|
|
Reading 23 - Passive Eq Investing |
|
Reading 8 –
The Behav Biases of Individuals |
|
Reading 9 – Behav Fin & Investment Process |
Reading 25 - Active EQ Investing - Port Con |
Reading 26 - |
|
Reading 11 –
CME Part 2 |
Reading 27 - |
Reading 28 - Overview of PWM |
|
Reading 13 - Principles of Asset Allocation |
|
Reading 14 - Asset Alloc w Real-Wrld Cnstrnts |
Reading 30 - Estate Planning in Gbl Cntxt |
Reading 31 - Conc Single-Asset Positions |
|
Reading 17 - Ccy Mgmt - An Intro |
|
Reading 18 - Overview of FI Port Mgmt |
Reading 34 - Trade Strategy and Exec |
Reading 21 - |
Reading 37 - Case study in PM - Instutional |
Reading 22 - Overview of Eq Port Mgmt |
Reading 38 - Case Study Risk Mgmt - PWM |
|
CF
Weighting Factor |
A |
B |
C |
D |
Total |
Beg Assets
(31 May) |
|
100 |
97.4 |
112.94 |
124.47 |
434.81 |
External cash
flows |
|
|
|
|
|
|
5th
June |
.83 |
10 |
15 |
|
|
25 |
8th
June |
.73 |
|
|
|
-15 |
-15 |
17th
June |
.43 |
|
-5 |
|
|
-5 |
24th
June |
.2 |
|
|
|
-6.5 |
-6.5 |
29th
June |
.03 |
|
-2.5 |
|
-4.0 |
-6.5 |
Ending assets
(30 June) |
|
110.55 |
105.2 |
113.3 |
100.5 |
429.55 |
Beginning
assets + weighted cashflows |
|
108.3 |
107.63 |
112.94 |
112.1 |
440.97 |
% of total
beginning assets |
|
23.0% |
22.4% |
25.9% |
28.63% |
100% |
% of total
beginning assets + weighted cash flows |
|
24.56% |
24.42% |
25.61% |
25.42% |
100% |
|
%
of beginning assets |
%
of beginning assets + weighted cash flows |
Return
for month of June |
Portfolio A |
23.0% |
24.56% |
.51% |
Portfolio B |
22.4% |
24.42% |
.28% |
Portfolio C |
25.97% |
25.61% |
.32% |
Portfolio D |
28.63% |
25.42% |
1.36 |
|
100% |
100% |
|
rc = (.0051 * .23) + (0.0028 *.224) + (.0032 *
.2597) + (.0136 * .2863) = 0.0065 = .65%
rc = (.0051 * .2456) + (0.0028 *.224) + (.0032 * .2561) + (.0136 * .2542) = 0.0062 = .62%
Relative Wealth
& SLR |
Biases are Primarily |
Adapt to or Moderate the biases
of the client |
Allowable Deviations Up and Down
from Optimal Weight |
High RW & low
SLR |
Emotional |
Adapt to |
10% to 15% |
High RW & low
SLR |
Cognitive |
Some of both |
5% to 10% |
Low RW & high
SLR |
Emotional |
Some of both |
5% to 10% |
Low RW & high
SLR |
Cognitive |
Moderate |
0% to 5% |
Neutral Rate |
4.0% |
Inflation
Target |
2.0% |
Expected Inflation |
4.0% |
GDP Long-Term
Trend |
3.0% |
Expected GDP |
5.0% |
Neutral Rate | 4.0% |
Inflation Target | 2.0% |
Expected Inflation | 5.0% |
GDP Long-Term Trend | 3.0% |
Expected GDP | 1.0% |
|
Fiscal Policy |
||
Monetary Policy |
|
Loose |
Tight |
Loose |
High Real
Rates + High Expected
Inflation = High Nominal
Rate |
Low Real Rates
+ High Expected
Inflation = Mid Nominal
Rate* |
|
Tight |
High Real
Rates + High expected
Inflation = Mid Nominal
Rate* |
Low Real Rates
+ High Expected
Inflation = Low Nominal
Rate |
Asset Alloc
Approach |
Relation
to Economic Balance Sheet |
Typical
Objective |
Typical
Uses and Asset Owner Types |
Asset Only |
Does not explicitly
model liabilities or goals |
Maximize Sharpe
ratio for acceptable level of volatility |
Liabilities
or goals not defined and/or simplicity is important Some foundations, endowments SWF Individual Investors |
Liability Relative |
Model legal
and quasi-labilities |
Fund
liabilities and invest excess asset for growth |
Penalty for
not meeting liabilities high Banks, Defined benefit pensions, Insurers |
Goals Based |
Model goals |
Achieve goals
with specified required probabilities of success |
Individual
Investors |
Reading 13 - Principles of Asset Allocation
|
Duration Matching |
Cash Flow Matching |
Yield curve assumptions |
Parallel YC shifts |
None |
Mechanism |
Risk of shortfall in cashflows in minimized by matching
duration and PV of liab stream |
Bond portfolio CF match liabilities |
Basic Principle |
CF come from coupon and principal repayments of the bond portfolio
and offset liability cash flows |
Cashflows, coupons and principal repayments of bond
portfolio offset liability CF |
Rebalancing |
Frequent rebalancing required |
Not required but often desirable |
Complexity |
High |
Low |
Yield Curve Scenario |
Barbell |
Bullet |
|
Level Change |
Parallel shift |
Outperforms |
Underperforms |
Slope Change |
Flattening |
Outperforms |
Underperforms |
Steepening |
Underperforms |
Outperforms |
|
Curvature Change |
Less Curvature |
Underperforms |
Outperforms |
More Curvature |
Outperforms |
Underperforms |
|
Rate volatility
change |
Decreased rate
volatility |
Underperforms |
Outperforms |
Increased rate
volatility |
Outperforms |
Underperforms |
Maturity |
Coupon |
Price |
Yield to Maturity |
Effective Duration |
Effective Convexity |
2 years |
5.10 |
101.50 |
4.30 |
1.870 |
5.34 |
10 years |
7.95 |
103.50 |
7.45 |
6.800 |
61.88 |
30 years |
9.15 |
97.00 |
9.45 |
9.920 |
171.72 |
Return Component |
Formula |
Barbell |
Yield income |
Annual coupon payment/Current bond price |
1.84/100.00 |
+ Rolldown return |
(Bond priceeh – Bond
pricebh)/Bond pricebh |
(100.46 – 100.00)/100.00 |
= Rolling yield |
Yield income + Rolldown return |
= 2.30% |
+ E(change in
price based on yield view) |
(–MDeh × ∆yield) +
[½ × Convexity × (∆yield)2] |
[–4.12 × –0.55%] + [½ × 24.98 × (–0.55%)2] |
= Total expected return |
= 4.60% |
Construct a condor to benefit from less curvature in the 5-year to 10-year area of the yield curve. The condor will utilize the same 1-year, 5-year, 10-year, and 30-year bonds held in the Fund. The maximum allowable position in the 30-year bond in the condor is $17 million, and the bonds must have equal (absolute value) money duration. |
Q 20.6 What is ths expected return on Buy-and-Hold portfolio ? |
Ride-the-Yield Curve Portfolio | ||
Investment horizon (years) | 1.0 | 1.0 |
Bonds maturity at purchase (years) | 1.0 | 2.0 |
Coupon rate | 1.40% | 1.75% |
Yield to maturity | 1.65% | 1.80% |
Current average portfolio bond price | A$99.75 | A$99.90 |
Expected average bond price in one year for portfolio | A$100.00 | A$100.10 |
Expected currency gains or losses | –0.57% | –0.57% |
Return Component | Formula | Buy-and-Hold Portfolio |
Yield income | Annual coupon payment/Current bond price | 1.4/99.75 |
+ Rolldown return | (Bond priceeh – Bond pricebh)/Bond pricebh | (100 – 99.75)/99.75 |
= Rolling yield | Yield income + Rolldown return | = 1.65% |
+ Expected currency gains or losses | -.57% | |
= Total expected return | = 1.08% |
|
Bullet |
Barbell |
Investment horizon (years) |
1.0 |
1.0 |
Average bond price for portfolio currently |
98.00 |
98.00 |
Average bond price for portfolio in one year (assuming stable yield curve) |
99.75 |
100.00 |
Expected effective duration for portfolio (at the horizon) |
3.95 |
3.95 |
Expected convexity for portfolio (at the horizon) |
19.50 |
34.00 |
Expected change in government bond yield curve |
–0.60% |
–0.60% |
Return Component |
Formula |
Bullet |
Barbell |
Yield income |
Annual coupon
payment/Current bond price |
0 |
0 |
Rolldown yield |
Bond priceeh – Bond pricebh)/Bond pricebh |
(99.75-98)/98=
1.78% |
(100-98)/98=2% |
Rolling yield |
Yield income +
Rolldown return |
1.78% |
2.04% |
E(change in price based on yield view) |
(–MDeh × ∆yield) + [½ × Convexity × (∆yield)2] |
(-3.95) (-.6)+.5
(19.5) (.6)^2 = 2.37 + .035 = 2.4051% |
(-3.95) (-.6)+.5
(34) (.6)^2 = 2.37 + .035 = 2.43% |
Total Expected Return |
|
4.1908% |
4.4720% |
|
Price |
Yield |
Maturity |
Effective Duration |
Citigroup 3.75% due 16 June 2024 |
103.64 |
3.24% |
7.96 |
7 |
US Treasury 1.5% due 31 March 2023 |
99.8 |
1.53% |
7 |
6.7 |
US Treasury 1.625% due 15 Feb 2026 |
98.7 |
1.77% |
9.88 |
9.1 |
|
Rating |
PD |
Spread Duration |
Z-Spread |
Expected Change in Z-Spread |
Loss Severity |
|
Bond D |
A |
0.25% |
3 |
0.75% |
+0.25% |
40% |
|
Bond E |
Baa |
0.50% |
3.5 |
1.00% |
+0.25% |
50% |
|
Bond F |
Ba |
0.75% |
4.0 |
1.25% |
+0.25% |
60% |
Bond D |
(s × t) – (∆s × SD) – (t × p × L) = .0075(1) - .0025 (3) – (1) (.0025) (.40) = .75 - .75 – .1 = -.1% |
Bond E |
(s × t) – (∆s × SD) – (t × p × L) = .01(1) - .0025 (3.5) – (1) (.005) (.50) = .01 - .00875 – .0025 =-.125% |
Bond F |
(s × t) – (∆s × SD) – (t × p × L) = .0125(1) - .0025 (4) – (1) (.0075) (.6) = .0125 - .01 – .0045 = .2% |
Index Rating Category | Current OAS in bps | Expected OAS in one year | Expected Credit Loss Rate | Spread Duration |
---|---|---|---|---|
A | 244 | 118 | 0.00% | 5.6 |
Baa | 334 | 206 | 0.04% | 6.1 |
Baa | Ba | 571 | 0.0% | 4.4 |
Senior The
safest and first one to receive the payouts. But, have the lowest interest
rate |
|
Mezz moderate
risk, and a bit higher interest rate |
Mezzanine
tranche of a CDO increases by more than the senior tranche whenever correlations
increase. |
Equity Most risky and offers the
highest interest rate. The payouts are made after all payouts are made for
super senior and mezzanine tranches |
As correlations increase, the values of the equity tranches usually increase relative to the values of the senior and mezzanine tranches. |
|
Fundamental |
Quantitative |
Style |
Subjective |
Objective |
Decision-making process |
Discretionary |
Systematic, non-discretionary |
Primary resources |
Human skill, experience, judgement |
Expertise in statistical modelling |
Information Used |
Research (company/Industry/economy) |
Data & statistics |
Analysis focus |
Conviction (high depth) in stock , sector, region-based selection |
A selection of variables, subsequently applied broadly
over a large number of securities |
Orientation of data |
Forecast future corporate parameters and establish views
on companies |
Attempt to draw conclusion from a variety of historical
data |
Port Construction |
Use judgement and conviction within permissible risk
parameters |
Use optimizers |
Company |
Price |
12-Month
Fwd EPS |
3-year
EPS Growth Forecast |
Dividend
Yield |
Industry
Sector |
Sector
Avg P/E |
A |
50 |
5 |
20% |
1% |
Industrial |
10 |
B |
56 |
2 |
2% |
0% |
Info. Tech |
35 |
C |
22 |
10 |
-5% |
2% |
Consumer Staples |
15 |
D |
32 |
2 |
2% |
8% |
Utilities |
- 16 |
- Company A's forward P/E is 50/5 = 10, and its P/E -to-growth ratio is 10/20 = .5
- Company B's forward P/E is 56/2 = 28, and its P/E -to-growth ratio is 28/2 = 14. P/E is lower than average sector P/E this is a good candidate for relative value approach.
- Company C is negative P/E and D is 16/2 = 8
Company A has favorable valuation relative to growth,
Examples of Investment Styles
Characteristics based |
Value, Growth or Blend/Core Capitalization Volatility |
Membership based |
Sector |
Country |
|
Market (developed or emerging) |
|
Positions based |
Long/short (net long, shot or neutral) |

Equity |
Event Driven |
Relative Value |
Opportunistic |
Specialist |
Multi-Manager |
Long/Short Equity Dedicated Short Bias Equity Market Neutral |
Merger Arb Distressed Securities |
Fixed Income Arb Convertible Bond Arb |
Global Macro Managed Futures |
Vol Strategies Reinsurance Strategies |
Multi-strategy FoF |
Conditional Risk Factor Model
Reading 28 - Overview of PWM
Reading 31 - Conc. Single Asset Positions
Year
Rate of return |
Wages
(2% annual growth) |
Present value od wages |
Probability of Survival |
Probability
weighted wages |
1 |
51,000 |
47,664 |
99% |
47,187 |
2 |
52,020 |
45,436 |
98% |
44,527 |
3 |
53,060 |
43,313 |
98% |
42,447 |
4 |
54,122 |
41.289 |
97% |
40,050 |
5 |
55,204 |
39,360 |
96% |
37,786 |
Total |
|
|
|
$211,997 |
Assets |
Liabilities |
||
Financial
Capital |
|
Debt |
|
Liquid Assets |
$275,000 |
Credit card debt |
15,000 |
Investment assets |
1,265,000 |
Car loan |
35,000 |
Personal
Property |
2,150,000 |
Home mortgage |
685,000 |
Subtotal |
$3,690,000 |
Home equity load |
60,000 |
Human Capital |
1,800,000 |
Subtotal |
$795,000 |
Pension value |
250,000 |
Lifetime
consumption needs bequest |
300,000 |
Total assets |
$5,740,000 |
Total Liabilities |
$4,595,000 |
|
|
Net Wealth |
$1,145,000 |
Net Payment Cost Index Calc |
|
Future value of premiums (annuity due): US$,2000 annual
payment, 20 years, 5% |
69,439 |
Future value of dividends (ordinary annuity): US$ 500
annual payment, 20 years, |
16,533 |
20-year insurance cost |
52,906 |
Annual payment for 20-year insurance cost (annuity due):
20 years, 5%
|
1524 |
Divide by US thousands of face value |
100 |
Net Payment Cost Index, cost per US $thousand per year |
US $15.24 |
Surrender
Cost Index Calc |
|
Future value of premiums (annuity due): US$,2000 annual
payment, 20 years, 5% |
69,439 |
Future value of dividends (ordinary annuity): US$ 500
annual payment, 20 years, |
-16,533 |
20-year cash value (given) |
-22,500 |
20-year insurance cost |
30,406 |
Annual payment for 20-year insurance cost (annuity due):
20 years, 5%
|
876 |
Divide by US thousands of face value |
100 |
Net Payment Cost Index, cost per US $thousand per year |
US $8.76 |
Loss Characteristics | High Frequency | Low Frequency |
High severity | Risk Avoidance | Risk Transfer |
Low severity | Risk Reduction | Risk Retention |
Investment
Approach |
Description |
Norway Model |
Traditional
style characterized by 60%/40% equity/fixed-income allocation, few
alternatives, largely passive investments, tight tracking error limits, and benchmark
as a starting position Cons: Limited
value-added potential |
Endowment
Model |
Characterized
by high alternatives exposure, active management and outsourcing Cons: Expensive and difficult to implement for
most sovereign wealth funds and because of their large asset sizes |
Canada Model |
Characterized
by high alternatives exposure, active management and insourcing Pros: High value-added potential and development of internal capabilities Cons: Potentially expensive and difficult to manage |
LDI Model |
Characterized
by focus on hedging liabilities and interest rate risk including via duration
matched, fixed income exposure. A growth component in the return-generating
portfolio is also typical. Cons:Certain risks (e.g longevity risk, inflation
risk) may not be hedged |
Factors
Affecting Calculation of Defined Benefit
Liabilities |
|
Factor |
Impact on
Liabilities |
Service/Tenure |
Depending on plan
design, often the longer the service or tenure, the larger the benefit
payments |
Salary/earnings |
The faster
salaries or earnings grow, the larger the benefit payment |
Additional or
matching contributions |
Additional or
matching contributions are often rewarded by a step change increase in benefit
payments |
Mortality/Longevity
assumptions |
If life
expectancy increases, the obligations or liabilities will increases |
Expected
Vesting |
If the
employment turnover decreases, expected vesting will increase |
Expected
Investment Returns |
In some
cases, increases in expected returns will result in a higher discount rate –
hence, lower obligations or liabilities |
Discount Rate |
A higher
(lower) discount rate results in lower (higher) liabilities |
Year | Rate of Return | Target rate min(rt – rT,0)^2 |
---|---|---|
1 | 6% | 0 |
2 | -2% | .0049 |
3 | 9% | 0 |
4 | 8% | 0 |
5 | -1% | .0036 |
Total | .0085 |
Key Aspects |
Key Question |
Universe Defining the universe |
What
is the feasible set of managers that fit the portfolio need ? |
Suitability |
Which
managers are suitable for the IPS ? |
Style |
Which
has the appropriate style? |
Active vs. Passive |
Which
fit the active versus passive decision ? |
Quantitative Analysis Investment due
diligence |
Which
manager “best” fits the portfolio need ? |
Quantitative |
What
has been the manager’s return distribution? |
Attribution and Appraisal |
Has
the manager displayed skill ? |
Capture Ratio |
How
does the manager perform in “up” markets vs “down” markets “ ? |
Drawdown |
Does
the return distribution exhibit large drawdowns ? |
Qualitative Analysis |
|
Investmen due diligence |
Which
manager best fits the portfolio need ? |
Qualitative |
Is
the manager expected to continue to generate this return distribution ? |
-
Philosophy |
What
market inefficiency does the manager seek to exploit ? |
-
Process |
Is
the investment process capable of exploiting this inefficiency ? |
-
People |
Do
the investment personnel possess the expertise and experience necessary to
effectively implement the investment process ? |
-
Portfolio |
Is
portfolio construction consistent with the stated investment philosophy and process
? |
Operational due diligence |
Is
the manager’s track accurate and does it fully reflect risks ? |
-
Process & procedure |
Is
the back office strong, safeguarding assets and able to issue accurate
reports in a timely manner ? |
-
Firm |
Is
the firm profitable, with a healthy culture, and likey to remain in business?
Is the firm committed to delivering performance over gathering assets ? |
-
Investment Vech |
Is
the vehicle suitable for the portfolio need ? |
-
Terms |
Are
the terms acceptable and appropriate for the strategy and vehicle ? |
|
Realization |
|
Below
expectations (no skill) |
At or
above expectations (skill) |
|
Hire/Retain |
Type I |
Correct |
Not Hire/Fire |
Correct |
Type II |
|
Active Share |
||
Low |
High |
||
Tracking risk |
High |
Sector rotation |
Conc. Stock pickers |
Low |
Closet indexer |
Diversified stock
pickers |