Documenti di Didattica
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Mark E. Oblad
For June 2010 Test
Code of Ethics
I. Act with integrity, competence, diligence, respect, and in an ethical manner with the public, clients,
prospective clients, employers, employees, colleagues in the investment profession, and other participants in
the global capital markets.
II. Place integrity of the investment profession and the interests of clients above their own personal interests.
III. Use reasonable care and exercise independent professional judgment when conducting investment analysis,
making investment recommendations, taking investment actions, and engaging in other professional activities.
IV. Practice and encourage others to practice in a professional and ethical manner that will reflect credit on
themselves and the profession.
V. Promote the integrity of, and uphold the rules governing, capital markets.
VI. Maintain and improve their professional competence and strive to maintain and improve the competence of
other investment professionals.
Such heuristics influence: analysts’ earnings forecasts, investors’ evaluation of mutual fund performance, corporate
takeover decisions and the type of portfolios selected by both individual and institutional investors.
Other heuristics: excessive optimism, illusion of validity, hindsight bias, illusion of control and self-attribution error.
Frame: form used to describe a decision problem; traditionally (incorrectly) assumed to be transparent
Frame dependence: equivalent frames may be opaque causing people to feel differently when faced with different but
equivalent frames; “the way people behave depends on the way that their decision problems are framed.”
• cognitive: the way people organize info
• the way people feel as they register the info
i. “house money” effect: more likely to take a gamble if you feel like you just got ahead.
Loss aversion: loss has about 2.5x the impact of a gain of the same magnitude [on emotions]
• “get-evenitis”
• Concurrent decisions: if lose in first game, may behave differently in second game for chance to get
even.
• Mental accounts: failure to see two decision problems together as a concurrent package.
• Hedonic editing: people prefer some frames to others; to choose frames that obscure losses
i. Prefer “transfer your assets” to “close account at a loss”
ii. People are not uniform in their tolerance for risk; some appear to tolerate risk more readily
when they face the prospect of a loss than when they do not
iii. People do not net two gains: they savor them separately (added attraction to gambling)
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iv. People are incapable of netting out moderately sized losses of similar magnitudes (shy away
from gambling)
Prospect theory
Emotional frames:
• self-control: controlling emotions; people put rules in place to guard against temptation: “don’t dip into
capital” and view dividends not as capital.
• regret minimization: emotion experienced for not having made the right decision; pain of loss and
feeling responsible for loss; may cause people to prefer dividends to finance consumption rather than
capital b/c of the regret from the (frame) of the missed capital appreciation
• money illusion: people think of money in nominal values (and disregard discounting for inflation)
De Bondt-Thaler winner-loser effect: investors who rely on representativeness heuristic become overly pessimistic
about past losers and overly optimistic about past winners causing price inefficiency
Frame dependence: loss aversion causes investors to shy away from stock resulting in relatively high returns (mental
accounting).
Myopic loss aversion: too short of evaluation horizons resulting in individual investors’ historical reluctance to hold
stocks.
House-Money Effect: results in more risk taking after runups and vice versa.
Overconfidence: 1. Investors take bad bets b/c they fail to realize that they are at an informational disadvantage; 2.
investors trade more frequently than is prudent
Fear induces an investor to focus on events that are especially unfavorable; hope induces to focus on events that are
favorable.
Layered pyramid: bottom: securities to provide security (money market; CDs); securities for specific goals (bonds);
top are securities for appreciation (stock, real estate).
• layers can be thought of as mental accounts
• priorities are the mental account associated w/ bottom layer
Use mean-variance to determine portfolio; provide investor w/ probability of achieving at least aspiration level, by
which the investor will evaluate in terms of fear, hope and aspiration.
Security design: layers can explain design of securities: guaranteed principal w/ possibility of upside.
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Portfolio selection: 1. investors excessively optimistic about their portfolio while not about the market; 2.
overconfident: surprised by price changes; 3. price forecasts anchored by past performance; 4. underestimate beta.
• also investors discount diversification
• reject positive tradeoff b/w risk and return
Optimism:
• inadequate insurance coverage
• younger people systematically think less likely to experience bad outcomes and more likely to
experience good outcomes
• failure to diversify
• excessive risk taking
Overconfidence:
• too much trading: investors who are high in desire for control and suffer from illusion of control are
prone to trade frequently.
• believe can pick winners
• internet stocks and day trading: single young men trade more and in riskier companies, resulting in
men earning 1.4% risk adjusted less return by one study and single men 2.3% less.
• Failure to diversify: even when assets other than stocks included
i. Naïve diversification: 1/n rule: divide 401k contribution equally among options in plan.
ii. Home bias: bias toward U.S. stocks (aversion toward ambiguity: fear)
“myopic loss aversion”: seeking to avoid short-term losses, despite the long time horizon usually involved in planning
for retirement
Failure to diversify:
• “1/n diversification heuristic”: split contributions equally amongst the n funds on offer, w/ little regard
to underlying asset composition of the funds.
i. “endorsement effect”: the entire selection of assets is seen as implicit guidance from employer
as to appropriate asset allocation strategy
• “too much choice”: negative relationship b/w # of funds on offer and employee participation
• Too much own-company stock; don’t realize it is riskier; preference to “invest in the familiar”/”home
country bias”; also “endorsement effect”
Employer may paternalistically design plan to maximize chance that most appropriate options are taken: opt-out
rather than opt-in; default contribution rates; default fund options and range and nature of fund choice on offer; nature
of info and advice
UK: DB plans: group personal pension (GPP) and stakeholder plans; DC plans: occupational money purchase (OMP)
• more common that there is “too little choice”
• no “own-company stock” problem
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Reading 12: Global Equity Strategy: the Folly of Forecasting: Ignore All Economists, Strategists, and Analysts
“Those who have knowledge don’t predict. Those who predict don’t have knowledge.”
Economists seem to lag reality; inflation forecasts appear to be largely a function of past inflation rates: adaptive
expectations.
Acute inefficiencies: discernible opportunities that can be exploited by accessible arbitrages; surrounding
uncertainties can be hedged or minimized; resolution occurs quickly.
Chronic inefficiencies: tend to be less discernible, more ambiguous, more resistant to rapid resolution from available
market forces, and generally longer tem in nature (arise from structural and behavioral sources: trading frictions,
organizational barriers, imbalances in capital flows, valuation ambiguities, lack of catalysts for resolution, convoy or
herding behavior, artificial peer comparisons, rebalancing inconsistencies, compulsive confirmation seeking, filtering
of conflicting data, misreading of market signals, inertia, formulaic action plans, and overly rigid “policy portfolios”)
Behavioral factors: convoy behavior, Bayesian rigidity, price-target revisionism, ebullience cycle
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• convoy behavior: herding behavior of institutional funds;
i. "Compounding consensus": tendency to seek the opinions of other "experts" who can confirm
one's own views
• Bayesian Rigidity: to relentlessly try to retain old views in the face of new information
• Price-Target Revisionism: price movements in predicted direction tend to be taken as confirmation of
wisdom, and the target is extended; to avoid: have plan to reduce positions as the original target is
approached
• Ebullience Cycle: during up markets, investors inclined to hold on firmly to winning positions (shining
examples of brilliance); in down: "unopened envelope" syndrome and propensity for inaction in the
face of losing positions
Market impact:
• holders out of game
• rebalancers have smoothing effect
• valuators: those who are contrarians and "reversionists" will act as moderators; momentum investors will have
exacerbating effect
• shifters: exacerbate market movements
Beta investors: buy indexes; alpha investor: chip away at chronic inefficiencies and behavioral biases
Investor Characteristics:
• Situational Profiling:
o Source of Wealth: self-made investors have greater familiarity w/ risk taking, but high sense of control
o Measure of Wealth: subjective nature of financial well-being; one portfolio may seem large to one and
small to another, affecting risk attitudes
o Stage of Life:
Foundation: establishing base on which to create wealth: skill, establish business, education
Accumulation: earnings accelerate
Maintenance phase: maintaining desired lifestyle and financial security (usually retired); risk
tolerance decreases
Distribution phase: transfer wealth
• Psychological Profiling: aka personality typing; bridges differences b/w traditional finance (economic analysis
of objective financial circumstances) and behavioral finance
o Traditional finance: investors assumed to 1. exhibit risk aversion, 2. hold rational expectations
(coherent, accurate and unbiased forecasters, reflecting all relevant info and learn from past mistakes)
and 3. practice asset integration
o Behavioral Finance: investors 1. exhibit loss aversion; 2. hold biased expectations; 3. practice asset
segregation
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loss aversion: prospect theory: investors place different weights on gains and losses; prefer an
uncertain loss to a certain loss, but prefer certain gain to uncertain gain
biased expectations: cognitive errors and misplaced confidence in ability to assess future
asset segregation: evaluate investment choices individually rather than in the aggregate
resulting in the following assumptions for portfolio construction:
• asset pricing reflects both economic considerations, such as production costs and prices
of substitutes, and subjective individual considerations, such as tastes and fears
• portfolios are constructed as “pyramids” of assets, layer by layer, in which each layer
reflects certain goals and constraints
Personality Typing: 1. ad hoc review by investment advisor based on interviews and past
investment activity; 2. client questionnaires
• Cautious Investors: strong need for financial security; demand low-volatility
investments w/ little potential for loss of principal; overanalyze; easily persuaded but
often do not seek professional advice
• Methodical Investors: relies on hard facts; undertake research; conservative; not
emotionally attached to investments
• Spontaneous Investors: constantly readjusting; not experts; doubt all advice;
overmanage;
• Individualist Investors: confident; work hard at info sources and reconcile
Decisions based primarily on Decisions based primarily on feeling
thinking
More risk averse Methodical Cautious
Less risk averse Individualist Spontaneous
Asset Allocation:
• Selecting asset allocation:
o 1. determine asset allocations that meet investor’s return requirements
o 2. Eliminate asset allocations that fail to meet quantitative risk objectives or other inconsistent w/ risk
tolerance
o 3. Eliminate asset allocations that fail constraints
o 4. Evaluate expected risk-adjusted performance and diversification attributes that remain; select most
rewarding
• Monte Carlo Simulation in Personal Retirement: provides a probability of meeting objectives estimate to
assess risk
o advantages:
more accurately portrays risk-return tradeoff than deterministic approach
gives info on possible tradeoff b/w short-term risk and risk of not meeting long-term goal
can model portfolio changes from tax effects
well suited to model stochastic process and resulting alternative outcomes
o disadvantages
relies on historical data
must evaluate performance of specific investments, not just asset classes, and adjust for fees
must account for tax consequences
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Classification of Income Tax Regimes
Regime 1 – Common 2 – Heavy 3 – Heavy Capital 4 – Heavy Interest 5 – Light Capital 6 – Flat and Light 7 – Flat and Heavy
Progressive Dividend Tax Gain Tax Tax Gain Tax
Ordinary Tax Progressive Progressive Progressive Progressive Progressive Flat Flat
Rate Structure
Interest Income Some interest taxed Some interest taxed Some interest taxed Taxed at ordinary Taxed at ordinary Some interest taxed Some interest taxed
at favorable rates or at favorable rates or at favorable rates or rates rates at favorable rates or at favorable rates or
exempt exempt exempt exempt exempt
Dividends Some dividends Taxed at ordinary Some dividends Some dividends Taxed at ordinary Some dividends Taxed at ordinary
taxed at favorable rates taxed at favorable taxed at favorable rates taxed at favorable rates
rates or exempt rates or exempt rates or exempt rates or exempt
Capital Gains Some capital gains Some capital gains Taxed at ordinary Some capital gains Some capital gains Some capital gains Taxed at ordinary
taxed favorably or taxed favorably or rates taxed favorably or taxed favorably or taxed favorably or rates
exempt exempt exempt exempt exempt
Example Austria, Brazil, Argentina, Colombia Canada, Denmark, Australia, Belgium, Kazakhstan, Ukraine
Countries China, Czech Indonesia, Israel, Germany, India, Kenya, Russia, Saudi
Republic, Finland, Venezuela Luxembourg, Mexico, New Arabia (Zakat)
France, Greece, Pakistan Zealand, Norway,
HK, Hungary, Spain, Switzerland,
Ireland, Italy, Taiwan, Turkey
Japan, Latvia,
Malaysia,
Netherlands,
Nigeria,
Philippines, Poland,
Portugal,
Singapore, South
Africa, Sweden,
Thailand, UK, US,
Vietnam
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Future value interest factor (if taxed annually): FVIFi = [1 + r(1 – ti)]n
Tax drag may exceed the tax rate: compounds over time. Tax drag increases as the investment return increases.
If cost basis differs: FVIFcgb = (1+r)n(1-tcg) + tcg – (1 – B)tcg = (1+r)n(1 – tcg) + tcgB; B is the percentage basis to market
value
Annual return after realized taxes: r* = r(1 – piti – pdtd – pcgtcg); the p’s are the percentages of return and don’t need to
add to 1 b/c unrealized capital gains are not included in the equation; does not capture tax effects of deferred CGs.
Future after-tax accumulation for each unit of currency in a taxable portfolio: FVIFtaxable = (1 + r*)n(1 – T*) + T* - (1 –
B) tcg
Accrual equivalent return: the IRR of the after-tax return: starting amount (1 + RAE)n = after-tax return
Accrual equivalent tax rate: the hypothetical tax rate that produces an after-tax return equivalent to the accrual
equivalent return: r(1 – TAE) = RAE
Future after-tax accumulation of a contribution to a tax-deferred account (like IRA): FVIFTDA = (1 + r)n(1 – Tn)
Future accumulation of a tax-exempt account (like Roth IRA): FVIFTaxEx = (1 + r)n
Risk: if investment returns taxed annual at ti, then return is reduced to σ(1 – ti)
Value created by using investment techniques that effectively manage tax liabilities: tax alpha
• asset location
o if strategy causes allocation of heavily taxed asset held in pension fund etc. to be too high, an offsetting
short position in heavily taxed asset outside the pension fund can offset the excessive exposure
• Trading behavior: optimally locating assets in TDAs and taxable accounts cannot overcome negative impact
of poor investment strategy that either produces negative pretax alpha or is highly tax inefficient
• Tax loss harvesting: realizing loss to offset gain or income, thereby reducing current year’s tax obligation;
recognizing an already incurred loss for tax purposes increases amount of net-of-tax money available for
investment
o highest-in, first-out (HIFO) tax lot accounting: sell highest cost basis first
• Holding Period Management: discourage short-term trading; gross up available long-term gain if held by
short-term tax rate to determine if short-term trade will yield greater; defer transaction just long enough for
long-term capital gains
• After-Tax Mean-Variance Optimization: pretax efficient frontiers may not be reasonable proxies for after-tax
efficient frontiers; also substitute after-tax standard deviations of returns for pretax standard deviations in the
optimization algorithm
Trust: vehicle through which an individual (settlor) entrusts certain assets to a trustee who manages the assets; many
civil countries do not recognize foreign trusts
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Civil law:
• forced heirship rules:
o children have right to fixed share of parent’s estate (may exist regardless of estangement or
nonmarital)
maybe move assets to offshore trust to avoid
maybe gift or donate assets during lifetime; some jurisdictions have “clawback” provisions for
lifetime gifts
o spouses have guaranteed inheritance rights
community property regimes: each spouse has automatically passing, indivisible 1/2 interest in
income earned during marriage (gifts and inheritances received b/f and after marriage are
separate property) (other half through will or intestate)
separate property regimes: each spouse is able to own and control property as individual and to
dispose, subject to spouses other rights
Net worth tax / Net wealth tax: on assets’ entire capital base
• lifetime gratuitous transfers (inter vivos transfers): lifetime gifts; gift tax may apply depending on residency or
domicile of donor, residency or domicile of recipient, tax status of recipient, type of asset and location of asset
• Testamentary gratuitous transfers: transfers upon death; taxation depending on residency or domicile of donor,
residency or domicile of recipient, type of asset and location of asset
• taxes may apply to transferor or the recipient; may be flat or progressive; usually after deduction for statutory
allowance; may depend on relationship of transferor or recipient (spouses often tax exempt)
Core Capital: amount of capital required to fund spending to maintain given lifestyle, fund goals and provide adequate
reserves for unexpected commitments
• survival probability: multiply future cash flow needs by probability that such cash flow will be needed
o joint probability if married couple: p(survival) = p(H survives) + p(W survives) – p(H survives) x p(W
survives)
N p ( Survival ) × Spending
o PV(Spending need) = ∑
j j
j =1 (1 + r ) j
o estimated that two people can maintain same living standard for 1.6 times the cost of one
o discount such probable cash flow needs
using the expected return of pension fund assets to discount liabilities they are intended to fund
systematically under-prices those liabilities
Monte Carlo simulation w/ expected returns and volatility
o safety reserve: for capital market volatility and uncertain future family commitments; suggested 2 yrs
of spending
• Monte Carlo simulation: determine core capital that sustains spending at least, say, 95% of the simulated trials
o Ruin probability: probability of depleting one’s financial assets b/f death)
o volatility reduces future accumulations: RG ≅ r − 1 σ ; geometric mean approximately equals
2
arithmetic mean minus half the volatility; also b/c withdrawals after down volatility reduce capital base
RVTaxFreeGift =
FVGift
=
[1 + r (1 − t ) ]
g ig
n
FVBequest [1 + re (1 − tie ) ] n (1 − Te )
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o taxable gifts:
RVTaxableGift =
FVGift
=
[1 + r (1 − t ) ] (1 − T )
g ig
n
g
, if paid by recipient; efficient if gift tax is
FVBequest [1 + re (1 − tie ) ] (1 − Te )
n
RVCharitableGift =
FVCharitableGift
=
(1 + r )
g
n
+ Toi [1 + re (1 − tie ) ] (1 − Te )
n
FVBequest [1 + re (1 − tie ) ] n (1 − Te )
Estate Planning Tools:
• Trusts: relationship in which trustee holds and manages assets for benefit of beneficiaries; avoid probate
o revocable trust: settlor is responsible for tax payments and reporting; assets reachable by creditors
o irrevocable trust: trustee responsible for tax payments and reporting; greater protection against
creditors
o fixed vs. discretionary trusts
o control
o asset protection (from creditors, from beneficiaries); use to avoid forced heirship rules
o tax reduction: may be progressive schedule and move assets into lower bracket; time discretionary
distributions; create trust in low tax jurisdiction
however, income of trust may be taxable to settlor
• Foundations: legal entity set up for particular purpose;
o can survive settlor
o allow for settlor’s wishes to be carried out
o control, avoidance of probate, asset protection, and tax minimization
• Life Insurance: death benefit proceeds paid to life insurance beneficiaries are tax exempt in may jurisdictions
o premiums also not in estate and not considered gift
o may have cash value building tax deferred
o avoids probate
o proceeds used to pay inheritance tax
o avoid forced heirship rules
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o asset protection: premiums not available to creditors
o can combine w/ discretionary trust
• Companies and CFCs:
o defer taxes; and set up in no-tax jurisdiction
o however, tax rules may quash w/ deemed distributions
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banking secrecy: benefits are security, privacy, intra-family dynamics and politics, and efficient
for clients residing abroad
tax evasion strategies predicated on bank secrecy and being exposed by increasing info
exchange b/w tax authorities
• Qualified Intermediaries: banks that document info for all customers and provide info
about U.S. customers upon request, w/o requirement to provide info on other non-U.S.
persons beneficially owning U.S. securities
Issues:
• Psychological
• risk and return
• taxes
Reducing exposure:
• outright sale: simplest and most expensive; results in max flexibility; eliminates residual risk; lower
amount of money to reinvest
• exchange funds: pool concentrated positions from multiple individuals
i. public exchange funds: partnership for >= 7 yrs; 20% exposure to other illiquid investments;
portion of pool distributed after 7 yrs
• but, management costs, lack of control and inflexibility
ii. private exchange fund alternative: usually single security; partner w/ another investor who
purchases same stock at current market prices; p’ship then enters into series of partial hedging,
borrowing and reinvesting transactions (avoiding constructive sales);
• increases borrowing ability
• lessens psychological blow
• no need for exposure to illiquid investments
• 7 yrs
• but unclear whether tax sound
• completion portfolios:
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i. single asset class completion portfolios: make other investments to offset the concentrated
position; may reinvest dividends
• passive structured strategy: reinvest dividends and use all available opportunities to
harvest investable losses experienced by one or several of the stocks in the completion
portfolio.
ii. multi-asset class completion portfolios: reach across asset or sub-asset classes
• requires substantial pool of other assets
• diversification process takes time
• hedging strategies: diversified but to avoid constructive sales; borrows against value of portfolio
(monetization) and reinvests
i. Constructive sale:
• short sale of same or substantially identical proprty
• offsetting notional principal K wrt the same or substantially identical property or
• futures or forward K to deliver same or substantially identical property
ii. Equity collars: pure hedging strategy: buy put and sell call (can cost money, be cashless, or
income-producing).
• suggested that 15% remaining exposure avoids constructive sale
iii. Monetization of position: w/ equity collar, could borrow up to ~90% of put strike price;
however, if more than 50%, must be nonpurpose loan and be intended for investments in
anything other than equities (however, may still increase leverage through margin).
iv. Variable Pre-Paid Forwards: forward sale of contingent number of shares of underlying stock
w/ agreed future delivery date in exchange for cash advance today.
• “properly constructed and documented, does not constitute a constructive sale and not
subject to margin lending restrictions.” (unbalanced collar)
v. debate over whether interest must be capitalized for tax purposes
Define portfolio efficiency in terms of client goals instead of relying on traditional measures of return and standard
deviation, then create strategies matched to each goal
Risk Measurement:
• traditionally standard deviation, etc.
i. however, return distributions are non-normal: skewed, excess kurtosis and heteroskedastic
ii. doesn’t describe risk in terms of clear outcomes / the way investors experience risk
• loss aversion: investors are not risk averse, but loss averse
i. risk measures should address : likelihood that loss will occur, severity of loss or both (say
probability of loss and downside deviation)
• risk measures are usually annualized or some short period, failing to convey risk over multiple periods
i. consider troughs occurring at end date
Risk Profiling:
• Decision Framing: slight differences in the way that questions are posed lead to very different answers about
people’s preferences
• Mental Accounting: multiple attitudes about risk; manage risk on goal-by-goal basis; maintaining separate
investment accounts, either mentally or in practice, and making decisions differently depending on the nature of
the account.
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Managing Behavioral Biases:
• loss aversion: develop strategies to manage losses
• mental accounting: develop strategies that can be aligned w/ investors’ separate goals and accounts
• biases should be controlled rather than accommodated
o Overconfidence: overestimate abilities; take risks w/o commensurate returns; overtrade
o Hindsight bias: believe that predicted event when didn’t
o Overreaction: to overinterpret patterns that are coincidental and unlikely to persist
o Belief perseverance: unlikely to change opinions even when new info becomes available
o Regret avoidance: tendency to avoid actions that could create discomfort over prior decisions, even
though those actions may be in the individual’s best interest
hold losers too long (disposition effect)
o recommendations:
goals and preferences should be defined as clearly as possible and supported through risk
management, using measures such as probability of breaching goal and potential loss
progress towards goals should be monitored, w/ performance evaluated in this context
strategy adjustments should be based on changes in circumstances or goals rather than behavioral
factors
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Reading 19: Lifetime Financial Advice: Human Capital, Asset Allocation, and Insurance
• Human capital as a risk-free asset: invest in stocks and gradually scale back as gets older
• Human capital as a risky asset: 1. if correlated w/ other risky financial assets, buy risk-free asset when young and
gradually move to risky-assets (as risky human capital declines); 2. if not correlated w/ other risky financial
assets, same as case 1.
• Impact of initial financial wealth: greater percentage allocation to risk-free asset (b/c initial wealth reduces
portion of wealth that is safe human capital)
• Correlation b/w wage growth rate and stock returns: make greater allocation to risk-free asset
Mortality risk:
• asset allocation and life insurance decisions should be made jointly
• life insurance is perfect hedge of human capital in event of death
• optimal amt of insurance depends on: 1. expected value of human capital and 2. risk-return
characteristics of the insurance contract.
• life insurance (θ) optimization: max E[ (1 − D )(1 − q x )U alive ( W x +1 + H x +1 ) + D( q x )U dead ( Wx +1 + θ x ) ]
θ x ,α x
i. q is subjective probability of death
ii. U is utility function
• as correlation b/w shocks to income and risky assets increases, optimal allocation to risky assets
declines and optimal quantity of life insurance declines (implies lower amt of human capital)
• the more financial assets one has, the less optimal quantity life insurance
• less risk tolerance, the more risk-free assets and the more life insurance
• demand for insurance decreases w/ age (primary driver of life insurance is human capital)
i. Asset/liability management (ALM): subset of company’s overall risk management practice that
typically focuses on financial risks created by the interaction of assets and liabilities; for given
financial liabilities, asset/liability management involves managing the investment of assets to
control relative asset/liability values.
ii. DB plans may state risk objective relative to level of pension surplus volatility
iii. Shortfall risk: risk (probability) that portfolio value will fall below some minimum acceptable
level over some time horizon
iv. risk objective to: minimize year-to-year volatility of future contribution payments
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v. risk objective to: minimize probability of making future contributions, if sponsor is currently
not making any contributions b/c plan is overfunded
• Return objectives: broadly: to achieve returns that adequately fund pension liabilities on inflation-
adjusted basis
i. consider: current funded status; contributions in relation to accrual of pension benefits;
ii. return objective may be such to eliminate future pension contributions
iii. return objective may be such to increase pension income in income statement
iv. may have separate return objectives for each of retired lives and active lives
• Liquidity requirement: net cash outflow: benefit payments minus contributions
i. consider percentage of retired lives; corporate contributions in relation to benefit
disbursements; options for early retirement or option to take lump-sum payments
• Time horizon:
i. whether plan is going concern or termination expected
ii. age of workforce and proportion of active lives
iii. may be multistage
• Tax concerns: usually tax exempt (though contributions and termination involve tax planning)
• Legal and regulatory factors:
i. ERISA for corporate and multi-employer plans: standards of care
ii. Taft-Hartley Labor Act for union plans
iii. fiduciary: person standing in special relation of trust and responsibility wrt other parties
• assets to be managed solely in interests of beneficiaries
• Unique circumstances:
i. due diligence wrt alternative investments
ii. prohibitions on investment in certain industries w/ negative ethical or welfare connotations; or
in companies operating in certain countries
Corporate Risk Management and the Investment of DB Pension Assets:
• managing pension investments in relation to operating investments: if business and pension risks are
positively correlated, high degree of operating risk would limit amt of risk that pension could assume
• coordinating pension investments w/ pension liabilities: ALM perspective to match interest-rate
sensitivity of assets and liabilities
DC Plans:
• sponsor directed: IPS is simpler subset of DB plan IPS
• participant-directed:
i. diversification: Section 404(c) of ERISA safe harbor for DC plan sponsors against claims of
insufficient or imprudent investment choice if plan has 1. at least 3 investment choices
diversified versus each other and 2. provision for participant to move freely among options.
ii. Company stock: should be limited to allow for diversification
• plan participants set on risk and return objectives
• IPS becomes overall set of governing principles rather than IPS for a specific plan participant
Hybrid and other plans: combination of DB (benefit guarantees, years of service rewards, ability to link retirement
pay to % of salary) and DC (portability, administrative ease and understandability) plans
• cash balance plans, pension equity plans, target benefit plans and floor plans
• Cash Balance Plan: DB plan w/ benefits displayed in individual recordkeeping accounts; facilitates
portability to a new plan.
i. contribution credit: % of pay based on age
ii. earnings credit: % increase in acct balance typically tied to long-term interest rates
iii. no actual account balance b/c no separate account
iv. some allow for some investment choices
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• ESOP: DC plans that invest all or a majority of assets in company stock; contributions based on
employee pay; vesting schedules; (not diversified)
• Foundation IPS:
i. risk objectives: desire to keep spending whole in real terms or to grow institutions, but can be
more fluid or creative and aggressive than pensions; still ability and willingness
ii. return objectives: total return; long-term return objective for foundations w/ indefinitely long
horizons: preserve real (inflation-adjusted) value of investment assets while allowing spending
at appropriate (statutory or decided-upon) rate; intergenerational equity/neutrality: equitable
balance b/w interests of current and future beneficiaries of foundation’s support;
• spending (say 5%) times investment management expenses (say 0.3%) times inflation
(say 2%)
iii. liquidity requirements: anticipated (spending rate) or unanticipated needs for cash in excess of
contributions; investment management expenses don’t count toward payout req, though
overhead associated w/ grant making does.
• may use smoothing rule that averages asset values over period of time to dampen
spending rate’s response to asset value fluctuations
• IRS allowes certain carry-forwards and carry-backs w/i limits
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• cash reserve to allow for end-of year rush spending in case of large asset growth
iv. Time horizon: usually into perpetuity, but sometimes intended to be “spent down”
v. Tax concerns:
• avoid UBTI, including debt-financed portion of income from debt-financed real estate
• private foundations must estimate and pay quarterly in advance 2% tax on net
investment income: dividends, interest and cap gains less foundation’s expenses related
directly to production of such income; reduced to 1% if charitable distributions for year
>= 5% and avg of previous 5 yrs’ payouts plus 1% of net investment income.
vi. Legal and regulatory factors:
• IRC Section 4944: graduated excise taxes if jeopardize carrying out of tax-exempt
purposes
• Uniform Management of Institutional Funds Act (UMIFA): primary state legislation
governing any entity organized and operated exclusively for educational, religious, or
charitable purposes.
vii. Unique circumstances:
• restrictions on diversification (may avoid w/ swaps)
• Endowments: long-term funds generally owned by operating non-profit institutions involved in
charitable activities
i. not subject to legally required spending level
ii. may be supplemented w/ quasi-endowments: funds functioning as endowment (FFE) w/ no
spending restrictions
iii. usually several funds, each w/ specific indenture detailing conditions and intended uses of gifts,
but may be unrestricted
iv. UMIFA both income and cap gains (realized and unrealized) included in determining total
return, freeing from strictures of yield as spending limit
v. frequently use trailing market value in calculating spending, to create stability; possible rules:
• simple spending rule: Spendingt = Spending rate x Ending market valuet-1
• Rolling three-year avg spending rule: Spendingt = Spending rate x (1/3) [Ending market
valuet-1 + Ending market valuet-2 + Ending market valuet-3]
• Geometric smoothing: Spendingt = Smoothing rate x [Spending ratet-1 x (1 + Inflationt-
1)] + (1 – Smoothing rate) x (Spending rate x Beginning market valuet-1); smoothing rate
usually 60 to 80%
vi. Endowment IPS:
• Risk objectives: consider in conjunction w/ spending policy and long-term objective
1. w/o smoothing rule, may have less tolerance for volatility
2. consider endowment’s role in operating budget and ability to adapt to drops in
spending
i. correlation w/ donor base may limit ability to take risk b/c cannot rely on
donors in down markets
3. consider recent returns in relation to smoothing rule (high recent returns
indicates greater risk tolerance)
4. may have short-term performance time horizons limited risk tolerance
• Return objectives: have high return objectives: significant, stable and sustainable flow
of income to operations
1. should maintain long-term purchasing power after inflation
2. consider high inflation for U.S. higher ed (HEPI averages 1% more than CPI or
GDP deflator)
3. low-volatility, low-return portfolio increases risk of endowment failing
objectives
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4. returns must exceed spending rate, expected inflation rate and cost of generating
investment returns
5. use Monte Carlo simulation to set (may be higher than point above)
• Liquidity requirements: perpetual and measured spending limit need for liquidity
1. need cash for capital commitments and for rebalancing
2. maybe major capital projects
3. generally suited for illiquid investments
• Time Horizon: extremely long
1. planned decapitalizations (large projects) may make for multistage horizons
• Tax concerns: exempt from taxation
1. avoid UBTI
2. dividend withholding tax from non-U.S. securities
• Legal and regulatory factors:
1. UMIFA:
i. allows for delegation of investment responsibility to external advisors
and managers and setting comp for such
ii. board must “exercise ordinary business care and prudence”
iii. spending gain as well as income ok
iv. if fall below historical book, then spend only income
2. 501(c)(3): ensure that no part of net earnings inure or accrue to benefit of any
private individual
i. excise taxes for individuals receiving “excess benefit transactions” (too
high comp)
• Unique circumstances:
1. variance in size: variety of expertise and resources
2. diligence of alternative investments: active management
3. whether investments limited to Qualified Purchasers (>$25M) can be considered
4. ethical investment policies:
i. voting shareholder proxies on issues of social or political significance
ii. exclusions for companies: child labor, gambling, tobacco, firearms,
violations of human rights
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• policyholder reserve (BS liability of estimated pmts to policyholders) rates set by
actuaries; to obtain a net interest spread to increase surplus policyholder reserves
• total return is difficult as only asset side of BS would reflect resulting volatility
• competitive pressures to offer competitive crediting rates
• Segmentation: sub-portfolio return objectives;
• need to grow surplus to support expanding business volume
iii. Liquidity requirements:
• disintermediation: withdrawing or borrowing against cash value; or surrendering policy
for cash value; has resulted in actuaries reducing duration estimates and portfolio
managers to reduce duration of portfolio
• Asset marketability risk: liquidity needs limit ability to invest in private placement
bonds, commercial mortgage loans, equity real estate and venture capital; also liquidity
requirements for forward commitments to purchase private placement bonds or
mortgages
• derivatives and lines of credit have decreased liquidity requirements
iv. Time horizon: traditionally the classic long-term investor, but segmentation creates unique time
horizons; ALM has tended to shorten time horizon
v. Tax concerns: subject to income, capital gains, etc.; focus on after-tax returns; only corporate
share of income (not policyholder share) is taxable
• could be tax law changes regarding deferral from inside buildup of cash values
vi. Legal and regulatory factors: heavily regulated by states—permitted lines of business, product
and policy forms, authorized investments; industry accounting rules and financial statement
forms
• Eligible investments: asset classes and quality standards; interest coverage ratios or
minimum credit ratings; max allocation to common stocks (~20% in U.S.)
• Prudent Investor Rule: replaced laundry lists of approved investments
• Valuation methods: uniform valuation methods established and administered by NAIC
vii. Unique circumstances: say company’s size and surplus position
• non-life insurance cos: (including health, property, liability, marine, surety and worker’s comp):
differences from life:
• shorter durations; longer claim processing and payments periods
• some liabilities exposed to inflation risk (but not interest rate risk directly)
• liabilities are relatively uncertain in value and timing; greater operating volatility
ii. underwriting (profitability) cycle: 3 to 5 yrs; resulting from adverse claims experience or
periods of extremely competitive pricing (often coincide w/ business cycle and require
liquidation of investments)
iii. models attempt to account for: 1. underwriting cycle; 2. liability durations by product line; 3.
any unique cash outflow characteristics
• non-life insurance co IPS:
i. Risk objectives: quasi-fiduciary role; risk of catastrophic events; current cost or replacement
cost coverage: inflation risk;
• Cash flow characteristics: can be erratic; low tolerance for loss of principal or
diminishing investment income; (no regulatory required asset-valuation reserve); ratio
of casualty insurance co’s premiums to total surplus: generally 2-to-1 or 3-to-1
• Common stock holdings to surplus ratio: often self-imposed limits on common stock
holdings
ii. Return objectives:
• Competitive policy pricing: lead to high return objectives; insurance cos may lower
premiums as a result of past high returns
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• Profitability: investment income and portfolio return are primary profitability
determinants; influenced by underwriting cycle; maximize return on capital and surplus
to extent that prudent ALM, surplus adequacy considerations and management
preferences allow (rather than policy crediting rate); investment returns expected to
offset underwriting losses
1. profitability measured using “combined ratio”: % of premiums that insurance co
spends on claims and expenses (been over 100%)
• Growth of surplus: allows for expansion of volume of underwriting
• Tax considerations: balance of taxable and tax-exempt bonds; managing and optimizing
operating loss carrybacks and carryforwards
• Total return management: active bond portfolio management strategies have increased
as a result of accounting rules requiring capital gains and losses to flow through income
statement
iii. Liquidity requirements: typically maintains portfolio of short-term securities and maintains
balanced or laddered maturity schedule
• uncertainty of cash flow
• variable tax position results in liquidity requirements to alter amount of tax-exempt
holdings
• interest rate conditions
iv. Time horizon:
• casualty liabilities typically shorter duration than that of life insurance
• underwriting cycles
• yield curve for tax-exempts is steeper, so move out on yield curve for yield
1. may be willing to sacrifice A/L matches to degree
• historically long-term for common stock, but recently more turnover in common stock
b/c realized gains and losses flow through income statement
v. Tax concerns:
• current tax provisions require series of calculations to determine net tax levied on tax-
exempt bond income; hence careful mix of tax-exempt and taxable securities
• uncertainty of further tax code modification
vi. Legal and regulatory factors:
• less regulated than life insurance;
• classes of eligible assets and quality standards
• otherwise remainder can be invested in broad array of assets (though some states have
additional reqs on max asset class holdings)
• not required to maintain asset valuation reserve
• new U.S. risk-based capital regulations: min amt of capital that must hold as function of
size and degree of asset risk, credit risk, underwriting risk, and off-balance sheet risk
vii. Determination of portfolio policies:
• limited risk tolerance is dominant
• capital appreciation to build surplus base and support additional investment in business
• underwriting experience
• current tax policy
Banks:
• liabilities chiefly of time and demand deposits, but also include purchased funds and sometimes publicly
traded debt
• assets are loan and securities portfolios; (also trading accounts, bank premises and fixed assets, and other real
estate owned)
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• net interest margin: net interest income divided by avg earning assets
• interest spread: avg yield on earning assets minus avg % cost of interest-bearing liabilities
• leverage-adjusted duration gap: DA – kDL where DA is duration of assets, DL is duration of liabilities and k =
market value of liabilities over market value of assets; positive interest rate shock: market value of net worth
will decrease for bank w/ positive gap; unaffected w/ zero gap, and increase w/ negative gap.
• position and aggregate Value at Risk (VAR): minimum value of losses expected over specified time at give
probability
• credit measures: internally developed and other like CreditMetrics:
• overall portfolio objectives:
o manage overall interest rate risk of balance sheet
o manage liquidity
o produce income
o manage credit risk
• pledging requirement: pledge gov’t securities against uninsured portion of deposits (in U.S.)
• Bank IPS:
o risk objectives: ALM considerations focusing on funding liabilities; below-average risk tolerance
o return objectives: earn a positive spread over cost of funds
o liquidity requirements: net outflow of deposits; demand for loans; management and regulatory concern
o time horizon: overall short maturity for liabilities than for portfolio; generally 3 to 7 yrs (intermediate)
o Tax concerns: securities portfolios are fully taxable; no longer tax exemptions for municipal securities
etc.; securities gains and losses affect net operating income: leads to managing earnings
o Legal and regulatory factors: reg restrictions on holding common shares and below-investment-grade
risk fixed-income securities
hold short-term gov’t securities: legal reserve and pledging reqs
risk-based capital regs
• Basel II: minimum 8% capital requirement for assets weighted 0%, 20%, 50%, 100%
and 150%
o Unique circumstances: no common unique circumstances
other institutional investors: mutual funds; closed-end funds; unit trust; ETFs; commodity pools; hedge funds;
nonfinancial corporations (major investors in money markets)
Selecting portfolios from asset-only perspective implicitly assumes that liabilities have no market risk
• pension liabilities: PV of deferred wages; focus on volatility of estimated benefit pmts and how they change
over time
Bt
o VL = ∑
t (1 + rt )
t
discount rate must reflect market-related exposures of benefit pmts: say real if inflation, then
rate should have real-rate bond component
o benefit volatility results from: volatility of wages, inflation, many non-market-related factors; growth
attributable to future service costs, new entrants and other non-market related factors
o Market related exposures:
inactive participants: fixed unless indexed for inflation
• mimic w/ bond; exposure to term structure
• mimic w/ real rate bonds if inflation indexed
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active participants: benefits attributable to past service and wages (accrued benefits) and
attributable to future service and wages (future benefit)
• accrued benefits: fixed unless inflation indexed
• future benefits: risk is capital market driven for funded liabilities; if plan is frozen, then
zero future benefit
o future wages: estimated future wage increases/benefits: future wage liability;
both real wage growth and wage inflation
future wage inflation: long-term relationship b/w general inflation and
wage inflation; exposed only until retirement, after which fixed
• so combination of real rate bonds and nominal bonds
future real wage growth: economic growth through labor’s share of
productivity increases; evidence of stability of share of labor in national
income, so linked to productivity increases; fixed at retirement, though
• so combination of equities and nominal bonds
future services rendered: uncertain
future participants: rarely funded; (zero if closed to new entrants)
Linking assets and liabilities via fundamental factors: combination of nominal bonds, real rate bonds and equities
• accrued benefit: discount rate market-related exposure -->term structure-->real rate, inflation and nominal
bond premium
• future wage liability-->change in wage level-->economic growth and inflation
B
accrued liabilities (w/ inflation indexation): VL − AB = ∑
t (1 + rt ) t
• future wage liability: V L − FW =
B
•
( s
)(
(1 + g ) − 1 (1 + r ) − 1d −s
)
; s yrs to retirement
r−g (1 + r ) d
• resulting sensitivity exposures sets asset allocation and is liability mimicking portfolio; is also appropriate
investment benchmark; this low risk portfolio is the baseline: often greater allocation to equities while
minimizing amt of unrewarded risk taken versus liability
o hedge the liability w/ derivatives
o use remaining capital on efficient return generation (asset-only)
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Reading 22: Allocating Shareholder Capital to Pension Plans
Marked-to-market funding status is picture of current status and doesn’t reveal risk of status change: asset/liability
mismatch is great concern;
• equity portion of pension portfolios often even larger than entire market cap of company
• mismatch doesn’t show up in accounting statements
• equivalent to fixed-interest for equity swap
• pension assets are encumbered by a lien against by the pensioners, while gains and losses flow to shareholders
• PBGC bears losses from default
• study result: companies w/ larger fraction of equity in pension portfolio tended to have larger beta
By failing to take account of pension assets and liabilities when estimate WACC, companies probably distorting
operating risk: 1. leaving out pension risk from total risk; 2. understates leverage ratio
• result is larger WACCs: too high of hurdle rates
• by lowering risk in pension plan, risk is freed up to be spent in core operations
o risk budget:
determine unleveraged/asset beta by adding pension assets to total assets and pension liabilities
to total liabilities; the beta of the assets will be the beta of the stocks in portfolio times % of
portfolio plus the beta of bonds (0). Then calculate asset beta.
Reading 23: Capital Market Expectations
Beta research: related to systematic risk and returns to systematic risk; development of capital market expectations
Alpha research: related to capturing excess risk-adjusted returns by a particular strategy
Challenges in Forecasting:
• Limitations of economic data
o time lag of collection, processing and dissemination
o changes in definitions and calculation methods (say CPI-U)
re-basing indices
• Data measurement errors and biases
o Transcription errors: errors in gathering and recording
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o Survivorship bias: data series reflect only survivors
o Appraisal (smoothed) data (say real estate or alternative investments): results in 1. calculated
correlations w/ other assets tend to be smaller in absolute value than true correlations; 2. true standard
deviation of asset is biased downward
• Limitations of historical estimates: analysis should include discussion of what may be different from past
o changes in technological, political, legal, and regulatory environments; disruptions such as wars
o change of regime: change of governing set of relationships creates nonstationarity (different parts of
data series reflect different underlying statistical properties)
o long data series:
risk that data cover multiple regimes
time series of required length may not be available
in order to get data series of required length, temptation is to use high-frequency data (weekly
or daily): more sensitive to asynchronism (discrepancy in dating of observations that occurs b/c
stale (out-of-date) data may be used in absence of current date) across variables, producing
lower correlation estimates
• Ex Post Risk Can be a Biased Measure of Ex Ante Risk
o ex post returns may reflect that didn’t materialize resulting in overstated estimates of ex ante returns
• Biases in Analysts’ Methods:
o Data-mining bias: repeatedly “drilling” or searching dataset to find statistically significant pattern
o Time-period bias: research findings that are sensitive to selection of starting and/or ending dates, may
bias out-of-time period analysis
• Failure to account for conditioning info: analyst should condition forecasts on the state of economy to
formulate most accurate expectations (say different betas in expansion economies and recession economies)
• Misinterpretation of correlations:
o distinguish b/w exogenous and endogenous variables;
o correlation may be spurious w/ no predictive relationship
test w/ multiple regression variable significance
test using time series analysis w/ independent variables including lagged value of dependent
variable, lagged value of tested variable and lagged value of control variables
• Psychological traps:
o anchoring trap: tendency to give disproportionate weight to first info received on topic
o status quo trap: tendency to perpetuate recent forecasts—to predict no change
o confirming evidence trap: bias that leads individuals to give greater weight to info that supports
existing or preferred point of view
examine all evidence w/ rigor
enlist an independent-minded person to argue against
be honest about motives
o overconfidence trap: tendency to overestimate accuracy of forecasts
o prudence trap: tendency to temper forecasts so that they don’t appear extreme; to be overly cautious in
forecasting
o recallability trap: tendency of forecasts to be overly influenced by events that have left strong
impression on person’s memory
o model uncertainty: uncertainty whether selected model is correct
input uncertainty: uncertainty whether inputs are correct
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•covariance of two markets given betas to world markets:
ρ σ ρ j ,M σ j 2
cov i , j = βi β jσ M2 = i , M i σ M = ρi , M σ i ρ j , M σ j
σM σM
• global investable market (GIM): practical proxy for world market portfolio consisting
of traditional and alternative asset classes w/ sufficient capacity to absorb meaningful
investment
o Survey and Panel Methods:
survey method: of expectations setting involves asking group of experts for expectations
• 2002 survey: 2 to 2.5% equity risk premium; other 3.9%
panel method: if survey involves a stable expert group queried
• Livingston Survey: covers U.S. GDP growth, CPI and PPI inflation, unemployment
rate, and 3-month T-bill and 10yr T-bond yields
o Judgment: economic and psychological insight to improve forecasts
checklists
Economic Analysis:
• Business cycle analysis: short-term inventory cycle (2-4 yrs); longer-term business cycle (9-11 years)
o chief measurements of economic activity:
GDP: consumption, investment, change in inventories, gov’t spending and exports less imports
output gap: difference b/w GDP trend (potential GDP) and actual; affects inflation
recession: two successive quarterly GDP declines
o inventory cycle: caused by companies trying to keep inventories at desired levels as expected level of
sales changes
up phase: businesses confident and increase production
down phase: business cuts back production to reduce inventories
inventory / sales ratio: when moved down, economy likely to be strong in next few quarters, as
businesses try to rebuild; when ratio moved sharply up, period of economic weakness can be
expected
• however, downward trend from improved technology (“just in time” inventory
management); but more visibility so sharper changes
o business cycle: 1. initial recovery; 2. early upswing; 3. late upswing; 4. slowdown; 5. recession
1. initial recovery: short phase (few months) when economy picks up from slowdown; business
confidence rising, though consumer confidence still low from unemployment; stimulatory
economic policies; usually upswing in inventory cycle; inflation still falling and output gap still
large
• gov’t bond yields may still be falling (matching declining inflation) or bottoming;
• stock market may rise sharply, w/ demand for cyclical and riskier assets
2. Early upswing (1 yr to several years): confidence up and momentum in economic activity,
w/o overheating or sharply higher inflation; consumers prepared to borrow and spend;
businesses build inventories and investment, w/ higher sales and increased capacity use; profits
rise from lower unit costs;
• short rates starting to rise as stimulus withdrawn;
• longer bond yields stable or rising
• stocks still trending up
3. Late upswing: output gap has closed and danger of overheating; high confidence and low
unemployment; high growth; inflation starts to pick up w/ accelerating wages
• interest rates rising from tighter monetary policy; pressure on credit markets from heavy
borrowing; central banks aiming for soft landing
• bond yields rising
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• stock markets rising still but nervously; volatile
4. Slowdown (few months to 1 year): economy slowing from rising interest rates; vulnerable to
shock; business confidence wavers; inflation still rising; businesses reduce inventories
(inventory correction);
• short-term interest rates are high and rising to peak
• bonds top out at first sign of slowing economy, then rally sharply (yields fall)
• yield curve inverts
• stock market falls, w/ utilities and financial services performing best
5. Recession (6 mos to yr): large inventory pullback and sometimes large decline in business
investment; consumers reduce big-ticket expenses; upon recession confirmation, monetary
policy cautiously eased; consumer and business confidence decline; profits drop sharply;
financial system may be stressed by bad debts, so cautious lending; major bankruptcies and
uncovered fraud; maybe financial crisis; maybe quickly risking unemployment
• short-term interest rates and bond yields drop;
• stock market begins to rise at later stages (b/f recovery)
trends affecting business cycle:
• growing China
• aging populations
• deregulation
• oil crises
• financial crises
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inflation should result in higher profits and higher stock prices, but too high results in efforts to
cool down the economy, resulting in lower stock prices
o Market Expectations and the Business Cycle:
“growth recession”: slowdown in growth, but not recession; more likely if:
• upswing was relatively short or mild
• no bubble or severe overheating in stock or property markets
• inflation relatively low, so central bank willing to cut interest rates quickly
• world economic and political environments are positive
• Evaluating Factors that Affect the Business Cycle: consumers; business; foreign trade; gov’t activity:
monetary and fiscal policy
o consumer spending: 60 – 70% of GDP
retail sales; store sales data; consumer consumption data
• can be erratic; affected by weather and holidays
after-tax income: wages, inflation, tax changes, employment growth
• non-farm payrolls
• weekly new unemployment claims
• savings rate
o business spending: business investment and spending on inventories
volatile: say decrease by 10-20% for recession and increase by same during upswing
inventories: rising may mean businesses are confident (early stages of inventory upswing), but
rise may be involuntary from lower sales (late stages of inventory cycle)
purchasing managers index (PMI); ISM survey of non-manufacturing companies
o foreign trade: 30-50% of GDP in smaller economies; 10-15% in larger
o gov’t policy: 1. try to control business cycle; 2. try to moderate inflation; 3. incumbents try to affect
policy during elections
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monetary policy: monetary authorities watch: 1. pace of economic growth; 2. amt of excess
capacity still available; 3. level of unemployment; 4. rate of inflation
• relative interest rates matter: in relation to neutral interest rates (4% argued in U.S.)
• Taylor Rule: target short-term interest rate based on rate of growth of economy and
inflation:
o say:
[ ]
Roptimal = Rneutral + 0.5 × ( GDPg forecast − GDPg trend ) + 0.5 × ( I forecast − I t arg et )
• money supply trends: long run stable relationship b/w growth of money supply and
nominal GDP
• if interest rates at zero, can then 1. push cash (bank “reserves”) directly into banking
system; 2. devalue currency; 3. promise to hold short-term rates low for extended
period; 4. bank to buy assets directly from private sector.
fiscal policy: change spending; cut or raise taxes;
• changes, not levels, are important; and deliberate changes (rather than changing levels
resulting from fluctuating tax revenues based on economy)
Exogenous Shocks:
• from changes in gov’t policy
• unexpected breakup of OPEC
• “peace dividend” from fall of Berlin Wall
• new products, markets and technologies
• Oil shocks: sudden rises affects consumers’ income and reduces spending; inflation rises, maybe offset by
contractionary effect of higher oil prices restricting employment and opening up output gap
• Financial Crises: bank lending and investor confidence
International Interactions:
• Macroeconomic linkages: foreign demand for exports; cross-border direct business investment; but not
perfectly integrated
• Interest Rate / Exchange Rate Linkages: formal or informal exchange rate links; unilateral pegs;
• Emerging Markets:
o Essential Differences b/w Emerging and Major Economies:
need higher rates of investment than developed countries in physical capital and infrastructure
and in human capital
periodic crises from managing foreign debt required for investment
volatile political and social environment
often relatively small and concentrated in areas such as commodities or narrow range of
manufactured goods; may rely heavily on oil imports
o Country Risk Analysis Techniques:
emerging bonds: risk of country being unable to service debt
stock: growth prospects and vulnerability to surprises
Checklist:
• 1. How sound is fiscal and monetary policy? ratio of fiscal deficit to GDP: persistently
above 4% is concern; ratio of debt to GDP: 70-80% extremely vulnerable
• 2. What are the economic growth prospects for the economy? if slow growth w/
population growth, likely political stress from falling per capital income
o Economic Freedom Index
• 3. Is the currency competitive, and are the external accounts under control?
o current account deficit
• 4. Is external debt under control? if reluctance to lend new money, may be exodus of
capital; ratio of foreign debt to GDP: 50% is dangerous; debt to current account
receipts: 200% in danger zone
• 5. Is liquidity plentiful? foreign exchange reserves in relation to trade flows and short-
term debt; ratio of reserves to short-term debt (maturing w/i 12 mos): under 100% is
risky
• 6. Is the political situation supportive of required policies? whether gov’t will
implement necessary adjustment policies: cutting budget deficit, privatization, ending
monopolies
Economic Forecasting:
• econometric models:
o limitations:
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finding adequate measures for real-world activities and relationships to be modeled
measurement error
relationships may change over time from changes of structure of economy
o constrains the forecaster to a certain degree of consistency and also challenges the modeler to reassess
prior views based on what the model concludes
o forecasts upturns much better than recessions
• leading indicators: lagging, coincident and leading
o diffusion index: how many indicators pointing up and how many down
o world:
OECD Composite Leading Indicators
o Europe:
Eurozone Harmonized Index of Consumer Prices
German Industrial Production
German IFO Business Survey
French Monthly Business Survey
o Asia Pacific:
Tankan Survey
China Industrial Production
o South America:
Brazil Industrial Production
o North America:
Conference Board’s Index of Leading Economic Indicators:
• 1. Avg weekly hrs, manufacturing
• 2. avg weekly initial claims for unemployment insurance
• 3. manufacturers’ new orders, consumer goods and materials
• 4. vendor performance, slower deliveries diffusion index
• 5. manufacturers’ new orders, non-defense capital goods
• 6. building permits, new private housing units
• 7. stock price, 500 common stocks
• 8. money supply, M2
• 9. interest rate spread, 10-yr Treasury bonds less federal funds
• 10. index of consumer expectations
• three consecutive mos of increases, or 3 consecutive mos of decreases, signaled upturn
or downturn in economy w/i 3 to 6 mos
• checklists:
o subjective
o ex:
1. Where in the cycle is the economy now? Aggregate
activity
review previous data on GDP growth and its components (consumer spending, business investment,
inventories, net exports, and gov’t spending)
how high is unemployment relative to estimates of “full employment”?
has unemployment been falling?
How large is the output gap?
What is the inventory position?
Where is inflation relative to target, and is it threatening to rise? inflation
2. How strong will consumer spending be? Consumer
Review wage/income patterns. Consumer
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How fast will employment grow? Consumer
How confident are consumers? Consumer confidence indices. Consumer
3. How strong will business spending be? Business
Review survey data (e.g., purchasing managers indices.) Business
Review recent capital goods orders. Business
Assess balance sheet health of companies. Business
Assess cash flow and earnings growth trends. Business
Has the stock market been rising? Business
What is the inventory position? Low inventory/sales ratio implies GDP strength. Business
4. How strong will import growth be? Government
Exchange rate competitiveness and recent movements. Government
Strength of economic growth elsewhere. Government
5. What is the government’s fiscal stance? Government
6. What is the monetary stance? Central bank
Review recent changes in interest rates. Central bank
What do real interest rates tell us? Central bank
What does the Taylor rule tell us? Central bank
Monetary conditions indices (i.e., trends in asset prices and exchange rate). Central bank
Money supply indicators. Central bank
7. Inflation Inflation
How fast is inflation rising, or are prices falling? Inflation
• Common Shares: consider (i) company earnings and (ii) interest rates, bond yields and liquidity
o price of oil; demand for airline travel
o Economic factors affecting earnings: long term: aggregate company earnings mainly determined by
trend rate of growth of economy
labor force growth; level of investment; rate of labor productivity growth
• overinvestment; gov’t overregulation; political instability; bursting of asset bubble
share of profits in GDP varies w/ business cycle and influenced by: final sales, wages, capacity
utilization, interest rates
• recession: reduced sales w/ burden of fixed costs; some companies (food companies)
may not change in earnings in recession, so may go up
• early stages of economic upswing: earnings recover strongly: capacity utilization and
increasing employment; wages modest; efficiency gains from recession;
• later upswing: wage growth; profits contract
o cyclical stocks: sensitive to business cycle from large fixed costs and
pronounced sales cycle (car manufacturers and chemical producers)
o P/E Ratio and the Business Cycle:
high and rises when earnings expected to rise
low and falling if earnings falling
but may anticipate future earnings recovery (Molodovsky effect)
high inflation tends to depress (past P/Es must be compared after controlling for inflation)
o Emerging Market Equities: ex post risk premiums in U.S. dollar terms positively correlated w/
expansion phases in G-7 economies (industrial production): trade, finance, direct sectoral linkages
country analysis
sector-specific research
• Real Estate: growth in consumption, real interest rates, term structure and unexpected inflation
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• Currencies:
o current account balance: import more --> currency depreciates
o strong domestic growth and opening of new industries: rise in fdi --> currency appreciates
o volatility from inflows and outflows for stocks, bonds and short-term instruments
o high interest rates: usually high inflows --> currency appreciates
o low interest rates ... currency usually depreciates
o however: high interests may be result of slowing economy --> currency depreciates
o approaches to forecasting:
PPP: exchange rate should offset any difference in inflation rates (useful for long run: say 5
yrs)
Relative Economic Strength: investment flows: strong economic growth creates attractive
investment opportunities (say high short-term deposit rate) --> currency appreciates
• if particularly high interest rates, speculators less likely to short currency b/c likely to
strengthen from higher rates
• converse: Japan’s carry trade as a result of low interest rates
Capital Flows: focuses on expected capital flows, particularly long-term such as equity
investment and fdi; inflows --> currency appreciates
• long-term capital flows may reverse usual relationship b/w short rates and currency:
central bank may want to raise interest rates to respond to weak currency that is
threatening to stimulate economy too much and boost inflation, effect may actually be
to push currency lower; reduced effectiveness of monetary policy.
Savings-Investment Imbalances: (may explain long-term equilibrium departures):
• if private sector or gov’t currency-related trends change (re current accounts), current
account position must change too and the exchange rate moves to help achieve that.
• currency needs to stay reasonably strong as long as domestic investment exceeds
savings; if economy becomes weak enough at this point and domestic investments no
longer exceed domestic savings, then currency will also weaken
o Gov’t intervention: difficulty in attempts to control b/c 1. total value of foreign exchange trading, in
excess of US$1 trillion daily, is large relative to total foreign exchange reserves of major central banks
combined; 2. gov’ts just another player in the market; 3. experience is not encouraging in the absence
of capital controls (unless willing to move interest rates and other policies).
Economic series and the economy: NBER has classified numerous economic series as: leading, coincident or lagging:
• leading: peaks and troughs occur before aggregate economic activity
o stock market is a good leading indicator of the economy: expectations of CFs; response to other
leading indicators
o cyclical indicator approach: expansion and contraction can be identified by movements reflected in
specific economic series
• coincident: peaks and troughs coincide
• lagging: peaks and troughs lag
• selected series: influence economy but don’t neatly fit into three above: U.S. balance of payments; federal
surplus/deficit
• composite series: combination of series
• ratio series: coincident over lagging sometimes leads leading or otherwise diverges
• analytical measures:
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o diffusion index: say % of reporting units in a series indicate a given result
trend of diffusion index always reaches peak or trough prior to index
o rates of change: (momentum)
o comparison w/ previous cycles: slower or faster
• Limitations:
o false signals: sudden reverses
o currency of data and revisions (esp if revisions are other direction)
o not all economic sectors represented (e.g., service, import-exports, int’l)
Surveys of Sentiment and Expectations: University of Michigan Consumer Sentiment Index; Conference Board
Consumer Confidence Index
Goldman Sachs Financial Conditions Index: increase in index indicates tightening / rising interest rates
Relationship b/w money supply and stock prices: necessary to forecast unanticipated changes in money supply growth
Inflation and interest rates: strong relation; (spread changes over time)
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Inflation, Interest Rates, and Stock Prices:
• 1. positive scenario: negative effect of interest rate increase (required rate of return) partially or wholly offset
by increase in growth of earnings and dividends (inflation pass through)
• 2. mild negative scenario: higher costs and not able to pass through, so higher k and flat g
• 3. very negative scenario: k increases; g declines
Microvaluation: 1. DDM; 2. FCFE; 3. earnings multiplier technique; 4. other relative valuation ratios
• DDM: discount the dividends:
o k: nominal risk-free rate: 10-yr Treasury note; 30-yr Treasury bond;
o k: equity risk premium: geometric for long-term: say 6.5% from Ibbotson Associates; other b/w 2%
and 6%
o g: current and expected changes in growth;
b x ROE
• ROE: NI/Equity = NI/Sales x Sales / Total assets x Total assets / equity
o so w/ dividend estimate and k and g, can them estimate market value; further can estimate implied
spread from current market prices
o can obtain implied k: k = D/p + g
• FCFE: = NI + Depr – capex – change in working capital – principal debt repayments + new debt issues
o single stage; two-stage
o estimate g from historical (say same in DDM)
o estimate k same as DDM
• Earnings multipliers:
o estimate of spread:
P = D1 / (k-g)
P/D1 = 1 /(k-g)
D1/P = k-g
o 1. estimate future EPS for stock series; 2. estimate earnings multiplier based on k-g spread
Expected EPS:
• 1. estimate sales per share based on GDP: single variable regression
• 2. estimate operating profit margin: profit / sales; (say EBITDA for operating profit)
o can estimate net profit margin, or
o can estimate net before tax profit margin and then estimate taxes, or
o estimate EBITDA profit margin
o affected by: 1. capacity utilization rate; 2. unit labor cost; 3. rate of inflation; 4. foreign competition
• 3. estimate depreciation per share for next year: estimate PPE and then use historical depr rate
• 4. estimate interest expense for next year: estimate 1. amt of total assets for firm based on expected total asset
turnover and 2. expected capital structure based on avg total debt to total assets
• 5. estimate corporate tax rate for next year: evaluate current tax rate and recent legislation
BRICs have larger US$GDP than G6 in less than 40 yrs; currently only 15%
Have less capital, so higher returns on capital, resulting in higher growth of capital stock
Technological catch up.
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• Maybe lower convergence in India and Brazil than Russia and China b/c lower education levels and poorer
infrastructure
• Maybe 1/3 of increase in US$GDP of BRICs from rising currencies and 2/3s from faster growth
Strategic Asset Allocation: establish exposures to IPS-permissible asset classes by integrating investor’s return
objectives, risk tolerance, and investment constraints w/ long-run capital market expectations.
• result is the Policy Portfolio
• In long run, diversified portfolio’s mean returns are reliably related to systematic risk exposures.
• Strategic asset allocation specifies investor’s desired exposures to systematic risk.
• b/c investors in aggregate are the market and costs do not net out across investors, return on avg actively
managed dollar should be less than return on avg passively managed dollar after costs
Tactical asset allocation (TAA): short-term adjustments to asset-class weights based on short-term expected relative
performance among asset classes.
• creates active risk
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o Black-Litterman model: take global market-value-weighted asset allocation (Market equilibrium
portfolio) as default and then incorporate deviate from weights reflecting views on asset classes’
expected returns and strength of views
Risk objectives:
• Investor’s expected utility for asset mix: U m = E ( Rm ) − 0.005 R Aσ m ; E is expected return for mix; R is
2
Capital Market Conditions Investor’s Assets, Liabilities, Net Worth, and Risk Attitudes
| |
Prediction procedure Investor’s Risk Tolerance Function
| |
Expected Returns, Risk, and Correlations Investor’s Risk Tolerance
| |
Optimizer
|
Investor’s Asset Mix
|
Returns
|
(back to top)
Optimization:
• mean-variance approach
o identify efficient frontier (part of minimum variance frontier bordered on the bottom by global
minimum variance portfolio)
o mean-variance optimization (MVO):
unconstrained MVF: asset-class weights sum to 1. (allows for short positions)
sign-constrained MVF: no short-positions and sum to 1.
• corner portfolios: 1. portfolios hold identical assets and 2. rate of change of asset
weights in moving from one portfolio to another is constant.
o corner portfolio theorem: In a sign-constrained optimization, the asset weights
of any minimum-variance portfolio are positive linear combination of
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corresponding weights in two adjacent corner portfolios that bracket it in terms
of expected return (or standard deviation of return)
o find adjacent portfolios for desired return and then weight such two portfolios to
obtain return; then weight underlying assets by such weights
most important inputs in mean-variance optimization are expected returns: highly sensitive to
small changes in inputs
for cash equivalents: risk-free rate suggests single-period perspective; reported positive
standard deviation suggest multiperiod perspective
capital allocation line is the line from the risk-free rate and tangent to efficient frontier
• may not be able to use tangency portfolio if have restraint on borrowing
Steps in BL Model
Step Purpose
1. Define equilibrium market weights and Inputs for calculating equilibrium expected returns
covariance matrix for all asset classes
2. Back-solve equilibrium expected returns Form neutral starting point for formulating expected returns
3. Express views and confidence Reflect investor’s expectations for various asset classes; the confidence
level assigned to each view determines the weight placed on it
4. Calculate the view-adjusted market Form the expected return that reflects both market equilibrium and
equilibrium returns views
5. Run mean-variance optimization Obtain efficient frontier and portfolios
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• Monte Carlo Simulation: simulation that imitates an asset allocation’s real-world operation in an investments
laboratory
• ALM: focuses on surplus efficient frontier
o surplus efficient frontier is bordered on bottom by minimum surplus variance (MSV) at which point
strategy might be cash flow matching or immunization
o surplus beta decision: increment of risk accepted above the MSV portfolio
o ALM w/ simulation:
1. determine surplus efficient frontier and set of efficient portfolios among range
2. conduct Monte Carlo simulation for each proposed asset allocation and evaluate
3. choose most appropriate.
o Surplus objective function’s expected value for particular asset mix for specified risk aversion:
U mALM = E ( SR m ) − 0.005 R Aσ 2 ( SR m )
• Experience-Based Approaches:
o 1. 60/40 stock/bond asset allocation is appropriate or at least a starting point for an average investor’s
asset allocation
o 2. Allocation to bonds should increase w/ increasing risk aversion
o 3. Investors w/ longer time horizons should increase their allocation to stocks
o 4. A rule of thumb for % allocation to equities is 100 minus age of investor
Tactical Asset Allocation: deliberately underweighting or overweighting asset classes relative to target weights
• can use derivative securities over asset classes: overlay strategy
• based on principles:
o 1. market prices tell explicitly what returns are available
o 2. Relative expected returns reflect relative risk perceptions
o 3. Markets are rational and mean reverting
• but consider:
o changes in assets’ underlying risk attributes
o changes in central bank policy
o changes in expected inflation
o position in business cycle
Traditional case: risk reduction (from low correlation) and superior expected returns
• Portfolio variance of return: σp2 = w12 σ12 + w22 σ22 + 2w1w2ρ1,2σ1σ2; Portfolio standard deviation of return: σp =
w12 σ12 + w22 σ22 + 2w1w2ρ1,2σ1σ2
• currency: return in $: r$ = r + s + (r x s); r is return in local currency and s is exchange rate movement; cross
product usually ignored
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• var(r$) = var(r+s) = var(r) + var(s) + 2cov(r,s) = σf2 = σ2 + σs2 + 2ρσσs; (ignoring cross product); σf2 is the
variance of foreign asset in $; σ2 is variance in local currency; σs2 is variance of exchange rate; and ρ is
correlation of local currency asset return and exchange rate movement
o contribution of currency risk is the difference between the combined standard deviation and the local
currency equity return standard deviation.
• historical correlation experience:
o equity: generally low correlations across equity markets with or without currency hedging
o bonds: low correlations when unhedged; regional blocs exist; hedged different b/c existence of
“leaning against the wind” policies of raising interest rates to defend currencies
• leads and lags: some lagged correlation but can be explained by differences in time zones and not by some
international market inefficiency that is exploitable, and drastically reduced correlations for longer periods
• Returns: int’l investing increases Sharpe ratios (both numerator and denominator effects)
o consider active vs. passive; costs and benefits of both
• Optimization must be based on forward-looking / expected returns: real growth; economic flexibility;
o forecasts may already be reflected in asset prices
• Currency risk: less than local equity risk but more than local bond risk
o market and currency risks are not additive
o currency risk can be hedged
o should be measured for whole portfolio rather than individual markets; offsets
o contribution of currency risk decreases as time period increases (PPP and mean reversion)
Low correlations: factors causing equity market correlations across countries to be relatively low are independence of
different nations’ economies and gov’t policies, technological specialization, independent fiscal and monetary
policies, and cultural and sociological differences
• for bonds: differences in national monetary and budgetary policies
Classification strategies:
1. Pure bond indexing (or fully replication approach): perfectly match benchmark (costly to implement)
2. Enhanced indexing by matching primary risk factors:
a. primary matched factors: say level of interest rates, yield curve twists, changes in spreads over
treasuries
b. by not fully replicating, reduces costs
c. can try to enhance return
3. Enhanced Indexing by small risk factor mismatches: increase return by tilting toward sector, quality, term
structure, etc.; intended to enhance return only slightly to cover admin
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4. Active management by larger risk factor mismatches: active management; deliberately larger mismatches
5. Full-blown active management: aggressive mismatches on duration, sector weights and other
Indexing:
• benchmark: generally:
o market risk: have comparable market risk (maturity and duration)
o income risk: comparable assured income streams
o credit risk: comparable, diversified and satisfying IPS
o liability framework risk: some relation to duration of liabilities if play a role
o risk profiles: yield curve changes (shift (90%), twist, other)
matching techniques:
• cell matching (or stratified sampling): divide benchmark into representative cells and
then match
• multifactor model: use set of factors that drive bond returns:
o effective duration; convexity adjustment;
o key rate duration and PV distribution of CFs:
key rate duration
divide into nonoverlapping periods and match PVs
o Sector and quality percent
o sector duration contribution:
o quality spread duration contribution
o sector/coupon/maturity cell weights
o issuer exposure (event risk)
• Tracking risk: variability w/ which portfolio’s return tracks benchmark index return:
standard deviation of active return; active return = portfolio’s return – benchmark
index’s return.
o tracking risk results from mismatches from: 1. portfolio duration, 2. key rate
duration and PV distribution of CFs; 3. sector and quality percent; 4. sector
duration contribution; 5. quality spread duration contribution; (and other factors
listed under multifactor model technique)
• Enhanced Indexing Strategies:
o lower cost enhancements: control costs (say competitive bidding)
o issue selection enhancements: conduct own credit analysis
o yield curve positioning: overweighting undervalued areas of curve and
underweighting overvalued areas
o Sector and quality positioning:
say tilt toward short-duration corporates
periodic over- or underweighting of sectors
o Call exposure positioning: determine probability of call around crossover point
Cash Flow Matching: select securities to match timing and amount of liabilities
• compared to immunization:
o no reinvestment risk
o cash flow matching requires conservative rates of return
o cash flow matching requires cash to be on or before liability date
o generally inferior to immunization
• extensions of basic CF matching:
o symmetric cash flow matching: short-term borrowing funds to satisfy liability prior to liability due date
(and matched CF maturity)
o combination matching (or horizon matching): creates portfolio that is duration-matched w/ added
constraint that it be cash-flow matched in first few years
• Application considerations:
o universe considerations: quality and characteristics of securities allowed to use
o optimization
o monitoring: periodic performance measurement
o transaction costs
Reading 29: Relative-Value Methodologies for Global Credit Bond Portfolio Management
Spread Analysis:
• Alternative Spread Measures:
o OAS has diminished from reduction in structures w/ embedded option
o zero-volatility spread
o swap spreads in Europe
o credit spread using U.S. agency benchmark curve
o credit-default swap spreads
• Closer look at swap spreads: many practitioners envision convergence to single global spread standard derived
from swap spreads
• Spread tools:
o 1. mean-reversion analysis
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o 2. Quality-Spread Analysis: examine spread differentials b/w low- and high-quality credits
o 3. Percent Yield Spread Analysis: ratio of credit yields to gov’t yields for similar duration securities;
not very predictive
Vp
adjustments to portfolio often such to keep duration same, so often reference to dollar duration:
D ×Vi
Dollar duration = i
100
o Other risk measures:
Semivariance: measures dispersion of return outcomes below target returns
Shortfall risk: probability of not achieving some specified return target
Value at risk (VAR): estimate of loss portfolio manager expects to be exceeded w/ given level
of probability over specified time
o Bond Variance v. Bond Duration: standard deviation difficult to use to measure risk: number of
parameters to estimate increases dramatically w/ number of bonds; variances and covariances change
w/ time
o Interest Rate Futures:
cheapest-to-deliver; delivery options: quality option; timing option; wild card option
Strategies w/ Interest Rate Futures: price negatively correlated w/ interest rates: increases
duration/sensitivity to interest rates
• Duration Management: use to match portfolio duration when deviates from target
o portfolio’s target dollar duration = Current portfolio’s dollar duration w/o
futures + dollar duration of futures Ks
o Dollar duration of futures = dollar duration per futures K x number of futures Ks
o Approximate # of Ks =
( DT − DI ) PI ( D − DI ) P DCTD PCTD ( D − DI ) P
= T × = T × ConvFactorForCTDBond
DollarDurPerFuturesK DCTD PCTD DollarDurPerFuturesK DCTD PCTD
• Duration Hedging: futures Ks involves taking futures position that offsets existing
interest rate exposure; if properly constructed as cash and futures prices move together
any loss realized by hedger from one position will be offset by profit in other
o basis risk: risk that basis (difference b/w cash price and futures price) will
change in unpredictable way
o cross hedging: bond to be hedged is not identical to underlying in futures; may
involve substantial basis risk
o price risk: risk that cash market price will move adversely; reason for hedging
o hedge ratio = factor exposure of bond (portfolio) to be hedged / factor exposure
of hedging instrument = (factor exposure of bond to be hedged / factor exposure
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of CTD bond) x (factor exposure of CTD bond / Factor exposure of futures K) =
DH PH
HedgeRatio = × ConvFactor ForCTDBond
DCTD PCTD
o Yield on bond to be hedged = a + b(Yield on CTD bond) + error term
b is beta yield
DH PH
o HedgeRatio = × ConvFactor ForCTDBond × YieldBeta
DCTD PCTD
• Interest Rate Swaps:
o Dollar duration of interest rate swap:
for pay float receive fixed: dollar duration of swap = dollar duration of
fixed-rate bond – dollar duration of floating rate bond
• Interest Rate Options:
o duration for option = delta of option x duration of underlying x (price of
underlying / price of option instrument)
o protective put establishes minimum value for portfolio
o covered call yields best results if prices are essentially going nowhere
o buy calls to protect against decline in reinvestment rates
o also caps, floors and collars
• Credit Risk Instruments:
o credit risk: default risk, credit spread risk, downgrade risk
o credit options: protect against credit risk;
1. credit options written on underlying asset:
• binary credit options provide payoffs contingent on occurrence of
specified negative credit events
o credit put option pays difference b/w strike price and
market price when event triggered
2. Credit Spread Options: payoff based on spread over benchmark:
• Payoff = Max [(Spread at option maturity – K) x Notional amt x
risk factor, 0]
o credit forwards:
for buyer of credit forward: payoff = (Credit spread at forward K
maturity – Ked credit spread) x Notional amt x risk factor
o credit swaps: credit default swaps, asset swaps, total return swaps, credit-linked
notes, synthetic collateralized bond obligations, basket default swaps
cds: for periodic premiums, agree to deliver physically or cash upon
default event
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• Currency risk: 1. expected effect captured by forward discount/premium; 2. unexpected movement of foreign
currency relative to forward rate
o interest rate parity: forward foreign exchange rate discount/premium over fixed period should equal
risk-free interest rate differential b/w two countries over period: f ≈ id − i f
o hedging currency risk: forward hedging, proxy hedging, cross hedging
forward hedging: use forward K b/w bond’s currency and home currency
proxy hedging: use forward K b/w home currency and currency highly correlated w/ bond’s
currency;
cross hedging: using two non-home currencies to convert to a less-risky exposure to investor
for hedged position while IRP holds, hedged bond return:
HR ≈ rl + f ≈ rl + ( id − i f ) = id + ( rl − i f ) ; sum of domestic risk-free interest rate plus bond’s
local risk premium
• Breakeven Spread Analysis: determine the size of spread widening that would offset any yield advantage
YieldAdvan tage
o spread widening that would eliminate yield advantage: W = ; use the higher of the
Duration
two countries’ durations
• Emerging Market Debt:
o Growth and Maturity of the Market: after 1980s Mexican crisis, Brady plan allowed emerging country
gov’ts to securitize their date: Brady bonds; has resulted in liquid market for Brady bonds
o Risk and Return Characteristics: potential for consistent attractive rates of return; countries can cut
spending and raise taxes and borrow from IMF and World Bank; have currency reserves; but volatile;
negative skewness; lack transparency: unclear laws and regs; little standardization in covenants and
lacks enforceable seniority structure
o Analysis of Emerging Market Debt: look at:
fundamentals: source of revenues, fiscal and monetary policies; current debt levels, willingness
of citizens to make sacrifices
risk of being able to exchange currency
political risk and currency risk
changes in liquidity and taxation
Convexity
• Value of mortgage security = value of Treasury security – value of prepayment option
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• many investors consider mortgages to be market-directional investments that should be avoided when interest
rates expected to decline
Hedging Methodology:
• Interest Rate Sensitivity Measure: Richard and Gord’s Interest Sensitivity (IRS): measures % price change in
response to shift in yield curve
o two bond hedge (say 2-yr and 10-yr Treasuries)
o calculate appropriate two-bond hedge for typical yield curve shifts and twists
o for shift: 1. compute prices for assumed interest rate increases and decreases (say 24.3 basis points as
the typical monthly change in level) for each of (i) the mortgage security (ii) the 2-yr, and (iii) the 10-
yr
o for shift: 2. determine 6 changes (yields) in step 1.
o for shift: 3. calculate averages from increase and decrease (absolute values) for each of 3 in step 2.
o for twist: 4. compute prices for assuming flattening and steepening (say 13.8 basis points as the typical
monthly twist) for each of 3
o for twist: 5. determine 6 changes (yields) in step 4
o for twist: 6. calculate averages from flattening and steepening (absolute values) for each of 3 in step 5
o for shift: 7. compute change in value of 2-bond hedge for level change in yield curve
H2 x (2-H priceL) + H10 x (10-H priceL)
o for twist: 8. compute change in value of 2-bond hedge for twist
H2 x (2-H priceT) + H10 x (10-H priceT)
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o 9. determine system of equations that equates change in value of 2-bond hedge to change in price of
mortgage security
H2 x (2-H priceL) + H10 x (10-H priceL) = -MBS priceL
H2 x (2-H priceT) + H10 x (10-H priceT) -MBS priceT
o 10. solve simultaneous equations for H2 and H10
• properly hedged mortgage securities are not “market-directional”
• underlying assumptions of 2-bond hedge: 1. yield curve shifts are reasonable; 2. prepayment model estimates
changing cash flows well; 3. underlying assumptions in Monte Carlo simulation hold; 4. avg price change is
good approximation of price change for small interest rate movements
Hedging Cuspy-Coupon Mortgage Securities: where small changes in interest rates have large effect on prepayments
and thus prices
• so, tangent line at yield is not a good proxy for price/yield changes
• more negative convexity than current coupon mortgages
• hedge by buying interest rate option
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•growth-at-a-reasonable price: above avg growth prospects selling at conservative
valuations (not as diversified as straight growth style)
• style rotators: invest in style that will be favored in the near term
• small cap style / micro cap style (underresearched, or better growth prospects)
• mid cap (underresearched but stronger than micro caps)
• large cap: emphasis on superior analysis and insight
o Technique for identifying investment styles:
returns-based style analysis on portfolio returns (RBSA): regress realized returns on return
series for set of securities indices (set must be mutually exclusive, exhaustive and risk distinct);
betas set to total 1.
• the weights set the “normal portfolio/benchmark”
• 1 minus style fit equals selection
• error term represents selection return
holdings-based style analysis (aka composition-based style analysis): categorize individual
securities by characteristics and aggregate results; evaluate:
• valuation levels
• forecast EPS growth rate
• earnings variability: (greater would be indicative of value-oriented)
• industry sector weightings: value-oriented would have financing and utilities; growth
have info tech and health care
• Barra fundamental multifactor risk model: commercial holdings-based style analysis
model
• consider category approach (stick security in basket representing one style); quantity
approach: divide security among baskets based on spectrum
Semiactive Equity Investing (aka enhanced index or risk-controlled active): perform better than benchmark w/o much
additional risk
• derivatives-based semiactive equity strategies: exposure to equity market w/ derivatives and enhance w/ other
than equity (say equitize cash and enhance by altering duration)
• based on stock selection: generate alpha by selecting stocks
• Grinold and Kahn’s Fundamental Law of Active Management: IR ≈ IC Breadth : info ratio approximately
equal to what you know about given investment (info coefficient) multiplied by square root of investment
discipline’s breadth (number of independent active investment decisions made each year)
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n
• portfolio active risk = ∑h
i =1
2
Ai σ Ai2 : square root of weighted sum of individual manager’s variances; assumes
uncorrelated
• Core-Satellite: to anchor a strategy w/ index or enhanced index and use active managers opportunistically
around anchor to achieve acceptable level of active return while mitigating some active risk associated w/
portfolio consisting entirely of active managers
o core should resemble benchmark
o further breakdown of active return:
manager’s return – manager’s normal benchmark = manager’s true active return
manager’s normal benchmark – investor’s benchmark = manager’s misfit active return
o manager’s total active risk = [(Manager’s “true” active risk)2 + (Manager’s “misfit” active risk)2]1/2
o manager’s risk-adjusted performance = IR = (Manager’s “true” active return) / (Manager’s “misfit”
active risk)
• Completeness Fund: when added to active managers’ positions, establishes overall portfolio w/ approximately
same risk exposures as investor’s overall equity benchmark
o can be passive or semiactive
o needs to be re-estimated periodically
o misfit may be optimal while completeness fund tends to eliminate misfit
• Other Approaches: Alpha and Beta Separation
o say index for beta exposure, then hire managers for portable alpha
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10 sectors (consumer discretionary, consumer staples, energy, financials, health care,
industrials, info tech, materials, telecomm, utilities)
24 industry groups
62 industries
132 sub-industries
o Industry Classification Benchmark
o North American Industry Classification System
Managerial Incentives:
• Sophisticated Mix of Incentives: bonuses and stock options; concern about future; threat of being fired;
financial distress; monitoring by large investors (also intrinsic motivation; fairness, horizontal equity, morale,
trust, corp culture, social responsibility and altruism, feelings of self-esteem, interest in job; though
economists concerned about residual incentives to act in firm’s interest over and beyond absence of rewards
and monitoring)
o monetary incentives:
comp package: salary, bonus and stock-based incentives
bonuses and shareholdings: substitutes or complements
comp base
straight shares or stock options:
exec comp controversy
o implicit incentives: keep job; avoid proxy fight; avoid bankruptcy or reorg;
o monitoring: by Boards, auditors, large shareholders, large creditors, investment banks, rating agencies
active monitoring: interfering to increase investors’ claims; exercise of control rights
speculative monitoring: adjust position in firm: invest further, hold, sell (the analyst)
o product market competition: beneficial effects; may also create gambling behavior
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Board of Directors:
• watchdogs or lapdogs:
o lack of independence: may be hand picked by CEO; may have business relationships; bribes: lucrative
consultancy etc; mutual interdependence of CEOs
o insufficient attention: unprepared and rely on management info
o insufficient incentives: mostly just fees and perks; huge barriers to liability
o avoidance of conflict: ongoing relationship
• Reforming the Board:
o teammates or referees
o knowledge versus independence: those closest to firm have knowledge but susceptible to conflicts of
interest
o Link from performance to board comp:
Cadbury report calls for: 1. nomination of recognized senior outside member where chairman
of the Board is CEO; 2. procedure for directors to take independent professional advice at
company’s expense; 3. majority of independent directors; 4. comp committee dominated by
nonexecutives directors and audit committee conferred to nonexecutive directors most whom
should be independent; also recommends against performance-based comp
Investor Activism:
• Active monitoring requires control:
o formal control: majority of voting shares etc.
o real control: sufficient ownership to build coalition
• proxy fight
• Pattern of ownership:
o pension funds play minor role in France, Germany, Italy and Japan; ownership concentration in such
countries is substantial; also cross-shareholdings
o ownership concentration: high in Italy, France, Germany, Sweden, Europe generally, East Asia
extremely dispersed in U.S. dispersed in Anglo-Saxon countries
o stability of holdings v. active management: Japan and German stable; Anglo-Saxon reshuffle
frequently
• Limits of Active Monitoring:
o who monitors the monitor: monitors not always acting in interest of their beneficiaries
o congruence w/ other investors:
undermonitoring: substantial free-riding by small institutional shareholders
collusion w/ management: quid pro quo
self-dealing: transactions w/ affiliated firms
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o Cost of providing proper incentives to monitor: entails liquidity costs to cause long-term holding which
allows for proper monitoring
o Perverse effects on the monitorees: become short-term focused
o Legal, fiscal, and regulatory obstacles: liability for directors; holding restrictions once reach ownership
threshold; diversification rule;
Cadbury Report:
• Code of Best Practice:
o 1. Board of Directors
o 2. Non-Executive Directors
o 3. Executive Directors
o 4. Reporting and Controls
o Notes and add’l recommendations
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Reading 34: International Equity Benchmarks:
• Need for Float Adjustment: consider cross-holdings; no int’l equity benchmark uses full cap any more
• Trade-Offs in Constructing Int’l Indexes:
o Breadth v. investability: consider illiquidity of smallest-cap in emerging markets
o Liquidity and crossing opportunities v. index reconstitution effects: most popular and widely used
indexes and benchmarks have greater index level liquidity for investors seeking to buy or sell index
fund position or actively managed position resembling index
also program/portfolio trades: crossing, but with a broker
reconstitution effects: upward price pressure on stocks chosen for inclusion in index and vice
versa
o Precise float adjustment v. transaction costs from rebalancing: no longer matter of controversy: all
indexes have some float adjustment
float bands allow for less transaction costs
o Objectivity and transparency v. judgment:
• Emerging market benchmark: MSCI EMF for emerging markets (similar to MSCI EAFE for developed
markets)
• some transaction costs and reconstitution effects in index changes
Real Effects of Financial Market Integration: inflow of foreign investment, boom, currency appreciation
Contagion:
• speculative attacks on the currency?
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o after gov’ts follow policies inconsistent w/ peg?
o as self-fulfilling: investors just decide to speculate against and cause crisis?
• if self-fulfilling, then channel for contagion
• income effect channel: reduced growth and lower income levels after crisis reduce demand for imports from
other countries
• “wake up call” channel: second country also experienced similar negative macroeconomic conditions or
followed similar inconsistent policies
• other channels: credit crunch; forced-portfolio recomposition or liquidity effect
Other issues:
• Corporate finance: emerging markets as testing ground for legal institutions / agency theories
• Fixed Income: high correlation b/w emerging market debt and equity returns
• Market Microstructure: price discovery; liquidity
• Stock Selection: information asymmetry; returns not explained by traditional asset pricing models
• Privatization: transfer of productive resources from public sector to private sector
Also:
• tax issues
• determining suitability
• communication w/ client
• decision risk
• concentrated equity position of client in closely held company
Real Estate:
• types:
o direct: residences, commercial real estate, agricultural land
o indirect:
homebuilders, real estate operating companies, etc.
REITs
• Equity REITs own and manger office buildings, apartment buildings, shopping centers,
etc.
• Mortgage REITs invest >75% of assets in mortgages; lend money to builders and make
loan collections
• Hybrid REITs: operate real estate and buy mortgages
Commingled real estate funds (CREFs )
• Opened ended and closed ended (closed are usually leveraged)
• Private investment vehicles
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Separately managed accounts
Infrastructure funds:
• Designs, finances, and builds projects
• Financed by debt and equity
• Leased to public sector to operate; allows public sector to avoid raising debt
• Benchmarks and historical performance:
o Direct real estate: in U.S.: National Council of Real Estate Investment Fiduciaries (NCREIF) Property
Index;
Value weighted
Includes subindices for apartments, industrial, office and retail and by geographic region
Based on property appraisals; underestimate volatility
Not an investable index
o Indirect real estate investment:
NAREIT
• Real time market-cap weighted index of all REITs actively traded on NYSE and Amex
• Also monthly equity REIT index
• Also other specialized subindexes
• Note that the underlying REITs often leveraged
• Real Estate: Investment Characteristics and Roles:
o Has intrinsic value
o Substantial income component
o Lack of liquidity
o Large lot sizes
o High transaction costs
o Heterogeneity
o Immobility
o Low info transparency
o Factors: interest rates (real interest rates); term structure of interest rates; change in GDP; growth in
consumption; population growth; unexpected inflation
o Inflation hedge?
o Idiosyncratic variables
o Benefits:
Deductible mortgage interest
Permits more financial leverage
Direct control over property
Can obtain diversification through different geographic locations
Low volatility compared to public equities
o Disadvantages:
Not easy to divide parcels; only large part of portfolio
High cost of info
High broker commissions
Substantial operating and maintenance costs
Risk of neighborhood deterioration
Political risk on tax deductions
o Follows economic cycles
o Provides some diversification benefits relative to stock/bond portfolio, but relatively less effective than
hedge funds and commodities
But unsmoothed NCREIF provided greater diversification benefits
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o Apartments have highest risk-adjusted returns; office have lowest
Commodity Investments:
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• Types:
o Direct commodity investment: cash market purchase involving actual possession and storage
o Indirect commodity investment: say as equity in companies specializing in production
• Benchmarks:
o Reuters Jefferies/Commodity Research Bureau (RJ/CRB) Index – uses unequal fixed weights based on
perceived relative importance
o Goldman Sachs Commodity Index (GSCI) – arithmetic averaging of monthly component returns; total
return version and spot version
o Dow Jones-AIG Commodity Index (DJ-AIGCI)
o S&P Commodity Index (S&PCI)
• Historical performance:
o On stand-alone basis, commodities have lower Sharpe ratio than U.S. and world bonds and equities
o Correlations w/ traditional asset classes are close to zero
o Return components: spot return / price return; collateral return; roll return (positive for long in
backwardation market)
• Investment characteristics:
o Understand investment characteristics of commodities on sector- or individual-commodity level
o Special risk characteristics:
Unusually low correlations w/ equities and bonds
Price risk in periods of financial and economic distress
Long-term growth in world demand in limited supply: long-term trend growth
Generally business cycle sensitive
Determinants of return:
• 1. business cycle-related supply and demand:
• 2. convenience yield: embedded consumption timing option; inverse relationship b/w
level of inventories and convenience yield
o Samuelson effect: term structure of forward price volatility generally declines w/
time to expiration (mismatched supply and demand at shorter horizons, but
equilibrium in longer horizons)
• 3. Real options under uncertainty:
Inflation: “natural” sources of return; protection against unexpected inflation
• Positive correlation w/ unexpected inflation
• Roles:
o Potent risk diversifier
o Inflation hedge: classes such as livestock and agriculture exhibit negative correlation w/ unexpected
inflation as measured by monthly changes in inflation rate; storable commodities directly linked to
economic activity exhibit positive correlation w/ changes in inflation and have superior inflation-
hedging properties
Hedge Funds:
• Types:
o Equity market neutral: roughly equal exposure long and short
o Convertible arbitrage:
o Fixed-income arbitrage: mispricing based on term structure of interest rates or credit quality
o Distressed securities:
o Merger arbitrage:
o Hedged equity: not equity market neutral
o Global macro:
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o Emerging markets:
o Fund of funds
• Groups:
o Relative value
o Event driven
o Equity hedge
o Global asset allocators
o Short selling
• Fees:
o AUM fee and incentive fee
o High-water mark
• Initial Lock-up period: maybe 1 to 3 yrs
• Benchmarks:
o CISDM of the University of Massachusetts
o Credit/Suisse/Tremont
o EACM Advisors
o Hedge Fund Intelligence Ltd.
o HedgeFund.net
o HFR
o MSCI
o Dow Jones Hedge Fund Strategy benchmarks
o HFR hedge fund indices
o MSCI Hedge Invest Index
o Standard & Poor’s Hedge Fund Indices
• Differences in major manager-based hedge fund indices:
o Selection criteria: which hedge funds are included
o Style classification:
o Weighting scheme:
o Rebalancing scheme:
o Investability:
• Absolute return vehicles? Defined as having no benchmark, while estimates of alpha must be made relative to
a benchmark
o Can establish comparable portfolios using 1. single factor or multifactor methodology; 2. optimization
to create tracking portfolios w/ similar risk and return characteristics
• Historical performance:
o HFCI has higher Sharpe ratio than any other reported assets; correlation of 0.59 w/ S&P 500
o b/c equity hedge funds load on similar return factors as S&P 500, offer less diversification than many
relative-value strategies and can be more rightly considered return enhancers
• Interpretation Issues:
o Biases in Index Creation: concern is whether index reflects actual relative sensitivity of hedge funds to
various market conditions, such that each index provides info on true diversification benefits of
underlying hedge fund strategies
o Relevance of Past Data on Performance: best forecast of future returns is one that is consistent w/ prior
volatility and not one that is consistent w/ prior returns
o Survivorship Bias
o Stale price bias: results in lower reported correlations
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o Backfill bias (inclusion bias): when missing past return date for component of index are filled at
discretion of component when it joins the index—only components w/ good past results will be
motivated to supply them
• Investment Characteristics:
o Common set of return drivers based on trading strategy factors (e.g., option-like payoffs) and location
factors (e.g., payoffs from buy-and-hold policy) help explain returns of each strategy
o Long-biased hedge funds are return enhancers rather than diversifiers
o Hedge funds attempting to be least affected by market direction may be diversifiers
• Role in portfolio:
o Scrutinize managers
o Emphasize style selection
o Often have option characteristics that present challenge when relying on MVO
o Mean-variance improvement
o Lower skewness and higher kurtosis
Adopt mean-variance, skewness and kurtosis-aware approach to hedge fund selection
Invest in managed futures: tends to have skewness opposite many hedge funds
• Other issues:
o Young funds outperform old funds on a total-return basis, or at least old funds do not outperform
young ones
o On average, large funds underperform small funds
o FOFs may provide closer approximation to return estimation than indices do
o Performance fees and lock-up periods: some evidence of better performance of funds w/ quarterly
lock-ups over monthly
o FOFs: style drift: may time one market and have become less useful in asset allocation strategies
o FOFs: don’t usually impose lock-up periods
o Fund size: smaller more nimble and higher risk-adjusted returns; larger have more clout
o Age (vintage) effects
• Hedge Fund Due Diligence:
o Structure
o Strategy
o Performance data
o Risk
o Research
o Administration
o Legal
o References
• Performance Evaluation:
o Returns: monthly usually;
Rate of return = [(Ending value of portfolio) – (Beginning value of portfolio)]/(Beginning value
of portfolio)
Usually compounding over 12 mos; frequency can materially affect reported performance b/c
entry and exit and drawdowns
Typically “look through” leverage as if asset were fully paid
Rolling return: moving average of holding-period returns that matches investor’s time horizon:
RR n ,t = ( Rt + Rt −1 + Rt −2 + ... + Rt −n ) / n ; RR12 ,t = ( Rt + Rt −1 + Rt −2 + ... + Rt −12 ) / 12
o Volatility and Downside Volatility:
Annualize monthly by multiplying by 12
Positive excess kurtosis and skewness
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∑ [min ( r )]
n
2
t − r * ,0
Downside deviation = i =1
n −1
Maximum drawdown: largest difference b/w high-water point and subsequent low
Length of drawdown period: time from high-water mark until next high-water mark
o Performance Appraisal Measures:
Sharpe ratio; limitations:
• Time dependent and increases proportionally w/ square root of time
• Doesn’t account for asymmetrical return distribution or negative or positive skewness
• Illiquid holdings bias upward
• Doesn’t account for serial correlation
• Doesn’t account for correlations w/ other investments
• Not very good predictive ability for hedge funds
• Can be gamed: lengthening measurement interval; compounding monthly returns but
calculating standard deviation from not compounded monthly returns
• Writing out of the money puts and calls on a portfolio
• Smoothing of returns w/ derivative structures
• Getting rid of extreme returns w/ total return swaps
Sortino ratio = (Annualized rate of return – annualized risk-free rate)/Downside deviation
Gain-to-loss ratio = (Number of months w/ positive returns / Number of months w/ negative
returns) x (Average up-month return/ average down-month return)
Calmar ratio
Sterling ratio
o Correlations: assumes normality
o Skewness and Kurtosis: positive skewness is good; high kurtosis means extreme returns
o Consistency:
Number of positive months
% positive months
Avg return in up-months
Number of negative months
% negative months
Avg return in down-months
Avg monthly return in index up-months
Avg monthly return in index down-months
Managed Futures: private pooled investment vehicles that can invest in cash, spot, and derivative markets for benefit
of investors and have ability to use leverage; run by general partners known as commodity pool operators (CPOs)
• skill based, absolute-return strategies
• types: private commodity pools; separately managed accounts; publicly traded commodity funds
o investment style: systematic (rule based or trend based) or discretionary (based on trader beliefs or
economic data)
o markets traded: currency, financial, or diversified (financial, currency and commodities)
o trading strategy (e.g., trend following or contrarian)
• Benchmarks:
o Mount Lucas Management Index: based on technical trading rules
o CISDM CTA: based on peer group
• Performance:
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o standard deviations comparable to U.S. blue-chip stocks;
o Sharpe ratio better than equities but not bonds
o correlations slightly negative w/ equities; 0.42 and 0.46 w/ U.S. and global bonds respectively
• Interpretation:
o survivorship bias
• Investment characteristics: potential for improved risk and return
o derivative markets are zero-sum games: passively managed, unlevered futures position should earn
risk-free return on invested capital less management fees and transaction costs
o momentum strategies and trend following; resulting in positive skewness
o diversification capabilities (to stocks and bonds)
• Roles:
o diversification from stocks, bonds and hedge funds
o improved Sharpe ratios
• other issues:
o performance persistence;
o leveraged
Distressed Securities: securities of companies in financial distress or near bankruptcy or already in Chapter 11:
• many investors cannot hold b/c of IPS; unresearched: exploit the inefficiency
• skill in negotiation or influencing management
• Types:
o hedge fund structure: more liquid
o private equity fund structure: closed end
o types of assets:
publicly traded debt and equity securities in distressed company
newly issued equity of co emerging from reorg (orphan equity)
bank debt and trade claims
“lender of last resort” notes
variety of derivative instruments for hedging purposes
• Benchmarks:
o subindexes of major hedge fund indices: EACM, CISDM, HFR; Altman-NYU Salomon Center
Defaulted Public Bond and Bank Loan Index
• Performance:
o non-normal: negative skewness (downside risk); large kurtosis (outlier events)
o high mean returns w/ low standard deviation: high Sharpe ratio
o low correlation w/ world stock and bond investments
• investment characteristics:
o consider IPS restrictions (limits to investment grade; might be required to sell fallen angels)
• Roles:
o Long-Only Value Investing: investing in undervalued distressed securities; if public debt: high-yield
investing; if orphan equities: orphan equities investing
o Distressed Debt Arbitrage: purchasing co’s traded bonds and selling short its equity
o Private Equity: become major creditor to influence
prepackaged bankruptcy: converting distressed debt to private equity
o Risks:
event risk
market liquidity risk
market risk
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J factor risk: judge’s track record in adjudicating bankruptcies and restructuring
not normal
illiquid
stale pricing
• other issues:
o Bankruptcy in U.S. v. other countries:
other countries, bankruptcy usually liquidation; rehabilitation of debtor is distinctive to U.S.
o Absolute Priority Rule: satisfy senior claims first (but new value exception)
o Prepackaged Bankruptcy Filing: debtor agrees in advance w/ creditors on plan of reorg b/f formally
files for Chap 11 protection
Commodity swaps: fixed price of swap is weighted average of corresponding forward prices.
n
∑ P( 0, t ) F i 0 ,t i
F= i =1
n
∑ P( 0, t )
i =1
i
∑Q P( 0, t ) Fti i 0 ,t i
∑Q P( 0, t )
i =1
ti i
Because fixed swap payment equal, while the futures prices vary, the mismatch creates a borrowing/lending
component.
F0,T = S 0 e ( r −δ )T
Synthetic commodity: long forward plus zero coupon bond w/ face value equal to forward price
Nonstorability: Electricity:
• different prices in summer and winter and in night and day
Gold Futures:
• Easily storable; often sold certificated; Has lease rate: use lease formula to determine lease rate; synthetic gold
generally preferable way to obtain exposure
Natural Gas:
• Seasonality and storage costs
• Difficult to transport internationally so, forward curves vary regionally
• Costly to store
• In U.S., demand highest in winter months
• Steady stream of production w/ variable demand (as opposed to corn)
Oil:
• Easy to transport
• Easier to store than gas
Hedging Strategies:
• Basis risk: the price of the commodity underlying the futures contract may move differently than price of
commodity you are hedging
o Say based on differing delivery locations and times
o Say differing grades
• Strip hedge: buy commodity over time for over-time obligation;
• stack hedge: enter futures w/ single maturity w/ number of Ks selected so that changes in PV of future
obligations are offset by changes in value of “stack” of futures Ks.
• Stack and roll: stacking futures Ks in near-term K and rolling over into new near-term K (profitable in
backwardation)
• Weather derivatives: (a cross hedge): contracts that make payments based upon realized characteristics of
weather
o Heating degree-day
o Cooling degree-day
Risk Governance:
• Enterprise risk management (ERM): centralized risk management for overall company at level close to senior
management. Steps:
o 1. Identify each risk factor exposed to
o 2. quantify each exposure’s size in money terms
o 3. map inputs into risk estimation calculation
o 4. identify overall risk exposures as well as contribution from each factor
o 5. set reporting process to senior mgmt: committee
o 6. monitor compliance
Identifying Risks: market risk (interest rate risk, exchange rate risk, equity price risk, commodity price risk); credit
risk; liquidity risk; operational risk; model risk; settlement risk; regulator risk; legal/contract risk; tax risk; accounting
risk; sovereign/political risk
• Market risk: interest rate risk, exchange rate risk, equity price risk, commodity price risk
• Credit risk: counterparty risk
• Liquidity risk: that financial instrument cannot be purchased or sold w/o significant concession in price
o Size of Bid-ask spread: a measure of liquidity risk
o Volume
• Operational Risk: risk from failure in co’s systems and procedures or from external events
• Model Risk:
• Settlement (Herstatt) Risk: paying counterparty while counterparty is declaring bankruptcy
o May net to reduce
• Regulatory Risk: how transactions will be regulated or that regulation will change
• Legal/Contract Risk: say fraud or illegal contract, or otherwise unenforceability of K
• Tax Risk: uncertainty associated w/ tax laws
• Accounting Risk: uncertainty about how transaction should be recorded and potential for accounting rules and
regulations to change
• Sovereign and Political Risks: changing political conditions in countries
o Sovereign risk: where borrower is gov’t
o Political risk: changes in political environment
• Other risks:
o ESG risk: environmental, social and governance
o Performance netting risk: potential for loss resulting from failure of fees based on net performance to
fully cover contractual payout obligations to individual portfolio managers that have positive
performance when other portfolio managers have losses and when there are asymmetric incentive fee
arrangements w/ the portfolio managers
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o Settlement netting risk: that liquidator of a counterparty in default could challenge netting arrangement
so that profitable transactions are realized for benefit of creditors
Measuring Risk
• Measuring Market risk:
o standard deviation / volatility
o active risk / tracking risk / tracking error volatility
o beta, duration, delta
o convexity, gamma
o vega, theta
• Value at Risk (VAR): probability-based measure of loss potential, expressed as % or units of currency;
“estimate of loss (in money terms) that we expect to be exceeded with a given level of probabiliby over a
specified time period.”
o requires: 1. probability level; 2. time period; 3. model
o analytical or variance-covariance method: infer VAR from standard deviation and normal distribution
delta-normal method: assume that change in option price is assumed to equal change in
underlying price multiplied by delta (avoids non normality of options)
o Historical Method (historical simulation method): set VAR according to actual historical experience /
historical distribution
nonparametric
o diversification effect: difference b/w sum of individual VARs (say for different divisions) and total
VAR
o Monte Carlo Simulation Method:
o “Surplus at Risk”: VAR as it applies to pension funds
o backtesting: process of comparing number of violations of VAR thresholds w/ figure implied by user-
selected probability level
• Extensions and Supplements to VAR:
o Incremental VAR (IVAR): measures incremental effect of an asset on VAR
o cash flow at risk (CFAR)
o earnings at risk (EAR)
o tail value at risk (TVAR): VAR plus the expected loss in excess of VAR, when such excess loss occurs
• Stress Testing: identify unusual circumstances that could lead to losses in excess of typical
o Scenario analysis: under different states of the world
actual extreme events
hypothetical events
o Stressing Models:
factor push: push prices and risk factors of underlying model in most disadvantageous way and
work out combined effect
maximum loss optimization: optimize mathematically the risk variable that will produce the
max loss
worst-case scenario analysis
• Measuring Credit Risk: likelihood of loss and amount of associated loss
o current credit risk (jump-to-default risk): risk of events happening in immediate future
o credit VAR (default VAR or credit at risk)
o option-pricing theory and credit risk: bond w/ credit risk can be viewed as default-free bond plus
implicit short put option on the assets written by bondholders for stockholders
o credit risk of forward Ks: current credit risk at expiration; otherwise, potential credit risk
o credit risk of swaps: credit risk present at series of points
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for interest rate and equity swaps: potential credit risk is largest during middle period of swap’s
life
currency swaps have greatest credit risk b/w midpoint and end of life
o credit risk of options: unilateral credit risk
• Liquidity Risk:
o maybe liquidity-adjust VAR estimates
• Measuring Nonfinancial Risks: maybe more suitable for insurance (maybe extreme value theory)
o operational risk:
o Basel II
Managing Risk:
• key components:
o effective risk governance model, which places overall responsibility at senior mgmt level, allocates
resources effectively and features appropriate separation of tasks b/w revenue generators and those on
control side of business
o appropriate systems and technology to combine info analysis in such way as to provide timely and
accurate risk info to decision makers
o sufficient and suitably trained personnel to evaluate risk info and articulate it to those who need info
for purposes of decision making
• Managing Market Risk:
o Risk Budgeting: might be set in terms of VAR units or on individual transaction size, amount of
working capital needed to support the portfolio or amount of losses acceptable for any given time
period, or IR for portfolio managers, or risk to the surplus. Also:
performance stopouts
working capital allocations
VAR limits
Scenario Analysis limits
risk factor limits
position concentration limits
leverage limits
liquidity limits
• Managing Credit Risk: one-sided risk
o Reducing Credit Risk by Limiting Exposure: limit transactions w/ any single counterparty
o Reducing Credit Risk by Marking to Market: OTC derivatives (options not marked to market)
o Reducing Credit Risk with Collateral: usually cash or highly liquid, low-risk securities
o Reducing Credit Risk with Netting: used in two-way contracts (forwards, swaps); also netting among
multiple contracts: closeout netting
cherry picking: bankrupt company enforcing only profitable contracts (not netting)
o Reducing Credit Risk w/ Minimum Credit Standards and Enhanced Derivative Product Companies:
Enhanced Derivatives Products Companies (EDPCs): subsidiaries separated from parent’s
debts so as to minimize counterparty risk
o Transferring Credit Risk with Credit Derivatives:
credit default swaps
total return swap
credit spread option
credit spread forward
• Performance Evaluation:
o Sharpe ratio
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o Risk-Adjusted Return on Capital (RAROC): divides expected return by a measure of capital at risk
o Return over Maximum Drawdown (RoMAD): average return in given year over maximum difference
b/w high-water mark and subsequent low
o Sortino Ratio: Sortino Ratio = (Mean portfolio return – minimum acceptable return (MAR))/Downside
deviation (below MAR)
• Capital Allocation: measure of capital:
o 1. nominal, notional, or monetary position limits (seldom sufficient risk control)
o 2. VAR-based position limits
o 3. Maximum loss limits
o 4. Internal capital requirements: say using VAR
o 5. Regulatory capital requirements
• Psychological and Behavioral Considerations: risk governance should anticipate points in cycle when
incentives of risk takers diverge from those of capital allocators (say when fall into negative performance)
o Hedging Total Currency Risk: both translation risk and economic risk
• Influence of the Basis: futures and spot exchange rates differ by a basis
o Basis risk: basis equals interest rate differential
o Implementing hedging strategies:
1. short-term Ks, rolled over at maturity
2. Ks w/ matching maturity
3. long-term Ks w/ maturity extending beyond hedging period
o Hedging Multiple Currencies:
try to find Ks on other currencies that are closely correlated w/ (nonactively traded) investment
currencies
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optimization techniques can be used to construct hedge w/ futures Ks in only a few currencies
practice:
• select independent major currencies w/ futures Ks available
• run multiple regression of domestic currency returns of portfolio on futures returns of
selected currencies
• use regression coefficients as hedge ratios
Insuring and Hedging w/ Options: as insurance or as hedging by accounting for relationship b/w premium and
underlying exchange rate
• Insuring w/ Options:
o Net dollar profit on put = V0 ( K − S t ) −V0 P0 when K>St; = −V0 P0 otherwise.
o Not a good hedge unless variations in spot price swamp the premium
• Dynamic hedging w/ options: match dollar loss (gain) in underlying w/ dollar gain (loss) in option
o Good currency hedge requires holding –V0/δ options; hedge ratio is 1/δ; (delta hedge)
o Hedge ratio fluctuates
o Where direction of currency movement is clearly forecasted, currency futures provider cheaper hedge
o Dollar beta: beta times portfolio value; for futures, beta times futures price
β − β S S
o Number of futures contracts to obtain target beta: N f = T
f
β f
• Creating equity out of cash: long stock = long risk-free bond + long futures
V (1 + r )
T
o Rounded off number of futures contracts to buy: N *f = ; resulting investment is no longer V
qf
N *f qf
but V*: V =
*
; and dividends are treated as reinvested and result in larger number of contracts
(1 + r ) T
than if just received the dividends, the implicit number of contracts starting with (growing to the
N *f q
previous number of contracts by the dividend reinvestment) is ; however transaction does not
(1 + δ ) T
actually capture dividends, just the performance of the index
o Equitizing Cash: do above transaction; maintains liquidity of cash
o Consider the under/over pricing of the futures
• Creating Cash out of Equity: Long stock + short futures = Long risk-free bond
o Effectively convert (V/S)(1+δ)T to cash;
V (1 + r )
T
o N *f = −
qf
− N *f qf
o V = *
(1 + r ) T
Asset Allocation w/ Futures:
• If reducing equity position, use futures to reduce the beta of the dollar amount of such reduction to zero: say
want to turn $10M of equity position to bonds, sell futures such that beta on $10M is zero; then buy bond
futures.
MDUR T − MDUR B B
o For the bonds: N bf =
f
MDUR f b
• Pre-Investing in an Asset Class: don’t have the cash currently, but will in future; long underlying + loan = long
futures; like a fully leveraged position in the underlying;
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If only foreign stock market return hedged, portfolio return is foreign risk-free rate b/f
converting to domestic currency; if both foreign stock market and exchange rate risk are
hedged, return equals domestic risk-free rate
Futures or Forwards?
• Risks that have specific dates: use forwards
• Forward market been around for longer than futures market and is liquid
• Dealers of forwards use futures to quickly hedge their own risk
• Forwards allow to keep private transaction activity
o Bear spreads: makes money if market goes down: sell call w/ exercise price and buy call w/ higher
exercise price; or: buy put w/ exercise price and sell put w/ lower exercise price
Value at expiration: VT = max( 0, X 2 − ST ) − max( 0, X 1 − ST )
Profit: Π = max( 0, X 2 − ST ) − max( 0, X 1 − S T ) − p2 + p1
Maximum profit = X 2 − X 1 − p 2 + p1
Maximum loss = p 2 − p1
Breakeven: ST = X 2 − p2 + p1
*
o Butterfly spreads: combines bull and bear spread: buy calls w/ exercise price X1 and X3 and sell two
calls w/ exercise price X2
Value at expiration: VT = max ( 0, ST − X 1 ) − 2 max ( 0, ST − X 2 ) + max ( 0, ST − X 3 )
Profit: Π = max ( 0, ST − X 1 ) − 2 max ( 0, ST − X 2 ) + max ( 0, ST − X 3 ) − c1 + 2c2 − c3
Maximum profit = X 2 − X 1 − c1 + 2c2 − c3
Maximum loss = c1 − 2c2 + c3
Breakeven: ST = X 1 + c1 − 2c2 + c3 and ST = 2 X 2 − X 1 − c1 + 2c2 − c3
* *
Strategy based on expectation of low volatility in underlying; profitable if less volatility than
market expects; if expect to be more volatile than market expects, sell the butterfly spread
Can create w/ puts: buy puts w/ exercise prices X1 and X3 and sell two puts w/ exercise price
X2.
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• Combinations of Calls and Puts: (aka range forward or risk reversals)
o Collars: underlying plus long put plus short call
zero-cost collar: premium received for call offsets premium paid for put
Value at expiration: VT = ST + max( 0, X 1 − ST ) − max ( 0, X 2 − ST )
Profit: Π = ST + max ( 0, X 1 − ST ) − max ( 0, X 2 − ST ) − S 0 ; (assuming zero-cost collar)
maximum profit = X2 – S0
maximum loss = S0 – X1
breakeven: ST = S 0
*
o Straddle: buy call and put as same price; bet on large volatility
makes sense only when investor believes market will be more volatile than everyone else
value at expiration: VT = max ( 0, ST − X ) + max( 0, X − ST )
profit: Π = max ( 0, ST − X ) + max ( 0, X − ST ) − c0 − p0
maximum profit = ST – c0 – p0; ∞
maximum loss = c0 + p0
breakeven ST*= ST + c0 + p0 or ST – (c0 + p0)
o Strap: add call to straddle
o Strip: add put to straddle
o Strangle: straddle with different exercise prices; similar graph as straddle but w/ flat section in stead of
point on bottom
o Box Spreads: combination bear and bull spread: buy call w/ exercise price X1 and sell call w/ exercise
price X2 and buy put w/ exercise price X2 and sell put w/ exercise price X1.
value at expiration:
VT = max( 0, ST − X 1 ) − max( 0, ST − X 2 ) + max( 0, X 2 − ST ) − max( 0, X 1 − ST ) ; thus: X2 – X1
profit: Π = X 2 − X 1 − ( c1 − c2 + p2 − p1 )
maximum profit = (same as profit)
maximum loss = (no loss possible, given fair option prices)
Breakeven: no breakeven; transaction always earns risk-free rate, given fair option prices
Using Interest Rates Swaps to Convert a floating-rate loan to a fixed-rate loan (and vice versa)
• (swaps are most common instrument used to manage interest rate risk)
• duration: pay-fixed is similar to long position in floating-rate bond and short position in fixed-rate bond.
• swaps function as hedge from planning and accounting perspective, but tremendously speculative from market
value perspective
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Strategies and Applications for Managing Exchange Rate Risk:
• Converting a loan in one currency into a loan in another currency:
o say issue bond in home country in home currency, swap proceeds for foreign currency and receive
interest payments in home currency (to further pay bond payments in home country) while paying
interest in foreign currency; (may have to come up with additional proceeds to cover the fixed
payments on the home country bond); at end of life, undo notional amounts of swap.
• Converting Foreign Cash Receipts into Domestic Currency: no exchange of notional principals; say pay fixed
amount in foreign currency and receive fixed amount in home currency
• Using Currency Swaps to Create and Manage Risk of Dual-Currency Bond: interest paid in one currency and
principal paid in another: say multinational generates sufficient cash in foreign currency to pay interest but not
enough to pay principal; (equivalent to issuing ordinary bond in one currency and combining w/ currency
swap that has no principal payments)
Costs of Trading:
• transaction cost components:
o explicit costs: broker commissions, taxes, stamp duties and exchanges fees
o implicit costs:
bid-ask spread
market impact
missed trade opportunity
delay costs (b/c of size of order and liquidity of market)
o (measures)
time-of-trade midqoute
volume-weighted average price (VWAP): avg price security traded at during day weighted by
trade volume
implementation shortfall: difference b/w money return on notional or paper portfolio in which
positions are established at prevailing price when decision to be made (decision price) and
actual portfolio return
• explicit costs (commissions, taxes, fees)
• realized profit/loss: price movement from decision price (often using previous day’s
close). though if broken over several days, each day has its own benchmark
• Delay costs (slippage): close-to-close price movement over day order placed when
order is not executed that day and based on amount of order actually subsequently
filled; This is zero for any shares traded same day as decide to trade.
• missed trade opportunity cost (unrealized profit/loss): price difference b/w trade
cancellation price and original benchmark price based on amount of order that was not
filled
market adjusted implementation shortfall: difference b/w money return on notional or paper
portfolio and actual portfolio return, adjusted using beta to remove effect of return on market
• if 1% market move and beta of 1.0, then subtract 1% from implementation shortfall; the
1% is not counted against you
Objectives in Trading
Focus Uses Costs Advantages Weaknesses
Liquidity at any Immediate execution High cost due to Guarantees execution High potential for
cost (I must trade) in institutional block tipping market impact and
size supply/demand info leakage
balance
Need trustworthy Large-scale trades; Higher commission; Hopes to trade time Loses direct control
agent (possible low-level advertising possible leakage of for improvement in of trade
hazardous trading info price
situation)
Costs are not Certainty of Pays the spread; may Competitive, market- Cedes direct control
important execution create impact determined price of trade; may ignore
tactics w/ potential
for lower cost
Advertise to draw Large trades w/ lower High operational and Market-determined More difficult to
liquidity info advantage org costs price for large trades administer; possible
leakage to front-
runners
Low cost whatever Non-info trading; Higher search and Lower commission; Uncertainty of
the liquidity indifferent to timing monitoring costs opportunity to trade trading; may fail to
at favorable price execute and create
need to complete at
later, less desirable
price
• Automated Trading:
o algorithmic trading: automated electronic trading subject to quantitative rules and user-specified
benchmarks and constraints
o smart routing: use algorithms to route orders to most liquid venues
o classifications of algorithmic execution systems:
Logical Participation Strategies:
• Simple Logical Participation Strategies:
o break up order over time according to prespecified volume profile: a VWAP
strategy
o or time-weighted average price (TWAP) strategy: assumes flat volume and
trades in proportion to time
o or percentage-of-volume strategy
• Implementation Shortfall Strategies: solves for optimal strategy to minimize trading
costs as measured by implementation shortfall
Opportunistic Participation Strategies: post some orders at beneficial prices, use hidden orders
and take advantage of crossing networks, seize liquidity when arises
Specialized Strategies:
• passive order strategies: no guarantee of execution
• “hunter” strategies: seek liquidity
• market-on-close algorithms: target closing price
• smart routing
Monitoring:
• Investor Circumstances and Constraints:
o changes in investor circumstances and wealth
o changing liquidity requirements
o changing time horizons
o tax circumstances
o changes in laws and regulations
o unique circumstances: say emotional ties to holding or SRI (socially responsible investing)
• Market and Economic Changes:
o Changes in asset risk attributes: mean return, volatility, correlations
o market cycles: tactical adjustments
o central bank policy
o yield curve and inflation
• Monitoring the portfolio:
o events and trends affecting prospects of individual holdings and asset classes
o changes in asset values that create unintended divergences from client’s strategic asset allocation
Rebalancing the Portfolio: 1. adjusting portfolio to strategic allocation; 2. changes from changes to investor’s
objectives and constraints or capital market expectations; 3. tactical asset allocation. here, discuss only 1.
• cost/benefit:
o drifts from strategic allocation results in expected utility loss
o level of portfolio risk may drift upward (higher risk returning more and taking greater % of portfolio)
o drift toward holding over priced assets
rebalancing by selling appreciated assets and buying depreciated assets can be seen as
contrarian
o transaction costs:
explicit costs
• illiquid assets; but may be able to accomplish some of rebalancing through cash flows
implicit costs
• bid-ask spread
• market impact
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o tax costs: incur short- or long-term capital gains; reduces deferral benefit from long-term capital gains
• Rebalancing disciplines:
o Calendar rebalancing: on periodic basis
o Percentage-of-Portfolio Rebalancing:
ad hoc approaches: say +/- 5% points of target allocation, or +/- 10% of target allocation %:
target +/- (target allocation x P%).
ad hoc doesn’t account for 1. transaction costs; 2. risk tolerance: tracking risk v. strategic asset
allocation; 3. correlation; 4. volatility; 5. volatilities of other asset classes
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• Constant-Proportion Strategy: CPPI: dynamic strategy in which target equity allocation is function of value of
portfolio less floor value:
o Target investment in stocks = m x (portfolio value – floor value)
o consistent w/ zero tolerance for risk when cushion is zero
o if m is greater than 1, then: constant-proportion portfolio insurance (CPPI)
consistent w/ higher tolerance for risk than buy-and-hold strategy
sell shares as stock value declines and buy shares as stock values rise
Fund Sponsor’s Perspective: enhances effectiveness of fund’s investment policy by acting as feedback and control
mechanism
Investment Manager’s Perspective: feedback and control loop, helping to monitor proficiency of various aspects of
portfolio construction process
3 components of performance evaluation: 1. account’s performance? (performance measurement) 2. why did account
produce observed performance? (performance attribution) 3. luck or skill? (performance appraisal)
Performance Measurement:
• w/o intraperiod external cash flows
MV1 − MV 0
o rt =
MV 0
MV1 − ( MV0 + CF )
o cash flow at start of period: rt =
MV0 + CF
( MV1 − CF ) − MV0
o cash flow at end of period: rt =
MV0
• Total Rate of Return: measures increase in investor’s wealth due to both investment income and capital gains
• Time-Weighted Rate of Return (TWR): compound rate of growth over stated evaluation period of one unit of
money initially invested in the account; requires account be valued every time external CF occurs
o chain linking: create wealth relative by adding return to 1; multiply all wealth relatives for cumulative
wealth relative; subtract one; or take to time period power to weight by time
o requires valuation on each date of CF
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• Money-Weighted Rate of Return (MWR): the IRR
o MV 1 = MV 0 (1 + R ) m + CF1 (1 + R ) m−L (1) + ... + CF n (1 + R ) m−L ( n )
• Linked Internal Rate of Return: take MWR of frequent periods and chain-link those
• (account valuations should be reported on trade-date, fully accrued basis: that is stated value of account should
reflect impact of unsettled trades and any income owed by or to the account but not yet paid)
Benchmarks:
• P = M + S + A: portfolio performance is equal to market return plus style return (together the benchmark
return) plus the active management return
• Properties of Value Benchmark:
o unambiguous
o investable
o measurable
o appropriate
o reflective of current investment opinions
o specified in advance
o owned
• Types of Benchmarks:
o absolute: say a return objective; not investable and not really valid benchmark
o manager universes: median manager or fund from broad universe; measurable, but not otherwise valid
benchmark
critique of median manager benchmark: not investable, is ambiguous, can’t verify
appropriateness, subject to survivor bias
o Broad market indexes: say S&P 500; may not reflect style
o Style Indexes: still may not reflect manager’s style
o Factor-Model-Based:
market model is one factor (beta)
normal portfolio: portfolio w/ exposures to sources of systematic risk that are typical for
manager, using manager’s past portfolios as guide
o Returns-Based: constructed using 1. series of manager’s account returns (ideally monthly and back to
beginning) and 2. series of returns on several investment style indexes over same period; allocation
algorithm solves from combination of investment style indexes that most closely tracks account’s
return
o Custom Security-Based: simply manager’s research universe weighted in a particular fashion
Building custom security-based benchmarks: steps:
• identify prominent aspects of manager’ investment process
• select securities consistent w/ investment process
• devise weighting scheme for benchmark securities, including cash position
• review preliminary benchmark and make modifications
• rebalance benchmark portfolio on predetermined schedule
o Tests of Benchmark Quality:
minimal systematic biases or risks in benchmark relative to account
tracking error: should reduce noise in performance evaluation process
risk characteristics: should systematically differ over time (okay to rotate from greater and
lesser, but shouldn’t stay on one side)
coverage: should have high overlap of securities
turnover: of the benchmark: if too high, then not really investable
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positive active positions: high proportion of positive active positions is good; high proportion
of negative active positions indicates not very good benchmark fit
o Hedge Funds and Hedge Fund Benchmarks: tend to be “absolute return”, have investment strategies
that incorporate high degree of optionality (skewness), but usually have clearly definable investment
universes
i =1
of the total fund’s beginning value and net external cash inflows by difference b/w the
manager’s benchmark return and the return of the manager’s asset category, and then summing
across all managers; (if stop here, would be passive in the benchmark)
∑ w × w × (r − rBij ) ;
A M
assumes that fund sponsor has invested in each of the managers according to managers’ policy
allocations
6. allocation effects: incremental contribution from difference b/w fund’s ending value and
value calculated at investment manager level
• Micro attribution: investment results of individual portfolios relative to designated benchmarks
[ ]
o value added: rv = ∑ ( w pi − wBi ) × ( ri − rB ) ; from both differing weights and differing returns from
n
i =1
securities selection: outperform only if both positive or both negative; underperform if one negative
and other positive (e.g., overweighting underperforming securities, or underweighting outperforming
securities)
o factor models (instead of looking at each individual security): market model is just beta.
sector weighting/stock selection micro attribution:
• return may be weighted sum of sectors: and thus difference to actual return is from
S S
• based on buy and hold: so category for trading and other to catch these effects
rv = ∑( w pj − wBj )( rBj − rB ) + ∑( w pj − wBj )( rpj − rBj ) + ∑ wBj ( rpj − rBj )
S S S
• j =1 j =1
j =1
PureSector Allocation Allocation / SelectionI nteraction Within −SectorSele ction
o pure sector allocation return: equals difference b/w allocation (weight) of
portfolio to given sector and portfolio’s benchmark weight for that sector, times
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the difference b/w the sector benchmark’s return and the overall portfolio’s
benchmark return, summed across all sectors
o within-sector selection return: equals difference b/w return on portfolio’s
holdings in given sector and return on corresponding sector benchmark, times
weight of benchmark in that sector, summed across all sectors
o allocation/selection interaction return: joint effect of portfolio managers’ and
security analyst’s decisions to assign weights to both sectors and individual
securities: difference b/w weight of portfolio in given sector and portfolio’s
benchmark of that sector, times difference b/w portfolio’s and benchmark’s
returns in that sector, summed across all sectors
can also have factor model based on fundamentals: company’s size, industry, growth
characteristics, financial strength, and other factors
o Fixed Income Attribution:
instead of sectors: gov’t bonds, agency and investment-grade corporate credit bonds, high-yield
bonds, mortgage-backed securities, etc.
determinants: changes in general level of interest rates; changes in sector, credit quality,
individual security differentials or nominal spreads to yield curve
yield curve twists, steepening, flattening
Total portfolio return:
• effect of external interest environment
o return of default-free benchmark assuming no change in forward rates
o return due to change in forward rates
• contribution of management process:
o return from interest rate management: performance from predicting interest rate
changes (also duration, convexity, and yield-curve shape change)
o return from sector/quality management: from selecting right issuing sector and
quality group
o return from selection of specific securities: specific securities w/i sector
o return from trading activity: effect from sales and purchases (residual)
• Performance Attribution:
o rj0 = I j + ( p j − I j ) + d j + c j
o
r= ∑w I j j + ∑w ( p
j j −Ij) + ∑w d j j + ∑w c j j
j
j
j
j
Market Re turnCompan ent SecuritySe lectionCon tribution YieldCompo nent CurrencyCo mponent
o Asset allocation:
r= ∑ wI *
j j0 + ∑ (w − w )I + ∑ (w c − w C ) + ∑ w ( p − I ) + ∑ w d
j
*
j j j j
*
j j j j j j j
j
j j j
j
I n 'ltB e n c h Rm teau r *kn I M a r k ec t aA t li loo n rCi bo un t ti o Cn u r r e nl oc cy aA t li on nt rCi bo u2 t i oSne c u r liet yc St i eo nt rCi bo un t i oY ni e l d C no emn pt o
here Ij0 is return on market index j, translated into base currency 0: Ij0 = Ij + Cj
o can also attribute based on:
Market timing
Industry and Sectors
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Factors and Styles
Risk Decomposition
o Measuring active currency exposure relative to benchmark:
any deviations from benchmark should be thought of as active exposure
using derivatives:
• linear approximation for forward sale: c j = s j + R j − R0 : exchange rate movement plus
f
o σ total =
1 T
∑
T −1 t =1
( ) 2
rt − r ; if monthly, annualize by multiplying by 12
o σ er =
1 T
∑
T −1 t =1
( )
ert − er
2
• Risk-Adjusted Performance:
o Sharpe ratio
o Treynor ratio
o Jensen measure
o (consider problems from what constitutes “passive” world market portfolio)
o Information ratio
• Risk Allocation and Budgeting: 1. absolute risk allocation among asset classes; 2. active risk allocation of
managers in each asset class
• Potential Biases in Risk and Return:
o infrequently traded assets
o option-like investment strategies
o survivorship bias: return
o survivorship bias: risk
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GIPS governance:
• GIPS Executive Committee (formerly Investment Performance Council)
i. Four standing subcommittees:
• GIPS Council: works w/ Country Sponsors in development, promotion and maintenance
of standards
• Interpretations Subcommittee: provides guidelines for new issues
• Practitioners/Verifiers Subcommittee: forum for 3rd-party service providers who apply
and implement GIPS
• Investors/Consultants Subcommittee: forum for end-users of GIPS info
GIPS:
Preface: Background of the GIPS Standards
I. Introduction
a. Preamble: Why Is a Global Standard Needed?
b. Vision Statement
c. Objectives
d. Overview
e. Scope
f. Compliance
g. Implementing a Global Standard
II. Provisions of the Global Investment Performance Standards
0. Fundamentals of Compliance
1. Input Data
2. Calculation Methodology
3. Composite Construction
4. Disclosures
5. Presentation and Reporting
6. Real Estate
7. Private Equity
III. Verification
a. Scope and Purpose of Verification
b. Required Verification Procedures
c. Detailed Examinations of Investment Performance Presentations
GIPS:
Preface: Background of the GIPS Standards
IV. Introduction
a. Preamble: Why Is a Global Standard Needed?
b. Vision Statement
c. Objectives
d. Overview
i. Firms required in include “all actual fee-paying, discretionary portfolios in aggregates, known
as composites, defined by strategy or investment objective.
ii. Show history for min of 5 yrs or since inception, and then add on yrs to build 10-yr record
e. Scope
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f. Compliance
g. Implementing a Global Standard
V. Provisions of the Global Investment Performance Standards
0. Fundamentals of Compliance
i. Must be firm-wide basis; the firm: “an investment firm, subsidiary, or division held out to
clients or potential clients as a distinct business; a distinct business entity is a “unit, division,
department, or office that is organizationally and functionally segregated from other units,
divisions, departments, or offices and retains discretion over the assets it manages and should
have autonomy over the investment decision-making process.
ii. Must document in writing policies and procedures used in establishing and maintaining
compliance w/ GIPS
iii. Compliance statement: “[Name of firm] has prepared and presented this report in compliance
with the Global Investment Performance Standards (GIPS®).”
iv. Must “make every reasonable effort” to provide all prospective clients w/ a compliant
presentation
v. Must provide a list and description of all composites to any prospective client asking, and must
provide upon request compliant presentation for any composite listed. Discontinued must stay
on list for 5 yrs.
vi. Recommends verification (which must be firm-wide). Verification language: “[Name of firm]
has been verified for the periods [dates] by [name of verifier]. A copy of the verification report
is available upon request.”
1. Input Data
i. All data and info necessary … captured and maintained
ii. Portfolio valuations: market rather than cost or book
iii. Trade-date accounting req’d: the “transaction is reflected in the portfolio on the date of the
purchase or sale, and not on the settlement date.”
iv. Accrual accounting req’d for fixed-income securities and other assets that accrue interest
v. Frequency and timing of portfolio valuations: beginning 1/1/10: on the date of all large external
cash flows; and as of the calendar month-end or the last business day of the month
2. Calculation Methodology
i. Time-Weighted Total Return adjusted from cash flows req’d:
MV 1 − MV 0
1. simplest form: rt =
MV 0
2. when external cash flows: “value portfolio whenever an external cash flow occurs,
compute a subperiod return, and geometrically chain-link subperiod returns expressed
in relative form: rtwr = (1 + rt ,1 ) × (1 + rt , 2 ) ×... × (1 + rt , n ) −1 ; rt,1 through rt,n are
subperiods.
3. (used to be able to use from 1/1/05 until 1/1/10 the Original Dietz method reflecting
MV1 − MV 0 − CF
midpoint assumption: rDietz =
MV 0 + ( 0.5 × CF )
4. daily weighted CFs required after 1/1/05 but not after 1/1/10:
MV1 − MV 0 − CF CD − Di
a. Modified Dietz: rModDietz = ; wi = where CD is
MV 0 + ∑ ( CFi × wi ) CD
total calendar days in month and D is the # of days from beginning of month that
CF occurs (so 5 for CF on the 5th).
∑ [CF × (1 + r ) ] + MV (1 + r )
wi
b. Modified or Linked IRR: solve for r: MV1 = i 0
5. returns from cash and cash-equivalents must be included in total return calculations
6. returns must be calculated after deduction of actual—not estimated—trading expenses
(but not custody fees)
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a. if bundled fees (all-in fees and wrap fees) and not extricable, then deduct entire
fee
7. recommendation: calculate returns net of nonreclaimable withholding taxes on
dividends, interest and capital gains (but accrue reclaimable withholding taxes)
8. Composite return calc standards: “Composite returns must be calculated by asset-
weighting the individual portfolio returns using beginning-of-period values or a method
that reflects both beginning-of-period values and external cash flows.”
a. Denominator of method using beginning-value plus external CFs:
V p = MV 0 + ∑( CF i × wi )
MV 0, pi
b. So, composite return using just beginning: rC = ∑ rpi ×
∑ 0, pi
MV
V pi
c. composite return using beginning and external CFs: rC = ∑ rpi ×
∑ V pi
d. after 1/1/10, composite returns must be calculated monthly using monthly asset-
weighting.
3. Composite Construction: “All actual, fee-paying, discretionary portfolios must be included in at least
one composite. Although non-fee-paying discretionary portfolios may be included in a composite
(with appropriate disclosures), nondiscretionary portfolios are not permitted to be included in a firm’s
composites.”
i. Discretionary: if the manager is able to implement the intended investment strategy.
Restrictions that impede investment process to extent that strategy cannot be implemented as
intended: presumed nondiscretionary.
ii. Defining investment strategies: must be defined according to similar investment objectives
and/or strategies, and the full composite definition as documented in the firm’s policies and
procedures must be made available upon request.
1. suggested hierarchy: Investment Mandate | Asset Classes | Style or Strategy |
Benchmarks | Risk/Return Characteristics
iii. including and excluding portfolios: must include new portfolios on a timely and consistent
basis after the portfolio comes under management unless specifically mandated by the client.
Preferably, beginning of next full performance measurement period. Must include terminated
portfolio in historical record of the appropriate composite up to last full measurement period.
1. cannot be switched from one composite to another unless documented changes in client
guidelines or the redefinition of the composite make it appropriate. Historical record
must remain in composite.
2. recommendation: event of significant external CFs, use temporary new accounts rather
than temporarily removing portfolios from composites. May be compelled to
temporarily remove portfolios from composites when large external CFs occur.
3. if minimum asset level threshold for inclusion, must strictly follow that policy: none
below can be included. May require time threshold so that temporarily devalued
portfolios don’t go in and out of composite. Any changes to minimum threshold:
cannot be applied retroactively. Firm should not market composite to prospective
clients falling below minimum threshold.
iv. Carve-Outs: cannot exclude cash; “When a single asset class is carved out of a multiple asset
class portfolio and the returns are presented as part of a single asset composite, cash must be
allocated to the carve-out returns in a timely and consistent manner.” 2 acceptable cash
allocation methods: “Beginning of period allocation” and “Strategic asset allocation” (for
strategic: the cash amount is the deviation for the target: so 2.5% when target is 37.5% and
actual is 35%.). From 1/1/10, carve-out returns cannot be included in single-asset-class
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composite returns unless the carve-out is actually managed separately with its own cash
balance.
4. Disclosures
i. Def of “firm”; if re-defined, disclose date and re-def
ii. All significant events that help interpret performance record
iii. Use of subadvisors and periods for which used
iv. Make available complete list (last 5 yrs) and description of all composites
v. Recommended: disclose firms w/I parent company
vi. Recommended: if verified, disclose and periods verified if not all
vii. Currency to express performance; disclose and describe exchange rate inconsistencies among
composites and b/w composite and benchmark
viii. Treatment of withholding tax
ix. Tax basis of benchmark vs. composite (Lux vs. U.S.)
x. Disclose availability of add’l info on calc and reporting returns (e.g., methodology, valuation
sources, treatment of large external CFs)
xi. Recommended: disclose when change of calc methodology or valuation sources has material
impact
xii. Fees: clearly label returns gross of or net of; for gross of, also disclose whether anything other
than direct trading expenses deducted; for net of, also disclose whether anything other than
direct trading expenses and investment management fee deducted; disclose appropriate fee
schedules; if bundled-fee, present % of portfolios for each annual period that are such and
disclose various types of bundled fees.
xiii. Investment objectives, style, and strategy of composite (more than broadly indicative name)
xiv. Composite creation date
xv. Measure of dispersion and which measure
xvi. If minimum asset level for inclusion in composite, disclose minimum and any changes thereto
xvii. Presence, use and extent of leverage or derivatives, if material, including use, frequency and
characteristics of instruments
xviii. Whether conforms to local laws and regs that differ from GIPS, and disclosure of such conflict
5. Presentation and Reporting
i. Show at least 5 yrs and extend thereafter until 10 yrs
ii. Annual returns (calendar yr unless noncalendar fiscal yr); number of portfolios; amount of
assets in composite; % of total firm assets composite represents or total firm assets; measure of
dispersion of individual portfolio returns if >=6 portfolios (high/low, interquartile range,
standard deviation)
iii. Can link to prior-to-1/1/00 non-GIPS-compliant performance if disclosed
iv. Cannot annualize partial-year returns
v. “portability”
1. Prior affiliation performance must be linked if: 1. substantially all the investment
decision-makers are employed by the new firm; 2. staff and decision-making process
remain intact and independent w/ the new firm; and 3. new firm has records that
document and support the reported performance.
2. linking must be disclosed
3. can be linked if: substantially all of the assets from past firm’s composite transfer to the
new firm
4. one yr to comply if GIPS-compliant firm acquires noncompliant firm
vi. single-asset-class carve-outs from multiple-asset-class portfolios: presentation must include %
of composite that is composed of carve-outs from 1/1/06 forward.
vii. Benchmarks: benchmarks reflecting composite’s investment strategy or mandate must be
presented for each annual period; if none shown, must explain why; dates and reasons for
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changes of benchmarks must be presented; for custom benchmarks, describe benchmark
creation and rebalancing process; once established, rebalancing must be consistently applied
viii. If composite includes any non-fee-paying portfolios, must present % of composite.
ix. Recommended: present composite performance gross of investment management and
administrative fees and before taxes except for nonreclaimable withholding taxes.
x. Recommended: present cumulative composite and benchmark returns
xi. Recommended: present equal-weighted mean and median returns for each composite
xii. Recommended: present composite-level country and sector weightings
xiii. Recommended: present charts and graphs
xiv. Recommended: present risk measures: beta, tracking error, modified duration, information
ratio, Sharpe ratio, Treynor ratio, credit ratings, value at risk and volatility or variability of
composite and benchmark
6. Real Estate
i. Publicly traded real estate securities, securities issued by public companies, CMBSs and private
debt investments (including commercial and residential loans for which the expected return is
solely related to contractual interest rates w/o any participation in the economic performance of
the underlying real estate) are treated under the regular GIPS standards and not the real estate
standards. Portfolio holding both must carve out.
ii. Despite regular GIPS, must be valued quarterly internally or externally, valued every 12
months externally and “Real estate investments must be valued by an external professionally
designated, certified or licensed commercial property valuer/appraiser at least once every 36
months.”
iii. Must present methods, sources, and frequency of valuations; also asset-weighted % of
composite real estate assets valued by an external valuation for each period as well as
frequency w/ which real estate investments are valued by external valuers.
iv. Must describe definition of discretion; generally: if manager has sole or primary responsibility
for major investment decisions.
v. Must present total return w/ income and capital appreciation breakdown; and calculation
methodology (e.g., whether chain-linked time-weighted; or adjusted to make the capital return
and income return equal total return); adjust for time-weighted cash flows
1. capital employed: C E = C 0 + ∑( CFi × wi )
( MV1 − MV0 ) − EC + S
2. capital return: rc = ; where E is capital expenditures and S is
CE
sale proceeds
INC A − E NR − INT D − T
3. income return: rI = ; INC is income accrued, E is
CE
nonrecoverable expenditures, INT is interest on debt and T is property taxes
4. total return: rT = rC + rI
vi. recommended: present capital and income segments of the appropriate real estate benchmark
vii. recommended: annual/annualized since-inception IRR for composite: SI-IRR; should disclose
time period and frequency of cash flows; should use quarterly cash flows at minimum.
viii. Recommended: present time-weighted rate of return and SI-IRR gross and net of fees, and
reflecting ending market value and also reflecting only realized cash flows excluding
unrealized gains.
7. Private Equity
i. Open-end and evergreen funds subject to regular GIPS standards and not PE standards
ii. Private Equity Valuation Principals
1. obligate firms to ensure that valuations are prepared w/ integrity and professionalism by
individuals w/ appropriate experience and ability under direction of senior management
and in accordance w/ documented review procedures
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2. valuation basis must be divulged
3. clearly disclose methodologies and key assumptions
4. logically cohesive and rigorously applied
5. must recognize events that diminish an asset’s value
6. present on consistent and comparable basis from one period to next; any change in
valuation basis or method must be disclosed
7. valuations at least annually, but quarterly recommended
8. recommended: valuations on fair value basis; hierarchy:
a. market transactions (e.g., most recent arms-length financing)
b. market-based multiples
c. risk-adjusted discounted expected cash flows
iii. must disclose net-of-fees (including net of carried interest, investment management fees and
transaction expenses; net of investment advisors fees … if applicable) and gross-of-fees SI-IRR
of composite for each year; use daily or monthly CFs and end-of-period valuation of
unliquidated holdings remaining in composite; stock distributions valued at time of distribution
iv. all closed-end PE investments to be included in composite defined by strategy and vintage year;
direct investments and investments made through other funds or p’ships must be in separate
composites
v. must disclose:
1. vintage years,
2. composite investment strategy,
3. total committed capital for composite,
4. valuation methodologies and change thereof,
5. if also complies w/ local or regional guidelines,
6. that valuation review procedures are available upon request
7. if fair value not used, why, number of investments not fair valued and their carrying
value in absolute amount and relative to total fund
8. unrealized appreciation or depreciation of composite for most recent period
9. whether using daily or monthly CFs for SI-IRR
10. if benchmarks disclosed, disclose calc methodology for benchmark and cumulative
annualized SI-IRR; if no benchmark disclosed, explain why
11. if not calendar, disclose period-end used
12. for discontinued PE composites: final realization or liquidation date must be stated
13. funding status: cumulative paid-in-capital (including paid-in but not yet invested), total
current invested capital, cumulative distributions paid out to investors in cash or stock,
TVPI, DPI, PIC, RVPI
14. recommended: disclose average holding period of investments over life
VI. Verification: review of performance measurement policies, processes, and procedures by an independent
third-party for purposes of establishing that a firm claiming compliance has adhered to the GIPS standard
a. Scope and Purpose of Verification:
i. Verification can only be as to whole firm; may have a detailed Performance Examination
conducted on a composite thereafter
ii. Minimum verification period is one year
iii. Verification report must confirm that firm has complied w/ all composite construction
requirements of GIPS on firmwide basis and that firm’s processes and procedures are designed
to calculate and present performance results in compliance w/ GIPS
iv. Must have report to claim verification
v. If not fully compliant, verifier must provide report to firm stating why cannot issue verification
report
vi. Minimum knowledge-based qualifications for verifiers
b. Required Verification Procedures
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i. Learn about firm, firm’s performance-related policies and valuation basis for performance
calculations
ii. Obtain selected samples of investment performance reports and other available info
iii. Determine firm’s assumptions, policies and procedures for establishing and maintaining
compliance including:
1. written def of investment discretion and guidelines therefor
2. list of composite definitions w/ written criterion for including account w/i
3. policy regarding timeframe for including new accounts in and excluding closed
accounts from composite
4. policies re input data: dividend and interest income accruals and market valuations,
portfolio and composite return calculation methodologies including assumptions on
timing of CFs, presentation of composite returns
5. info on use of leverage and derivatives, investments in securities or countries not
included in composite’s benchmark, timing of implied taxes on income and realized cap
gains if firm reports on after-tax basis
6. “any other policies and procedures relevant to performance presentation”
iv. Stuff to gather:
1. sample performance presentations and marketing materials
2. all of firm’s performance-related policies, such as firm’s definition of discretion, the
sources, methods, and review procedures for asset valuations, the time-weighted rate-
of-return calculation methodology, the treatment of external cash flows, the
computation of composite returns, etc.
3. complete list and description of composites
4. composite definitions, including benchmarks and written criteria for including accounts
5. list of all portfolios under management
6. all investment management agreements or contracts, and clients’ investment guidelines
7. list of all portfolios that have been in each composite during the verification period, the
dates they were in the composites, and documentation supporting any changes to the
portfolios in the composites.
8. sample historical portfolio- and composite-level performance data
v. Determinations:
1. determine has been and remains appropriately defined
2. determine defined and maintained composites consistently in compliance
3. determine benchmarks are appropriate
4. determine list of composites is complete
5. determine that all actual discretionary fee-paying portfolios are included in at least one
composite, and that all accounts are included in their respective composites at all times,
and that none belonging is excluded
6. determine def of discretion has been consistently applied
7. determine accounts consistently apply discretionary and non-discretionary
8. obtain complete list of open and closed accounts; select appropriate sample
9. confirm timing of inclusion and shifting of accounts conforms to definition
10. recalculate sample of returns and dispersion measures and determine computations
conform
11. review sample of composite presentations for compliance
vi. must maintain sufficient info to support verification report
vii. firm must provide representation letter to verifiers of major policies and other reps
c. Detailed Examinations of Investment Performance Presentations
• Other issues:
i. After-Tax Return Calculation Methodology: not required by GIPS
ii. Guidance Statement for Country-Specific Taxation Issues
• Preliquidation return:
1. Consistent use of “anticipated tax rates”
i. Anticipated income tax rate = Federal tax rate + [State tax rate x (1 –
Federal tax rate)] + [Local tax rate x (1 – Federal tax rate)]
ii. if client’s tax rate unknown, then may use maximum federal tax rate for
specific category of investor etc.
2. “realized taxes”: Treal = (G Lreal × TLcgr ) + (G Sreal × TScgr ) + ( INC tA × Tincr )
MV1 − MV 0 − CF − Treal
3. Preliquidation after-tax Modified Dietz: rPLATModDie tz =
MV 0 + ∑ ( CFi × wi )
4. After-tax LIRR: MV1 − Treal = ∑ [CF × (1 + r )
i
wi
] + MV (1 + r )
0
• Objectives of GIPS:
i. To obtain worldwide acceptance of a common standard for calculating and presenting
investment performance
ii. To ensure accurate and consistent performance data
iii. To promote fair, global competition for all markets
iv. To foster the notion of industry self-regulation
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