
Steps in the Portfolio
Management Process
• The Planning Step.
– Identify and specify the investor’s objectives and
– Create the investment policy statement
– Form capital market expectations
– Create the strategic asset allocation
• The Execution Step
– Select specific assets and implement decisions
– Optimize the portfolio
– Determine need for tactical asset allocation
• The Feedback Step
– Monitoring and rebalancing
– Performance evaluation
Types of Investment Objectives
• Risk objective
– How to measure? Volatility, tracking risk, downside
– Investor appetite for risk
– Investor ability to take risk – spending needs, wealth
targets, obligations, ability to increase savings
– How much risk is investor both willing and able to
– Specific risk objective
– How should risk be allocated to specific
Types of Investment Objectives
• Return objective
– How to measure return – total return, nominal, real,
pre-tax or after-tax?
– Return desired – is it realistic and consistent with
risk objective?
– Return needed – Specific objectives for ending
wealth require specific returns in order to be met.
– Specific return objective – incorporates above points
into measurable annual return objective that could
be absolute (i.e. 10%) or relative (i.e. greater than
inflation or a benchmark return.)
Types of Investment Constraints
• Liquidity – the need for cash in excess of savings or
new contributions at specific times in the future
• Time Horizon – Short, long or a combination
– Affects ability to assume risk
– Can lead to different asset allocation
– Must consider investor tolerance for temporary risks
– Can be constrained by multiple objectives at different
• Tax concerns
• Legal and regulatory factors
• Unique circumstances
Investment Policy Statement
• Plays a central role in the portfolio
management process
• Outlines investor objectives and
constraints, as well as manager
requirements for reporting, rebalancing,
fees, strategy and style
• Ensures that all future investment
decisions are consistent with outlined
objectives and constraints
Elements of an Investment Policy

Client description
Purpose of establishing policies and guidelines
Duties and investment responsibilities of client, manager,
custodian and investment committee, particularly:
– Fiduciary duties
– Communication
– Operational Efficiency
– Accountability

Statement of investment goals, objectives and constraints
Schedule for review of performance and IPS
Performance measures and benchmarks
Special considerations
Investment strategies and style
Guidelines for portfolio rebalancing
Approaches to Investing
• Passive approach does not react to changes in capital
market expectations
– Indexing – holds a portfolio designed to replicate the return of
a benchmark index
– Strict buy and hold strategy selects a group of non-indexed
securities to hold until maturity
• Active approach responds to changing conditions.
– Holdings differ from benchmark according to management’s
assessment of each holding
– Goal is to produce excess return (alpha) relative to the
• Semiactive, risk-controlled active or enhanced index
approach seeks positive alpha while tightly controlling
risk factors
Capital Market Expectations
• Managers should form long-term
forecasts of the risk and return
characteristics of asset classes
• Forms the basis for choosing portfolios
that minimize risk relative to return or
maximize return relative to risk
• Influences asset allocation strategy and
frequency of rebalancing
Strategic Asset Allocation
• Combine IPS with capital market
expectations to determine target weight
for each asset class (possibly maximum
and minimum weight range)
• Single period perspective simplest
• Multiple period perspective can address
liquidity and tax considerations arising
from rebalancing as well as serial
correlations in returns, but is more costly
Portfolio Selection, Composition
and Implementation
• Portfolio Selection/Composition Decision
– Managers initiate portfolio decisions based on
analysts’ input
– May involve a quantitative optimization process
• Portfolio Implementation Decision
– Trading desk implements decision
– Must incorporate transaction costs, including explicit
(commissions, fees and taxes) and implicit costs
(bid-ask spread, market impact, and opportunity
costs when orders are unable to be filled or are filled
Elements of Performance
• Performance evaluation is needed to
monitor investor progress toward goals
and measure manager skill
• Skill assessment has three components
– Performance measurement – rate of return
– Performance attribution – sources of return
include strategic allocation, market timing
and security selection
– Performance appraisal – comparison to
Monitoring and Rebalancing
• Changes in investor circumstances or in market
and economic conditions provide feedback to
the portfolio management process
• Process needed to keep informed of changes in
client circumstances and possible changes in
strategic asset allocation that may result
• Changing economic and market conditions
cause assets to drift away from target weight
and necessitate rebalancing portfolio to ensure
client objectives and constraints remain satisfied
The Portfolio Management
• Portfolio management is an ongoing process in
– Investment objectives and constraints are identified and
– Investment strategies are developed
– Portfolio composition is decided in detail
– Portfolio decisions are initiated by portfolio managers
and implemented by traders
– Portfolio performance is measured and evaluated
– Investor and market conditions are monitored
– Any necessary rebalancing is implemented
Formulating an Investment Risk

Risk objective will largely determine the return objective

How measured

Investor willingness to accept risk
Investor’s ability to take risk

Variance, Standard deviation
Tracking error relative to benchmark
Downside risk, Value at risk
How much volatility would inconvenience investor
Wealth targets and achievability
Financial strength outside portfolio (income, ability to save)
Risk tolerance/aversion – how much is investor both willing and able
to bear
Specific objective translates “low risk tolerance” into “loss in any
given year should not exceed x%.”
Risk budgeting – how should the desired level of risk be allocated
among various assets?
Formulating an Investment Return
• Must be consistent with risk objective
• How measured?
– Total return
– Real or nominal
– Before or after tax
• How much is desired
• How much is required in order to meet
• Specific objective – “average annual
return in excess of 5% after tax.”
Liquidity Requirements
• Liquidity requirements are needs for cash
that exceed contributions or savings
• Stem from liquidity events
– Planned – buying a house in 2 years
– Unplanned – house damaged in hurricane
• Requires allocation to assets that can be
readily converted into cash without
impacting value
• May also be met using insurance or
derivative strategies
Investment Time Horizon
• Time period associated with investment objective
– short term or long-term (> 10 years)
• Other constraints interact with time horizon to
affect portfolio choice
• Longer time horizon typically allows:
– higher risk tolerance
– higher allocation to risky assets
• Multiple time horizons must be considered and
can modify ability to accept risk
• Investor willingness and ability to accept risk can
limit risk taking available with longer horizon
Other Constraints
• Tax concerns
– Different tax rates applied to income/dividends/gains
– Tax advantaged savings vehicles
– Estate taxes
– Potential policy changes
• Legal and Regulatory
– Limits on allocations to certain assets
– Limits on investments in tax-advantaged accounts
– ERISA, etc.
• Unique circumstances
– Social concerns
– Health needs
– Dependents
– Expertise
Ethical Conduct
• Portfolio manager conduct affects the wellbeing of clients and others
• Acting in a position of trust, which must be
• Ethical conduct is a foundational
requirement for managing investment
• Reflected in the Code of Ethics and
Standards of Professional Conduct
Managing Individual
Investor Portfolios
by James W. Bronson, CFA
Matthew Scanlan, CFA
Jan R. Squires, CFA
PowerPoint Slides by
William A. Trent, CFA
Copyright 2007 John Wiley & Sons, Inc. All rights reserved. Reproduction or translation of this work beyond that
permitted in Section 117 of the 1976 United States Copyright Act without the express permission of the copyright
owner is unlawful. Request for futher information should be addressed to the Permissions Department, John Wiley &
Sons, Inc. The purchaser may make back-up copies for his/her own use only and not for distribution or resale. The
Publisher assumes no responsibility for errors, omissions, or damages caused by the use of these programs or from
the use of the information contained herein.
Chapter 2
Managing Individual Investor Portfolios
• Major learning outcomes:
– Review situational profiling for individual
investors and discuss source of wealth,
measure of wealth and stage of life as
approaches to situational profiling
– Prepare an elementary situational profile for
an individual investor
– Discuss the role of psychological profiling in
understanding individual investor behavior
Key Learning Outcomes
• Formulate the basic principles of the behavioral
finance investment framework.
• Discuss the influence of investor psychology on
risk tolerance and investment choices.
• Discuss the use of a personality-typing
questionnaire for identifying an investor’s
personality type.
• Formulate the relationship of risk attitudes and
decision-making styles with individual investor
personality types.
• Discuss the potential benefits for both clients
and investment advisers of having a formal
investment policy statement.
Key Learning Outcomes
• Review the process involved in creating an
investment policy statement for a client.
• Discuss each of the major objectives that an
individual investor’s investment policy statement
• Distinguish between an individual investor’s
ability to take risk and willingness to take risk.
• Discuss how to set risk and return objectives for
individual investor portfolios.
• Discuss each of the major constraints that an
individual investor’s investment policy statement
Key Learning Outcomes
• Formulate and justify an investment policy
statement for an individual investor
• Demonstrate the use of a process of elimination
to arrive at an appropriate strategic asset
allocation for an individual investor.
• Demonstrate the strategic asset allocation that is
most appropriate given an individual investor’s
objectives and constraints.
• Compare and contrast traditional deterministic
versus Monte Carlo approaches in the context of
retirement planning.
• Discuss the advantages of the Monte Carlo
approach to retirement planning.
Situational Profiling
• Attempts to categorize investors by stage
of life and economic circumstance
• Risk of oversimplifying complex behavior,
but can be a useful first step
• Components of a situational profile
– Source of wealth
– Measure of wealth
– Stage of life
Situational Profiling: Source and
Measure of Wealth
• Source of wealth
– Can indicate risk tolerance
– Entrepreneur may be willing to take business risk
but unwilling to take risks that are outside his or her
– Heir(ess) may be less experienced and unable to
recover from investment setbacks
• Measure of wealth
– How much is enough
– Investor perceptions can differ
– Higher perception of wealth generally allows higher
risk tolerance
Situational Profiling: Stage of Life

Foundation stage:
– Establishes base for wealth creation (skill, education, business formation)
– Relatively young, long time horizon, increased ability to accept risk
– Need for liquidity may outweigh risk tolerance

Accumulation stage
– Rising income and expenses (marriage, children, home)
– Later income still rises but expenses decline (children grow up, home paid off),
increasing ability to save
– Increased wealth and still-long time horizon increase risk tolerance

Maintenance stage (early retirement)
– Need to maintain lifestyle and financial security
– Shorter time horizon, less risk tolerance
– Some risky assets needed to preserve purchasing power

Distribution stage
– Gifting to heirs or charities
– Tax constraints require early planning

Life events can send an investor backward (new career or family)
or forward (injury or illness) to a different stage
Psychological Profiling
• Personality plays an important role in establishing
investor’s risk tolerance and return objectives
• Bridges the gap between traditional finance and
behavioral finance
• Traditional finance measures objective
circumstances, and assumes investors are risk
averse, hold rational expectations and practice
asset integration (portfolio context)
• Behavioral finance assumes investor psychology
leads investors to be loss averse, hold biased
expectations and practice asset segregation (each
asset viewed independently)
Behavioral Finance Investment

Investors are loss averse
– Do not view risk as uncertainty but rather as the potential for gain or
– More weight placed on losses than on gains
– Actually seek risk to avoid a certain loss even when resulting in lower
expected value

Investor expectations are biased
– Overconfident about future predictions
– Overestimate significance of rare events and the representativeness of
one asset for another

Investors segregate assets
– Do not consider interaction
– Segregate into mental accounts by purpose or preference

To accommodate behavior, portfolios should be constructed to
include subjective constraints and be layered to reflect asset
segregation (with the layers forming an integrated whole).
Personality Typing Questionnaire
• Personality influenced by complex forces
• Understanding personality can lead to better
management of expectations and behavior
• Often investor personality type is an ad hoc subjective
judgment by the advisor
• Questionnaire can assess investor consistency with
regard to behavior and decision making style
• Questionnaire results can be scored across risk
tolerance and investment decision making dimensions
to categorize investor into one of four groups
(methodical, cautious, individualist and spontaneous)
Investor Personality Types

Methodical – Risk averse, decisions made based primarily on thinking

Cautious – Risk averse, decisions made based primarily on feeling

Loss averse
Uncomfortable making decisions but also not easily persuaded by advisors
May overanalyze and miss opportunities due to indecision
Individualist – Less risk averse, decisions made based primarily on thinking

Rely on hard facts
More conservative, less emotional
Self assured
Gain information from multiple sources and take time to reconcile differences
Put faith in hard work and insight
Confident in results of their efforts
Spontaneous – Less risk averse, decisions made based primarily on feeling

Constantly adjusting portfolio
Although non-expert themselves, doubt the advice of others
Overmanaged, high-turnover portfolios
More concerned with missing a trend than with risk
Profits often eroded by trading costs
Benefits of a Formal Investment
Policy Statement
• For Clients:
– Educational process
– Reduces need to blindly trust adviser
– Portable document if change in advisers or
second opinion is necessary
• For advisers:
– Protects adviser
– Can clarify motivation for decisions
– Can help identify questionable situations
before they become serious
Creating an Investment Policy
Statement – Return Objective
• Should be considered concurrently with risk
– Conflicts must be resolved: delay retirement,
increase savings, accept higher risk, etc.
– Decision must be made for surplus returns as well:
should they be protected or do they allow greater
risk taking in seek of higher returns
• Required return is that needed to achieve
primary or critical long-term objectives
• Desired return accommodates less critical
(though still important) goals
• Return requirements historically classified as
growth or income, but distinction flawed
• Total return is the appropriate approach
Creating an Investment Policy
Statement – Risk Objective
• Ability to take risk (objective, financial measure)
– Short term and long-term financial needs
– Importance of achieving goals and consequences of
– How much loss can be borne without jeopardizing
major goals
• Willingness to take risk (subjective,
psychological measure)
– Conservative investor may be less willing than they
are able
– Aggressive investor may be more willing than they
are able
Creating an Investment Policy
Statement – Liquidity Constraint
• Ability to meet anticipated and
unanticipated demands for cash
• Transaction costs and price volatility
determine a portfolio’s liquidity
• Liquidity required for ongoing expenses,
emergency reserves, and negative
liquidity events
• Home and business are illiquid assets
that may require separate consideration
Creating an Investment Policy
Statement – Time Horizon Constraint
• Short or Long Term
– Less than three years (short)
– More than 15 years (long)
– 3-15 years (intermediate – depends on
investor perception)
• Single or multiple time horizons?
• Stage of life not always inverse to time
horizon – as wealth increases multigenerational plans are more likely
Creating an Investment Policy
Statement – Taxes Constraint
• Universal and complex
– Income tax
– Gains tax (profits on investments)
– Wealth transfer tax (gift or estate taxes)
– Property tax (real or financial property)
• Investment plans must be based on after-tax perspective
• Tax deferral – more frequent periodic payments diminish
wealth, so some plans try to defer tax payment as long as
• Tax avoidance – tax exempt investments typically come at
expense of lower returns, liquidity or control
• Tax reduction – different rates for income or gains
• Wealth transfer – Early transfers (pre-death) may be
desirable and also may result in longer tax deferral
Creating an Investment Policy Statement
– Legal and Regulatory Constraint

Vary by country and change frequently
Investment managers must be sure to avoid
offering advice that constitues practice of law
– Revocable trusts are controlled by grantor, who pays
relevant taxes
– Irrevocable trusts are controlled by trustee, and trust
pays own taxes

Family foundations can be set up to facilitate
gifting to children, grandchildren or gifting with a
retained interest
Jurisdiction of taxation and applicable laws
Strategic Asset Allocation – Process of

Selecting the most satisfactory asset
allocation for an investor consists of four
1. Determine asset allocations that meet return
requirement (total, after tax return)
2. Eliminate allocations that fail to meet quantitative
risk objectives or are inconsistent with investor
risk tolerance
3. Eliminate allocations that fail to satisfy other
investor constraints
4. Select from remaining allocations that which
offers the best risk-adjusted performance and
Monte Carlo Approach to
Retirement Planning
• Creates path-dependent scenarios based on probability
distribution to predict end-stage results
• Superior to steady-state (deterministic) forecasting
because incorporates variability across long-term
assumptions and impact of resulting paths on ending
• Generates probability distribution of ending wealth rather
than a single point estimate
• Gives insight on trade-off between short-term risk and
long-term failure to achieve objective
• Can capture volatility due to varying tax assumptions
• More closely approximates likely investment outcomes
Managing Institutional
Investor Portfolios
by Charles Tschampion, CFA
Lawrence Siegel
Dean J. Takahashi
John L. Maginn, CFA
PowerPoint Slides by
William A. Trent, CFA
Copyright 2007 John Wiley & Sons, Inc. All rights reserved. Reproduction or translation of this work beyond that
permitted in Section 117 of the 1976 United States Copyright Act without the express permission of the copyright
owner is unlawful. Request for futher information should be addressed to the Permissions Department, John Wiley &
Sons, Inc. The purchaser may make back-up copies for his/her own use only and not for distribution or resale. The
Publisher assumes no responsibility for errors, omissions, or damages caused by the use of these programs or from
the use of the information contained herein.
Chapter 3
Managing Institutional Investor
• Major learning outcomes:
– Contrast a defined-benefit plan to a definedcontribution plan from the perspectives of both the
employee and employer
– Discuss investment objectives and constraints for
defined-benefit plans
– Evaluate pension fund risk tolerance when risk is
considered from the perspective of the (1) plan
surplus, (2) sponsor financial status and profitability,
(3) sponsor and pension fund common risk
exposures, (4) plan features, and (5) workforce
Key Learning Outcomes
• Formulate an investment policy statement for a
defined-benefit plan
• Evaluate the risk management considerations in
investing pension plan assets.
• Formulate an investment policy statement for a
defined-contribution plan.
• Discuss hybrid pension plans (e.g., cash
balance plans) and employee stock ownership
• Distinguish among the types of foundations with
respect to their description, purpose, source of
funds, and annual spending requirements.
Key Learning Outcomes
• Discuss investment objectives and constraints
for foundations, endowments, insurance
companies, and banks.
• Formulate an investment policy statement for a
foundation, an endowment, an insurance
company, and a bank.
• Contrast investment companies, commodity
pools, and hedge funds to other types of
institutional investors.
• Evaluate the factors that affect the investment
policies of pension funds, foundations,
endowments, life and non-life insurance
companies, and banks.
Key Learning Outcomes
• Differentiate among the return objectives, risk
tolerances, liquidity requirements, time horizons, tax
considerations, legal and regulatory environment, and
unique circumstances of pension funds, foundations,
endowments, insurance companies, and banks.
• Compare and contrast the asset/liability management
needs of pension funds, foundations, endowments,
insurance companies, and banks.
• Compare and contrast the investment objectives and
constraints of institutional investors given relevant data
such as descriptions of their financial circumstances and
attitudes toward risk.
Defined-Benefit (DB) vs DefinedContribution (DC) Plans
• DB plans promise a certain benefit in the
future, DC plans promise a certain contribution
• DC plans confer no future liability to the plan
sponsor, in contrast to DB plans.
• DC plan participants bear investment risk, DB
plan sponsor bears investment risk.
• DB plan participants bear risk of early plan
termination. In a DC plan, participants own
their account.
• DC plans are more portable if the participant
changes jobs.
Defined Benefit Plan Objectives
and Constraints

Risk objective must consider:
– Plan status (funding ratio)
– Sponsor financial status and profitability
– Sponsor and pension fund common risk exposures
– Plan features
– Workforce characteristics

Return objective is to achieve inflation-adjusted returns that
adequately fund its pension liabilities.
Constraints include:
– Liquidity (difference between annual contributions and
– Time horizon is long if plan is continuing, but average age of
workforce is a consideration.
– Taxes: Investment returns are tax exempt.
– Legal and regulatory: Investment policies are governed by law.
– Unique circumstances include sponsor financial condition and specific
investment prohibitions.
Evaluating Risk Tolerance for
Defined Benefit Retirement Plans
• Risk tolerance governed by multiple factors.
• Plan surplus (assets in excess of liabilities) – risk
tolerance can increase with surplus, but need to accept
risk declines.
• Sponsor financial status – A sponsor with less debt
and higher profits can accept more investment risk as
shortfalls can be made up with additional contributions.
• Common risk exposures between sponsor and plan –
The lower the correlation between sponsor operating
results and plan returns, the higher the investment risk
• Plan features – early retirement or lump sum options
reduce plan duration and reduce risk tolerance.
• Workforce characteristics – more risk can be tolerated
by plans serving relatively young workforce and by
plans with a higher ratio of active lives to retired lives.
Investing Pension Plan Assets:
Risk Management
• Primary purpose of plan assets is to fund
future liabilities.
• Asset/Liability management is a primary
• Plan may set a risk objective relative to the
volatility of the plan surplus.
• Risk can also be expressed as a threshold
for shortfall relative to a specified funded
Investment Policy Statements for
Defined Contribution Plans
• Principal investment issues for sponsor are
diversification (menu of plan options) and limits
to investments in company stock.
• Sponsor’s IPS documents ways to meet
fiduciary responsibility with regard to plan
options and procedures to ensure that individual
objectives and constraints can be met.
• Each plan participant is responsible for defining
his/her own investment objectives and
Hybrid Pension Plans and Employee
Stock-Ownership Plans
• Hybrid plans seek to combine the best aspects of both
defined contribution plans (portability of assets,
administrative ease and understandability by
participants) and defined benefit plans (benefit
guarantees, awards for length of service, ability to link
retirement income to a percentage of salary).
• In most hybrid plans, employer bears investment risk
(as with a DB plan) but employee receives an
understandable statement (as with a DC plan.)
• Employee Stock Ownership Plans (ESOPs) are ways
of encouraging company share ownership by
– Regulations vary widely from country to country
– Diversification of assets becomes an important consideration
for ESOP participants
Types of Foundations
• Independent (private or family)
– Makes grants to aid social, educational,
charitable or religious activities
– Funds provided by individual, group or family
– Decision making authority lies with donor,
family member or independent trustees
– Must spend at least 5% of average assets
plus expenses
Types of Foundations
• Company sponsored
– Legally independent, but with close ties to
corporation providing funds
– Funds provided via endowment or annual
contributions by a for-profit company
– Decision-making authority lies with board of
trustees, usually controlled by company
– Must spend at least 5% of average assets
Types of Foundations
• Operating Foundation
– Uses resources to conduct research or
provide service (such as running a museum)
– Funds typically provided by individuals,
groups or families
– Decisions made by an independent board of
– Must use 85% of investment income in
operational activity. Some also must spend
at least 3.3% of average assets per year
Types of Foundations
• Community Foundation
– Publicly supported organization making
grants for social, educational, charitable or
religious purposes (public charity)
– Funds provided by the public, multiple
– Decisions made by Board of Directors
– Not subject to minimum annual spending
Foundations: Investment
Objectives and Constraints

Risk objective
– High risk tolerance because maintaining spending level is more a
desire than a necessity

Return objective
– Preserve real value of assets while permitting desired or mandated
spending rate
– Intergenerational equity arises when spending rate can be sustained in
real terms in perpetuity (i.e. mandated 5% spending rate + investment
expenses + inflation rate = required return to assure intergenerational

– Liquidity needed to provide for mandated spending levels
– Time horizon = perpetuity
– Tax concerns are minimal (unrelated business income, 2% excise tax)
– Legal and Regulatory – must comply with UMIFA or non-US
– Unique circumstances – many foundations have large holdings in a
single company
Endowments: Investment Objectives
and Constraints

Risk objective
– Must be consistent with goal of stable, real income over time
(intergenerational equity)
– Can be higher if institution can adapt to fluctuations by altering
– If smoothing mechanisms are used, periods of high return can
increase risk tolerance in subsequent periods

Return objectives
– High return needed to maximize sustainable real income

– Liquidity – sufficient to cover short-term spending needs
– Time horizon is long-term, with short term spending considerations
– Tax considerations are minimal
– Legal and Regulatory – UMIFA or equivalent, tax exempt status, etc.
– Unique circumstances – vary by endowment
Life Insurance Companies: Investment
Objectives and Constraints
• Risk objective
– Significant future liabilities and sensitivity to interest rates reduce
result in low risk tolerance
– Many match assets with liabilities to the extent possible and have
higher risk tolerance for “surplus” funds
• Return objective
– Earn a positive spread over the rates paid to policyholders
• Constraints
– Liquidity – usually not a concern, but rises with increased annuity
payments and interest rate volatility
– Time horizon – overall long-term, though often segmented to match
product classes
– Tax concerns – commercial entities subject to tax
– Legal and regulatory factors – heavily regulated. Investments must
be “eligible,” required to follow prudent investor rule, must maintain
uniform valuation methods
– Unique circumstances – Vary by insurer
Non-Life Insurance Companies:
Investment Objectives and Constraints
• Risk objective
– Ability to meet claims is paramount, and claims risk is
unpredictable. Low risk tolerance.
• Return objective
– Influenced by competitive pricing, profitability, surplus funds, tax
• Constraints
– Liquidity needs – significant
– Time horizon – short duration of liabilities interacts with more
favorable returns for longer-duration assets
– Tax concerns – complicated and typically requires complex
– Legal and regulatory factors – fairly permissive with regard to

Banks: Investment Objectives and
Risk objective
– Constrained by asset/liability management (ALM) –
short-term deposits used to finance long-term loans
– Below average risk tolerance

Return objective
– Positive spread over rate paid to depositors

– Liquidity – significant need to cover deposit outflows
and lending
– Time horizon – intermediate, balancing the needs of
return and managing interest rate risk
– Tax concerns – fully taxable portfolios
– Legal and regulatory – restrictions on stock and subinvestment grade bond investing
Investment Companies, Commodity
Pools and Hedge Funds

Investment intermediaries whose sole
corporate purpose is investing
Each has specific investment
objectives and constraints, legally
outlined in a prospectus or other
No general investment objectives and
constraints are applicable to all
investment intermediaries
Capital Market Expectations
by John P. Calverly
Alan M. Meder, CFA
Brian D. Singer, CFA
Renato Staub
Key Learning Outcomes
• Discuss the role of capital market
expectations in the portfolio management
• Review a framework for setting capital
market expectations
Learning Outcomes
• Identify and discuss the following as they affect
the setting of capital market expectations:
– The limitations of economic data
– Data measurement errors and biases
– The limitations of historical estimates
– Ex post risk as a biased measure of ex ante risk
– Biases in analysts’ methods
– The failure to account for conditioning information
– The misinterpretation of correlations
– Psychological traps
– Model uncertainty
Learning Outcomes
• Review and demonstrate formal tools for setting
capital market expectations, including:
– Statistical tools
• Sample estimators
• Shrinkage estimators
• Time-series estimators
• Multi-factor models
– Discounted cash flow models
– The risk premium approach
– Financial equilibrium models
Learning Outcomes
• Explain the use of survey and panel methods
and judgment in setting capital market
• Distinguish between the inventory cycle and the
business cycle
• Identify and interpret business cycle phases and
their relationship to short- and long-term capital
market returns
• Review the relationship of inflation to the
business cycle and characterize the relationship
between inflation/deflation and cash, bonds,
equity, and real estate
Learning Outcomes
• Discuss the effects on the business cycle of the
following factors:
– Consumer spending
– Business investment and spending on inventories
– Monetary and fiscal policy
• Demonstrate the use of the Taylor rule to predict
central bank behavior
• Review the shape of the yield curve as an
economic predictor and the relationship between
the yield curve and fiscal and monetary policy
Learning Outcomes
• Distinguish between business cycles and
economic growth trends and demonstrate the
application of business cycle and economic
growth trend analysis to the formulation of
capital market expectations
• Identify and interpret the components of
economic growth trends and explain how
governmental policies and exogenous shocks
can affect economic growth trends
• Identify and interpret macroeconomic and
interest and exchange rate linkages between
Learning Outcomes
• Review the differences between emerging
market and developed economies and explain
the country risk analysis techniques used to
evaluate emerging markets
• Compare and contrast the major approaches to
economic forecasting
• Demonstrate the use of economic information in
forecasting returns for cash and equivalents,
nominal default-free bonds, defaultable debt,
emerging market debt, inflation-indexed bonds,
common shares (developed and emerging
market), real estate, and currencies
Learning Outcomes
• Evaluate how economic and competitive
factors affect investment markets, sectors,
and specific securities
• Identify and interpret the major
approaches to forecasting exchange rates
• Recommend and justify changes in the
component weights of a global investment
portfolio based on trends and expected
changes in macroeconomic factors
The Role of Capital Market
• Capital market expectations are the
investor’s expectations concerning the risk
and return prospects of various asset
classes (macro) as opposed to specific
assets (micro)
• Essential input to formulating a strategic
asset allocation
Framework for Setting Capital
Market Expectations
• Specify the final set of expectations needed, including the
time horizon to which they apply
• Research the historical record
• Specify the method(s) and/or model(s) that will be used and
their information requirements
• Determine the best sourced for information needs
• Interpret the current investment environment using the
selected data and methods, applying experience and
• Provide the set of expectations that are needed, documenting
• Monitor actual outcomes and compare them to expectations,
providing feedback to improve the expectations-setting
Limitations of Economic Data
• Analyst must understand definition, construction,
timeliness and accuracy of any data used,
including biases
• Time lag can be an impediment to use
• Data are frequently revised by collecting officials
• Definitions and calculation methods change over
• Data collectors often re-index, introducing the
risk of mixing data indexed to different bases
Data Measurement Errors and
• Transcription errors – errors in gathering and
recording data (most serious if they reflect a
• Survivorship bias – including only those entities
that have survived for the entire measurement
period tends to paint an overly optimistic picture
• Appraisal (smoothed) data – understates
volatility and correlation with other assets due to
infrequent measurement
Limitations of Historical Estimates
• Things could be different, altering risk/return
– Technological
– Political
– Legal and regulatory environments
– Disruptions (war, natural disaster)
• Such regime changes result in nonstationarity –
differing underlying properties during different
parts of a time series
• Amount of data needed for statistical analysis
may require a long time series, increasing
nonstationarity risk (if the data is even available)
Ex Post Risk as a Biased Measure
of Ex Ante Risk
• Prices at any one time reflect risk factors that
may not materialize
• When the risk fails to materialize, asset prices
• Since the risk did not materialize, it is not
incorporated in the ex-ante estimate (i.e. risk is
• The return did materialize, so it is incorporated
in ex-ante estimates (return is overestimated)
Biases in Analysts’ Methods
• Data mining – with enough data there will
be random correlations that are not
economically meaningful
• Time period bias – research findings often
sensitive to start and end dates for
measurement period
Accounting for Conditioning
• Analysis must consider relevant new facts
• Historical averages incorporate many
economic environments
• Data should be conditioned to current
Misinterpretation of Correlations
• Three possible explanations for a correlation
between variable A and variable B:
– A predicts B
– B predicts A
– A third variable (C) predicts both B and A
• Without investigating and modeling underlying
linkages, correlation relationships should not be
used in a prediction model
• Apparently uncorrelated variables may have a
strong (but nonlinear) relationship
• Multiple regression analysis may help avoid
some errors
Psychological Traps
• Anchoring – gives disproportionate weight to the first
information received on a topic
• Status quo – tendency to perpetuate recent observations
in forecasts
• Confirming evidence – giving greater weight to
information that supports existing or preferred point of
view than to evidence that contradicts it
• Overconfidence – overestimating accuracy of forecasts
• Prudence – tempering forecasts to not appear extreme
• Recallability – forecasts overly influenced by events that
left a strong impression on the forecaster’s memory
Model Uncertainty
• Model uncertainty is the risk that the
model is not correct or appropriate
• Input uncertainty relates to whether the
inputs to the model are correct
• Model and input uncertainty make it
difficult to evaluate inefficiencies or market
Tools for Setting Capital Market
• Statistical methods – descriptive or inferential
– Sample estimators – estimate future mean and
variance on sample’s past mean and variance
– Shrinkage estimators – weighting historical estimate
with other parameters in order to reduce impact of
extreme values
– Time series estimators – forecasting variable based
on lagged variable itself or lagged values of other
– Multi-factor models – explains returns to an asset in
terms of the values of a set of return drivers or risk
Formal Tools for Setting Capital
Market Expectations
• Discounted cash flow models – expressing
current value as discounted value of future cash
• Risk Premium Approach – expresses expected
return as risk free rate plus an appropriate risk
• Financial Market Equilibrium Models – describe
relationships between expected return and risk
in which supply and demand are in balance
Survey/Panel Methods and
• Survey and panel methods consolidate the
opinions of a group of experts
• Judgment can improve forecasts relative
to objective methods
Inventory Cycles
• Inventory cycle (2-4 years)
– Inventories rise with confidence of sales
– Sales disappointment leads to excess
– Prices must be cut
– Inventory gets worked down
– Sales pick up, leading to shortages
Business Cycles

Business cycle (9-11 years)


Early upswing

Output gap closed, danger of overheating
Inflation starts to pick up
Rising interest rates, stock markets rising but volatile

robust growth without inflation
Rising capacity utilization and profits
Short rates start rising, long rates stable
Late upswing

still large output gap
bond yields bottoming, stocks often surge
risk pays.
Slowing economy, sensitive to shocks
Peaking interest rates
Interest sensitive stocks perform best

Declining GDP
Falling short-term interest rates and bond yields
Stock market bottoms early and begins to rise ahead of business cycle recovery
Inflation and the Business Cycle
• Inflation tends to rise in the late stages of
the business cycle and fall during
recession and the early recovery stages
• Challenge to keep inflation low without
causing deflation or recession
• Deflation undermines debt-financed assets
and central bank power
Inflation and Asset Classes
• Cash – inflation increases interest rates,
resulting in positive relationship
• Bonds – inflation erodes terminal value and fixed
coupons, resulting in negative relationship
• Stocks – do best when inflation is expected, do
poorly in either high inflation or deflation
• Real estate – positive relationship to inflation
due to higher cash flows and asset values
Factors Affecting Business Cycle
• Consumers
– 60-70% of GDP so typically the most important factor
– Monitor retail sales and personal income
• Business
– Smaller but more volatile
– Monitor surveys such as ISM, PMI
• Monetary policy
– Mechanism for intervening in cycle
– Watch inflation, pace of growth, unemployment and
capacity utilization
Predicting Central Bank Behavior
Using the Taylor Rule
• Taylor rule is a guideline used to assess the
central bank’s stance and predict changes
• Links target short-term rate to inflation and
growth in GDP
• Simple equal-weighted rule might set target rate
equal to a neutral rate plus half the differences
between the forecast and target weights of GDP
and inflation
• So with a neutral rate of 3% and both GDP and
inflation running 1% above target, the Taylor rule
would predict a short-term rate of 3% + 0.5% +
0.5% = 4.0%
The Yield Curve as Economic
• If fiscal and monetary policy are both tight
(loose), economic growth is likely to slow
• When policies are at odds, results are more
• Yield curve changes tend to reflect policy
– Loose fiscal and monetary policy = steep yield curve
– Loose monetary, tight fiscal = moderately steep yield
– Tight monetary, loose fiscal = flat yield curve
– Tight monetary and fiscal = inverted yield curve
Economic Growth Trends
• Long-term path of GDP
• Business cycles fluctuate around this trend
• Trends are usually easier to forecast than
• Sudden trend changes are called shocks
• Economic growth trend is a key input to
discounted cash flow models of expected
Components of Economic Growth
• Growth from labor inputs
– Growth in size of potential labor force
– Growth in actual labor force participation
• Growth from labor productivity
– Growth from capital inputs
– Total factor productivity growth (increased
Effects of Government Policy on
Economic Growth Trends
• Pro-growth government policy:
– Fiscally sound
– Minimal intrusion on private sector
– Encourages private sector competition
– Supports infrastructure and human capital
– Tax policies are sound (simple, transparent
and stable)
Exogenous Shocks and Economic
Growth Trends
• Exogenous shocks are events external to
an economy that alter its course
• Not predictable but occur regularly
• Could have short term or long term impact
• Most frequent shocks are oil shocks and
financial crises
International Economic Linkages
• Macroeconomic
– Balance of trade
– Foreign direct investment
• Interest rates/exchange rates
– Currency pegs – interest rates determined by
faith in the peg
– Interest rate differentials – capital flows
toward higher yield, boosting the relative
value of the currency in which the higher
yielding security is denominated
Differences Between Emerging and
Developed Economies
• Emerging countries are catching up
• Need higher investment rates in physical and
human capital
• If domestic savings are inadequate foreign
capital is needed
• More volatile political and social environments
• Many need major structural reform to unlock
• Tend to be commodity-driven or have expertise
in a narrow industrial range
Country Risk Analysis
• How sound are fiscal and monetary policy
• What are the economic growth prospects
• Is the currency competitive, and are
external accounts under control
• Is external debt under control
• Is liquidity plentiful
• Is political situation supportive of required
Approaches to Economic
• Econometric modeling
– Applies quantitative methods and analysis grounded
in economic theory to analysis of economic data
– Can combine historical data with estimated variables
to forecast GDP
– Useful in simulating effect of changes in variables
• Economic Indicators
– Leading, lagging and coincident variables
– Diffusion indexes combine multiple indicators
• Checklist approach
Econometric Modeling
• Advantages
– Robust multi-factor models that can closely approximate reality
– Once built, new data can quickly and consistently be collected
and used
– Quantifies the effect of changes in exogenous variables
• Disadvantages
– Complex and time consuming to formulate
– Data inputs and relationships are difficult to forecast and not
– Requires careful analysis of output
– Rarely forecasts recessions well
Leading Indicator Based
• Advantages
– Usually intuitive and simple to construct
– May be available from third parties
– May be tailored to fit individual needs
– Effective use of third party indicators is well
documented in literature
• Disadvantages
– Has not historically worked consistently due to nonstatic relationships between inputs
– Can provide false signals
Checklist Approach
• Advantages
– Limited complexity
– Flexible structure easily incorporates changes
• Disadvantages
– Subjective
– Time consuming
– Need to limit complexity due to manual nature
of process
Using Economic Information to
Forecast Asset Class Returns
• Cash and equivalents
– Cash managers can earn higher return by
taking longer maturities or accepting credit
– Yield curve reflects the consensus of what will
happen to exchange rates
– Manager must distinguish between what
future events are reflected in the price from
those that will surprise the market
Using Economic Information to
Forecast Asset Class Returns
• Nominal default-free bonds
– Conventional government bonds of developed
countries have little or no default risk
– Return disaggregates into real return and
inflation premium
– Investor must compare own forecast for
inflation with that imbedded in the yield. If the
investor believes inflation will be less than
expected, the bonds are a good buy
Using Economic Information to
Forecast Asset Class Returns
• Defaultable debt
– Default risk represented by additional yield
relative to Treasuries
– Spreads tend to rise during recession as cash
flow stresses increase risk of default
– Spreads tend to narrow when economy
– Understanding when a bond is pricing in
greater default risk than necessary can
identify attractively priced securities
Using Economic Data to Forecast
Asset Class Returns
• Emerging Market Bonds
– Sovereign debt of non-developed countries
– Usually emerging countries must borrow in
foreign currency denominations
– Unable to inflate their way out of debt by
printing money
– Default risk similar to domestic corporate debt
of similar rating
– Country risk analysis involves an
understanding of politics
Using Economic Information to
Forecast Asset Class Returns
• Inflation-indexed bonds
– Allow direct observation of market inflation
expectations via comparison with similar
conventional bonds
– Yield still varies with real economy, with the
volatility of inflation (which increases their
hedging value) and according to supply and
Using Economic Information to
Forecast Asset Class Returns
• Common shares
– Economy affects earnings (cash flow) and
interest rates (discount rate) in opposite
– Trend growth dependent upon labor force
growth, investment and productivity
– Profit cycle follows business cycle
– In emerging economies, ex-post risk premia
have been higher and more volatile than in
developed countries
Using Economic Information to
Forecast Asset Class Returns
• Real Estate
– Returns affected by growth in consumption,
real interest rates, the term structure of
interest rates and unexpected inflation
– Economic cycles can also affect cost of
building materials and construction labor
– Lower interest rates are net positive for real
estate valuations
Using Economic Information to
Forecast Asset Class Returns
• Currencies
– Exchange rate reflects balance between
supply and demand
– Imports increase supply of currency, typically
reducing relative currency value
– Capital flows may overwhelm trade impact
– Differences between local interest rates can
make foreign currencies more attractive,
though if they reflect a slowing economy this
benefit may be outweighed by the risks
Approaches to Forecasting
Exchange Rates
• Purchasing Power Parity
– Movements in exchange rates should offset
any difference in inflation between two
– Governments take PPP seriously
– Over long-term (5-10 years) PPP appears to
– Capital flows can overwhelm PPP effects for
considerable time
Approaches to Forecasting
Exchange Rates
• Relative Economic Strength
– Focuses on investment flows rather than trade flows
– Strong economies attract capital, causing currency to
– Foreign investors must consider whether higher yield
offsets risk of inflated currency
– Indicates currency response to economic news but
not “true” value of currency
– Combined with PPP approach can form a complete
Approaches to Forecasting
Exchange Rates
• Capital Flows
– Focuses on expected capital flows, particularly longterm investments
– May reverse the normal relationship to short-term
interest rates as the stimulative effect of lower rates
outweighs the lower yield
• Savings-Investment Imbalances
– Explains currency movements in terms of the effect of
investment imbalances
– Higher need for investment must be met with foreign
– Excess investment needs not offset by trade
imbalance will be offset by rising exchange rate
Asset Allocation
By William F. Sharpe
Peng Chen, CFA
Jerald E. Pinto, CFA
Dennis W. McLeavey, CFA
Key Learning Outcomes
• Summarize the function of strategic asset
allocation in portfolio management
• Discuss the role of strategic asset
allocation in relation to exposures to
systematic risk
• Compare and contrast strategic and
tactical asset allocation
• Appraise the importance of asset
allocation for portfolio performance
Learning Outcomes
• Contrast asset-only and asset/liability management
(ALM) approaches to asset allocation
• Explain an advantage and a disadvantage of
implementing a dynamic versus a static approach to
strategic asset allocation
• Discuss and interpret the specification of return and risk
objectives in relation to strategic asset allocation
• Evaluate whether an asset class or set of asset classes
has been appropriately specified
• Select and justify an appropriate set of asset classes for
an investor
Learning Outcomes
• Evaluate the theoretical and practical effects of including
an additional asset class such as inflation-protected
securities, international developed markets or emerging
market securities, or alternative assets in an asset
• Formulate the major steps in asset allocation
• Compare and contrast the following approaches to asset
allocation: mean-variance, resampled efficient frontier,
Black-Litterman, Monte Carlo simulation, ALM, and
experience based
• Discuss the structure of the minimum-variance frontier
with a constraint against short sales
Learning Outcomes
• Determine and justify a strategic asset allocation, given
an investment policy statement and capital market
• Summarize the characteristic issues relating to asset
allocation for individual investors and for institutional
investors (i.e. defined benefit plans, foundations,
endowments, insurance companies, banks) and critique
a proposed asset allocation in light of those issues
• Critique and revise a strategic asset allocation, given an
investment policy statement and capital market
• Determine and justify tactical asset allocation (TAA)
adjustments to asset-class weights given a description of
a TAA strategy and expectational data
Function of Strategic Asset
Allocation in Portfolio Management
• Strategic asset allocation combines
investor’s objectives and constraints with
long-term capital market expectations into
IPS-permissible asset classes
• Purpose is to satisfy investor’s objectives
and constraints
• Process leads to a set of portfolio weights
called the policy portfolio
Strategic Asset Allocation and
Systematic Risk
• Strategic asset allocation aligns portfolio’s risk
profile with investor’s objectives
• Investors expect compensation for accepting
non-diversifiable (systematic) risk
• Distinct asset classes have distinct risk
• Strategic asset allocation effectively controls
systematic risk exposures
• Strategic asset allocation also provides the
investor with a set of benchmarks for appropriate
asset mix and long-term risk tolerance
Strategic versus Tactical Asset
• Strategic allocation sets investor’s long-term
exposures to systematic risk
• Tactical asset allocation (TAA) involves shortterm adjustments to asset weights based on
short-term predictions of relative performance
• TAA is an active and ongoing investment
discipline, whereas strategic asset allocations
are revisited only periodically or when the
investor’s circumstances change
Asset Allocation and Portfolio
• Some studies have indicated that asset
allocation explains the vast majority of portfolio
returns, far outweighing timing and security
• Cross-sectional studies have shown asset
allocation to explain much less (though still a
very significant amount) of portfolio returns
• However, other studies have shown that the
dispersion of results can vary more due to
security selection than asset allocation, and thus
indicate that skillful investors would gain more
from security selection
Asset and Asset/Liability
Management Approaches
• Asset/Liability Management (ALM)
explicitly models future liabilities and
adopts an asset allocation best suited to
funding those liabilities
• Asset-only approach does not explicitly
model liabilities, though they are indirectly
considered via investor objectives and
Dynamic versus Static Approaches
to Asset Allocation
• Dynamic Approach
– Asset allocation, actual returns and liabilities
in one period directly affect the optimal
decision for the following period
– Considering linkages can help improve
asset/liability management
• Static Approach
– Does not consider links between time periods
– Less costly and complex to model and
Risk and Return in Strategic Asset
• Return objective
– Qualitative objectives describe fundamental goals
– Quantitative objectives specify return needed to achieve goals
– Compounding must be considered through geometric return and
multiplicative rather than additive formulations
• Risk objective
– Qualitative (below average or above average)
– Quantitative
• numerical risk aversion measured through interview
• Acceptable level of volatility
• Shortfall/downside risk
• Safety-first criterion
Criteria for Specifying Asset
• Assets within a class should be relatively
• Asset classes should be mutually exclusive
• Asset classes should be diversifying
• Asset classes as a group should comprise the
majority of world investable wealth
• Asset class should have the capacity to absorb a
significant fraction of the investor’s portfolio
without compromising liquidity
When to Include an Asset Class
• Assets should be considered in a portfolio if they
improve the portfolio’s mean-variance efficient
• This occurs if the asset class Sharpe ratio
exceeds the product of the existing portfolio’s
Sharpe ratio and the correlation between the
asset class return and the portfolio’s return
• For example, an asset with a Sharpe ratio of 0.2
and a correlation of 0.9 to the return of a
portfolio with a Sharpe ratio of 0.15 should be
added because 0.2 > 0.15(0.9) = 0.135
International Assets
• When investing in international assets,
investors should consider the following
special issues:
– Currency risk affects both return and volatility
and investors must decide whether to hedge
– Increased correlations in times of stress
– Emerging markets are less liquid, less
transparent and exhibit non-normal return
Inflation Protected Bonds
• High correlation within class
• Low correlation with other assets improves
• Particularly suitable for managing liabilities
that are also affected by inflation
Alternative Investments
• Label of convenience for a diverse set of
assets including real estate, hedge funds
and private equity
• Resources necessary to research such
investments not available to all investors
• Correlations between various alternative
assets and traditional assets require
separate consideration
Asset Allocation Steps
• Investor Specific
– Consider investor’s net worth and risk attitudes
– Apply a risk tolerance function
– Determine the investor’s risk tolerance
• Capital Market Situation
– Identify capital market conditions
– Implement a prediction procedure
– Generate expected returns, risks and correlations
• Combined Investor-Market Relationship
– Use an optimizer to determine allocation given investor’s risk
– Select asset mix
– Actual returns determine feedback for process
Mean-Variance Optimization
• Investors should choose from efficient
portfolios consistent with the investor’s risk
• Unconstrained: asset class weights must
sum to one
• Sign-constrained: no short sales (negative
Unconstrained Mean-Variance
• Need to know the weight of two minimum-variance
portfolios to know the weights of any others
• Consider three asset classes:
– Minimum variance portfolio w (70/20/10) has an expected return
of 10%
– Minimum variance portfolio 1-w (50/30/20) has an expected
return of 8%
– The weights of a minimum variance portfolio with an expected
return of 9.5 = 10w + 8(1-w) = 75% portfolio w and 25% portfolio
– The individual asset class weights follow. For example, the
weight of asset A is 0.7(0.75) + 0.5(0.25) = 65%
Sign-Constrained Mean-Variance
• No non-negative asset class weights
• Corner portfolios define a segment of the
minimum variance frontier in which:
– Portfolios hold identical assets
– Rate of change of asset weights in moving form one
portfolio to another is constant
• If adjacent corner portfolios are known, any
minimum variance portfolio with a return
between the two corner portfolios can be
combined as a weighted average of the two
corner portfolios
Resampled Efficient Frontier
• Mean variance optimization is subject to
substantial estimation error, lending little
confidence to a single optimization
• Can take several efficient portfolio simulations
using different parameters for expected return,
risk and covariance as sensitivity analysis
• These can then be integrated into a resampled
efficient frontier
• Resampled efficient frontier tends to be more
diversified and more stable over time
Black-Litterman Optimization
• Unconstrained (UBL): Weights of asset classes
in a global benchmark (e.g. MSCI World) are
adjusted to reflect investor’s views according to
a Bayesian procedure considering the strength
of the investor’s beliefs
• Black-Litterman (BL): Reverse engineers
expected returns implicit in diversified portfolio
and combines them with investor’s views and
confidence regarding the views
Monte-Carlo Simulation in Asset
• Calculates and statistically describes the
outcomes resulting in a strategic asset
allocation under random scenarios for
return, inflation and other relevant
• Provides information concerning the range
of possible results and the relative
likelihood of each
Asset Allocation Using AssetLiability Management
• Designed to ensure payment of each
liability as it comes due
• Must consider risk characteristics of
liabilities as well as assets
• Focus on surplus (net worth) efficient
Experience Based Approaches to
Asset Allocation
• Rely on tradition, experience and rules of thumb
• Often consistent with economic theory
• Inexpensive to implement
– 60/40 stock bond allocation as neutral starting point
– Allocation to bonds increases with risk aversion
– Allocation to stocks increases with time horizon
– Allocation to equities = 100 – age
Strategic Asset Allocation for
Individual Investors
• Taxable
• Human capital – present value of future income
– must be considered but is not readily tradable
– Safer labor income permits a higher equity allocation
– Human capital correlations with stock market
(stockbrokers, etc) should result in lower equity
– Labor flexibility should permit higher equity allocations
• Mortality risk – family loses human capital with
early death – can be hedged with insurance
• Longevity risk – outlive assets in retirement –
annuity products help reduce this risk
Strategic Asset Allocation for
Defined Benefit Plans
• Investments often regulatorily constrained
• Must maintain liquidity to pay current benefits
• Asset/Liability Management used to control:
– Shortfall risk
– Volatility of pension surplus
– Volatility of contributions
• Asset-only Management seeks to minimize
standard deviation relative to required return
Strategic Asset Allocation for
Foundations and Endowments
• Tax exempt long term investors
• Need to fund spending and maintain real
value of assets
• Typically high equity allocations because
fixed income does not provide significant
real return
• Tend to focus on asset allocation and lowcost passive management techniques
Strategic Asset Allocation For
Insurance Companies
• Must complement and coordinate with
operating policy
• Appropriate asset mix must:
– Counterbalance risks inherent in insurance
products involved
– Achieve stated return objectives
• Taxable
• Often segment portfolios to correspond
with specific product lines
Strategic Asset Allocation for
• Taxable investors with short- to
intermediate-term liabilities
• Securities portfolio subject to distinct set of
• Asset allocation must:
– Manage overall interest rate risk
– Maintain liquidity to satisfy liabilities
– Produce income
– Manage credit risk
Tactical Asset Allocation
• Active management at the asset class
• Often takes place after strategic allocation
decision but before decisions on managing
specific asset classes
• Overlay strategy makes strategic
allocations and adjusts asset class
weights using derivatives
Tactical Asset Allocation Principles
• Market prices explicitly describe the
returns available (cash yield approximates
future returns)
• Relative expected returns reflect relative
risk perceptions
• Markets are rational and mean reverting
Fixed Income Portfolio
By H. Gifford Fong
Larry D. Guin, CFA
Key Learning Outcomes
• Compare and contrast, with respect to investment
objectives, the use of liabilities as a benchmark with the
use of a bond index as a benchmark
• Discuss the range of benchmark index-oriented bond
investment strategies and compare and contrast pure
bond indexing, enhanced indexing, and active investing
with respect to the objectives, techniques, and
advantages and disadvantages of each
• Discuss criteria for selecting a benchmark bond index,
and justify the selection of a benchmark index given a
description of the investor’s risk aversion, income needs,
and liabilities
• Review and justify the means (e.g. matching duration
and key rate durations) by which an enhanced indexer
may seek to align the risk exposures of the portfolio with
those of the benchmark bond index
Learning Outcomes
• Contrast and illustrate total return and scenario analysis
• Evaluate the effects of leverage on the rate of return on
an investor’s equity and discuss the use of repurchase
agreements (repos) to finance bond bond purchases and
the factors that affect the repo rate
• Design a bond immunization strategy that will ensure
funding of a predetermined liability and evaluate the
strategy under various interest rate scenarios
• Demonstrate the process of rebalancing a portfolio to
reestablish the dollar duration of the portfolio to a desired
• Justify the importance of spread duration
Learning Outcomes
• Evaluate the extensions to classical
immunization theory
• Critique the risks associated with managing a
portfolio against a liability structure (cap risk,
contingent claim risk, and interest rate risk)
• Compare and contrast immunization strategies
for a single liability, multiple liabilities, and
general cash flows
• Compare and contrast risk minimization with
return maximization in immunized portfolios
Learning Outcomes
• Critique the following measures of portfolio risk:
Standard deviation, Target semivariance, Shortfall risk,
Value at risk
• Demonstrate the advantages of using futures instead of
cash market instruments to alter portfolio risk
• Formulate, construct, and evaluate an immunization
strategy using interest rate futures
• Discuss the types of credit options written on an
underlying asset
• Compare default risk, credit spread risk, and downgrade
risk, and demonstrate which credit derivative instruments
address each risk, including how they can be used in
portfolio management
Learning Outcomes
• Evaluate the sources of excess return for an
international bond portfolio
• Analyze
– The change in value of a foreign bond when domestic
interest rates change, given the bond’s duration and
the country beta
– The contribution of a foreign bond to a domestic
portfolio’s duration, given the duration of the foreign
bond and the country beta
• Recommend and justify whether to hedge an
international bond investment
Learning Outcomes
• Illustrate how breakeven spread analysis
can be used to evaluate the risk in seeking
yield advantages across international bond
• Discuss the advantages and risks in
investing in emerging market debt
• Discuss the selection of a fixed-income
Liabilities as a Benchmark
• Some investors have specific liabilities that must
be met
– Portfolio leverage
– Legal promises such as retirement benefits
– Ongoing cash flow needs
• In such cases, investment success is
determined by whether the liabilities are met
• Liabilities are both an objective and the portfolio
A Bond Index as a Benchmark
• Some investors (for example, a fixed
income mutual fund) have no specific
liabilities to meet
• Not having a cash flow constraint, these
managers have more freedom to invest
• These managers will use a bond market
index as a benchmark
• Their objective will be to either meet or
exceed the return on the bond index
Pure Bond Indexing
• Goal is to produce a portfolio that perfectly
matches the benchmark portfolio
• Owns all bonds in same proportion as
• Difficult and expensive to implement due
to illiquidity and infrequent trading of many
• Rarely attempted due to difficulty,
inefficiency, and high cost to implement
Enhanced Indexing by Matching
Primary Risk Factors
• Uses a sampling approach with the objective of matching
primary index risk factors and earning a higher return
• Primary risk factors include changes in interest rate
levels, twists in the yield curve and changes in credit
• Sampling reduces construction and maintenance costs,
typically more than offsetting the higher tracking error
compared to full replication
• Reaction to macro events will be similar to the
benchmark, but manager can add value by finding
undervalued bonds
Enhanced Indexing by Small Risk
Factor Mismatches
• Matches duration (sensitivity to interest
rates) of bond market index
• Manager can tilt portfolio in favor of any
other risk factor such as credit spreads,
yield curve, or sector exposure
• Mismatches are small
• Mainly seek to add sufficient return to
offset administrative costs
Active Management by Larger
Factor Mismatches
• Actively pursues opportunities in the
market to add return
• Objective to produce sufficient return to
overcome additional transaction costs
while controlling risk
• Takes deliberate and sometimes sizeable
mismatches to risk factors including credit
spreads, yield curve, and (to a lesser
extent) duration
Full Blown Active Management
• Full blown active management seeks to
maximize return
• Will accept large mismatches on any risk
factor, including duration, in order to add
return relative to the benchmark
Benchmark Index Selection Criteria
• Should benchmark to an index with
characteristics (below) that resemble those of
the desired portfolio
• Market value risk – duration affects market value
of bonds – longer duration more risky
• Income risk – dependability of income stream –
shorter duration more risky
• Liability framework risk – match duration and
other factors to liabilities that must be managed
Enhanced Indexing Strategies
• Tracking risk arises from mismatches between the
portfolio and the benchmark along the following factors:
– Portfolio duration – exposure to parallel shifts in the yield curve
– Key rate duration – exposure to nonparallel shifts in the yield
– Sector and quality percent – percentage of bonds of various
yields, ratings and sector exposure
– Sector duration – exposure to changes in sector spreads
– Quality spread duration – exposure to changes in credit spreads
– Sector/coupon/maturity cell weights – select securities from cells
designed to replicate various qualities
– Issuer exposure – controls against issuer-specific event risk
Total Return and Scenario Analysis
• Total return analysis assesses the effect of a
trade on portfolio total return given a specific
interest rate forecast
• Scenario analysis runs several total return
analysis assumptions
– Allows assessment of the distribution of possible
– Can be reversed to calculate the range of interest rate
movements that would result in a desired outcome
– Contribution of components of total return can be
– Can be applied to entire trading strategies
Portfolio Leverage
• Leverage magnifies the return on a portfolio
• If earn less than cost of borrowing, returns are
• Repurchase agreements (repos) are
arrangements to sell a set of securities and buy
them back at a pre-specified date and price
• Repos offer lower-cost borrowing for issuers and
higher returns for lenders compared to
Factors Determining Repo Rate
• Quality of collateral – higher quality, lower rate
• Term of the repo – longer term, higher rate
• Delivery requirement – physical delivery reduces default
risk, leads to lower rate
• Availability of collateral – buyer of securities (lender of
funds) may accept a lower rate if the underlying
securities are hard to get
• Prevailing interest rates – repo rates are typically tied to
Fed Funds rate
• Seasonal factors – some institutions have seasonal
factors that affect their supply of and demand for funds
Immunization Strategies
• Changes in interest rates affect both
reinvestment income and portfolio value
• Immunization strategies “lock in” total return over
a given time horizon by finding the portfolio in
which the two total return factors exactly cancel
each other out
• To immunize a single period, the portfolio must
– duration equal to the investment horizon
– Initial present value of cash flows equal to the present
value of the future liability
Rebalancing an Immunized
• Changes in yield fluctuate over time,
resulting in changes in duration relative to
time passage
• Must rebalance when benefits outweigh
• Must be willing to accept some duration
mismatch to avoid transaction costs
• Must accept some transaction costs to
avoid a large duration mismatch
Rebalancing to Dollar Duration
• Dollar duration = Duration X Portfolio Value X
• To rebalance dollar duration, investors must:
– Calculate present dollar duration based on prevailing
time to maturity and yield curve
– Calculate rebalancing ratio by dividing original dollar
duration by new dollar duration. Subtracting one and
converting to percent gives the percentage of each
position that needs to be changed
– New market value X percentage change needed is
the amount of cash needed for rebalancing
Spread Duration
• Spread duration measures change in
value relative to benchmark of a parallel
100 bp change in spread
• Portfolio spread duration is market
weighted average of component spread
• Higher spreads represent acceptance of
credit risk
Extensions to Classical
Immunization Theory
• Multifunctional duration or key rate duration
extends immunization to non-parallel shifts in
the yield curve.
• Alternative measures relax the assumptions to
allow for parallel shifts and interim cash flows.
• Return maximization analyzes the risk and
return tradeoff for immunized portfolios
• Contingent immunization provides flexibility to
pursue active strategies provided a minimum
return is assured, below which immunization
would be triggered
Risks Associated with
Asset/Liability Management
• Asset/liability management seeks to match assets with
future liabilities. This is subject to three major risk
• Interest rate risk – assets decline in value as interest
rates rise. If assets must be sold in order to meet a
liability, a shortfall could arise.
• Contingent claim risk – contingent claims may halt
interest payments or result in early return of principal
(which must be reinvested at lower rates)
• Cap risk – caps on floating interest rates will prevent
assets from performing in line with interest rates
Single versus Multiple Liability
• Immunization to a single investment horizon is
appropriate only when there is one liability that must be
• Immunization to a liability stream requires funds to pay
all liabilities even if there is a parallel shift in interest
• Duration alone is not sufficient – the components of total
return must separately immunize each liability
• Composite duration of assets and liabilities must match
• Distribution of asset durations must be wider than the
distribution of liabilities
Return Maximization in Immunized
• The general purpose of portfolio
immunization is to reduce risk
• In some cases, pursuing additional return
more than offsets any loss of immunization
• Minimum acceptable return is determined
by required terminal value plus a safety
margin (the cushion spread)
• Immunizes the lower bound of the
confidence interval limit on realized returns
Standard Deviation as a Measure
of Fixed Income Portfolio Risk
• Assumes returns are normally distributed
• Allows for probability distributions
(confidence intervals)
• In reality returns not normally distributed,
particularly when bonds have call features
or other embedded options
Semivariance as a Measure of
Fixed Income Portfolio Risk
• Measures the dispersion of outcomes below the target
rate of return
• Theoretically superior to variance or standard deviation
because most investors are only concerned about
downside risk
• Not widely used because:
– Computationally challenging for large portfolios
– Contains no additional information if returns are symmetric
– Return asymmetries are difficult to forecast and may not
be a good forecast anyway
– Uses only half the data, which costs statistical accuracy
Other Measures of Risk in Fixed
Income Portfolios
• Shortfall risk relates to the probability of failing to
achieve a specified target. Its deficiency is that it
does not account for the magnitude of losses in
money terms.
• Value at risk (VAR) estimates the loss in money
terms the portfolio is likely to encounter with a
given level of probability over a given time
period. Its deficiency is that it does not indicate
the magnitude of worst-case scenarios.
Using Futures to Alter Fixed
Income Portfolio Risk
• Futures offer a number of advantages over cash markets
as a means of controlling duration, including liquidity,
cost effectiveness, ability to reduce duration by shorting
futures and deep markets
• To alter duration using futures must estimate number of
contracts to buy or sell
– Target dollar duration = Current dollar duration + Dollar duration
of futures contracts
– Dollar duration of futures = Dollar duration per contract X
Number of contracts
– Number of contracts = ((target duration – initial duration) X
portfolio value)/(dollar duration per futures contract)
Immunizing a Fixed Income
Portfolio Using Futures
• Difference between cash price and futures price is called
basis. Basis risk is the risk that basis will change
unpredictably between time hedge is placed and time it
is lifted
• If bond underlying hedge differs from portfolio bond
(cross hedging), basis risk can be substantial and
replaces unhedged price risk with basis risk
• Hedge ratio = factor exposure on portfolio divided by
factor exposure on the hedging instrument
• If concerned only with rate exposure and assume a fixed
yield spread between the bond being hedged and the
cheapest-to-deliver (CTD) bond on the futures contract,
the hedge ratio = (duration of hedged bond X price of
hedged bond)/(duration of CTD X price of CTD)
Types of Credit Options
• Call option gives buyer the right to buy one
fixed income futures contract at the strike
• Put option gives buyer the right to sell one
fixed income futures contract at the strike
• Also have options on shape of the yield
curve and on default spreads
Using Derivatives to Hedge
Different Types of Credit Risk
• Default risk – risk that the issuer may fail to meet its
• Credit spread risk – risk that the spread between the
risky bond and risk-free securities will vary after
• Downgrade risk – risk that a rating agency will lower its
rating on the issuer
• Binary credit options pay off only if a specified negative
event occurs. They can be used to hedge default risk or
downside risk.
• Credit spread options pay off based on the spread over a
benchmark rate and may be used to hedge credit spread
Sources of Excess Return in
International Bond Portfolios
• Bond market selection – choosing the best country in
which to invest
• Currency selection – selecting the amount of currency
risk to retain
• Duration/yield curve management – Getting the most
favorable returns within the market
• Sector selection – Government, corporate, local
currency, dollar-denominated
• Credit analysis of issuers – identifying improvement or
deterioration in advance of rating changes
• Investing in markets outside the benchmark – adding a
risk mismatch in search of excess return
Effect of Domestic Interest Rates
on Value of Foreign Bonds
• Duration of a bond measures the percentage change in
value for a 100bp change in interest rates
• International rates are not perfectly correlated with
domestic rates
• Can estimate country beta empirically to relate the
movements in each country’s rates
• For a domestic portfolio, the percentage change
attributable to a foreign bond equals country beta X
• The bond’s weight in the portfolio will also affect the
weighted average duration in the domestic portfolio by
country beta X duration
When to Hedge International
• Currency movements can affect international bond
returns significantly
• A forward hedge uses a forward contract between bond
currency and home currency to neutralize currency risk
– Unhedged return = bond return + currency return
– Hedged return = bond return + forward discount (premium)
• If interest rate parity holds, hedged return = domestic
risk-free rate + bond’s local risk premium
• Should hedge currency exposure when the expected
change in interest rates is less than the differential
between domestic and foreign short-term rates
Breakeven Spread Analysis
• Quantifies the amount of spread widening
(W) that would diminish a foreign yield
• For a 200 bp yield advantage (50 bp per
quarter) and a foreign bond duration of 6:
– Change in price of foreign bond = 6 X Change
in yield = 6W
– Breakeven = 0.50% X 6W
– W = 0.0833% = 8.33 basis points
Investing in Emerging Market Debt
• Advantages
– Low correlation = favorable diversification
– Increasingly earning investment grade ratings
– Has been resilient to multiple financial crises
– Can react quickly to negative economic events by cutting
spending and raising taxes
– Access to lenders such as IMF and World Bank
– Large foreign currency reserves
• Risks
– High volatility
– Negative skewness of returns
– Lack of transparency
– Lack of legal and regulatory structure
– Tendency to over-borrow with little recourse in event of default
Selecting a Fixed-Income Manager
• Outperformance net of fees is difficult
• Style analysis – how does portfolio differ from
benchmark construction?
• Selection bets – decomposition of returns can
identify manager skill in credit analysis
• Investment process – what methods are used
and what are the drivers of alpha
• Correlation of alphas – similarities between
managers should be avoided for better
Equity Portfolio Management
By Gary Gastineau
Andrew R. Olma, CFA
Robert G. Zielinski, CFA
Key Learning Outcomes

Discuss the role of equities in the overall portfolio

Discuss the roles for passive, active and semiactive (enhanced
index) equity investment approaches and distinguish among those
approaches with respect to expected active return and tracking risk

Recommend an equity investment approach based on an investor’s
investment policy statement (IPS) and beliefs concerning market

Distinguish among the predominant weighting schemes used in the
construction of equity share indices, evaluate the biases of each,
and explain the composition of major equity share indices worldwide
Learning Outcomes

Compare and contrast alternative methods for establishing a
passive exposure to an equity market including indexed separate or
pooled accounts, index mutual funds, exchange-traded funds, equity
index futures and equity total-return swaps

Compare and contrast the full replication, stratified sampling, and
optimization approaches to constructing an indexed portfolio, and
recommend an approach given a description of the investment
vehicle and the index to be tracked

Explain and illustrate equity investment styles, identify and explain
the rationales and primary concerns of value investors and growth
investors and the key risks of those styles, and demonstrate the
difficulties in applying style definitions and distinguishing among
Learning Outcomes

Discuss, compare, and contrast techniques for identifying
investment styles and characterize the style of an investor given a
description of the investor’s security selection method, details on
security holdings, or the results of a returns-based style analysis

Discuss, compare, and contrast the various methodologies used to
construct equity style indices

Explain and interpret the equity style box and evaluate the effects of
style drift

Explain the implementation of a socially responsible investing
Learning Outcomes

Compare and contrast long-short and long-only investment
strategies, including their risks and potential alphas, and explain
why pricing inefficiencies may exist on the short side

Explain the process of equitizing a long-short portfolio

Compare and contrast the selling disciplines of active investors

Contrast derivative-based and stock-based enhanced indexing
strategies, and demonstrate the fundamental law of active
management, including its use to justify enhanced indexing

Explain and interpret a systematic approach to optimizing
allocations to a group of managers
Learning Outcomes
• Compare and contrast the core-satellite and
completeness fund approaches to managing a portfolio
of active managers
• Distinguish among the components of total active return
(“true” active return and “misfit” active return), their
associated risk measures (“true” active risk and “misfit”
risk” and explain their relevance for evaluating a portfolio
of managers
• Explain alpha and beta separation as an approach to
active management and demonstrate the use of portable
Learning Outcomes
• Review the due diligence process of identifying,
selecting, and contracting with equity managers,
including the qualitative and quantitative factors
in developing a universe of manager candidates
(such as past performance information) and the
use of equity manager questionnaires and fee
schedules (ad valorem and performance based)
• Review the process of structuring equity
research and security selection, including topdown and bottom-up security selection
The Role of Equities
• Equities represent a significant source of
wealth and percentage of total investable
assets worldwide
• Domestic and international equity markets
offer diversification benefits
• Common equities offer better inflation
protection than conventional bonds
• Comparatively high long-term real rates of
Passive Approach to Equity
• Does not attempt to reflect expectations through
• Best suited for investors who believe markets are
relatively efficient
• Attempts to match the performance of a benchmark
• Mainly concerned with tracking risk
• Must monitor index for changes in security weights due
– Additions or deletions from the index
– Corporate actions such as share buybacks or secondary
• Aims for lowest tracking risk and no active return relative
to the benchmark index
Active Approach to Equity
• Seeks to outperform the benchmark portfolio
through use of skill
• Best suited for investors who believe there are
market inefficiencies that can be exploited
• Buys stocks expected to outperform the index
and sells those expected to underperform
• Not concerned with tracking risk and aims to
maximize active return relative to the benchmark
Semiactive Approach to Equity
• Also called enhanced indexing
• Seeks to outperform an active portfolio
while keeping tracking error within
acceptable limits
• Tries to build a portfolio with limited
volatility around the benchmark’s returns
• Aims to have the highest information ratio
(mean active return divided by tracking
risk) of the three strategies
Price Weighted Equity Indices
• Weight each stock in the index according to its share price
• Simple to construct
• Index value is the sum of the share prices of each stock in the
index, so historical data may be available further back than
the index was actually available
• Requires adjustments for stock splits, additions and deletions
• Index performance skewed by the performance of the highestpriced stocks
• Performance represents performance of buying and holding
one share of each stock in the index
• Best known price weighted index is the Dow Jones Industrial
Value Weighted Equity Indices
• Weighted according to market capitalization of
component stocks (also called cap weighted)
• Subcategory is float-weighted, which weights only
according to the publicly traded shares
• Performance represents performance of a portfolio that
buys and holds all the available shares of all the
component stocks in the index
• Automatically adjusts for value changes, facilitating
construction and management
• Biased toward performance of the largest companies by
market capitalization – which tend to be either mature or
• The S&P 500 and most major indices are value-weighted
Equal Weighted Equity Indices
• Weights each stock in the index equally
• Performance represents investing an
equal amount of money in each
component stock
• Must be rebalanced periodically because
performance differences will cause
weights to drift from equality
• Smaller stocks may not be sufficiently
liquid to index in this manner
Conventional Index Mutual Funds
• Mutual fund shareholders buy shares from the
fund and sell them back to the fund once a day
(at market close)
• Cost structure varies widely – Difference
between best- and worst- performing fund can
be 2 percentage points or more
• Each shareholder has own account with fund
and must be accounted for
• Shareholders subject to taxes even if they do not
realize the gains or dividends directly
Exchange Traded Index Funds
• Shareholders buy and sell amongst themselves
throughout the day
• Dealers can create and redeem shares with inkind deposits and withdrawals once daily at
market close
• Do not need to account for individual
• In-kind deposits and withdrawals are more taxefficient
• Do not need to buy or sell securities based on
investor cash flows
Indexed Separate or Pooled
• Extremely low cost due to low
administrative requirements
• Vary in their response to anticipated
changes in index components (give up
return in exchange for lower tracking risk)
• Can manage portfolio using full replication,
stratified sampling or optimization
Equity Index Futures
• Futures contracts available that can be
exchanged for physicals, with the physical
being the basket of stocks represented by
an index
• Exchanging futures for physicals sharply
reduces transaction costs
• Facilitates risk management for many
market participants
Equity Total Return Swaps
• One counterparty receives the total return
of an equity index portfolio, the other can
receive an interest rate or the return on a
different index
• Historically (but no longer) offered tax
advantages for high-tax investors
• Motivations include asset allocation shifts
and international tax differentials
Indexing Using Full Replication
• Indexing method in which every index component is
owned according to its index weight
• Works best with a limited number of liquid stocks
• Should result in minimum tracking risk
• Self-rebalances as stock prices fluctuate
• Return should lag the index by the sum of:
– Cost of management and administration
– Transaction costs related to index composition changes
– Transaction costs for investing and disinvesting cash flows
– Drag on performance from any cash position
• Not effective when index components are illiquid
Indexing Using Stratified Sampling
• Divides index along a number of dimensions
– Market capitalization
– Industry
– Growth vs value
• Each stock placed in a cell according to the dimensions
that best describe it
• Weight of each cell is replicated in index by buying any
components of the cell
• Retains basic characteristics of the index without
requiring purchase of every stock
• Tracking error reduced with finer degrees of cell
definition and more dimensions
Indexing Using Optimization
• Mathematical approach to index construction
• Risk exposures of index and individual securities
are measured against a multifactor risk model
• Objective function specifies securities to hold
and proportions of each in order to minimize
tracking risk subject to appropriate constraints
• Takes into consideration covariance among risk
factors (unlike stratified sampling)
• Imperfect specification of risk factors and
periodic trading to keep factors in balance result
in underprediction of tracking risk
Value Investing Style
• More concerned about stock’s relative cheapness than
about its growth prospects
• Look for low price relative to earnings or book value
• Rationales:
– Earnings tend to revert to mean, presenting opportunities when
earnings are temporarily depressed
– Investors overpay for “glamour” stocks, presenting opportunities
• Risks
– Stocks may be cheap for a good reason the investor does not
– Correction of mispricing may require longer time than investment
Growth Investing Style
• Believe future earnings growth justifies
higher current P/E ratio
• Requires market to continue paying a
premium for the greater growth prospects
• Risk that expected growth fails to
Returns-Based Style Analysis
• Characterizes a portfolio as revealed by its
• Regresses portfolio return against a set of
indices that are:
– Mutually exclusive
– Exhaustive with respect to manager’s universe
– Distinct sources of risk (not highly correlated)
• Coefficients on respective index betas must be
non-negative and sum to 1
• Coefficients, if stable, represent a “normal
Returns Based Style Analysis
• Advantages
– Characterizes entire portfolio
– Facilitates portfolio comparisons
– Aggregates effects of investment process
– Different models usually give similar results and
– Clear theoretical basis for portfolio categorizatio…
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