CFA 2017 Level III - Study Guide Vol 5

20
18
w
ile
y
ra
ve
nc
fa
st
ud
y@
gm
ai
l.c
om
20
18
w
ile
y
ra
ve
nc
fa
st
ud
y@
gm
ai
l.c
om
Wiley Study Guide for 2017
om
Level Ill CFA Exam Review
l.c
ai
Complete Set
gm
y@
ud
st
fa
nc
ve
ra
y
ile
w
18
20
Thousands of candidates from more than 100 countries have relied on these Study Guides
to pass the CFA®Exam. Covering every Leaming Outcome Statement (LOS) on the exam,
these review materials are an invaluable tool for anyone who wants a deep-dive review of
all the concepts, formulas, and topics required to pass.
Wiley study materials are produced by expert CFA charterholders, CFA Institute members,
and investment professionals from around the globe. For more information, contact us at
info@efficientlearning.com.
om
l.c
ai
gm
y @
ud
st
fa
nc
ve
ra
y
ile
w
18
20
Wiley Study Guide for 2017
om
Level 111 CFA Exam Review
l.c
ai
gm
y@
ud
st
fa
nc
ve
ra
y
ile
w
18
20
WILEY
Copyright© 2017 by John Wiley & Sons, Inc. All rights reserved.
Published by John Wiley & Sons, Inc., Hoboken, New Jersey.
Published simultaneously in Canada.
No part of this publication may be reproduced, stored in a retrieval system, or transmitted in any
form or by any means, electronic, mechanical, photocopying, recording, scanning, or otherwise,
except as permitted under Section 107 or 108 of the 1976 United States Copyright Act, without
either the prior written permission of the Publisher, or authorization through payment of the
om
appropriate per-copy fee to the Copyright Clearance Center, Inc., 222 Rosewood Drive, Danvers,
MA 01923, (978) 750-8400, fax (978) 646-8600, or on the Web at www.copyright.com. Requests
to the Publisher for permission should be addressed to the Permissions Department, John Wiley &
l.c
Sons, Inc., 111 River Street, Hoboken, NJ 07030, (201) 748-6011, fax (201) 748-6008, or online
at http://www.wiley.com/go/pennissions.
ai
Limit of Liability/Disclaimer of Warranty: While the publisher and author have used their best
efforts in preparing this book, they make no representations or warranties with respect to the
gm
accuracy or completeness of the contents of this book and specifically disclaim any implied
warranties of merchantability or fitness for a particular purpose. No warranty may be created or
extended by sales representatives or written sales materials. The advice and strategies contained
@
herein may not be suitable for your situation. You should consult with a professional where
appropriate. Neither the publisher nor author shall be liable for any loss of profit or any other
y
commercial damages, including but not limited to special, incidental, consequential, or other
damages. ud
For general information on our other products and services or for technical support, please contact
st
our Customer Care Department within the United States at (800) 762-2974, outside the United
States al (317) 572-3993 or fax (317) 572-4002.
fa
Wiley publishes in a variety of print and electronic formats and by print-on-demand. Some
nc
material included with standard print versions of this book may not be included in e-books or in
print-on-demand. If this book refers to media such as a CD or DVD that is not included in the
ve
version you purchased, you may download this material athttp://booksupport.wiley.com. For
more information about Wiley products, visit www.wiley.com.
ra
Required CFA® Institute disclaimer:
"CFA® and Chartered Financial Analyst® are trademarks owned by CFA Institute. CFA Institute
y
(formerly the Association for Investment Management and Research) does not endorse, promote,
ile
review or warrant the accuracy of the products or services offered by John Wiley & Sons, Inc."
Certain materials contained within this text are the copyrighted property of CFA Institute. The
w
following is the copyright disclosure for these materials:

18
"Copyright 2016, CFA Institute. Reproduced and republished with permission from CFA Institute.
All rights reserved."
20
These materials may not be copied without written permission from the author. The unauthorized
duplication of these notes is a violation of global copyright laws and the CFA Institute Code of
Ethics. Your assistance in pursuing potential violators of this law is greatly appreciated.
Disclaimer: John Wiley & Sons, Inc.'s study materials should be used in conjunction with
the original readings as set forth by CFA Institute in the 2017 CFA Level III Curriculum. The
information contained in this book covers topics contained in the readings referenced by CFA
Institute and is believed to be accurate. However, their accuracy cannot be guaranteed.
ISBN 978-1-119-34833-7
om
Contents
l.c
About the Authors xi
ai
Wiley Study Guide for 2017 Level Ill CFA Exam
gm
Volume 1: Ethics and Professional Standards
& Behavioral Finance
@
Study Session 1: Code of Ethics and Standards of Professional Conduct
y
Reading 1: Code of Ethics and Standards of Professional Conduct
ud
Lesson 1: Code of Ethics and Standards of Professional Conduct
Reading 2: Guidance for Standards I-VII
st
Lesson 1: Standard I: Professionalism
Lesson 2: Standard II: Integrity of Capital Markets 36
fa
Lesson 3: Standard Ill: Duties to Clients 46

nc
Lesson 4: Standard IV: Duties to Employers 70

Lesson 5: Standard V: Investment Analysis, Recommendations, and Actions 84
ve
Lesson 6: Standard VI: Conflicts of Interest 97

Lesson 7: Standard VII: Responsibilities as a CFA Institute Member or CFA Candidate 107
ra
Study Session 2: Ethical and Professional Standards in Practice

Reading 3: Application of the Code and Standards 119
y
Lesson 1: Ethical and Professional Standards in Practice, Part 1: The Consultant 119
ile
Lesson 2: Ethical and Professional Standards in Practice, Part 2: Pearl Investment

w
Management 120
Reading 4: Asset Manager Code of Professional Conduct 121
18
Lesson 1: Asset Manager Code of Professional Conduct 121

20
Study Session 3: Behavioral Finance

Reading 5: The Behavioral Finance Perspective 131
Lesson 1: Behavioral versus Traditional Perspectives 131
Lesson 2: Decision Making 136
Lesson 3: Perspectives on Market Behavior and Portfolio Construction 140
Reading 6: The Behavioral Biases of Individuals 147
Lesson 1: Cognitive Biases 148
Lesson 2: Emotional Biases 154
Lesson 3: Investment Policy and Asset Allocation 159
©2017Wiley 0
CONTENTS
Reading 7: Behavioral Finance and Investment Processes 165

Lesson 1: The Uses and Limitations of Classifying Investors into Types 165
Lesson 2: How Behavioral Factors Affect Advisor-Client Relations 168
Lesson 3: How Behavioral Factors Affect Portfolio Construction 169
Lesson 4: Behavioral Finance and Analyst Forecasts 172
Lesson 5: How Behavioral Factors Affect Committee Decision Making 178
Lesson 6: How Behavioral Finance Influences Market Behavior 179
om
Volume 2: Private Wealth Management & Institutional Investors
l.c
Study Session 4: Private Wealth Management (1)
ai
Reading 8: Managing Individual Investor Portfolios
Lesson 1: Investor Characteristics: Situational and Psychological Profiling
gm
Lesson 2: Individual IPS: Return Objective Calculation
Lesson 3: Individual IPS: Risk Objective
Lesson 4: Individual IPS: The Five Constraints
@
Lesson 5: AComplete Individual IPS 10
Lesson 6: Asset Allocation Concepts: The Process of Elimination 18
y
Lesson 7: Monte Carlo Simulation and Personal Retirement Planning
ud 20
Reading 9: Taxes and Private Wealth Management in aGlobal Context 21
st
Lesson 1: Overview of Global Income Tax Structures 21
Lesson 2: After-Tax Accumulations and Returns for Taxable Accounts 23
fa
Lesson 3: Types of Investment Accounts and Taxes and Investment Risk 31

Lesson 4: Implications for Wealth Management 34
nc
Reading 10: Domestic Estate Planning: Some Basic Concepts 39

ve
Lesson 1: Basic Estate Planning Concepts 39

Lesson 2: Core Capital and Excess Capital 42
ra
Lesson 3: Transferring Excess Capital 46

Lesson 4: Estate Planning Tools 51
Lesson 5: Cross-Border Estate Planning 53
y
ile
Study Session 5: Private Wealth Management (2)

w
Reading 11 : Concentrated Single-Asset Positions 59

Lesson 1: Concentrated Single-Asset Positions: Overview and Investment Risks 59
18
Lesson 2: General Principles of Managing Concentrated Single-Asset Positions 60

Lesson 3: Managing the Risk of Concentrated Single-Stock Positions 66
20
Lesson 4: Managing the Risk of Private Business Equity 71

Lesson 5: Managing the Risk of Investment in Real Estate 74
Reading 12: Risk Management for Individuals 77
Lesson 1: Human Capital and Financial Capital 77
Lesson 2: Seven Financial Stages of Life 78
Lesson 3: AFramework for Individual Risk Management 80
Lesson 4: Life Insurance 83
Lesson 5: Other Types of Insurance 88
Lesson 6: Annuities 91
Lesson 7: Implementation of Risk Management for Individuals 95
0 © 2017Wiley
CONTENTS
Study Session 6: Portfilio Management for Institutional Investors

Reading 13: Managing Institutional Investor Portfolios 103
Lesson 1: Institutional IPS: Defined Benefit (DB) Pension Plans 103
Lesson 2: Institutional IPS: Foundations 111
Lesson 3: Institutional IPS: Endowments 115
Lesson 4: Institutional IPS: Life Insurance and 117
Non-Life Insurance Companies (Property and Casualty)
Lesson S: Institutional IPS: Banks 120
om
Reading 14: linking Pension Liabilities to Assets 123
Lesson 1: linking Pension Liabilities to Assets 123
l.c
ai
Volume 3: Economic Analysis, Asset Allocation, Equity & Fixed Income Portfolio Management
gm
Study Session 7: Applications of Economic Analysis to Portfolio Management
Reading 1S: Capital Market Expectations
@
Lesson 1: Organizing the Task: Framework and Challenges
Lesson 2: Tools for Formulating Capital Market Expectations, Part 1: Formal Tools
y
Lesson 3: Tools for Formulating Capital Market Expectations, Part 2: Survey and
Panel Methods and Judgment ud
Lesson 4: Economic Analysis, Part 1: Introduction and Business Cycle Analysis
13
19
st
Lesson 5: Economic Analysis, Part 2: Economic Growth Trends, Exogenous Shocks, and
International Interactions 27
fa
Lesson 6: Economic Analysis, Part 3: Economic Forecasting 30

nc
Lesson 7: Economic Analysis, Part 4: Asset Class Returns and Foreign Exchange Forecasting 33
Reading 16: Equity Market Valuation 39
ve
Lesson 1: Estimating aJustified P/ERatio and Top-Down and Bottom-Up Forecasting 39

Lesson 2: Relative Value Models 46
ra
Study Session 8: Asset Allocation and Related Decisions in Portfolio Management (1)
y
Reading 17: Asset Allocation 53

ile
Lesson 1: What Is Asset Allocation? 54

Lesson 2: Asset-Only versus Asset-Liability Approaches 57
w
Lesson 3: Selection of Asset Classes 61

Lesson 4: Corner Portfolios 67
18
Lesson 5: Mean Variance Optimization (MVO) and Other Modelling Techniques 71

20
Study Session 9: Asset Allocation and Related Decisions in Portfolio Management (2)
Reading 18: Currency Management: An Introduction 81
Lesson 1: Review of Foreign Exchange Concepts 81
Lesson 2: Currency Risk and Portfolio Return and Risk 87
Lesson 3: Currency Management: Strategic Decisions 90
Lesson 4: Currency Management: Tactical Decisions 93
Lesson 5: Tools of Currency Management 96
Lesson 6: Currency Management for Emerging Market Currencies 104
© 2017Wiley
CONTENTS
Reading 19: Market Indexes and Benchmarks 105

Lesson 1: Distinguishing between aBenchmark and aMarket Index and
Benchmark Uses and Types 105
Lesson 2: Market Index Uses and Types 109
Lesson 3: Index Weighting Schemes: Advantages and Disadvantages 111
Study Session 10: Fixed-Income Portfolio Management (1)

Reading 20: Fixed-Income Portfolio Management-Part I 119
om
Lesson 1: Managing Funds against aBond Market Index 119
Lesson 2: Managing Funds against Liabilities: Classical Immunization 126
l.c
Lesson 3: Managing Funds against Liabilities: Other Immunization Strategies 131
Lesson 4: Managing Funds against Liabilities: Cash Flow Matching 136
ai
Reading 21 : Relative-Value Methodologies for Global Credit Bond Portfolio Management 139
Lesson 1: Credit Relative-Value Analysis
gm
139
Lesson 2: Primary Market Analysis 142
Lesson 3: Secondary Trade Rationales 143
@
Lesson 4: Liquidity and Trading Analysis 145
Lesson 5: Spread Analysis and Structural Analysis 145
y
Lesson 6: Credit Curve Analysis 148
ud
Study Session 11: Fixed-Income Portfolio Management (2)
st
Reading 22: Fixed-Income Portfolio Management-Part II 153
Lesson 1: Use of Leverage and Repos 153
fa
Lesson 2: Derivative-Enabled Strategies 157

nc
Lesson 3: International Bond Investing 166

Lesson 4: Selecting a Fixed Income Manager 170
ve
Study Session 12: Equity Portfolio Management

ra
Reading 23: Equity Portfolio Management 175

Lesson 1:The Role of the Equity Portfoli and Approaches to Equity Investing 175
y
Lesson 2: Passive Equity Investing 176

ile
Lesson 3: Active Equity Investing 182

Lesson 4: Semiactive Equity Investing 193
w
Lesson 5: Managing aPortfolio of Managers 196

Lesson 6: Identifying, Selecting, and Contracting with Equity Portfolio Managers 200
18
Lesson 7: Distressed Securities 201

20
Volume 4: Alternative Investments, Risk Management, & Derivatives
Study Session 13: Alternative Investments for Portfolio Management

Reading 24: Alternative Investments for Portfolio Management
Lesson 1: Alternative Investments: Definitions, Similarities, and Contrasts
Lesson 2: Real Estate
Lesson 3: Private EquityNenture Capital
Lesson 4: Commodity Investments 16
© 2017Wiley
CONTENTS
Lesson 5: Hedge Funds 21

Lesson 6: Managed Futures 30
Lesson 7: Distressed Securities 32
Study Session 14: Risk Management

Reading 25: Risk Management 39
Lesson 1: Risk Management as a Process and Risk Governance 39
Lesson 2: Identifying Risk 40
om
Lesson 3: Measuring Risk: Value at Risk (VaR) 44
Lesson 4: Measuring Risk: VaR Extensions and Stress Testing 52
l.c
Lesson 5: Measuring Risk: Credit Risk 53
Lesson 6: Managing Risk 60
ai
Study Session 15: Risk Management Applications of Derivatives
gm
Reading 26: Risk Management Applications of Forward and Futures Strategies 65
Lesson 1: Strategies and Applications for Managing Equity Market Risk 65
@
Lesson 2: Asset Allocation with Futures 74
Lesson 3: Strategies and Applications for Managing Foreign Currency Risk 83
y
Reading 27: Risk Management Applications of Option Strategies 89
Lesson 2: Interest Rate Option Strategies

ud
Lesson 1: Options Strategies for Equity Portfolios 89
103
st
Lesson 3: Option Portfolio Risk Management Strategies 116
fa
Reading 28: Risk Management Applications of Swap Strategies 121

Lesson 1: Strategies and Applications for Managing Interest Rate Risk 121
nc
Lesson 2: Strategies and Applications for Managing Exchange Rate Risk 137
Lesson 3: Strategies and Applications for Managing Equity Market Risk 148
ve
Lesson 4: Strategies and Applications Using Swaptions 153

ra

Volume 5: Trading, Monitoring and Rebalancing, Performance Evaluation,
y
& Global Investment Performance Standards

ile
Study Session 16: Trading, Monitoring, and Rebalancing

w
Reading 29: Execution of Portfolio Decisions

Lesson 1:The Context ofTrading: Market Microstructure
18
Lesson 2: The Costs ofTrading 10

Lesson 3:Types ofTraders and Their Preferred Order Types 15
20
Lesson 4:Trade Execution Decisions and Tactics and Serving the Client's Interests 17
Reading 30: Monitoring and Rebalancing 25
Lesson 1: Monitoring for IPS Changes (Individual and Institutional) 25
Lesson 2: Rebalancing the Portfolio 32
Lesson 3:The Pero Id-Sharpe Analysis of Rebalancing Strategies 35
©2017Wiley
CONTENTS
Study Session 17: Performance Evaluation

Reading 31: Evaluating Portfolio Performance 41
Lesson 1: Performance Measurement 41
Lesson 2: Benchmarks 49
Lesson 3: Performance Attribution (4 Models) 55
Lesson 4: Performance Appraisal 65
Lesson 5:The Practice of Performance Evaluation 71
om
Study Session 18: Global Investment Performance Standards
Reading 32: Overview of the Global Investment Performance Standards 75
l.c
Lesson 1: Background of the GIPS Standards 75
Lesson 2: Fundamentals of Compliance 76
ai
Lesson 3: Input Data 78
Lesson 4: Return Calculation Methodologies 79
gm
Lesson 5: Composite Construction Lesson 85
Lesson 6: Disclosure, Presentation, and Reporting 89
@
Lesson 7: Real Estate, Private Equity, and Wrap Fee/Separately Managed Accounts 96
Lesson 8: Valuation Principles and Advertising Guidelines 102
y
Lesson 9: Verification and Other Issues 104
ud
st
fa
nc
ve
ra
y
ile
w
18
20
0 © 2017Wiley
ABOUT THE AUTHORS
Wiley's Study Guides are written by a team of highly qualified CFA charterholders
and leading CFA instructors from around the globe. Our team of CFA experts work
om
collaboratively to produce the best study materials for CFA candidates available today.
Wiley's expert team of contributing authors and instructors is led by Content Director Basit
l.c
Shajani, CFA. Basil founded online education start-up Elan Guides in 2009 to help address
CFA candidates' need for better study materials. As lead writer, lecturer, and curriculum
ai
developer, Basil's unique ability to break down complex topics helped the company grow
organically to be a leading global provider ofCFA Exam prep materials. In January 2014,
gm
Elan Guides was acquired by John Wiley & Sons, Inc., where Basil continues his work
as Director of CFA Content. Basil graduated magna cum laude from the Wharton School
of Business at the University of Pennsylvania with majors in finance and legal studies.
@
He went on to obtain his CFA charter in 2006, passing all three levels on the first attempt.
Prior to Elan Guides, Basil ran his own private wealth management business. He is a past
y
president of the Pakistani CFA Society.
ud
There are many more expert CFA charterholders who contribute to the creation of
Wiley materials. We are thankful for their invaluable expertise and diligent work.
st
To learn more about Wiley's team of subject matter experts, please visit:
fa
www.efficientlearning.com/cfa/why-wiley/.
nc
ve
ra
y
ile
w
18
20
©2017Wiley 0
20
18
w
ile
y
ra
ve
nc
fa
st
ud
y@
gm
ai
l.c
om
STUDY SESSION 16: TRADING, MONITORING,
AND REBALANCING
om
l.c
ai
gm
y @
ud
st
fa
nc
ve
ra
y
ile
w
18
20
©201 7Wiley
20
18
w
ile
y
ra
ve
nc
fa
st
ud
y@
gm
ai
l.c
om
EXECUTION OF PORTFOLIO DECISIONS
READING 29: EXECUTION OF PORTFOLIO DECISIONS
Time to complete: 1.5 to 2.5 hours
Reading summary: Trading requires balancing execution tinting against both direct and
indirect trade costs. Be able to calculate and explain these costs. Be able to explain how
different types of markets function, the kinds of trades that work best in those markets, and
trader motivations that lead them to various types of trades.
INTRODUCTION
om
Wealth advisors wish to manage their client portfolios effectively, but at low cost. Toward
that end, they may use portfolio managers who in turn use buy-side traders. These trades
l.c
are charged with making error-free executions quickly and at costs favorable to the firm's
clients. Portfolio managers must communicate effectively with traders, as well as measure
ai
and evaluate their executions. Portfolio managers are therefore required to have some
gm
fantiliarity with the mechanics of trading.
This lesson will provide you with the tools to understand:
@
1. Market structure, quality, and participants;
y
2. Measures of trading and transactions costs, and their calculation;
3.
4.
ud
Trading personalities, strategies, and algorithms; and
Best execution, its criteria, and procedures for its assurance.
st
LESSON 1: THE CONTEXT OF TRADING: MARKET MICROSTRUCTURE
fa
MARKET MICROSTRUCTURE
nc
Market microstructure describes processes that traders use to translate the portfolio
manager's decisions into executed trades. Traders with accurate microstructure information
ve
can formulate more effective and efficient strategies, and helps portfolio managers
understand why execution price varies from their value estimates. For example, a need for
ra
quick execution may require that traders accept a higher purchase or lower sale price.
y
ile
LOS 29a: Compare market orders with limit orders, including the price
and execution uncertainty of each. Vol 6, pp 7-9
w
Order Types
18
Market orders emphasize a need for executing orders quickly at the best price available,
which implies price uncertainty. For example, in a market with 3,000 shares available at
20
$24 and 8,000 shares available at $24.25, an order for 10,000 shares will be filled by first
purchasing 3,000 shares at $24 and buying the remaining 7,000 shares at $24.25.
Limit orders , however, are designed to achieve a price at least as favorable as the lintit.
For example, if the 10,000 share order had been subntitted with a lintit of $24.10 rather
than $24.25 as required to purchase the remaining 7 ,000 shares, then the first 3,000 shares
would be filled but the remaining shares would go unfilled (unless a seller with a sell limit
down to $24.10 or lower stepped into the market).
©2017Wiley
Traders must understand how the markets in which they trade allow them to present orders:
Market on open (close)- An order to be executed at the open (or close) of the
market, presumably because these times have good liquidity and will result in a
more favorable price outcome.
Market not-held order-Brokers who help fill orders for traders are "not held" to a
particular price or time interval to execute the trade. Brokers who feel they may get
a better price later may allow the trader to wait on price.
Participate but do not initiate- Traders do not hold the shares out to other broker/
om
dealers, but instead prefer to let the other party determine the timing of a trade in
exchange for, hopefully, better price execution.
Best efforts order-Traders offer the security only when a favorable trade price
l.c
exists, but are usually not allowed to hold the order indefinitely.
Undisclosed (or reserve, hidden, or iceberg) order-Limit order with instructions
ai
to only show some partial amount of the full order. Large buy/sell orders will tend
gm
to increase/decrease offer prices. Hiding part of the order quantity may prevent
counterparties to the trade from holding out for a more favorable price.
@
Traders must also understand special types of trades:
Principal trade-The broker commits capital to execute a trade quickly, often at a
y
price favorable to the broker. The trade often takes place on time-driven orders that
ud
are larger than the market can easily accommodate.
Portfolio trade (or basket trade, program trade)- Execution of a trade involving
st
a list (basket) of securities, often in an index such as the S&P 500 Index. The
diversification of the trade often makes it more palatable to the other side of the
fa
trade and can be executed at a favorable cost.

nc
LOS 29c: Compare alternative market structures and their relative

ve
advantages. Vol 6, pp 9-17

ra
Types of Markets
y
Markets are designed to provide price and volume information that is visible to all
ile
participants (transparency), as well as the ability to trade large quantities quickly without
dramatically affecting the price (liquidity), and to ensure that trades settle under all market
w
conditions (settlement assurance). Since the 1990s, traders have a much broader range of
choices of venues in which to trade securities. This market fragmentation has accelerated
18
with computerized trading platforms that don 't require much, if any, human involvement.
Dealer Markets
20
Dealer markets are those in which an entity (the dealer or market maker) purchases and
sells securities out of its own inventory in order to provide market liquidity. Natural
liquidity occurs among a large pool of potential buyers and sellers. Dealers can help in
markets that don't have natural liquidity (e.g., bond markets), where most issues trade less
frequently than equities.
In a true dealer market, the dealer stands between all buyers and sellers and the market
does not provide quoted prices from other buyers or sellers. In other dealer markets (e.g.,
NASDAQ), however, trader quotes are shown along with dealer quotes. Dealers purchase
©2017Wiley
at a bid price and sell at an ask price, with the resulting profit (spread) accruing to the
dealer. To complete the nomenclature of transparency, the bid size is the volume associated
with the bid price and the ask size is associated with the ask price. Traders wishing to sell
a security benefit from a higher bid price; traders wishing to buy a security benefit from a
lower ask price.
Market (or inside) bid describes the highest price a dealer is willing to pay; market (or
inside) ask describes the lowest price at which a dealer is willing to sell. Therefore, a
multiple-dealer market may show inside bid and inside ask prices from different dealers.
om
The inside quote includes both the market bid and market ask prices.
The mid-quote for a security is halfway between the market bid and ask prices at any given
l.c
time.
ai
Although a particular dealer may offer a more favorable quoted price for a security, it may
make sense to specify another dealer, with a better ability to stand behind the quote (if
gm
allowed by the market). For example, counterparties in the currency markets must also be
concerned with the credit quality of the other counterparty.
@
In closed-book markets, not all bid-ask data may be available to all parties and the trader
may have to pay commission to a broker to locate the best price. Price improvement results
y
when a trader steps in front of the best quoted bid or ask (i.e., sellers get a higher bid and
buyers get a lower ask price than quoted).
ud
st
fa
LOS 29b: Calculate and interpret the effective spread of a market order
and contrast it to the quoted bid-ask spread as a measure of trading cost.
nc
Vol 6, pp 10--11
ve
Trading costs can be determined from the quoted bid-ask spread. The trader may, however,
ra
receive more favorable prices on either or both the bid and ask sides. Therefore, effective
spread may better measure the trading cost:
y
ile
. [ . . (Bid price+ Ask price)]

Effecllve spread = 2 x Execullon pnce -
w
2
18
Note that this calculates effective spread for a purchase, and will be mid-quote less
20
execution price for a sale.
Effective spread better captures actual costs because it considers price improvement
offered by dealers over the quoted spread as well as market impact (i.e., tendency for
large trades to move the market). Average effective spread (i.e., dollar-weighted or share-
weighted) is often used when orders execute across several prices. Average effective spread
can often be used to identify liquidity. Higher volume securities typically allow narrower
dealer spreads, presumably because the dealer takes less risk of being unable to offload
the position quickly. Lower volume securities require wider dealer spreads to compensate
dealers for the risk of being unable to offload the position quickly.
©2017Wiley 0
Example 1-1
A market order to sell 10,000 shares of Cumin Company was executed at various times
during the first five minutes of trading. Trade prices and volumes were as follows:
Transaction Bid Ask

Shares Price Price Volume Price Volume
1,000 21.24 21.22 1,000 21.26 3,000
om
3,000 21.30 21.26 5,000 21.30 3,000
6,000 21.16 21.10 3,000 21.20 8,000
l.c
Based on this information, which of the following will be lowest?
ai
A. Mean effective spread.
gm
B. Dollar-weighted effective spread.
@
C. Share-volume weighted effective spread.
Solution:
y
A.
ud
First, calculate the effective spreads:
st
(Bidprice+ Askprice)J
Effective spread = 2x [ Execution price
2
fa
= 2(21.24-21.24) = 0
nc
2(21.30-21.26) = 0.04 and 2(21.16-21.15) = 0.02

ve
Average effective spread is (0 + 0.04 + 0.02)/3 = 0.02.

ra
Dollar weights of three trades are based on the total dollar trading volume of $21 ,240,
$63,900, and $126,960. The dollar weights are 0.100, 0.301, and 0.599 for the three
trades, respectively.
y
ile
Dollar-weighted spread is 0.100(0) + 0.301(0.04) + 0.599(0.02) = 0.024

w
Share-volume weighted spread is 0.10(0) + 0.30(0.04) + 0.60(0.02) = 0.024.

18
Therefore, mean effective spread is lowest.

20
Order-Driven Markets
Transactions prices in order-driven markets are established by public limit orders to buy
or sell. No dealer stands between buyers and sellers, although either buyer or seller may
be represented by a broker. Dealers may trade with other traders in order-driven markets.
Traders do not choose the other side of the trade (as in dealer-driven markets) because
orders execute with the first applicable quote in the market. In some cases, trades may be
executed at more favorable prices because traders do not need to go through a dealer who
gets a cut. Alternatively, trades may be executed at less favorable prices because no dealer
exists to provide liquidity when liquidity is limited.
© 2017Wiley
EXECUTION OF PORTFOLIO OECISIONS
For equity trades, order-driven markets have become more popular.
Types of order-driven markets include:
Electronic crossing networks-Crossing networks serve primarily institutional

investors by batching orders and matching them (crossing them) at various times
during the day, at prices derived from other markets in volume based on the
smallest quantity submitted. Traders are not assured of a match because there is no
dealer standing ready to buy or sell. The orders are anonymous to the market, so
om
information about the buyers and sellers is not leaked. Although orders submitted
indicate the demand (buy) or supply (sell) quantities of a security, there is no price
discovery because orders trade at the prevailing price for that batch of orders. That
l.c
is, more buyers cannot be brought into the market by higher prices. Therefore,
traders who do not purchase or sell as much as they desire may trade the remainder
ai
on other markets or leave the remaining order on the ECN for the next batch to
process. Unmatched orders are not announced.
gm
Auction markets-Periodic/batch auction markets have periodic price setting and
continuous auction markets have ongoing price setting. Some stock exchanges
@
open and close by batching orders at the prevailing market price, and the Tokyo
stock market operates this way after the mid-day lunch break. Auction markets
allow price discovery and avoid the problem of partial fills by finding a price at
y
which sell orders can be filled.
ud
Electronic limit-order markets (automated auctions, ECNs)--Similar to electronic
crossing networks because they are anonymous and computer-based, these markets
st
instead provide continuous execution and allow price discovery. NYSE area
exchange and Paris Bourse are examples. These may also be referred to as electronic
fa
communications networks, and the acronym ECN is reserved for these rather than
nc
for electronic crossing networks. Hedge funds or day traders may make a profit by
providing liquidity in such markets, thus helping to create tighter spreads.
ve
Brokered Markets
ra
In the U.S., broker markets traditionally referred to a less formal communications process
away from the exchange floor, and now describe a process whereby a broker skillfully
y
introduces a trade to dealers or to the market. This process primarily exists now in lower-
ile
liquidity situations such as block orders and on smaller public exchanges. Block orders
have been defined here as large trades relative to liquidity size.
w
Brokers may risk their own capital on all or a portion of the security (i.e., position the
trade), use their reputation to instill confidence in the other side of the trade, or simply
18
weed out potentially unsuitable traders who would be likely to front-run the initiator (i.e.,
exploiting information about the initiator's reasons for buying or selling to execute their
20
own trades at more favorable prices).
Hybrid Markets
Hybrid markets combine features of separately described markets. The New York Stock
Exchange (NYSE), for example, batches orders presented after the close and before the
next open (batch auction market). It then trades continuously during the day (continuous
auction markets). Specialists then help provide liquidity similar to the role of dealers in
quote-driven markets.
©2017Wiley 0
Example 1-2
Which of the following market types would be least likely to attract large institutional
traders more interested in price than in immediacy of the trade?
A. Continuous auction market.
B. Electronic crossing network.
om
C. Electronic limit-order market.
Solution:
l.c
A. While auction markets can aid in price discovery at which a large order can be
ai
successfully executed, this may require discounts to a desired price. Auction
gm
markets also may react negatively to a large sell order, believing that the sale
contains information. This can cause liquidity to diminish and require an
additional discount.
y @
The Roles of Brokers and Dealers
ud
LOS 29d: Compare the roles of brokers and dealers. Vol 6, pp 18-19
st
fa
Portfolio managers and traders should have a deep understanding of the roles undertaken
by dealers and brokers. In some cases, sell-side firms (i.e., investment banks and retail
nc
brokerage) act as both a broker and a dealer, taking a commission from trading clients
while acting as a dealer in the security. While a trader gains by narrower bid-ask spread,
ve
a dealer gains by wider bid-ask spreads. Brokers, on the other hand, tend to have a less
adversarial relationship with dealers.
ra
For the investor or trader, brokers:

y
Present orders to the market;

ile
Find buyers/sellers, sometimes requiring the broker to act as a dealer;

Use discretion (sometimes for their own gain);
w
Supply market information such as demand/supply, counterparty identities, and

risks of trading; and
18
Provide support services (e.g., recordkeeping, cash management, arranging

financing for leverage, etc.).
20
Dealers and other sell-side traders want to know a trader's motivation and are reluctant to
deal blindly with another party (i.e., due to asymmetric information problems). Otherwise,
participants may suffer the adverse selection accompanying a trader's desire to sell (buy)
at an uninformed dealer's bid (ask) price. Brokers may be useful in mediating dealer/trader
concerns about the transaction.
© 2017Wiley
LOS 29e: Explain the criteria of market quality and evaluate the quality of
a market when given a description of its characteristics. Vol 6, pp 19-21
Market Quality
Markets may be judged by their liquidity, transparency, and order completion.
Liquidity
om
Liquid markets are characterized by:
l.c
Resilience-Changes in perceived value tend to be small and quickly reflected in
price;
ai
Quote depth- A reasonable quantity of securities at each quoted bid and ask price;
and
gm
Narrow bid-ask spreads- Tight quoted and effective spreads indicate low
transactions costs to traders.
@
Liquid markets allow trading on specific insights without significant price impact.
Liquidity adds value to companies wishing to list shares on an exchange because the
y
exchange allows investors to assume a position with little risk that they will be unable to
ud
sell the shares. Liquid investments enable companies to attract maximum amount of capital
from an initial or subsequent offering because companies can avoid selling their stocks
st
with an illiquidity discount if their stocks are highly liquid.
fa
Market liquidity develops as the result of:

nc
Many participants (both buying and selling);

Diversity (investment needs, opinions, and information);
ve
Convenience (well thought out trading software or accessible physical location);

and
ra
Integrity (investigation of complaints, auditing financial condition, and trader

compliance, etc.).
y
Transparency
ile
Market transparency can be divided into:

w
Pre-trade transparency-Traders easily gain accurate information about prices and

18
trade volume; and

Post-trade transparency-Fast and accurate trade reporting.
20
Assured Completion
Assured order completion implies that clearing firms or individual brokers guarantee
completion of the trade, and trading counterparties are held to their obligations.
©2017Wiley
Example 1-3
A decline in market quality could best be illustrated by:
A. tighter quoted spreads.
B. tighter effective spreads.
C. decreasing quoted depth.
om
Solution:
l.c
C. Decreasing quoted depth implies a decline in market quality because buyers
and sellers wishing large volume at a particular price must break up their orders
ai
(i.e., less liquidity).
gm
LESSON 2: THE COSTS OF TRADING
@
LOS 29f: Explain the components of execution costs, including explicit and
y
implicit costs, and evaluate a trade in terms of these costs. Vol 6, pp 21- 29
ud
Traders often compare execution markets and strategies with an eye toward minimizing
st
costs along with the relative immediacy of their need to trade. Trading costs today are
viewed as negative performance, so managers and traders must assess implementation
fa
costs versus the information advantage they possess for security value relative to price.
nc
Transaction Cost Components

ve
Explicit trading costs arise from broker commissions, exchange fees, duties and taxes, etc.
Implicit trading costs, however, could not be explicitly shown on a trade ticket but must be
ra
derived from information about a trade:

y
Bid-ask spread;
ile
Market impact (price impact)- Price movement resulting from the need to attract
additional demand or supply;
w
Unrealized profit/loss (missed trade opportunity cost)- Arising from failure to

execute a desired trade in a timely manner, often as a result of attempting to get a
18
better price; and

Slippage (delay costs)-Arising from lack of liquidity (e.g., quoted depth) at a
particular price.
20
In addition to opening and closing prices, or the midpoint quote, traders also use volume-
weighted average price (VWAP) as a reference to determine if they traded at a good
price. VWAP is the price for each share transacted multiplied by that NO transaction's
percentage of total volume for the period, usually daily. A number of vendors (e.g.,
Bloomberg) supply this data for transacted securities so that each firm does not need to
independently calculate this measure.
VWAP offers little information on trades that represent a large portion of periodic volume,
however, because such a trade heavily influences the weighted-average. In the extreme,
©2017Wiley
a single trading desk that purchases all the shares during the day would have an average
price equal to VWAP.
A trader can also game the VWAP measure by, for example, waiting until the end of the
day to determine whether trading at a particular price will be better than VWAP (which
approaches its daily value toward the end of the trading day). If the end-of-day price is not
better than VWAP, the trader can wait until the next day to enter the trade at the opening
price. Using VWAP calculated over multiple days can help reduce this incentive, but
results in less precision for estimated trading costs. Multiple-day VWAP may be useful,
om
however, for measuring effectiveness of trading illiquid assets.
l.c
Example2-1
ai
Attempting to game effective spread as a transactions cost measure by waiting for the
market to approach a limit price will most likely result in:
gm
A. delay costs.
@
B. showing losses on the sell side.
y
C. increases in estimated transactions costs.
Solution:
ud
st
C. Although trading in this manner will result in negative estimated transactions
fa
costs, there will be increased likelihood of positive opportunity costs and delay
costs.
nc
ve
LOS 29g: Calculate and discuss implementation shortfall as a measure of

ra
transaction costs. Vol 6, pp 24-27

y
The most exact approach to transactions cost measurement involves establishing a

ile
hypothetical portfolio with security prices determined at the trading decision (i.e., decision
price, strike price, or arrival price), and measuring the difference with the actual portfolio.
Implementation shortfall captures implicit costs, which may be high for large executions,
w
as well as the explicit costs of trading. Implementation shortfall for purchases is calculated
as the hypothetical portfolio return less the actual portfolio return; implementation
18
shortfall for sales is calculated as the difference between the actual portfolio return and the
hypothetical portfolio return.
20
Thus, positive implementation shortfall/or purchases indicates that the actual purchase
cost more than the hypothetical purchase; positive implementation shortfall/or sales
indicates the actual sale generated less than the hypothetical sale. In both cases, this results
from the friction of transactions costs.
In order to understand each component of implementation shortfall, first consider that there
will be a desired (hypothetical) number of shares SH purchased or sold at the portfolio
manger's decision (hypothetical) price PH. Note that the decision price could be stated as a
mid-quote price, rather than the bid (for sales) or the ask (for purchases).
©2017Wiley
The actual number of shares purchased/sold Swill be transacted at the execution price P£ ·
If the order to purchase/sell shares is carried over from one day to the next, however, the
closing price from the previous day (rather than the desired/ hypothetical price) will then
become the relevant price PR for determining realized profit and slippage costs. Unrealized
profit/loss on the actual portfolio will depend on the last available valuation price PL-
The components of implementation shortfall costs for purchases can then be calculated as
a percentage against the hypothetical portfolio value (SH x PH) as follows:
om
Explicit costs- Commissions, taxes, and fees.
l.c
. . Commissions, taxes, and fees
Exp1c1t costs= - - - - - - - - - -
SH xPH
ai
gm
Realized profit/loss- Price movement from the decision price (i.e. , the relevant
price, often the previous close) to execution price for the portion of the order
executed:
y @
ud
st
Slippage (delay costs)- Price movement if an order is not executed the same day:
fa
nc
ve
ra
Unrealized profit/loss (missed trade opportunity cost)- Trade cancellation price

less the original benchmark (hypothetical) price for the unfilled portions of the
original order.
y
ile
UPL =(SH -S)x(PL -PH)

w
SHxPH
18
Implementation shortfall itself will be the sum of the various components, or can be
simplified and represented/or purchases as:
20
For sales, the prices used in the numerator for all the above computations will be reversed.
© 2017Wiley
Example2-2
XYZ Corporation shares close Monday at $31.00. Before trading on Tuesday, a portfolio
manager sends a day order to her trading desk to purchase 1,000 shares of XYZ at
$29.98 or better per share. The order expires unfilled at the end of the day with a closing
price of $30.00. Before trading on Wednesday, the PM sends a new day order to her
trading desk to purchase 1,000 shares of XYZ at $30.01 or better. The trader is able to
fill 750 shares at $30.01 with a commission of $112.50. The price of XYZ shares closes
om
at $30.15 on Wednesday. The PM decides not to submit another order for the remaining
250 shares.
l.c
The implementation shortfall components are:
Commission and fees of36 bp (112.50/31,000).
ai
Realized profit/loss (late trade opportunity cost):
gm
RPL= Sx(PE-PR)
SH xPH
@
750 x ($30.01-$30.00)
0.00024or2bp
1, 000 x $31.00
y
ud
Slippage costs (delay) from the desired price if execution were to occur at the
relevant price:
st
Delay= Sx(PR - PH)
fa
SHxPH
nc
750 x ($30.00-$31.00)
-0.02419 or - 242 bp
l,000x$31.00
ve
Unrealized profit/loss (missed trade opportunity cost):

ra
UPL= (SH-S)x(PL -PH)

SH xPH
y
= (l,000-750)x($30.15-$31.00) _-0.006 r_ bp
ile
850 69
l,000x$31.00
w
Implementation costs for this purchase are the total of these items, or-273 bp.
This can also be found using the formula for implementation costs, and provides
18
a good check:
20
Implementation shortfall= Commissions+S(PE-PL)+SH(PL -PH)

SHxPH
112.50+ 750($30.01-$30.15) + 1,000($30.15 -$31.00)
31,000
= -0.02718 or- 272 bp
The difference is due to rounding.
©2017Wiley
Note that the negative sign indicates a negative shortfall (a favorable result
because the shares were executed at a favorable price), although pre-trade cost
estimates will always be positive owing to the commissions and fees and the
assumption of trading at a relevant price.
Some firms complement implementation shortfall by accounting for the anticipated trading
costs as if the trades were executed in an expected market and component costs are at
om
expected levels.
The application of benchmark price based on trading cost measures (i.e., VWAP, effective
l.c
spread, and implementation shortfall) cannot be effective if a market lacks accurate
price and volume information. Further, the implementation shortfall approach cannot be
ai
effective if the asset trades infrequently because the relevant price will reflect only a trade
that happened much earlier.
gm
Exhibit 2-1: Comparison ofVWAP and Implementation Shortfall
@
Volume-Weighted Average Price (VWAP) Implementation Shortfall
Advantages Easy to understand Recognizes price immediacy
y
Easy to compute Allows cost attribution
Can assist traders during execution
Best for smaller trades in non-trending
ud Works in optimization programs by
reducing turnover
markets
st
Cannot be gamed
Disadvantages Does not account for costs of delayed or Requires extensive data collection/
fa
cancelled trades interpretation

Misleading for trades that are high Unfamiliar framework for traders to use
nc
percentage of volume
Trade size/market impact do not factor in
ve
Delaying trades can improve trade price,

but may increase opportunity cost
ra
y
LOS 29h: Contrast volume weighted average price (VWAP) and

ile
implementation shortfall as measures of transaction costs. Vol 6, pg 28
in pretrade analysis to
w
LOS 29i: Explain the use of econometric methods

estimate implicit transaction costs. Vol 6, pp 30-31
18
Pretrade Analysis: Econometric Models for Costs

20
Econometric models that help produce reliable pre-trade cost estimates are typically
related to:
Risk- Volatility of security returns;

Liquidity- Price level, volume, market cap, trading frequency, bid-ask spread, and
index membership;
Trade size as a percentage of average daily volume;
Momentum- More costly to purchase in an up market than a down market; and
Trading style-Market orders (aggressive) cost more than limit orders (passive).
@ © 2017Wiley
The cost function estimated with the model using these variables can be used to estimate:
Optimal trade size; and

Trading costs to use in assessing quality of actual trade execution.
Example2-3
Elvin Bishop has identified an econometric trading cost model that estimates Market
om
A has trading costs, excluding transactions charges, 20 bp greater on average than in
Market B. Transactions charges, however, tend to run 20 bp greater on average in Market
B than in Market A. Which of the following is the best description of how Bishop should
l.c
conduct his trades in a thinly traded security where time is not of the essence?
ai
A. Transact in Market A only.
gm
B. Transact in Market B only.
C. Transact in either Market A or Market B, depending on quote depth.
@
Solution:
y
A. ud
Because the trading costs (usually associated with lack of liquidity, etc.) in
Market A are higher, but Market B has higher transactions costs (i.e., broker
st
commissions, fees, etc.), Bishop should transact in Market B when he can go
direct to a dealer and Market A when he requires a broker, as in the case of a
fa
thinly traded security.

nc
LESSON 3: TYPES OF TRADERS AND THEIR PREFERRED ORDER TYPES

ve
ra
LOS 29j: Discuss the major types of traders, based on their motivation
to trade, time versus price preferences, and preferred order types.
y
Vol 6, pp 33-36
ile
Investment management sty le direct! y affects implementation strategy and, therefore,

w
cost. Strategies that take a more active management approach (i.e., based on momentum,
news, frequent rebalancing, etc.) tend to have higher transactions and trading expenses. A
18
successful strategy depends on information content of the trades earning returns greater
than costs.
20
Therefore, trade urgency (i.e., necessity for quick and certain execution) becomes the
fundaroental determinant of trading strategy. Urgent trades must be executed quickly to
take a position before the market becomes aware of news about the company. Non-urgent
trades may instead use limit orders to attain a particular price.
©2017Wiley
Trader Motivations
A trader's motivation suggests trader classifications:
Information motivated-New information can move prices, and traders depend on

quick execution to capture profits from under- or over-valued securities before the
rest of the market assimilates the information. These are usually a single security,
transacted in large blocks. These traders avoid publicity and notoriety so that other
traders won' t avoid taking the other side of the trade.
om
Value motivated-Research and valuation suggest theoretical price targets. These
traders purchase securities when actual prices fall below the theoretical prices
(value). These traders may make infrequent trades over a longer time horizon in
l.c
order to avoid price movements away from their intention.
Liquidity motivated-Traders may need liquidity to fund other positions with more
ai
profit potential, adjust portfolio exposures to certain assets, or simply to buy a new
boat. These traders often provide liquidity for other types of traders and should not
gm
relinquish their positions in such securities too quickly.
Passive-index and other passive strategies attempt to implement strategies with
@
lower costs, therefore are less sensitive to the timing of trades. Indexes themselves
do not consider transactions costs, so to be effective against an index, the trader
must find other cost advantages.
y
ud
Other types of traders may span more than one strategy. Dealers, for example, require
quick executions to earn money off the spread, and will tend to trade more like
st
information-motivated traders in that regard. However, they are willing to let the other
party determine the timing of the trade in exchange for getting their price, much like
fa
passive traders.
nc
Arbitrageurs, on the other hand, exploit small price discrepancies in the same asset across
different markets. Thus, they are dependent on quick executions at favorable prices.
ve
Day traders typically seek to hold positions in momentum securities for a very short
ra
period, but often accommodate other traders much like dealers.

y
Exhibit 3-1: Trader Type by Motivation and Preferences

ile
Trader Type Motivation Preference Holding Period

Information Unassimilated information Time Minutes/hours
w
Value Valuation errors Price Days/weeks

18
Liquidity Divest securities, invest Time Minutes/hours

cash, buy things
Passive Rebalance (to index) Price Days/weeks
20
Dealers/Day traders Accommodate other traders Indifferent Minutes/hours
Traders in alternative assets tend to follow similar patterns (with the exception of not
having a counterpart to day traders). However, alternative assets tend to be less liquid and
may require greater holding periods.
©2017Wiley
Traders' Selection of Order Types
Buy-side traders use various types of orders depending on market conditions and portfolio
manager preferences.
Information-Motivated Traders
These traders typically seek the rapid execution and price certainty available through a
dealer, and may act as principals in many cases. Dealers often require price concessions,
om
however, to move the large amount of inventory often required for such trades. These
traders may use market orders to disguise the knowledge, supposedly novel, on which they
are trading.
l.c
Value-Motivated Traders
ai
Because value-motivated traders have independently assessed value, they can use a limit
gm
order slightly above the current price but below their fair value estimate. As the market
starts to recognize the undervalued security and bid up its price, the limit order is triggered.
The trader can then put in a sell order close to the fair value estimate. These traders can
@
control price, but not timing of the execution.
y
Liquidity-Motivated Traders
ud
These traders typically desire low price impact and low commissions, and can often be
st
more patient than information-motivated traders as to timing of executions. Such traders
may be willing to expose themselves as requiring liquidity, so dealers may be allowed to
fa
offer fewer protections about how the trades are handled.

nc
Passive Traders
ve
These traders typically use limit orders, portfolio trades, and crossing networks to reduce
trading costs, and may be able to completely eliminate bid-ask spread costs. In exchange,
ra
they accept uncertainty with respect to execution within a reasonable time. These strategies
are best suited to moderate-sized trades in markets with broad (rather than concentrated)
participation.
y
ile
LESSON 4: TRADE EXECUTION DECISIONS AND TACTICS AND SERVING

THE CLIENT'S INTERESTS
w
This section examines the combinations of security characteristics, market types, and order
18
types useful in implementing various strategies.

20
Handling Trades
A good trader creates a daily strategy that minimizes costs in the context of market
conditions and the portfolio manager's trading needs. Traders must also consider cash
balances, client trading restrictions, and broker allocation commitments. Additional
considerations by trade type include:
Small, liquidity-motivated trades-Suitable for direct market access (DMA) that

permits buy-side traders to place trades directly to the market via the brokers'
platform. Also suitable for algorithmic trades in which preprogrammed trading
©2017Wiley
instructions are delivered to the brokers' platform. The main point here is not to
involve senior traders and brokers in trades where they carmot add value.
Large, infannatian-mativated trades- Senior traders and skilled brokers can
make a difference here by providing the market with only the information content
necessary to give the market incentives to trade larger transactions while balancing
impact and delay costs.
The process starts by deterntining the size of the specific order to trade and the urgency of
that trade. The tactical concerns then revolve around:
om
Trading tactics, such as how to reveal only the information necessary to complete
the trade;
l.c
Which specific securities within the position to trade (e.g. , to optimize tax
consequences);
ai
Using DMA/algorithmic trades or the special handling a trader/broker can bring;
Lowest overall cost platform;
gm
Alternative plan if the low cost plan fails;
Deterntining which broker to use, if one is needed; and
@
Feedback to provide to the portfolio manager.
Objectives in Trading and Trading Tactics
y
ud
LOS 29k: Describe the suitable uses of major trading tactics, evaluate their
relative costs, advantages and weaknesses, and recommend a trading tactic
st
when given a description of the investor's motivation to trade, the size of
fa
the trade, and key market characteristics. Vol 6, pp 37-40

nc
In developing and implementing trading tactics, traders often make errors related to:
ve
Giving up profit during execution of a value-motivated transaction (i.e. , selling

time too cheaply);
ra
Giving up profit during execution of an information-motivated transaction (i.e. ,

buying time too expensively); and
y
Releasing information that allows other traders to exploit or avoid the position.
ile
The latter is often the most costly mistake.

w
Liquidity at Any Cost

18
These traders are often able to attract brokers interested in the information content of their
trades, but usually only get the liquidity they need by giving price concessions or at high
20
commission rates. Liquidity traders often create a market disturbance when they enter
the market as their institutional size trades challenge the existing liquidity in the market.
Normally non-aggressive traders (e.g., mutual funds) may be pushed into this position if
they receive excessive end-of-day liquidation requests.
© 2017Wiley
Costs-Are-Not-Important Focus
Market orders exemplify this focus, dominated by mixed investment strategies in which
information, value, or liquidity focus is difficult to assign. This focus works best for small
trade sizes and actively traded issues. Traders do not actively need to execute these orders
because exchanges set up procedures to ensure fair execution, with the executed price
often very close to expected fair value. Market orders are easy to execute and are often
used to generate soft dollars for the brokerage.
om
Traders may use buy-limit orders that improves on the best bid or sell-limit orders that
improve on the best ask price. In most other cases, however, traders hand off discretion to
the market.
l.c
Need-Trustworthy-Agent Focus
ai
Traders in thinly traded issues may choose to execute orders through a floor trader
gm
who can uncover interest or take advantage of it as it arrives in the market. The trader's
order may be packaged with other orders, or may be split up and executed as special
orders. Such trades often reveal important information to the floor broker, and may even
@
encourage them to participate in trades. This makes it difficult for the trader to know if the
information was used in his/her best interests.
y
Advertise-to-Draw-Liquidity Focus ud
st
Advertising publicly displays trading interest in advance of the actual order, as in the case
of IPOs, secondary offerings, and sunshine trades, which advertise the price to keep it
fa
more stable based on the volume involved. This has the disadvantage of alerting traders to
a possible front-running opportunity by trading in front of the actual trade to establish the
nc
contra-position.
ve
Low-Cost-Whatever-the-Liquidity Focus
ra
These trades attempt to earn extra profit by using a limit sell order above the inside ask
price or a limit buy order below the inside bid price. Because of the potential wait for
the order to fill, these are best suited to passive or value strategies. Minimizing trading
y
costs also drives these trades. Disadvantages of waiting include the possibility of new
ile
information entering the market and creating less profit potential. Buy limits under the
market price run the risk of being hit when unfavorable news hits the market. At that point,
w
prices may fall even further.

18
Considerations associated with these trading strategies are shown in Exhibit 4-1.
20
©2017Wiley
Exhibit 4-1: Trading Objectives
Focus Purpose Costs Advantages Disadvantages

Liquidity at Immediate! y Upsetting Guaranteed Information
any cost execute large supply/demand execution leakage and
blocks market impact
possible
Need Low level Higher Price Lose trade control
trustworthy advertising on commissions; improvement
om
agent large trades; information due to ability
possible leakage to wait
hazardous
l.c
situation
Costs are not Certain Spread; potential Market- Lose trade control
ai
important execution price impact determined
gm
price
Advertise to Large trades High Market- Possible front
draw liquidity without (organizational deterrnined running
@
information and operational) price
advantage cost
y
Low cost Indifferent to High search and Favorable Execution
whatever the
liquidity
timing; non-
informational
ud
monitoring costs;
low commission
price possible uncertainty;
possible
st
trades movement away
from price
fa
point results in
nc
"chasing" the
market with limit
orders
ve
ra
Automated Trading
y
LOS 291: Explain the motivation for algorithmic trading and discuss the
ile
basic classes of algorithmic trading strategies. Vol 6, pp 40-44

w
Where very large transactions make more sense to execute in order-driven markets with
the help of a broker, smaller trades with generally adequate liquidity may find less costly
18
execution using dealers in quote-driven markets. The evolution of markets has also led to
automated trading (i.e., non-manual trading) such as:
20
Algorithmic trading- Based on quantitative rules and subject to user defined

constraints and benchmarks (e.g., portfolio trades for an entire basket of
securities); and
Smart routing- Automatically routing trades to the venue with lowest cost
execution.
Algorithmic trading executes orders with controlled risks and costs by breaking larger
orders up to match market flow. Traders should be cautious that an algorithmic system that
executes the easiest trades first also considers more difficult trades or the trader could be
stranded at the end of the trading day.
© 2017Wiley
"Algo" trading may be as simple as rules-based pairs trading, in which a long position
in one stock and a short position in another stock will be simultaneously bought or sold
depending upon certain conditions (e.g. , price ratio crosses a particular threshold). This
early strategy has developed into trading that considers horizon, style, and venue rules:
Logical participation strategies

o Simple logical participation strategies- Participate in market flow without
undue visibility and price disruption:
Volume-weighted average price (VWAP) strategy-Match the
om
expected (forecast) volume for the stock.
Time-weighted average price (TWAP) strategy-Breaks order up
for exposure at various time periods during the day, useful when
l.c
the volume is light or erratic.
Percentage of volume strategy-Trading occurs as some percentage
ai
of overall market volume until completed.
o Implementation shortfall- Also known as the arrival price strategy,
gm
this approach seeks to minimize the weighted-average of impact and
opportunity costs by "front-loading" executions into the early part of the
@
trading day. These strategies are especially useful when there is a need for
formal control to assure executions such as in the case of portfolio trades or
y
multi-period trading when a portfolio manager hands off to a new manager.
Opportunistic strategies- These strategies typically involve passive holding
ud
and opportunistically seizing liquidity. In pegging and discretion strategies,
for example, traders may incur negative costs by buying at the bid price or, if
st
the spread is narrow, at the ask price. This may involve crossing internally or
fa
externally using hidden orders.

Specialized strategies-Smart routing can be thought of as a type of specialized
nc
strategy. Other strategies involve passive orders which do not guarantee execution,
"hunter" strategies that attack liquidity when offered, and benchmark-based
ve
algorithms (e.g. , market on close that purchases a basket at the closing price).
The Reasoning Behind Logical Participation Algorithmic Strategies

ra
LOS 29m: Discuss the factors that typically determine the selection of a
y
specific algorithmic trading strategy, including order size, average daily

ile
trading volume, bid-ask spread, and the urgency of the order. Vol 6, pp 4~7
w
Many studies have concluded that increasing order size tends to increase market impact
18
costs. Simple logical participation strategies assume that traders minimize market impact A question
costs when they trade in proportion to market volume. This follows the logic that trades regarding
appropriate trading
have a price-time tradeoff and breaking large orders into smaller orders will improve price
20
strategy given bid-

at the expense of time. ask spread, order
size, average daily
trading volume
for the investment,
Simple logical participation strategies such as volume weighted average price (VWAP) and urgency would
will be more appropriate when trades have low urgency, low bid-ask spreads, and represent make an excellent
multiple choice
a small percentage of trading volume in the security. question.
The more sophisticated implementation shortfall strategies recognize that market impact
costs must also be balanced against missed trade opportunity costs, which increase with
the time between order entry and execution. This recognition suggests that implementation
shortfall strategies trade a high proportion of volume early in trading rather than later, and
©2017Wiley
the weighted average of higher market impact costs will be offset by the weighted average
of lower missed trade opportunity costs.
Implementation shortfall strategies will be more appropriate when greater trade urgency
requires a balance between market impact costs and missed trade opportunity costs (e.g.,
information trading, acquisition, etc.).
Traders will be most likely to forego algorithmic trading for a broker or crossing system
when there is low urgency but high bid-ask spreads.
om
Example4-1
l.c
A trader sees the following pending trades on his blotter:
ai
Symbol Side Shares Avg. Vol Price % Spread Urgency
gm
A Buy 25,000 50,000 14.25 0.45 Low
B Buy 215,000 4,250,000 48.17 0.04 Low
@
c Sell 50,000 500,000 24.50 0.04 High
y
Which of the following shares (represented by their symbols) would most likely be
traded using a broker? ud
st
A. A
fa
B. B
nc
c. c
ve
Solution:
A. The shares of A are high in relation to average volume, and the percentage
ra
spread is great, meaning that a broker could bring value to the transaction.
Shares of B would most likely be traded using an algorithm sensitive to
y
VWAP because they represent a small fraction of daily volume and margins
ile
are narrow. Shares of C would most likely be algorithmically traded, but using
implementation shortfall rather than VWAP due to the high urgency of the
w
trade.
18
Trade Management Guidelines (CFA Institute)

20
LOS 29n: Explain the meaning and criteria of best execution. Vol 6, pp 47--48
CFA Institute's Trade Management Guidelines ("the Guidelines") were designed to

provide investment managers with an ethical approach to best execution for clients. Best
execution concerns the methods used to make trades in a way that minimizes frictional
trading costs within the constraints (e.g., urgency) necessary for the trade.
©2017Wiley
The Guidelines identify the following characteristics of best execution:
Value of trading decisions and portfolio strategy cannot be separated (e.g.,

urgency/information decisions necessitate a different cost outcome than value
decisions);
Trading costs cannot be deterntined ex ante because best execution occurs through
negotiation between buyers and sellers;
Ex post measurement of best execution may be possible over a sequence of trades,
but seldom on an individual-trade basis; and
om
Trading is a process with standards that address behaviors rather than outcomes.
l.c
LOS 290: Evaluate a firm's investment and trading procedures, including
processes, disclosures, and record keeping, with respect to best execution.
ai
Vol 6, pp 48-49
gm
The Guidelines recommend practices rather than specific methods for measuring
transactions costs. Thus, the Guidelines have been segmented into:
@
1. Processes- Firms should formalize policies and procedures to achieve best
execution for clients. These policies and procedures should address managing trade
y
decisions and measuring the quality of outcomes.
2. ud
Disclosures- Firms should disclose information about agents, trading techniques,
and venue selection, as well as any trade-related conflicts of interest.
st
3. Recordkeeping- Firms should maintain records supporting client disclosures and
compliance with the firm's policies and procedures.
fa
nc
The Guidelines focus firm efforts on best execution which, in the end, results from serving
client needs for trading expertise.
ve
Importance of Ethical Focus

ra
LOS 29p: Discuss the role of ethics in trading. Vol 6, pg 49

y
Trading has come to rely less on using middlemen. Brokerage commissions have
ile
diminished as a source of income, implicit costs have increased as a percentage of total

trade costs. This has made it difficult to align buy-side client/trader interests with sell-
w
side broker/dealer interests. As a result, trading has become adversarial and each party's
information is seen as a potential threat. Traders must rely on other traders' reputations
18
and their willingness to build and maintain long-term relationships, especially where it
concerns each trader's willingness to stand behind their promises.
20
Traders who fail to act ethically will soon find no trust among their peers.
Both the portfolio manager and buy-side trader must focus on client interests and act in
a fiduciary capacity. The trader's loyalty to his firm and other traders must be carefully
balanced against the fiduciary duty to the client.
©2017Wiley
20
18
w
ile
y
ra
ve
nc
fa
st
ud
y@
gm
ai
l.c
om
MONITORING AND REBALANCING
READING 30: MONITORING AND REBALANCING
Time to complete: I to 2 hours
Reading su mmary: You should be able to discuss monitoring investor portfolios for
material changes in investor circumstances, divergence from economic expectations
and relationships, and changes in portfolio allocation relative to the SAA. Be able to
recommend and justify changes to an !PS/SAA when investor circumstances change. You
should also be able to compare and contrast various strategies for rebalancing portfolios
when they diverge from the SAA.
om
INTRODUCTION
l.c
After a well-defined investment policy statement (IPS) is developed, a portfolio manager
must keep his fiduciary duty by regularly monitoring the client's portfolio. To ensure the
ai
client's objectives are met and constraints are addressed, a portfolio manager often needs
gm
to rebalance the client's portfolio. Rebalancing the portfolio is particularly important in
response to changes in the client's circumstances, volatilities in market, and fluctuations in
asset values.
@
This lesson will provide you with the tools to:
y
I. Discuss fiduciary duties related to monitoring an investor's portfolio and the
ud
cross-feedback between a portfolio and the investor related to changes in investor
circumstances, economic/market conditions, and individual holdings in the
st
portfolio;
fa
2. Recommend and justify portfolio revisions given benefits and costs of various
rebalancing methods ; and
nc
3. Develop appropriate rebalancing strategies given the investor's return expectations

and risk tolerance.
ve
LESSON 1: MONITORING FOR IPS CHANGES (INDIVIDUAL AND

ra
INSTITUTIONAL)
y
LOS 30a: Discuss a fiduciary's responsibilities in monitoring an investment

ile
portfolio. Vol 6, pp 66--83

w
Monitoring involves systematically tracking information to achieve investment goals.

18
Investment managers should monitor all aspects of their client portfolios, including:
Investor circumstances and constraints;

20
Changes in markets and the economy; and

Portfolio results.
Monitoring Changes in Investor Circumstances and Constraints
Advisors should pay attention to client needs and circumstances in all interactions, but
special opportunities to assess client circumstances arise at periodic review meetings.
Private wealth managers will typically meet with clients semi-annually or quarterly while
institutional managers will tend to meet with clients annually for an asset allocation review.
©2017 Wiley
MONITORING ANO REBALANCING
Investor Circumstances
LOS 30b: Discuss the monitoring of investor circumstances, market/

economic conditions, and portfolio holdings and explain the effects that
changes in each of these areas can have on the investor's portfolio.
Vol 6, pp 67-83
om
For private wealth clients, life events like changes in marital status, employment, health,
birth of a child, or death of a parent may affect expected family income, expenditures,
retirement plans, and risk tolerance. These changes often call for a review of an investment
l.c
policy statement and the overall financial strategy. For institutional clients, changes in
governance practices, mandates from trustees, requirements for beneficiaries, and operating
ai
expenses all could potentially contribute to the need for portfolio changes. Frequent
communications should be established with clients to ensure awareness of changes.
gm
Investor return requirements may change as financial goals move toward achievement or
disaster, as measured by the investor's wealth. Increases in wealth typically allow investors to
@
pursue greater returns because they can accept greater risk. Investment managers, however,
should counsel clients not to change their expectations based on short-term market results.
y
Liquidity Needs
ud
st
A liquidity requirement involves anticipated or unanticipated needs for cash in excess of
new contributions. For private wealth investors, change in liquidity needs might be the
fa
result of divorce, retirement, loss of employment, lawsuit settlement, and purchase of a

nc
home. For institutional clients, events such as a withdrawal of benefits from defined-pension
plans and need for capital projects might require additional liquidity. Investment managers
should try to meet changing liquidity needs for private or institutional clients, although such
ve
needs may constrain the investments selected away from less liquid investments.
ra
Time Horizon
y
Time horizons are different for individuals and institutions. While individual investors
go through a typical 60-year investment life cycle, institutions are often assumed to exist
ile
in perpetuity. Portfolio managers typically reduce investment risk as an individual ages

by allocating assets to safer instruments such as bonds. The multi-stage time horizon
w
for individuals as they move through their life cycles will often require managers to
make more than one adjustment to the strategic allocation. An unexpected death of the
18
breadwinner, for example, will require immediate attention.

20
Institutional investors, on the other hand, typically work with clients who have unlimited
time horizons and for whom appropriate asset allocation will hardly change. Investment
policy may require abrupt changes, however, when the last income beneficiary dies
and the remaining funds (residue) pass to those with claims on the remaining funds
(remaindermen). Sudden employment changes at a company may necessitate asset
allocation and other changes to a pension fund.
© 2017Wiley
LOS 30c: Recommend and justify revisions to an investor's investment

policy statement and strategic asset allocation, given a change in investor
circumstances. Vol 6, pp 69-70
Example 1-1
The Todd's have unexpectedly become pregnant. All pregnancy-related expenses will
om
be covered by their employer's healthcare plan. The Todd's will most likely change their
financial plans based on:
l.c
A. greatly increased cash needs.
B. introduction of new time horizons.
ai
gm
C. need for greater return on investments.
Solution:
@
B. The most likely change will be an introduction of an accumulation plan to send
y
young Todd to college. There is no need for greatly increased cash balances
ud
because the funds can remain invested until they are required for college expenses.
We do not have enough information to assume the need for a greater return on
investments, and don't know what the current return might be. Also, with greater
st
return requirements comes greater risk. A couple's need or willingness for more
fa
risk is not always indicative of their ability to assume greater risk.

nc
Tax Considerations
ve
Investors are subject to changes in amount, tinting, and type of taxes over time. Therefore,
ra
tax efficiency (the percentage of after-tax to pre-tax return) becomes of great importance to
tax-paying investors. Investment managers should consider the effect of holding period and
portfolio turnover on an investor's overall tax situation.
y
ile
Simple tax strategies include:

w
Intra-temporal loss recognition (i.e., year-end sale of positions with losses to offset
gains in other areas);
18
Inter-temporal income and expense management (i.e. , managing gains and income
into years with lower income or tax rates, and managing losses and expenses into
years with higher income or higher tax rates);
20
Tax avoidance (e.g., municipal bond or other tax-advantaged investments, IRAs);

and
Tax-advantaged charitable contributions (e.g. , giving securities with a low basis
and high gain to a charity may offer deductions from income at fair value with
minimal or no other tax consequences).
While this seemingly affects only managers of taxable accounts, institutional managers
should also monitor changes to tax laws because they can affect the relationship among
asset classes on which asset strategies have been based.
©2017Wiley
Legal and Regulatory Issues
Portfolio managers must understand how laws and regulations affect their duty and ability
to manage client assets, and monitor them to ensure compliance. For example, the recently
adopted prudent investor rules allow much broader discretion for U.S. portfolio managers
than under the previous prudent man rules. It is the manager's responsibility to ensure
the portfolio is in compliance with the laws as well as taking advantage if investment
opportunity arises.
om
Unique Circumstances
Unique circumstances are client-specific factors that constrain portfolio choices but are
l.c
not addressed in other categories. Examples include moral objections to certain industries,
highly concentrated stock holdings, highly appreciated holdings, etc. Institutional investors
ai
may also have unique circumstances such as socially responsible investing (SRI) mandates,
corporate governance concerns, etc.
gm
Example 1-2
@
An executive in a major corporation has a high value investment portfolio but has
y
spending desires that cannot be satisfied by earnings from that portfolio. One of the
ud
holdings is a concentrated position in non-dividend paying, highly appreciated employer
stock that the investor feels he must maintain to show confidence in his company.
st
Satisfying his current income desires will result in delaying retirement by as long as
10 years, depending on market performance for the assets. The best method to reduce
fa
tension between current income desires and longer-term financial goals is to:
nc
A. delay retirement.
ve
B. defer the spending.

ra
C. sell the highly appreciated employer stock.
Solution:
y
ile
B. The most direct method that will meet his longer-term goals is to defer
spending. Delaying retirement may or may not be possible given his position
w
as an executive of the company. Selling the highly appreciated stock will result
in a large capital gains tax liability that must be paid out of current income (or
18
the sale of the stock). There are other tax advantageous ways to better match the
gain with losses or otherwise dispose of concentrated JXJSitions.
20
Highly concentrated and highly appreciated holdings are both common and carry
significant tax implications. Several tax-advantaged approaches to reduce the impact of
these positions are presented in Exhibit 1-1.
©2017Wiley
Exhibit 1-1: Monetization and Hedging Strategies
Strategy/Description Advantages Drawbacks

Zero-premium collar- Locks in band of values Caps potential upside.
Long puts and short call for the position. Involves commission on
options on the stock. Defers capital gain until options.
Funding purchase of put shares are sold. Hedge is on! y effective
options with strike price during life of the
om
below market by selling call options.
options with strike price May attract scrutiny of
above market. tax authorities if allowed
l.c
at all.
Variable prepaid forward Defers capital gains Gives away part of
ai
-Combine a collar with a until actual sale of appreciation to lender.
loan and long the underlying shares. Incurs commissions and
gm
shares. When loan comes 70-90 percent of interest expense.
to due, sell shares to pay position converted to May attract scrutiny of
@
off loan and share any cash via loan. tax authorities if allowed
appreciation with the lender. at all.
y
Private exchange fund- Tax-free exchange. Shares must be part of
Index fund exchanges fund
shares for index constituent
Increased ud
diversification.
index.
Fund may not be
st
shares. Low ongoing expenses. interested.
Discount to market value
fa
may be required.
Substantial share
nc
position often required.

Exchange fund- Many
ve
Tax-free exchange. Incurs expense and other

investors place disparate Increased fees.
holdings in a fund in diversification. Other potential expenses.
ra
exchange for shares of the Incomplete

fund. diversification.
y
ile
w
Examplel-3
18
An executive in a major corporation has a high value investment portfolio but has
spending desires that cannot be satisfied by earnings from that portfolio. One of the
holdings is a concentrated position in non-dividend paying, highly appreciated employer
20
stock that the investor feels he must maintain to show confidence in his company.
Satisfying his current income desires will result in delaying retirement by as long as
IO years, depending on market performance for the assets. The best method to increase
income from the portfolio in a tax efficient manner is via a:
A. zero premium collar.
B. variable prepaid forward.
C. private exchange for S&P 500 index fund shares.
©2017Wiley
Solution:
C. The private exchange for S&P 500 index fund shares will allow this investor
to receive a dividend against the value of the highly appreciated shares
contributed. Because this was an exchange, there will be no capital gains tax
liability. The zero premium collar and variable prepaid forward strategies do not
diversify the concentrated position in highly appreciated shares, which also pay
no dividend.
om
Changing Capital Market Expectations
l.c
Financial markets not only respond to economic change, but also to investor perceptions
ai
of asset value relationships given potential economic change. Portfolio managers should
provide a broad and inclusive monitoring on the following attributes of the financial
gm
markets and the economy for signs of changes that could affect client portfolios.
Mean-Variance Inputs
@
Investors who experience a change in relationship between risk and return for the asset
y
classes in which they invest must either reallocate their portfolio or reconsider investment
ud
objectives. Potential changes in risk-return relationships offer portfolio managers the
opportunity to capture tactical allocation gains for their clients, protect them from
st
unwelcome risk, or both.
fa
Asset pricing theory suggests that the market will only compensate systematic risk
(undiversifiable risk). Hence, active asset managers' ability to identify mispricing and
nc
exploit inconsistencies helps investors profit from such opportunities. Increasing volatility
often causes other asset managers to sell, while astute asset managers recognize it as an
ve
opportunity to purchase underpriced securities.

ra
Valuation Levels
Assets tend to become overpriced (overbought) during good times, with an expectation
y
that such growth will continue. Conversely, assets tend to become underpriced (oversold)
ile
during bad times. Active asset managers recognize market turning points and make tactical
asset allocation decisions that capture the value of those changes. Individual securities
w
often suffer similar periods of under- or overvaluation. Astute asset managers will be
prepared to act when they spot securities about to change fortune.
18
Long-term bonds tend to lose value during recessions because investors demand additional
20
risk premium during bad times. Short-term bonds will be less affected by bad times
because the money will be returned more quickly.
Policy Interest Rate Shifts
Central bank policy affects money supply, which further affects liquidity and interest rates.
These changes to relative costs of holding money versus spending it change the price of
financial assets. Increasing interest rates (restricting credit) usually hurts stock prices.
© 2017Wiley
Inflation and Interest Rates
Recall yield curve provides insights on investors' required return on various maturities.
Increasing yield typically hurts long-term securities more than short-term securities
because shorter maturity securities allow faster reinvestment at higher interest rates.
Portfolio managers closely monitor the yield curve for changes in inflation because they
affect both yield and equity securities. The yield securities lose value when actual inflation
increases more than expected as investors require higher returns.
om
Yield curves become steeply upward sloping during recessions as longer-term bonds
require greater price concessions. During expansions, yield curves flatten somewhat. Prior
to recessions, yield curves tend to slope downward in anticipation of lower interest rates.
l.c
Lower credit quality issues may fall in price (increase in yield) as the possibility of default
increases during bad times or periods of high interest rates.
ai
Part of the increased price of goods captured in inflation measures, however, actually
gm
accrues to the bottom line for equity securities so they tend to decrease proportionately less.
These changes all have price impacts that portfolio managers may exploit.
@
Portfolio Performance
y
ud
Portfolio managers engage in different types of activities depending on how asset values
within the portfolio change:
st
Rebalancing-Changes within the existing strategic asset allocation (SAA) are
fa
required when asset values deviate from a client's intended investment objectives
(e.g., when higher equity returns increase the proportion of equity holdings in the
nc
portfolio). Portfolio managers may remedy this to some extent by changes to sector
and style exposure within existing asset classes.
ve
Reallocation-Prospects for various asset classes and their relative risk-return

characteristics change. In some cases, tactical asset allocation (i.e., allocation
ra
change within narrow parameters around the SAA) may remedy a temporary
divergence from long-term expected asset class risk and return. Portfolio managers
y
may also remedy relative valuation within asset classes by changes to sector and
style exposure.
ile
Intra-asset class substitution-Prospects for individual holdings within each class

change.
w
Portfolio managers must weigh the costs of portfolio changes (e.g., taxes, transactions
18
costs, etc.) with the expected benefits in terms of risk and return.
20
Adherence to an SAA often involves:
Discipline-Selling outperforming investments rather than holding too long and

suffering losses. Holding underperforming investments rather than selling them
before the strategy is realized.
Independence-Refusing to join popular trends and investing in unpopular areas
with prospects unrecognized by the crowd.
Deviation from established roles- Rather than seeking comfort in what has
worked in the past, successful portfolio managers often demonstrate the discipline
to stick with the investment policy and go against the crowd.
©2017Wiley
In many cases, portfolio managers may be forced by clients to maximize satisfaction rather
than return. Otherwise, clients who feel uncomfortable with strict adherence to an SAA
may limit future trading or abandon even a very successful strategy.
Example 1-4
The expected risk-return characteristics for certain commodities have changed as a result
of two economically prominent countries outlawing physical precious metals ownership.
om
This would most likely result in a portfolio manager engaging in:
A. rebalancing.
l.c
B. reallocation.
ai
C. intra-asset class substitution.
gm
Solution:
@
B. This would most likely be considered reallocation because substantial
relationships among asset classes (commodities v other asset classes) will have
y
changed. This would not be considered rebalancing because it did not result
ud
simply from price growth of a higher returning asset class. It would also be
less likely to fit into intra-asset class substitution because the whole asset class
st
commodities will be affected if one precious metal cannot be substituted for
another with substantially similar class characteristics.
fa
nc
LESSON 2: REBALANCING THE PORTFOLIO

ve
Portfolio managers monitor portfolios to make sure returns are on track to meet investor
expectations, but must periodically make "course corrections" to keep the portfolios on
ra
track. Rebalancing is one type of course correction. Although rebalancing has been used
in other contexts, here it refers to "returning a portfolio to the SAA after price changes of
individual assets cause unacceptable deviations."
y
ile
Benefits versus Costs

w
LOS 30d: Discuss the benefits and costs of rebalancing a portfolio to the
18
investor's strategic asset allocation. Vol 6, pp 84-88

20
Benefits
Disciplined rebalancing to the strategic asset allocation deters investors to deviate from
their investment goals and objectives in discouraging moments. Deviations from an
optimal SAA will presumably cause a loss of utility to the investor. Therefore, rebalancing
benefits the investor by minimizing expected losses in utility. The cost of not rebalancing is
the present value of losses in utility expected from failing to rebalance.
© 2017Wiley
Higher returns are theoretically associated with greater risk. Therefore, as higher return
assets grow to an ever larger percentage of portfolio assets, portfolio risk will also
increase. As higher risk asset classes outperform, failing to rebalance may result in holding
overpriced assets and, ultimately, lower future returns. Investors thus lose utility by holding
too much of a particular asset class that has higher risk. Again, this can be related back to
volatility/risk. Higher risk may cause clients to abandon a portfolio strategy and ultimately
fail to meet return expectations.
Rebalancing to a fixed percentage asset ntix can be considered a contrarian investment
om
strategy that earns returns by supplying liquidity; i.e., the contrarian investor adds
additional securities for momentum investors and provides cash for short sellers. Empirical
studies show that rebalancing tends, over time, to lower risk and increase return.
l.c
Costs
ai
Rebalancing tends to add to costs in the following ways:
gm
Transaction costs- It is difficult to measure transaction costs because they do not
just include comntission but also the loss of opportunity and market impact of such
@
a transaction. Costs for transactions (both explicit and implicit) in liquid, public
markets can be measured somewhat reliably. Costs for transactions in illiquid
y
or non-public markets (e.g., real estate or private equity) cannot be estimated as
ud
reliably. Allocations to illiquid investments may be reduced by applying their cash
flows to other asset classes, but cannot always be increased as easily.
st
Tax impact- The sale of appreciated asset classes will tend to trigger capital gains
or income tax liability, especially when considered a "short-term" gain. The cost of
fa
a short-term gain will typically be greater, so recognizing short-term losses, long-

nc
term capital losses, long-term capital gains, and short-term gains (in that order) is
usually the optimal strategy.
ve
Rebalancing Strategies
ra
A rebalancing strategy generally involves returning the portfolio to its SAA. The most
commonly adopted rebalancing strategies are calendar rebalancing or percentage-of-
y
portfolio rebalancing. These are several methods known as constant mix strategies,
ile
because they are based on a constant percentage allocation to each asset class.
Scheduled Rebalancing
w
18
LOS 30e: Contrast calendar rebalancing to percentage-of-portfolio

rebalancing. Vol 6, pp 89-93
20
Calendar rebalancing involves returning the actual portfolio to its SAA based on
periodic schedule such as monthly, quarterly, senti-annually, or annually- with quarterly
rebalancing being the most popular model. Rebalancing often corresponds with client
periodic reviews. The advantage of this method is that it is simple and does not require
constant portfolio monitoring. The disadvantage of this method, however, is that the
rebalancing has nothing to do with market behavior. On the other hand, frequent
rebalancing when the portfolio does not significantly deviate from the SAA results in
unnecessary costs.
©2017Wiley
Conditional Rebalancing
Percentage-of-Portfolio rebalancing (also called percent range or interval rebalancing)

involves setting ranges around the SAA for a class that act as rebalancing triggers when
exceeded. For example, a particular asset class may have a trigger of ±5%. Each asset
class in the portfolio may have a different trigger point depending on its percentage of the
portfolio and its risk characteristics.
Because this method of rebalancing relates to market performance, it provides a tighter
om
control over the portfolio and triggers rebalancing regardless of time lapsed. Thus, daily or
even real time monitoring may be necessary, depending on the level of control desired.
l.c
The ad hoc approach to percentage rebalancing sets the corridor around the asset class
percentage based on some percentage of the allocation itself. For example, 10% corridors
ai
would mean an allocation of 40% to bonds would require a ±4% corridor. If the bond
allocation strayed below 36% or above 44%, then the portfolio would be reallocated to
gm
ensure a 40% bond exposure.
@
LOS 30f: Discuss the key determinants of the optimal corridor width of
an asset class in a percentage-of-portfolio rebalancing program.
y
Vol 6, pp 90-94
ud
st
The following factors should be considered when setting the reallocation trigger:
fa
Transactions costs (wider corridors for asset classes with higher cost transactions);
Risk tolerance (wider corridors for investors with greater risk tolerance);
nc
Correlation with the rest of the portfolio (wider corridors for higher correlations); and
Asset class volatility (narrower corridor for higher volatility asset classes).
ve
Remaining portfolio volatility (narrower corridor for highly volatile portfolio

without subject asset class)
ra
y
Example2-1
ile
A portfolio has international equity, domestic equity, and domestic bond asset classes.
w
International equity has the highest transactions costs. Domestic bonds has the lowest
cross-correlation with the other asset classes. The domestic equity class includes a
volatile company stock position with low basis. Which asset class is most likely to have
18
the widest corridor for percentage-of-portfolio rebalancing?

20
A. Domestic bonds.
B. Domestic equities.
C. International equities.
Solution:
C. International equities will have the widest corridor because the costs of
rebalancing will make more frequent rebalancing unprofitable. The low
cross-correlation of domestic bonds and tax consequences of rebalancing the
domestic equity class will result in wider corridors before those are rebalanced.
©2017Wiley
Other Strategies
Calendar and percentage-of-portfoli<>-Rebalancing occurs at calendar intervals
only if the corridors have been exceeded. This is attractive for the lower monitoring
costs, as well as reducing the rebalancing costs when calendar rebalancing is not
warranted by low deviation from optimal SAA.
Equal probability rebalancing-Corridors are based on a common multiple of
the asset class standard deviations. For asset classes with normally distributed
returns, this provides an equal probability of any asset class triggering rebalancing.
However, this method does not address transactions costs or correlations.
om
Tactical rebalancing- Less frequent rebalancing during trending markets and
more frequent rebalancing during reversals. This method, similar to calendar
rebalancing, ties changes to market conditions that favor rebalancing.
l.c
Rebalancing to Allowed Range
ai
gm
LOS 30g: Compare the benefits of rebalancing an asset class to its target
portfolio weight versus rebalancing the asset class to stay with its allowed
range. Vol 6, pp 93-94
@
Rather than rebalance all the way back to target weights, rebalancing to the allowed range
y
may offer an attractive alternative. For example, the rebalancing guidelines may require
ud
rebalancing to halfway back to the SAA percentage guideline, or some other arbitrarily
determined standard. This tends to allow room for tactical adjustments and will often
st
reduce transactions costs. This also provides managers with flexibility in rebalancing
illiquid asset classes. Currently, there are no empirical studies to support if one method is
fa
superior to the others.

nc
LESSON 3: THE PEROLD-SHARPE ANALYSIS OF REBALANCING

STRATEGIES
ve
ra
LOS 30h: Explain the performance consequences in up, down, and

nontrending markets of 1) rebalancing to a constant mix of equities and
y
bills, 2) buying and holding equities, and 3) constant proportion portfolio

ile
insurance (CPPI). Vol 6, pp 94-100

w
LOS 30j: Judge the appropriateness of constant mix, buy-and-hold, and

CPPI rebalancing strategies when given an investor's risk tolerance and
asset return expectations. Vol 6, pp 94-100
18
20
Perold and Sharpe analyzed how the choice of methods for rebalancing to a strategic asset
allocation can integrate with investor risk tolerance. Perold-Sharpe analysis begins with a
portfolio that includes two assets: I) stocks with market risk, and 2) bills with zero risk.
The value of all such portfolios can be expressed as:
VPortfolio = VRisk-free + VRisky
©2017Wiley
Buy-and-Hold Strategies
A buy-and-hold strategy purchases asset classes in a particular percentage mix, but then
makes no subsequent changes.
As a result, the portfolio has unlimited upside potential but never falls below the floor
value (equal to the risk-free asset value established at the outset).
This relationship can be seen as a ratio m of stocks value to free asset value (i.e., total
om
portfolio value less floor value):
l.c
m= Vstocks
floor)
ai
( VPortfolio -
gm
The relationship between stock gains and portfolio gains means that m will always have a
@
target of I (i.e., 100 percent of the free asset value), so this strategy performs well in rising
stock markets but performs poorly in falling markets.
y
The investor's risk tolerance will be zero if the stock portion loses all value and will
ud
increase directly as the free asset value increases.
st
Constant Mix Strategies
fa
A constant mix strategy requires buying stocks when prices fall and selling stocks when
nc
prices rise to maintain a constant percentage mix of stocks in the portfolio and the floor
value is zero:
ve
m = Ystocks
ra
VPortfolio
y
Investors can select a value form between 0 and I , which means the investor desires to
ile
hold stocks at all wealth levels. Such investors have decreasing risk tolerance as total
wealth decreases and increasing risk tolerance as wealth increases (i.e., risk tolerance
w
varies proportionately with wealth).

18
A constant mix strategy will outperform buy-and-hold when the market experiences
frequent reversals but will underperform in a rising market or when reversals are small and
20
infrequent.
A Constant Proportion Strategy: CPPI
A constant proportion strategy requires selling stocks when prices fall and buying stocks
when prices rise to maintain the same proportion m of stock value to free asset value. There
is a floor value as in buy-and-hold, which grows with the return on the risk-free asset.
However, the difference between the portfolio value and the floor becomes a "cushion"
that must be maintained and m represents a constant ratio of stocks to the cushion. The
© 2017Wiley
investor then selects m to be greater than I (i.e., stocks will be greater than I 00 percent of
the cushion, which was based on the original floor value).
CPPI investors-like buy-and-hold investors- have no risk tolerance below their specified
floor. However, risk tolerance at asset values above the cushion increases faster than with
buy-and-hold strategies.
Linear, Concave, and Convex Strategies
om
LOS 30i: Distinguish among linear, concave, and convex rebalancing
strategies. Vol 6, pp 94-100
l.c
ai
Buy-and-hold represents a linear rebalancing strategy because portfolio values increase at
the same rate as stock returns when they become more positive or negative.
gm
Constant mix represents a concave rebalancing strategy because portfolio values increase
at an increasing rate as stock returns become more positive, and decrease at a decreasing
@
rate as stock returns become more negative. A concave strategy represents the sale of
portfolio insurance because it provides liquidity when the market falls.
y
ud
Constant proportion represents a convex rebalancing strategy because portfolio values
increase at a decreasing rate as stock returns become more positive, and decrease at an
st
increasing rate as stock returns become more negative. A convex strategy represents the
purchase of portfolio insurance because it receives liquidity when the market is falling.
fa
Thus, this strategy is known as CPPI.

nc
Exhibit 3-1: Comparison of Rebalancing Strategy Payoffs

ve
ra
Constant Mix (concave)

//// _____ /---
y
ile
//// I
/
w
,/
--r
/
/ / Constant Proportion
/ (convex)
18
I
I
I
I
20
Buy-and-Hold
Stock Market Value$
The choice of strategy truly depends on the investor's risk tolerance, asset-class return
expectation, and the types of risk that concern the investor.
©2017Wiley
Exhibit 3-2: Summary of Rebalancing Approaches
Constant Mix Buy-and-Hold CPPI

Market Conditions
UP- Momentums Underperform Outperform Outperform
FLAT- Reversals Outperform Neutral Underperform
DOWN - Momentums U nderperform Outperform Outperform
Implications
om
Payoff curve Concave Linear Convex
Portfolio insurance Selling insurance None Buying insurance
l.c
Multiplier D<m< I m;I m>I
ai
Executing the Rebalancing Strategy
gm
Portfolio managers often have two choices in portfolio rebalancing decisions; executing
cash market trades (buy/sell decisions) or using a derivatives overlay. Choices between
@
these two methods depend on the assets owned, the tax consequences, and available
derivatives.
y
Cash Markets ud
Cash market transactions involve buying or selling individual security positions or ETFs.
st
Cash market trades will often require more time to execute and may require higher capital
fa
commitments than derivatives. Tax considerations may favor cash market trades over
derivatives trades if there is no equivalent derivatives trade on an after-tax basis, or if the
nc
jurisdiction has unfavorable tax consequences for the derivatives trade (as in the U.S.).
Even for non-taxable portfolios, individual derivative exposures may be limited by policy
ve
or a particular asset class may not be replicated by any derivatives.

ra
Derivatives
Futures and total return swaps are often used for rebalancing due to many potential
y
advantages:
ile
Lower transactions costs;

w
More rapid implementation of systemic exposure versus individual security

positions; and
18
Minimal impact on the underlying strategy because it does not require trading
individual positions.
20
As the result of liquidity limits and the lack of replicable positions, managers tend to use
some combination of cash market and derivatives strategies.
© 2017Wiley
STUDY SESSION 17: PERFORMANCE EVALUATION
om
l.c
ai
gm
y @
ud
st
fa
nc
ve
ra
y
ile
w
18
20
© 2017Wiley
20
18
w
ile
y
ra
ve
nc
fa
st
ud
y@
gm
ai
l.c
om
EVALUATING PORTFOLIO PERFORMANCE
READING 31: EVALUATING PORTFOLIO PERFORMANCE
Time to complete: 2.5 to 3.5 hours
Reading summary: Although relatively brief, this lesson spans an important part of
the portfolio management process. You should be able to explain portfolio evaluation
components and money-versus time-weighted return calculations. Be able to quickly
decompose return into its components, which can be perhaps the most difficult part of this
lesson. Also, understand how to appraise the manager's part in generating return and the
link to decisions involving manager engagement and continuation.
om
LESSON 1: PERFORMANCE MEASUREMENT
l.c
LOS 31a: Explain the following components of portfolio evaluation:
performance measurement, performance attribution, and performance
ai
appraisal. Vol 6, pp 122-123
gm
Performance evaluation addresses three areas:
@
1. Performance measurement- Return calculated on changes in investment value;
2. Performance attribution- The relative importance of sources of performance (i.e.,
y
why did the account produce that performance); and
3. ud
Performance appraisal- Examining the likelihood of performance levels to
continue (i.e. , management luck or skill).
st
LOS 31b: Demonstrate the importance of performance evaluation from the
fa
perspective of fund sponsors and the perspective of investment managers.

Vol 6, pp 121-122
nc
Investment managers need a performance evaluation process to measure investment

ve
results- and variance from a relevant benchmark- for their clients. Many !Ms also have
a deep interest in continuing or improving performance results and use such evaluation to
ra
seriously examine how aspects of their investment process contribute to success or failure.
y
Fund sponsors often use performance evaluation for direction and to help them adhere to
ile
the objectives and constraints of an investment policy statement. Performance evaluation

can also show fund trustees whether they are meeting their fiduciary duties to beneficiaries.
Trustees can then make determinations about the effectiveness of !Ms used for various
w
aspects of fund management.

18
The Holding Period Return

20
The simplest rate of return is realized when an investor buys and holds an asset with no
external cash flows (contributions or withdrawals) during the measurement period. For
example, a client may have an investment account under management and neither invests
additional funds to the account nor withdraws funds from the account. From the account
prospective, the assets held may generate cash flows, such as dividend income or coupon
income. The account may also have trading activities, such as acquisition or liquidation
of assets. However, there are no external cash flows. The client does not invest additional
funds , nor does he withdraw funds from the account.
The rate of return of this simple account over a particular measurement period is the
holding period return.
©2017Wiley
MY, - 1
MVo
where:
MV, is the market value of the account at time t; and r, is the holding period
return over the investment period. Notice that we use the account's market
value, which captures any income, as well as realized and unrealized gains.
om
Some variations of the above scenario include a net cash flow either at the beginning or at
the end of the reporting period. The net cash flow can be either an inflow, where the client
l.c
invests more funds, or an outflow, where the client withdraws funds.
ai
If a cash inflow occurs at the beginning of the reporting period, the cash was available
for investment during the entire period and should be included as part of the beginning
gm
account value:
@
r, = MY,-(MV0 + CF0 )
MV0 + CF0
y
ud
If the cash inflow occurs at the end of the reporting period, it was not available for
st
investment during the period and should be removed from the ending market value:
fa
, = (MY,-CF,)-MV0
nc
' MVo
ve
Of course, outflows would have reverse effects.

ra
Example 1-1
y
ile
Mark has an investment account with FXI Advisors Inc. FXI sends Mark quarterly
statements about his account's value. At the beginning of the quarter, his account
w
balance was $875,000. At the end of the quarter, his account balance was $847,000.
18
Calculate the rate of return of Mark's investment account under each of the following
three cases:
20
A. Mark did not make any contributions or withdrawals during the quarter.
B. Mark invested $25,000 at the beginning of the quarter.
C. Mark withdrew $10,000 at the end of the quarter.
© © 2017Wiley
EYAWATING PORTFOLIO PERFORMANCE
Solutions:
A. Given that there is no external cash flows in the first case, we have the rate of
return computed as follows:
r = MY,-MVo
' MVo
847,000-875,000
-3.20%
om
875,000
B. Given that Mark invested $25,000 at the beginning of the quarter, we have the
rate of return computed as follows:
l.c
r = MY,-(MV0 +CF0 )
ai
' MV0 +CF0
gm
847 ,000-(875,000+ 25,000)
-5.89%
875, 000 + 25, 000
C. Given that Mark withdrew $10,000 at the end of the quarter, we have the rate of
@
return computed as follows:
y
r = (MV, -CF,)-MV0
' MVo
ud
(847,000+ 10,000)-875,000
st
-2.06%
875,000
fa
nc
Note that investors desire both income and capital gains. Income from holding a portfolio
comes from dividends and coupon interests the portfolio generates. Capital gains, both
ve
realized and unrealized, reflect the price appreciation from the last reporting period. The
total return of a portfolio is the sum of income yield from dividends and/or interest and
ra
capital gains yield.

y
Total return = Income yield + Capital gains yield

ile
The Time-Weighted Rate of Return

w
LOS 31c: Contrast and interpret time-weighted and money-weighted

18
rates of return and discuss how each is affected by cash contributions and
withdrawals. Vol 6, pp 126-130
20
In reality, cash flows often occur between reporting periods. The assumptions we made
in the previous section, where cash flo ws occur exactly at either the beginning or the end
of a reporting period, are naive and unrealistic. How do we incorporate cash flows within
a reporting period to compute rate of return over a reporting period? We explore two
approaches, the time-weighted rate of return Crrw,l and the money-weighted rate of return
(rmwr).
The concept of time-weighted rate of return is straightforward. Due to external cash flows,
the reporting period is partitioned into multiple sub-periods at the time of each external
©2017Wiley
cash flow. A clean holding period return is then computed for each of the sub-periods.
The time-weighted rate of return is then the compounded return over all the sub-periods.
Consider the following expression:
rtw, =(l+ r, 1)(1+ r, 2 ) ..• (l+r,,,)- I
where:
r,, is the holding period return of sub-period i, and there are a total of n
om
sub-periods.
l.c
Example 1-2
ai
Mark has an investment account with FXI Advisors Inc. At the beginning of the quarter,
gm
his account balance was $875,000. On day 15, the market value of the account was
$892,000 and Mark invested an additional $17,000 into the account. On day 45, the
market value of the account was $860,000 and Mark withdrew $8,000 from the account.
@
At the end of the quarter, day 91, his account balance was $847,000.
y
Calculate the time-weighted rate of return of his investment account over the 91-day
quarter. ud
Solution:
st
fa
To reach the time-weighted rate of return, we need to compute total return over each
sub-period. There are three sub-periods in this case: first 15 days, next 30 days, and
nc
remaining 46 days.
MY,, - MVo
ve
lf1 = MVo
892,000 - 875,000
ra
1.94%
875,000
MY,, - (MY,, +CF,,)
y
'i2 =
MY,, +CF,,
ile
860,000 - (892,000+ 17,000)

- 5.39%
w
892,000+ 17,000
MY,, - (MY,,+ o;,J
18
lf3 = A1Yr2 + CFt2

847,000 -(860,000 - 8,000)
20
--0.59%
860,000-8,000
The time-weighted rate of return for the quarter is -4.12 percent.
Note that the time-weighted rate of return captures the rate of return of the portfolio
independently of the external cash flow decisions of the client/investor. It cleanly measures
the performance of the portfolio manager's investment decisions. It's not driven by the
investments and redemptions of the client, which are largely outside the manager's control.
@ © 2017Wiley
The Money-Weighted Rate of Return
The money-weighted rate of return is also known as the internal rate of return. It captures
the portfolio's return based on the external cash flows to/from the portfolio, as well as
the performance of the portfolio. In a certain way, it can be viewed that in addition to the
performance of the portfolio managed by a portfolio manager, the client/investor may
strategically "time" the market by making additional investments to the portfolio and
withdrawals from the portfolio. Consequently, the rate of return reflects the joint effect
of portfolio return as well as market-timing of the cash flows to/from the portfolio by the
om
client. For that reason, the money-weighted rate of return is also known as the cash-flow-
weighted rate of return.
l.c
As in corporate finance, we rely on a financial calculator to perform the iterative
computations required to compute the IRR. By convention, the initial cash flow (CF0) is
ai
the beginning value of the portfolio and is input as a negative number. Each contribution
(CF,) is then a negative cash flow and each withdrawal is a positive cash flow. The ending
gm
value is the last cash flow (CF,), which is input as a positive number.
@
Examplel-3
y
Mark has an investment account with FXI Advisors Inc. At the beginning of the quarter,
ud
his account balance was $875,000. On day 15, the market value of the account was
$892,000 and Mark invested an additional $17,000 into the account. On day 45, the
market value of the account was $860,000 and Mark withdrew $8,000 from the account.
st
At the end of the quarter, day 91, his account balance was $847 ,000.
fa
Calculate the money-weighted rate of return of his investment account over the 91-day
nc
quarter.
ve
Solution:
To reach the money-weighted rate of return, we need to have initial and ending account
ra
value, as well as size and timing of each cash flow to the portfolio during the reporting
period.
y
ile
The money-weighted rate of return for the quarter can be computed using the IRR
function of a financial calculator (TIBA2+):
w
CFo; -875,000;
18
CF,; O; Fi; 14;

CF2 ; -17,000; F 2 ; l;
20
CF3 ; O; F 3 ; 29;
CF4 ; +8,000; F4 ; 1;
CF5 ; O; F 5 ; 45;
CF6; +847,000; F6; l;
Compute IRR.
Rmw'; -0.0469% per day, or -4.18% over the 91-day quarter
The money-weighted rate of return is -4.18 percent in the reporting quarter.
©2017Wiley
The money-weighted rate of return can be viewed as the average growth rate of all funds
invested in an account. Because the portfolio manager cannot control the client's cash
Hows to/from the portfolio, the money-weighted rate of return does not necessarily truly
reflect the investment skill and performance of the portfolio manager.
The time-weighted rate of return can be viewed as the growth rate of funds initially
invested at the beginning of a reporting period. The two rates of returns clearly measure
different dimensions of an investment account. While the time-weighted rate of return and
the money-weighted rate of return are often similar, they can be substantially different
om
when the sizes of cash Hows to/from the portfolio are significantly large.
l.c
Example 1-4
A reporting period is set to be IO days. A client has a $1 million investment in a fund.
ai
The fund generates zero return in the first nine days. At this point, the end of day 9,
gm
the client invests another $4 million in the fund. The next day, the fund increases by
5 percent.
@
Calculate and interpret the time-weighted rate of return and the money-weighted rate
of return.
y
Solution: ud
The time-weighted rate of return is the chain-linked rate of return. It's the compounded
st
rate of return of the first sub-period of nine days and the second sub-period of one day.
fa
r1w, =(I+ r, 1)x (I+ r,i)-1=Ix1.05-1=5.00%

nc
The money-weighted rate of return is determined by cash flows. Note that at the
beginning of day IO, the client has $5 million invested and that after a 5 percent
ve
increase, his account value is $5.25 million.

ra
The money-weighted rate of return for the quarter can be computed using the IRR
function of a financial calculator:
y
CF0 = - 1;
ile
CF1 =O;fi=8;
w
CF2 =-4;F2 =I;

CF3 = 5.25;F3 = l;
18
Compute IRR.
20
Rmw' = l.6897%per day,orl8.24%over the IO-day period
The money-weighted rate of return is 18.24% percent in the reporting period.
Note that in this example, the time-weighted rate of return of 5 percent measures the rate
of growth of the money of $1 million that is initially invested in the fund. Subsequent
investments and withdrawals do not impact the value of the time-weighted rate of return.
The money-weighted rate of return of 18.24 percent measures the average growth of all
money invested in the fund, including the initial $1 million and the subsequent $4 million.
©2017Wiley
Because the large sum of $4 million enters the market just in time before the large market
increase, the client's money-weighted rate of return of 18.24 percent is significantly higher
than the fund's time-weighted rate of return of 5 percent.
Remember that the time-weighted rate of return captures the performance of the fund,
while the money-weighted rate of return captures the return to a specific client. A fund
manager produces the same time-weighted rate of return for all its clients. However, due
to the fact that different clients generate different cash flows to/from the fund, the money-
weighted rate of return to each client can be significantly different from one another. The
om
fund manager has no control of clients' external cash flows. Consequently, the fund's
performance is best captured by the time-weighted rate of return.
l.c
The Linked Internal Rate of Return
ai
The time-weighted rate of return is a chain-linked rate of return. One weakness of the
time-weighted rate of return is that it requires that we know the rates of return between all
gm
cash flow dates.
Compared to the time-weighted rate of return, the money-weighted rate of return does not
@
require we know all returns over sub-periods. Instead we just need to know the sizes and
timing of all cash flows, which are usually readily available.
y
ud
We understand that a money-weighted rate of return is an internal rate of return (IRR)
over a reporting period. If we have multiple reporting periods, the overall return over the
st
multiple reporting periods can be constructed using a linked IRR (LIRR).
fa
Example 1-5
nc
A fund reports its money-weighted rate of return over each quarter. The money-weighted
ve
rates ofreturn over the last three quarters in 2014 are 14 percent, - 7 percent, and
6 percent.
ra
Calculate the rate ofreturn of the fund over the last three quarters of 2014.
y
Solution:
ile
The return over the three reporting periods (quarters) is a linked IRR. We simply
w
compound three quarterly returns to reach the overall return.

18
ruRR = (l + rt1)x(l+ r, 2 )x(l+ r, 3 )- l

= l.14 x 0.93 x l.06 - l = 12.38%
20
The return over the last three quarters of 2014 is a linked IRR, which is 12.38 percent.
Annualizing Returns
Notice that the rate produced by the time-weighted return, which geometrically links the
holding period returns for each sub-period, is not an annualized return. In fact, it is bad
form to annualize performance data for periods of less than a year because you make the
inherent assumption that the past performance will simply extrapolate over the remaining
months.
©2017Wiley @
For periods longer than one year, an average return provides some meaningful information.
To annualize returns from multiple years, we geometrically link each annual return and
take the nth root.
om
Example 1-6
An investment manager reports his portfolio returns for the most recent four quarters and
l.c
additional annual returns for the preceding two years as shown in the following table.
ai
Date Return
gm
Q420X3 3.2%
Q3 20X3 1.1
Q220X3 2.0
@
Ql 20X3 -0.9
y
20X2 6.2
20Xl ud 7.4
Calculate the manager's 3-year average annual return.

st
fa
Solution:
nc
The time-weighted return is the most appropriate for evaluating the manager. First,
compute the annual time-weighted return for the year 20X3.
ve
rX3 = (1.032)(1.011)(1.020)(0.991)-1 = 5.46%

ra
Then compute the annualized return:

rann~I = [(1.055)(1.062)(1.074)]113 - 1 = 6.35%
y
ile
w
Data Quality Issues

18
LOS 31d: Identify and explain potential data quality issues as they relate to
calculating rates of return. Vol 6, pg 133
20
Users of performance evaluation data should understand data quality limitations.

Information from efficient markets (e.g. , developed country equity and bond markets)
usually has substantially fewer problems associated with reliability than information
from many alternative asset categories and inefficient markets (e.g., developing markets).
Alternative assets sometimes use return data from estimated prices or infrequently traded
assets (e.g., real estate, venture capital, etc.).
Even in developed countries, return calculations based on thinly-traded asset prices could
be suspect. Investment managers may use the dealer's matrix pricing, which is based on
© 2017Wiley
economic sector, credit rating, and maturity of similar securities. Investment managers
may also report infrequently traded assets at cost or last trade price rather than a price that
reflects current value.
The best estimate of current account value also uses trade date accounting and accrued
cash flows, rather than settlement date accounting and when-received cash flow.
LESSON 2: BENCHMARKS
om
LOS 31e: Demonstrate the decomposition of portfolio returns into
components attributable to the market, to style, and to active management.
l.c
Vol 6, pp 133--135
ai
Quantitative performance metrics are only relevant when compared to some baseline value.
Furthermore, the baseline should be a fair comparison. In the investment business, that
gm
baseline value for comparison is called a benchmark. We need to evaluate a return based
on an appropriate benchmark. What do we mean by appropriate? The short answer is that
we should find a benchmark that matches the manager's investment style.
@
A benchmark is not only useful in evaluating the overall performance of a portfolio, but
y
can also be used to decompose the return into its component sources. The asset manager
ud
is hired by the fund sponsor to make decisions about where and how to invest capital. The
choice of benchmark might be guided by the sponsor's mandate and/or the manager's
st
investment style. In either event, an active manager adds value by departing from the
benchmark return. That value added can be positive or negative.
fa
We define the following:

nc
P is the return performance of a portfolio under management.

ve
Bis the return on a benchmark that matches the portfolio's investment style.
Mis the return on the market portfolio.
ra
A is the portfolio manager's active return: A = P - B.

Sis the return contribution due to style selection: S = B - M.
y
With the terms defined, we have the following tautological expression:

ile
w
P=P
18
P=B+(P-B)
P=M +(B-M)+(P-B)= M +S+A
20
The last expression can be interpreted as a portfolio's return being determined by the market
index return (MJ enhanced by the manager's style (S), and his ability to pick individual
securities (A). Style is sometimes referred to as allocation or sector selection, and the ability
to pick individual securities is sometimes called security selection or active management.
An example might help to crystalize this concept. A portfolio manager invests in

technology companies. She may invest in any stocks around the world. However, she
chooses to invest in the U.S. She further chooses to invest in tech stocks. In a reporting
©2017 Wiley
period, the portfolio return Pis 14 percent. During the same time period, the U.S. stock
market index yields 18 percent; and the tech stock sector index yields 11 percent.
Because she invests exclusively in tech stocks, her appropriate benchmark should be the
tech stock sector index. Her performance of 14 percent should be benchmarked against the
return on the tech stock sector index of II percent. Here is the analysis.
P= M +(B - M)+(P - B)= 18%+(11% - 18%)+(14% - ll %) = 14%
om
The market yields 18 percent. Her choice of investing exclusively in tech stocks costs
her 7 percent (a negative 7 percent return). However, the choice of U.S. companies as her
l.c
active management yields a positive 3 percent enhancement. The conclusions are that her
exclusive bet on the tech sector costs her 7 percent, and her bet on U.S. companies rewards
ai
her 3 percent. Overall, she is 4 percent behind the market return of 18 percent.
gm
Example2-1
@
Jack Johnson, CFA, is a portfolio manager who favors low PIE energy stocks. Last year,
Jack's portfolio produced a rate of return of 22 percent, while the overall market index
y
yielded only 12 percent. The energy sector index yielded 18 percent.
ud
Calculate Johnson's return contributions due to style and active management.
st
Solution:
fa
We partition the portfolio return into three components: market return, style return, and
nc
active management return.
P = M +(B - M)+(P -B )= 12%+(18% - 12%)+(22% - 18%)= 22%

ve
Jack's bet on the energy sector yielded 6 percent; His bet on low PIE in the energy
ra
sector yielded another 4 percent. So the contribution due to style is 6 percent and the
contribution due to active management is 4 percent.
y
ile
Characteristics of a Valid Benchmark

w
LOS 31f: Discuss the properties of a valid performance benchmark and

explain advantages and disadvantages of alternative types of benchmarks.
18
Vol 6, pp 135-139
20
A benchmark is an important reference point on which performance is evaluated. However,

benchmarks are not unique. Ali valid benchmarks should share the following common
properties:
Unambiguous: A benchmark is well-defined.

Investable: The benchmark is a passive alternative to active management.
Measurable: The return performance of a benchmark is readily available.
Appropriate: A benchmark is consistent with the portfolio manager's style.
Reflective of current investment opinions: The manager has knowledge of securities
in the benchmark and exposure of risk factors in the benchmark.
© 2017Wiley
Specified in advance: A benchmark is clearly specified before the beginning of an

evaluation period.
Acknowledged: Both the sponsor and manager recognize the benchmark as a fair
basis of comparison.
Types of Benchmarks
An easy way to
remember the seven
Given that we understand common features embedded in a valid benchmark, let's exantine properties of a valid
different types of benchmarks. We have the following: performance bench-
om
mark is to reorgan-
ize the first letters
Absolute: An absolute return can be a return objective, but it is not a valid into the acronym
SAMURAI.
benchmark because it is not investable. However, it is commonly used and
l.c
considered the simplest benchmark.
Manager universe: Another frequently used benchmark is the performance of the
ai
median manager. However, it is not a valid benchmark because it does not carry
many properties of a valid benchmark. For example, it is not investable and it
gm
cannot be specified in advance.
Board market index: It is a valid benchmark and widely used. However, it may
not suit all managers' styles. A manager who invests in utility firms may not find
@
the U.S. S&P 500 Index to be the best benchmark for the purpose of performance
evaluation.
y
Investment style index: They are valid and well accepted benchmarks. Examples
ud
include large-cap growth index, small-cap growth index, large-cap value index, and
small-cap value index. However, different definitions of an investment style index
st
may lead to multiple indices of the same investment style and produce multiple
benchmarks. For example, the large-cap value index is not uniquely defined.
fa
Factor-model-based: Factor models identify key risk factors that determine asset
nc
returns. Based on exposures to different risk factors, called factor loadings, factor
models produce predictions of benchmark returns based on risk factor loadings.
Return-based: These benchmarks are based on both the investment manager's
ve
returns and returns on multiple indices with different investment styles.

An allocation algorithm determines the benchmark return. Return-based
ra
benchmark is similar to factor-model based benchmark, but it has the returns of the
investment manager's portfolio involved.
y
Custom security-based: A custom security-based benchmark may be the most

ile
appropriate benchmark of all because the construction of the benchmark exactly

reflects the investment philosophy. It is constructed specifically for an investment
w
portfolio and it carries all properties of a valid benchmark. However, the downside
of a custom security-based benchmark is that it can be expensive to construct and
18
maintain the benchmark.

20
LOS 31g: Explain the steps involved in constructing a custom security-

based benchmark. Vol 6, pp 139-140
To construct a custom security-based benchmark, we should follow the steps:
1. Identify key elements of the manager's investment process.

2. Select securities consistent with the manager's investment process.
3. Design a weighting scheme for benchmark securities, including a cash position.
4. Review the benchmark and make modifications.
5. Rebalance the benchmark on a predetermined schedule.
©2017Wiley
The construction of a custom security-based benchmark should be the outcome of

communication and agreement between the client or the client's consultants and the
investment manager. The goal is to keep the benchmark's composition consistent with the
manager's investment process.
LOS 31h: Discuss the validity of using manager universes as benchmarks.

Vol 6, pp 140--141
om
Now, let's revisit the manager universe approach where our portfolio manager's return
is compared to the return of the median manager benchmark. Analyzing this benchmark
helps us to better understand necessary properties and features of a valid benchmark. Note
l.c
that we previously list seven properties of a valid benchmark. Median performance of
manager universe fails to carry six out of seven properties.
ai
Unambiguous: The benchmark is not clearly defined, until all returns are realized.
gm
lnvestable: It is not possible that an investor holds the median performance of
manager universe and earns returns on the benchmark.
Measurable: Yes. After returns are all realized, the return performance of the
@
benchmark is readily available. This property is the only property that is satisfied
by the manger universe benchmark.
y
Appropriate: The benchmark is not consistent with the portfolio manager's style.
ud
Manager universe includes managers who elect all different investment styles.
Reflective of current investment opinions: The manager has no knowledge of
st
securities in the benchmark and exposure of risk factors in the benchmark.
Specified in advance: Manager universe is not at all specified before the beginning
fa
of an evaluation period.
nc
Acknowledged: The manager cannot accept the accountability of the benchmark

because the benchmark portfolio is not even defined at the beginning of an
evaluation period.
ve
Another important weakness of manager universe is related to something called

ra
"survivorship bias." Survivorship bias comes into existence when, over time, inferior
managers drop out of the manager universe. As a result, the return of the median performer
y
of surviving manager universe overstates the base value because "losers" have been
ile
removed from the population before the median manager is determined.

w
Detennining Benchmark Quality

18
LOS 31i: Evaluate benchmark quality by applying tests of quality to a

variety of possible benchmarks. Vol 6, pp 142--143
20
The quality of a benchmark is important for clients, managers, and fund sponsors. Here,
we discuss some tests of benchmark quality.
Systematic Bias
A high quality benchmark should carry a minimal amount of systematic bias relative to the
account under evaluation. Over time, the factor loading, or slope, or beta, of the account
returns against the benchmark returns should not be statistically significantly different
from 1.0.
©2017Wiley
Additionally, the correlation between active return A ; P - B and style return S ; B - M

should be statistically insignificantly different from zero. If we define E; P - M, the
difference in return between the account and the market index, the correlation between E
and S should be positive.
P; M +(B-M)+(P-B); M +S+A
Correlation(A,S) ; 0
Correlation(E,S) ; Correlation(P-M,B-M) > 0
om
Tracking Error
l.c
We define tracking error as the volatility of A , or (P - B). A high quality benchmark should
ai
have the feature that the volatility of A is less than the volatility of E.
gm
Tracking error; Volatility(A)< Volatility(E)
Volatility(?- B) <Volatility(? - M)
y @
Risk Characteristics
ud
Over time, the risk exposure of the account should be similar to the risk exposure of the
st
benchmark. Otherwise the benchmark does not fully reflect the investment process of the
account and systematic bias arises.
fa
Coverage
nc
On average across time, the account and the benchmark should have significant overlap
ve
in asset holdings. The manager may change her bets (tilt) over time, but if her portfolio
holdings have little overlap with the benchmark, the benchmark would not be a good
ra
reference to evaluate the account performance.
Turnover
y
ile
The benchmark should not have excessive turnover. Excessive turnover makes it difficult to
passively track the performance of the benchmark.
w
Positive Active Positions

18
The account manager places positive active weights on assets that she expects to
20
outperform and places negative active weights on assets that she expects to underperform.
Asset tilts should mostly be positive.
Hedge Fund Benchmarks
LOS 31j: Discuss issues that arise when assigning benchmarks to hedge
funds. Vol 6, pp 143--146
Hedge funds have become increasingly popular in recent years to institutions and high
net worth individuals. In a naive way, we may simply interpret that hedge fund managers
©2017Wiley
attempt to explore profits by shorting over-valued assets and buying under-valued assets in
such a way that the overall portfolio is not exposed to market risk. In most cases, a hedge
fund involves both long and short positions.
Based on the traditional definition, the value of a portfolio is the net asset value of the
portfolio. However, because of the nature of long and short positions in a hedge fund, the
net asset value of a hedge fund may be zero. The value of the long assets in a hedge fund
may be offset by the value of short assets in the hedge fund. Consequently, the traditional
definition of return, listed below, may not work for hedge funds. Note that MV0 can be zero
om
or be very close to zero.
l.c
ai
gm
In the context of a hedge fund, we define value-added return below:
y @
where:
r, is the value-added return.
rp is the portfolio return.
ud
st
r 8 is the benchmark return.
fa
We use Wp; and W& to represent portfolio weights on asset i in the portfolio and in the
nc
benchmark, respectively. Consequently, w,; represents the active weight of asset i in the
portfolio. We have the following:
ve
ra
n n n
L wvi = L wPi- L wBi = 0
io"'l i=l i=l
y
n n n n
rv = ~)wvi Xlj) = ~)(wpi -wBi)Xlj ] - LJwPi X!j)- ~)w8; X!j) = rp- r8
ile
i=l i=I
w
Sometimes, practitioners use an absolute return as a benchmark to evaluate hedge fund

18
performance. Alternatively, they may also use return-based or security-based benchmark

building approaches to construct separate long and short benchmarks for hedge fund
20
managers.
Another widely used measure to evaluate hedge fund performance is the Sharpe ratio. A
Sharpe ratio is a measure of excess return over a risk-free rate relative to the volatility of
returns. One way to evaluate the performance of a hedge fund is to compare its Sharpe
ratio to the Sharpe ratios of the universe of hedge funds.
© 2017Wiley
LESSON 3: PERFORMANCE ATTRIBUTION (4 MODELS)
Performance attribution attempts to identify tbe sources of return that explain the
difference between an account performance and its benchmark performance. There are
two basic forms of performance attribution: macro attribution and micro attribution.
Macro attribution is often performed at the fund sponsor level. Micro attribution is often
performed at the investment manager level.
If a manager replicates his benchmark by adding the same securities to his portfolio in
om
the same proportions as tbe benchmark, tbe returns will be virtually identical (except
for transaction fees) and the value added (r,) will be zero. It is by deviating from the
benchmark that the manager adds value. He has but two choices; he can deviate by altering
l.c
the weights (tilting the portfolio) away from the benchmark or he can deviate by selecting
different securities than those in the benchmark.
ai
Tilting portfolio weights may occur at the level of investment style (e.g., value vs. growth,
gm
tech sector vs. retail sector), and/or at the level of individual stock selection (e.g., 1.3
percent vs. zero percent or 2.5 percent vs. -0.7 percent of the portfolio invested in Apple
Inc.). Investment management is all about asset allocation.
@
Any particular weighting scheme determines a corresponding fund performance. Good fund
y
performance is associated with heavily betting on assets with superior performance and with
ud
heavily negative betting on assets with inferior performance. Performance attribution refers
to identifying sources of abnormal returns, sources such as a manager's talent in choosing the
st
right sectors and talent in picking the right stocks in a given sector, among others.
fa
Macro Attribution
nc
LOS 31k: Distinguish between macro and micro performance attribution

ve
and discuss the inputs typically required for each. Vol 6, pp 14S-150
ra
From the perspective of a fund sponsor, a fund or an account refers to a collection of

investments of various asset classes, and for each asset class there may be multiple
y
investment managers individually making investment decisions. The goal is to analyze tbe
return attribution of the fund. Superior (inferior) returns are due to allocations of various
ile
asset classes (e.g., stocks vs. bonds, or domestic equity vs. international equity), or skills
of different investment managers, or for a given investment manager the ability to pick
w
individual securities.
18
The macro attribution approach requires three sets of inputs:

20
Policy allocations;
Benchmark portfolio returns;
Fund returns, valuations, and external cash flows.
Fund sponsors specify policy allocations. A policy allocation may state that a particular
fund invests 60 percent of its assets in domestic stocks and 40 percent of its assets in
bonds. Additionally, it might specify that there be three equity investment managers and
that each manager controls one-third of the domestic stock portion of the fund, meaning
each equity investment manager controls 20 percent of the total fund value. The policy
allocation might also specify that two bond investment managers control tbe bond portion
©2017 Wiley
of the fund, with the first bond investment manager controlling 75 percent of the bond fund
and the second bond investment manager controlling the remaining 25 percent of the bond
fund.
Fund Policy Allocations

Domestic Stocks 60%
Equity manager# 1 33.33%
Equity manager #2 33.33%
om
Equity manager #3 33.33%
Domestic Bonds 40%
l.c
Bond manager # 1 75%
Bond manager #2 25%
ai
Total Fund 100%
gm
Fund sponsors and investment managers also agree on and specify benchmark portfolios.
Each investment manager has a clearly defined benchmark that closely matches the
@
investment style of the investment manager. For example, the benchmark of the first equity
manager may be a mid-cap value index because the first equity manager invests in mid-
y
cap value stocks, while the benchmark of the second equity manager may be a large-cap
growth index. ud
st
With policy allocation and benchmarks clearly defined, we can identify which sector and
which investment manager underperforms/outperforms in a particular reporting period.
fa
Exhibit 3-1 demonstrates the performance attribution of the fund. The first two columns
nc
list the policy allocations. The next three columns list account beginning value, new cash
flows into and out of the account at the end of the reporting period, and account ending
ve
value, with all amounts in $million. The next column lists the actual account returns. The
last column lists the benchmark returns during the reporting period.
ra
Exhibit 3-1: Account Valuations, Cash Flows, and Returns

y
ile
Policy Beginning Net Ending Actual Benchmark

Asset Class Allocations Value CF Value Return Return
w
Domestic Equities 60% $120.00 $3.20 $133.70 8.52% 8.60%

Equity manager# 1 20% $40.00 $4.20 $48.71 10.20% 8.50%
18
Equity manager #2 20% $40.00 -$1.80 $40.76 6.70% 9.00%

Equity manager #3 20% $40.00 $0.80 $44.23 8.40% 8.30%
20
Domestic Bonds 40% $80.00 $3.70 $87.55 4.60% 4.05%

Bond manager# 1 30% $60.00 $3.70 $66.95 5.10% 4.50%
Bond manager #2 10% $20.00 $0.00 $20.60 3.00% 2.70%
Total Fund $200.00 $6.90 $221.24 6.93% 6.78%
Comparing the actual returns and benchmark returns, we have the following observations:
Equity manager# 1 beat the corresponding benchmark, suggesting that she

correctly overweighs (underweights) stocks with superior (inferior) performance.
© 2017Wiley
Equity manager #2 lagged the corresponding benchmark. He made some wrong

bets in stock selections.
Equity manager #3 roughly matched the benchmark performance, maybe due to
lack of active management.
Both bond managers beat the corresponding bond benchmarks.
Overall equity fund lagged benchmarks.
Overall bond fund beat benchmarks.
The total fund yielded a rate of return of 6.93 percent, narrowly beating the
benchmark performance of 6. 78 percent.
om
If the fund sponsor allocated a lower weight in equity funds, the overall fund
performance would be improved.
If the fund sponsor allocated a higher weight (instead of 20 percent) to equity
l.c
manager # 1, the overall fund performance would be improved.
ai
LOS 311: Demonstrate and contrast the use of macro and micro
gm
performance attribution methodologies to identify the sources of investment
performance. Vol 6, pp 150-160
@
Now let's conduct a macro performance attribution analysis using the previous example.
We will apply the following steps:
y
Net contributions
ud
Risk-free rate
st
Asset categories
Benchmarks
fa
Investment managers
nc
Allocation effects
We explain each step in detail using the previous numerical example. All dollar amounts
ve
are in $millions in Exhibit 3-2.

ra
Exhibit 3-2: Performance Attribution

y
Incremental Incremental
Fund Value Return Value
ile
Beginning value $200.00

w
Net contribution $206.90 0.00% $ 6.90

Risk-free asset $207.36 0.22% $ 0.46
18
Asset categories $220.33 6.27% $12.97

Benchmarks $221.01 0.33% $ 0.68
20
Investment managers $221.13 0.06% $ 0.12

Allocation effects $221.24 0.05% $ 0.10
Total fund $221.24 6.93% $21.24
1. Net contributions: At the beginning of the reporting period, the fund has $200
million. Net contribution at the beginning of the period is $6.90 million, making
the total assets under management $206.90 million.
©2017Wiley @
2. Risk-free asset: A very conservative way of managing assets is to park funds

temporarily in short term Treasuries. We report the return (0.22 percent) and value
($0.46 million) increments if all funds are invested in short-term Treasury bills.
3. Asset categories: Clearly, most funds do not put all their assets in risk-free
assets, such as short-term Treasury bills. A fund's policy allocation specifies a
number of asset classes, such as domestic stocks, international stocks, domestic
corporate bonds, and Treasury bonds. The returns in excess of the risk-free rate
are reported in the next row. The excess return is 6.27 percent and it translates into
$12.97 million in increase in value.
om
A A
'Ac= I,wc; x(rc; - r1 ) = I,Cwc; x w 0 )-r1
l.c
i=l i=l
ai
Where there are A asset categories and W c; is the policy weight assigned to asset
gm
category i. re; is the rate of return on asset category i. The rate of return on the risk-
free asset is represented by rp
4. Benchmarks: The excessive return due to passively investing in a benchmark of the
@
chosen investment style is represented by r15• There are A asset categories and M
investment managers. W c; is the policy weight assigned to asset category i. r Ci is the
y
rate of return on asset category i. wij is the percentage of assets in asset category i that
ud
are assigned to manager j. r 8 ij is the rate of return of manager j's benchmark in asset
category i.
st
fa
nc
ve
In this case, passive investments in benchmark indices generate 0.33 percent excess
returns.
ra
5. Investment managers: Value of active management may generate excess returns.

So far, we consider only passive investment in benchmark indices. r 1M represents
excess return due to active investment, which includes an investment manager's
y
active portfolio weight tilting based on the investment manager's skills.

ile
w
18
Where rAij is the actual return on the jth manager's portfolio within asset category
20
i. In our case, the rate of return r 1M is 0.05 percent, which amounts to $0. l 0 million
addition to the total fund.
6. Allocation effects: This factor can be considered as a plug variable. It is the
difference between the ending value of the fund and the fund value computed at the
level of investment manager active returns.
In this case, the value difference is around $0.10 million and the return difference
is 0.05 percent. Now the total return of the fund is summed to 6.93 percent. The
total ending value is $221.24. These performance measures in Exhibit 3-2 match
exactly the corresponding measures in Exhibit 3-1.
©2017Wiley
Micro Attribution
Micro attribution analyzes sources of performance of an individual portfolio, instead of

examining the performance of a total fund with multiple investment managers. Micro
attribution investigates one portfolio from one particular investment manager. It attempts to
identify the sources of the manager's active return, also known as the value-added return,
which is the difference between the manager's actual return and benchmark return.
Using the terms defined previously, we have:
om
l.c
Rewriting the above equation, using a portfolio return as the weighted average of
ai
individual stock returns, we have:
gm
n
r, = rp- rB = L[(wp; -wB;)X (r; -rB)]
@
i=l
y
The above expression warrants another look. The left-hand side is the value-added return
ud
of the portfolio. The right-hand side is the source of the value-added return. The right-
hand states that positive value-added returns are sourced from positive portfolio weight
st
tilt (Wp; - W& > 0) on outperforming stocks (r;- rB > 0), or negative portfolio weight tilt
(Wp; - WB; < 0) on underperforming stocks (ri - rB < 0). When a stock outperforms the
fa
overall benchmark, the investment manager would like to have allocated a higher weight
than the weight in the benchmark portfolio in order to beat the benchmark portfolio and
nc
generate positive value-added returns. Similarly, when a stock underperforms the overall
benchmark, the investment manager would like to have allocated a lower weight than the
ve
weight in the benchmark portfolio in order to beat the benchmark portfolio and generate
positive value-added returns.
ra
In summary, we would like to have the sign of active weight (Wp; - W&) to be the same
as the sign of the abnormal performance (r; - rB). In this case, the product of these two
y
terms [(Wp; - W&) x (r; - rB)l , as outlined in the above expression, produces a positive
ile
contribution to the value-added return. On the contrary, if the sign of active weight
(Wp; - WB;) is different from the sign of the abnormal performance (r; - rB) , then the
w
product of these two terms would be negative, which implies a negative impact on the
value-added return.
18
Analyzing returns security by security can quickly become unwieldy. A large portfolio
20
can easily hold hundreds of individual securities. In practice, most attribution programs
make use of factor models, which measure a portfolio's sensitivity to economic factors or
company fundamentals using regression analysis. For instance, the market model relates a
portfolio's return (Rp) to the broad market index (RM).
E(Rp) =ap +~pRM +Ep , and
E(RB) = aB + ~ B RM + EB
©2017Wiley
The model is used to compute the expected return on the portfolio and the benchmark. The
regression parameters are used to determine how much of the value added was sourced
from active return, due to manager skill (A).
E(rP - r8 ) = (aP -a 8 )+(pP -P 8 )RM

A = RP - E(rp - r8 )
om
The portfolio's realized return less the expected excess return [E(rp - r 8 )] is the active
return (A).
l.c
Example3-1
ai
A fund sponsor is performing a micro attribution analysis of one of its account managers
gm
using the market model to estimate expected returns.
E(R;) =a;+ P;RM + E;
@
Based on a regression of historical returns, the manager's portfolio has a zero-factor
loading (intercept) of 1.2 percent and a market factor loading (beta coefficient) of 1.5.
y
The corresponding benchmark portfolio has a zero-factor loading of I. 7 percent and a
ud
market factor loading of 0.9. In the reporting period, the market index yields 8 percent
and the portfolio yields IO. I percent.
st
Calculate the return attributed to active management skill.
fa
nc
Solution:
Using the single factor model, the excepted return on the benchmark is:
ve
E(r8 ) = a 8 + P8 xr1 = l.7%+0.9x8% = 8.9%

ra
The target portfolio yields IO. I percent. The active return is partially due to expected
return on the portfolio and partially due to investment manager's skill.
y
ile
The expected incremental return of the portfolio is:

E(rp - r8 ) = (l.2%-l.7%)+(1.5-0.9)8% = 4.3%
w
However, the excess return is only:

18
I0.1%-8.9%=1.2%
20
The deficit of 3.1 percent is due to the manager's poor investment skill or poor luck
in this reporting period. When the evaluation period is short, it is difficult to identify
the source of this underperformance (i.e. , luck or skill). However, when the evaluation
period is sufficiently long, we have confidence in determining whether the investment
manager has investment skills.
© 2017Wiley
Sector Weighting Micro Attribution
Portfolio construction may start out by identifying the most promising industries and
market sectors. After a list of sectors are selected and portfolio weights in all sectors are
determined, the investment manager picks individual securities within each sector and
determines their within-sector weights.
Investment managers place bigger than benchmark weights (i.e., positive active weights)
on sectors that they believe will out-perform the overall benchmark. Similarly, they place
om
smaller (even negative weights) than benchmark weights on sectors that they believe will
underperform. This process is executed at both the industry/sector level and within each
sector, at the stock selection level.
l.c
Micro performance attribution can be done in this context, where the analysis reveals
ai
the strengths and weaknesses of the investment manager in sector selection and/or stock
section within a given sector. We start from the definition of value-added returns:
gm
s s
@
rv = rp-r8 = LCwPi Xrp 1)- L<w8 X rBi)
i
i=l i=l
y
where:
S is the number of sectors.
ud
Wp; is portfolio weight on sector i.
st
WBi is benchmark weight on sector i.
fa
rpi is portfolio return on sector i.

r8 i is benchmark return on sector i.
nc
ve
It is not challenging to transform the above equation and derive a variation of the above
equation as:
ra
s s
r, rp-r8 L[(wp,-w 8 ,)x(r8 ,-r8 )] + L[(wp,-w8 ,)x(rp,-r8 ,)]
y
= =
i= l i= l
ile
s
+L[WB; x (rp; -rBi)]
w
i=l
18
The above expression indicates that there are three components in value-added returns:
20
The first term is the pure sector allocation effect;

The second term is the sector allocation and stock selection interaction effect;
The third term is the within-sector stock selection effect.
We use Exhibit 3-3 to demonstrate the return attribution. A simple portfolio is invested
in only four sectors: technology, energy, retail, and financial. Benchmark weights for the
overall portfolio are given in the third column: 27 percent in technology, 16 percent in
energy, 34 percent in retail, and 23 percent in financial.
©2017 Wiley
Exhibit 3-3: Sector Weighting and Stock Selection Micro Attribution

Sector Sector Pure Total
Portfolio Benchmark Portfolio Benchmark Sector Interaction Selection Value
Sector Weight Weight Return Return Allocation Effect Effect Added
Technology 39% 27% 20% 19% 0.73% 0.12% 0.27% 1.12%
Energy 8% 16% -13% -10% 1.83% 0.24% -0.48% 1.59%
Retail 18% 34% 14% 16% -0.50% 0.32% -0.68% -0.86%
Financial 35% 23% 22% 17% 0.49% 0.60% 1.15% 2.24%
om
Sum 100.00% 100.00% NIA NIA 2.56% 1.28% 0.26% 4.10%
l.c
The investment manager tilts asset allocation weights based on her subjective bets among
ai
the sectors. Her portfolio weights are listed in the second column. They are 39 percent,
8 percent, 18 percent, and 35 percent, respectively, across the four sectors.
gm
In addition to her bets in different sector weights, the investment manager also chooses
individual stocks within each of the four given sectors. For example, let's assume that
@
there are 100 stocks in the retail sector. The benchmark return of the retail sector is the
market-cap (value) weighted average of 100 retail stock returns in the sector. However, the
y
investment manager favors low PIE retail stocks. Her retail portfolio is made up of all retail
ud
stocks whose PIE is below 20x. Additionally, she chooses an equal weighting scheme in
her portfolio construction.
st
Clearly, her retail portfolio is different from the retail sector benchmark index. She bets on
fa
low PIE retail stocks to outperform high PIE retail stocks. Furthermore, for low PIE retail
stocks, she under weights large-cap stocks and over weights small-cap stocks, relative
nc
to the retail benchmark sector index. The goal of such active management is to beat the
benchmark index. In this particular example, the retail benchmark index yields 16 percent
ve
in this reporting period, but the retail portfolio yields only 14 percent. The investment
manager fails to beat the benchmark index in the retail sector. Her portfolio weight tilt in
ra
individual stock selection produces an inferior outcome to the passive index performance.
Column 8 in Exhibit 3-3 reports a -0.68 percent return to the effect of her selection of
securities different from those in the benchmark.
y
ile
s
w
Selection effect= ~)w& x(rp; -r&)l

i=I
18
20
Now we understand the process of portfolio construction has two steps:
Select sectors and select portfolio weights in sectors;

For any given sector, select individual stocks within that sector and assign portfolio
weights to stocks in the given sector.
In Exhibit 3-3, Column 2 provides portfolio weights; Column 3 provides sector benchmark
portfolio weights; Column 4 provides portfolio returns; and Column 5 provides sector
benchmark returns. Return attribution components, allocation effect, interaction effect, and
selection effect, are reported in the next three columns of Exhibit 3-3. The sum of the three
terms, which is the total value-added return, is reported in the last column.
© 2017Wiley
In Column 4, we have portfolio returns across four sectors. The overall actively managed
portfolio return is simply the weighted average of returns across these actively managed
sectors. We have:
s
rp = L(Wp; X rp;) = 16.98%
i=l
om
Similarly, the return of the benchmark portfolio is the weighted average of returns across
sector benchmark indices. We have:
l.c
s
r8 = L.<wm x r8 ;) = 12.88%
ai
i=l
gm
The value-added incremental return is the difference between the actively managed
portfolio return and the benchmark return.
@
I r, = rp - r I
y
8 =16.98%- 12.88% = 4.10%
ud
Now, let's examine the return attribution due to sector allocations. We continue to use
st
retail sector as an example. Note that the investment manager strategically chooses
fa
18 percent of weighting on the retail sector when the benchmark allocation is 34 percent.
Clearly, the investment manager bets that the retail sector underperforms the overall
nc
benchmark portfolio. That's the reason why she under-weighs the retail rector. However,
as it turns out, the retail sector yields a return of 16 percent, beating the return of the
ve
overall benchmark portfolio of 12.88 percent. Underweighting the retail sector impacts the
actively managed portfolio negatively because she puts less weights in a winner sector. The
ra
return contribution due to this bet is captured in the sector allocation effect.
s
y
Sector allocation effect= L[(wp; - w8 ;)x(rm - r8 ) ]

ile
i=I
w
The definition of sector allocation effect states that an overweighting in a winner sector
18
generates positive return contributions and that an underweighting in a winner sector

generates negative return contributions. Similarly, an overweighting in a loser sector
generates negative return contributions; and an underweighting in a loser sector generates
20
positive return contributions. All return contributions are relative to the benchmark returns.
Finally, the interaction effect captures the interplay of sector allocation and stock
selection effects. In the retail sector example, the interaction effect contributes a positive
0.32 percent to value-added returns.
s
Interaction effect= L[(wp; -w8 ;)x(rp; -rmll
i=I
©2017Wiley
In summary, the investment manager allocates 18 percent to the retail sector, and
strategically chose specific portfolio weights among all stocks in the retail sector (some
portfolio weights may be zero, while some others may be even negative if short selling is
allowed). The value-added return contribution of the retail sector to the overall four-sector
portfolio is the sum of the sector allocation, stock selection, and interaction effects in the
retail sector.
I,,~ta;/= -0.50%+0.32%+(-0.68%) =-0.86% I
om
This amount is reported in the last column of Exhibit 3-3. The sum of the last column is
l.c
4.10 percent, which is the value-added return.
At the overall portfolio level, sector allocation decisions contribute 2.56 percent; stock
ai
selection decisions contribute 0.26 percent; and the interaction between the two contributes
gm
1.28 percent. It appears that the investment manager is good at making sector bets, which
generates 2.56 percent of active returns, and that the investment manager is not so great at
picking stocks within a given sector, which generates only 0.26 percent of active return.
@
The interaction between the sector allocation and stock selection appears to be good,
generating 1.28 percent of active return to the portfolio. The overall 4.10 return seems
y
to be a significant value-added return to the portfolio. It appears that the manager has
investment skills. ud
Fundamental Factor Model Micro Attribution
st
fa
LOS 31m: Discuss the use of fundamental factor models in micro

performance attribution. Vol 6, pp 16G-162
nc
ve
Fundamental and economic factors and the degree of exposures to these factors affect
portfolio returns. Consider the simplest CAPM model. A stock portfolio with a high
beta tends to outperform (underperform) the market portfolio when the market returns
ra
are positive (negative). It is simply because the high beta portfolio carries a high factor
loading, and consequently high risk exposure. To compensate investors, the portfolio with
y
a high beta is expected to produce a high return.

ile
Market risk, measured by beta, is only one of the many risk factors. Other factors may
w
generate similar risk premium to investors with risk exposures. Such risk factors include,
but are not lintited to, market return, market timing, growth, value, size, leverage, yield,
18
liquidity, momentum, and sector specific risk factors.
Fundamental factor model nticro attribution analyzes active returns in the context of a
20
factor model. The analysis identifies the portfolio exposure to these risk factors above
and beyond the exposure of normal benchmark exposures. The incremental exposure
in each risk factor is a strategic decision of the investment manager as a result of active
management. The return contributions due to the incremental exposures are part of the
investment manager's active returns. For example, if an investment manager expects a
bearish market in the next quarter, she may strategically reduce the beta exposure in her
portfolio so that her portfolio beta is significantly below the beta of the normal benchmark
portfolio. The difference in beta generates a positive return differential, which attributes to
her active management.
©2017Wiley
Any excess returns that cannot be explained by the factor model are attributed to the
investment manager's investment skills.
Fixed-Income Micro Attribution
LOS 31n: Evaluate the effects of the external interest rate environment and
active management on fixed-income portfolio returns. Vol 6, pp 162-167
om
Micro performance attribution can be performed on both stock and fixed-income
portfolios. A fixed-income portfolio manager has the choice to invest in different bond
market segments, including government bonds, agency and investment grade corporate
l.c
bonds, high-yield bonds, and mortgage-backed and asset-backed securities. The choices of
different market segments, and portfolio allocation across different market segments, are
ai
very much similar to the choice of industry sectors and portfolio allocation across different
industry sectors facing an equity investment manager. Different bond market segments are
gm
similar to different industry sectors. Different bonds within a market segment are similar to
different stocks within a given specific sector. Consequently, the micro return performance
attribution at the equity portfolio level can be replicated at the fixed-income portfolio level.
@
The term structure of default-free interest rates defines the yield curve, which affects
y
the value and returns of essentially all fixed-income securities. A bet on yield curve
ud
movement plays a critically important role in the returns of an actively managed fixed-
income portfolio. A fixed-income portfolio manager may choose to change the duration
st
and convexity of her portfolio to best reflect her forecast of movements in a yield curve,
lengthening duration when interest rates are expected to fall and shortening duration when
fa
they are expected to rise.

nc
Additionally, non-government bonds compensate investors for bearing default risk. Credit
spread measures the incremental yield on a bond that is subject to default risk. Credit
ve
spread changes over time. A fixed-income portfolio manager may strategically change
allocation weights across bond market segments to reflect her forecasts of changes in credit
ra
spreads.
y
The investment manager can choose the exposure of interest rate risk by controlling the
ile
level of duration and convexity of the fixed-income portfolio. She can also choose the
exposure of credit spread risk by allocating her portfolio across different bond market
w
segments. The total return on her portfolio is made up of the following components:
Effect of the external interest environment

18
Return on the default-free benchmark, assuming no change in forward rates

Return due to changes in forward rates
20
Contribution of the investment manager

Return from interest rate management
Return from sector/quality management
Return from selection of specific securities
Return from trading activities
©2017Wiley
LOS 31o: Explain the management factors that contribute to a fixed-

income portfolio's total return and interpret the results of a fixed-income
performance. Vol 6, pp 165-166
While managers cannot control interest rates or spreads, they can control their portfolios'
duration and sector exposures. Fixed-income attribution analysis focuses on the manager's
performance in addressing the factors within his control.
Interest rate management effect: It measures how well the manager predicts
om
movements in interest rates. It is essentially the difference of the return of the
portfolio's default-free bond return less the return of the Treasury universe. Interest
l.c
rate management effect can be attributed to duration, convexity, and changes in the
shape of a yield curve.
Sector/quality effect: It measures how well the manager selects "winner"
ai
sectors and credit quality groups. It is akin to the allocation effect in the micro
gm
performance attribution of an equity portfolio.
Security selection effect: It measures how well the manager selects "winner" bond
issues within a given bond market segment. It is akin to the security selection
@
effect in the micro performance attribution of an equity portfolio.
Trading activity: It measures how trading turnover affect total returns and is
y
measured as a residual after all three effects listed above are accounted.
LESSON 4: PERFORMANCE APPRAISAL

ud
st
In the preceding two sections, we investigated performance measurement and performance
fa
attribution. We understand how to measure portfolio returns and how to attribute active
returns to various sources of active management. Now the question we eventually need to
nc
address is a challenging one. We need to determine whether a positive active return is due
to superior investment skill or dumb luck.
ve
Investment skill is the ability to deliver positive alpha consistently over time. Many fund
ra
managers may deliver abnormal returns over a short period of time. We would like to
believe that they have investment skills, but we are not so sure about the truth. On the
other hand, most people would agree that Warren Buffett has investment skills because his
y
track record is time-tested. However, even the great Buffet is capable of a bad year, and
ile
sometimes bad luck goes against even the best managers.

w
When we analyze value-added return, we need to consider not only just the magnitude of
the value-added return, but also the variability of the return. One key word in the definition
18
of investment skill is consistency. What we would like to see is that an investment manager
delivers significant value-added returns relative to the volatility of value-added returns.
20
Risk-Adjusted Appraisal Metrics
LOS 31p: Calculate, interpret, and contrast alternative risk-adjusted

performance measures, including (in their ex post forms) alpha,
information ratio, Treynor measure, Sharpe ratio, and M2. Vol 6, pp 16S-171
Return should not be interpreted in isolation. A manager may earn a high return by
assuming a great deal of risk. In this section, we explore risk-adjusted measures of return.
© 2017Wiley
Although, we might immediately ask how risk is to be incorporated into our metrics: as
systematic risk (Pl or total risk (a).
Ex Post Alpha
Also known as Jensen's alpha, it is computed based on the ex post Security Market
Line (SML) to evaluate the performance of a portfolio. Note that the ex post alpha is
significantly different from the ex ante alpha. The ex ante alpha is based on expectations.
If markets are efficient, an ex ante alpha should be zero. The ex post alpha is based on
om
realizations of the following variables (I) the return on an account or portfolio; (2) the
return on market portfolio or market index; and (3) the risk-free rate. Motivated by the
ex ante CAPM model, we run a regression to compute the ex post alpha. The regression
l.c
model is given below:
ai
gm
Where R, is the return on the portfolio over period t ; rft is the risk-free rate over period t ;
@
RM, is the market return over period t; p is the ex post beta of the portfolio; and a is the ex
post alpha of the portfolio. A superior manager will exhibit a positive ex post alpha.
y
ud
LOS 31q: Explain how a portfolio's alpha and beta are incorporated into
the information ratio, Treynor measure, and Sharpe ratio. Vol 6, pp 168-172
st
fa
Treynor Measure
nc
The Treynor measure is closely related to the ex post alpha. It is the ex post excess return
over the risk-free rate relative to the amount of systematic risk the portfolio carries.
ve
ra
y
ile
Where RA is the average return of the portfolio over a perj__od of time; if is the average
risk-free rate of return over the same period of time; and PA is the estimated ex post beta.
w
Note that the Treynor ratio, TA, should be interpreted as a slope measure. If the portfolio
manager has NO investment skills, then the Treynor ratio should be the slope of the ex post
18
SML line. If the portfolio manager has positive (negative) investment skills, the Treynor
ratio should be greater (less) then the slope of the ex post SML line.
20
Additionally, the conclusion of performance appraisal based on Treynor ratio is always the
same as that based on ex post alpha. We observe a positive ex post alpha if and only if the
Treynor ratio is above the ex post slope of the SML line.
©2017Wiley @
Sharpe Ratio
Risk adjustments in ex post alpha and in the Treynor ratio are based on the amount of
systematic risk, or beta, in the portfolio. Sharpe ratio performs risk adjustment based on
the total risk.
om
The Sharpe ratio is located in the space where we draw the Capital Market Line (CML).
l.c
The space is mean- standard deviation space, or return- total risk space. The Sharpe ratio
is benchmarked against the slope of the CML. The Sharpe ratio of a portfolio is higher
ai
than the slope of the CML if and only if the location of the portfolio is above the CML,
suggesting superior performance.
gm
M-Squared (M2)
@
M-squared is closely related to the Sharpe ratio. It measures the rate of return the market
index would earn if the specific portfolio under appraisal is on the CML. Consequently, M2
y
should be compared against the ex post market return. If the ex post market return is less
ud
than M2, we conclude that the portfolio produces superior performance.
st
fa
nc
An alternative interpretation of M2 is the rate of return the portfolio would have earned
ve
if the portfolio has the same level of total risk as the market index. By construction, M2
and the Sharpe ratio always produce the same conclusion on whether a portfolio delivers
ra
superior performance. However, the conclusion may be inconsistent with the conclusion
drawn based on either the ex post alpha or Treynor ratio. The reason is that M2 and the
Sharpe ratio are based on total risk adjustment, while the ex post alpha and the Treynor
y
ratio are based on systematic risk adjustment. If a manager assumes a great deal of
ile
unsystematic risk, that will not show up in the ex post alpha or Treynor measures because
they only consider systematic risk.
w
Information Ratio
18
Information ratio measures the performance of a portfolio relative to its benchmark.

20
JRA
- RA -R..
- - -
CJA-B
Where portfolio Bis portfolio A's benchmark portfolio. Given this reference, the
numerator measures the active return of the portfolio (A), and denominator measures the
active risk, which is also called tracking error. Information ratio measures active return per
unit of risk of deviating from the benchmark portfolio.
© 2017Wiley
Note that Shrupe ratio can be interpreted as a special case of Information Ratio. If we set
the benchmark portfolio B to be the risk free security, the information ratio degenerates to
the Shrupe ratio.
Criticism of Risk-Adjusted Metrics
Not everyone considers these risk metrics to be fair and valid appraisals of manager
performance. Some objections include:
om
Doubts about the validity of CAPM;
Sensitivity to the selected market portfolio proxy;
The benchmarks chosen might not represent investable portfolios; and
l.c
The regression parameters might not be stable.
ai
Quality Control Charts
gm
LOS 31r: Demonstrate the use of performance quality control charts in
performance appraisal. Vol 6, pp 172-176
@
Quality control charts are one effective and visual means of presenting performance of an
y
investment manager over time. We understand that there is significant noise in performance
ud
data. Managers with investment skills may underperform the benchmark during any
specific reporting period. Conversely, managers without investment skills may outperform
st
the benchmark during any specific reporting period. It's a challenging task to reliably
differentiate managers with investment skills from random fluctuations.
fa
We use statistical methods to help us to systematically evaluate the data. For any manager
nc
under review, we begin with the null hypothesis that the manager has no investment skill,
meaning the manager's value-added return is zero. To perform our statistical analysis, we
ve
make two assumptions:

ra
The manager's active returns are normally distributed.

The variance of the normal distribution does not change over time
(homoskedastic).
y
ile
Our data include the time series of value-added returns of the manager. We transform
individual periodic value-added returns into cumulative value-added returns. We plot
w
the cumulative value-added returns across time to produce a quality control chart.
Additionally, we plot the upper and lower bounds of a confidence band along the zero line.
18
Like a confidence interval, the confidence band covers the region where the cumulative
value-added returns are statistically insignificant from zero. If we find that the cumulative
20
value-added return line to be within the confidence band, we fail to reject the null
hypothesis that the manager under evaluation has no investment skills. Alternatively, if we
find that the value-added line breaks out from the upper (lower) bound of the confidence
band, we conclude statistically significant evidence that the manager has superior (inferior)
investment skills to our specified degree of confidence.
Exhibit 4-1 plots three quality control charts. Note that the vertical axis is the cumulative
value-added returns, and that the horizontal axis is time in years. The upper and lower
bounds of confidence band are plotted in the figure. The width of the confidence band gets
narrower over time because we have increasingly more statistical power as the impact of
short-term noise is reduced over a long time horizon.
©2017Wiley
Exhibit 4-1: Quality Control Charts

(a)
Cumulative value-added return
pper bound of
nfidence band
+- e
Time (years)
om
confidence band
l.c
ai
{b)
gm
...._Value-added line
@
pper bound of
nfidence band
y
ud
st
fa
nc
(c)
ve
~
ra
Upper bound of
~fidence band
y
ile
w
..,.___Value-added line
18
20
In Exhibit 4-l(a), the value-added line stays within the confidence band, suggesting that
there is no statistically significant evidence against the null hypothesis that the manager
has no investment skill. Our conclusion is that the manager does not provide value-added
return. The fund sponsor may consider terminating the manager's employment contract.
In Exhibit 4-1 (b), the value-added line breaks the upper bound of the confidence band,
suggesting that there is statistically significant evidence against the null hypothesis that the
manager has no investment skill. Our conclusion is that the manager does provide positive
value-added return. The value-added return is due to skill and not luck. The fund sponsor
may consider renewing the manager's employment contract.
©2017Wiley
In Exhibit 4-l(c), the value-added line breaks the lower bond of the confidence band,
suggesting that there is statistically significant evidence against the null hypothesis that
the manager has no investment skill. Our conclusion is that the manager provides negative
value-added return. The negative value-added return is due to poor skills and not bad luck.
The fund sponsor should consider terminating the manager's employment contract.
LESSON 5: THE PRACTICE OF PERFORMANCE EVALUATION
om
LOS 31s: Discuss the issues involved in manager continuation policy
decisions, including the costs of hiring and firing investment managers.
Vol 6, pp 179-181
l.c
As seen in the performance appraisal process, manager skill can be determined as beating
ai
a benchmark with the same or lower risk (i.e., with value added). Fund sponsors should
keep investment managers with average annual outperformance of 2 percent or greater
gm
relative to their benchmarks and fire managers with average underperformance of 1 percent
or greater. The problem lies with 0 value added managers; they are numerous and difficult
to separate from outperforming and underperforming managers.
@
Fund sponsors and individual investors have good reason to carefully consider their hiring
y
and continuation policies. In addition to the time it will require for the trustees and fund
ud
sponsor to evaluate and select a new manager, moving the portfolio will likely involve
transaction costs. In fact, a good portion of the underperforming manager's portfolio may
st
have to be liquidated to transfer to the newly hired manager.
fa
LOS 31t: Contrast Type I and Type II errors in manager continuation

nc
decisions. Vol 6, pp 181-183

ve
Just as there are two types of errors in hypothesis testing in statistics, there are two types of
errors in keeping and firing investment managers:
ra
Type I error: keeping (hiring) managers who do not have investment skills.
Type II error: firing (not hiring) managers who do have investment skills.
y
ile
Fund sponsors may be tempted to widen confidence bands on the manager performance
quality control chart to decrease the probability of keeping an underperforming manager
w
(Type I error). However, widening confidence bands also makes it harder to spot true
talent, and firing a manager with investment skill becomes more likely (Type II error).
18
Also, broad confidence bands will tend to increase manager turnover costs. On balance,
20
it may be best to accept some underperforming managers in order to keep outperforming

talent and lower transaction costs. Each sponsor or investor must determine this tradeoff
based on their own preferences.
©2017Wiley
20
18
w
ile
y
ra
ve
nc
fa
st
ud
y@
gm
ai
l.c
om
STUDY SESSION 18: GLOBAL INvESTMENT
PERFORMANCE STANDARDS
om
l.c
ai
gm
y @
ud
st
fa
nc
ve
ra
y
ile
w
18
20
©201 7Wiley
20
18
w
ile
y
ra
ve
nc
fa
st
ud
y@
gm
ai
l.c
om
OVERVIEW OF THE GLOBAL INVESTMENT PERFORMANCE STANDARDS
READING 32: OVERVIEW OF THE GLOBAL INVESTMENT

PERFORMANCE STANDARDS
Time to complete: 3.5 to 5 hours
Reading summary: The GIPS standards represent ethical principles investment firms
can use to guide calculation and presentation of performance results. While you are not
required to reference standards by number, you should be able to discuss the framework
and scope of the standards and apply them not only in situations where violations
occur, but to establish best practices within the firm. Know and be able to differentiate
om
requirements from "best practices" (i.e., "recommendations") in all areas. Understand
the reasons for using time-weighted return calculation and how to build composites of
l.c
portfolios for presentation to the investing public. Also, be able to explain the standards
with respect to disclosure, results reporting, presentation, and advertising. Pay particular
attention to special topics such as constructing composites, linking past firm performance,
ai
measures of dispersion, and calculating after-tax returns. Finally, prepare thoroughly to
gm
discuss various levels of verification.
LESSON 1: BACKGROUND OF THE GIPS STANDARDS
@
LOS 32a: Discuss the objectives, key characteristics, and scope of the
y
GIPS standards and their benefits to prospective clients and investment
managers. Vol 6, pp 207-215 ud
st
Investment management is a highly competitive field, with each firm wishing to present
its results in the most favorable light in order to earn business. An investment firm or
fa
individual portfolio manager might attempt to gain a competitive advantage by presenting

nc
only results favorable to their firm such as:
Reporting simulated returns;

ve
Annualizing partial period results;

Choosing a benchmark favorable to actual portfolio return;
ra
Personally estimating prices, especially for infrequently traded assets;

Misrepresenting portfolio composites by eliminating underperforming accounts;
y
Calculating returns from a low to a high point rather than a standard measurement
ile
period;
Using client contributions during the period to misrepresent asset growth in the
w
portfolio; and
Directing a prospect's attention toward the most favorable aspects of reported
18
performance and directing attention away from or simply not reporting unfavorable
aspects of performance.
20
GIPS-compliant calculation and reporting, especially when verified, provides investors

with reliable data for making decisions. Further, GIPS compliant presentations have
become almost universally required among institutional investors concerned about
fiduciary duty and some require third-party verification. Firms without GIPS-compliant
performance presentations are having increasing difficulty winning business.
©2017Wiley
OVERVIEW OF THE GLOBAL INVESTMENT PERFORMANCE STAN DA RDS
The process of implementing GIPS compliance may also:
Improve data quality for internal decision-making;

Enhance oversight of investment operations; and
Provide comfort to marketing staff that they are presenting accurate data.
Only firms as a whole may claim GIPS compliance, and then only on a firmwide basis (i.e.,
they may not claim GIPS compliance unless all parts of the firm comply with the standards).
Further, firms must present all fee-paying, discretionary composites (i.e., groups of accounts
om
defined by a mandate, strategy, or objective). Software vendors, consultants, and third party
performance measurement firms (e.g., custodians) may not claim GIPS compliance.
l.c
Firms that present performance that complies with local laws and regulations but conflicts
with the GIPS standards must disclose the discrepancy.
ai
The GIPS standards are ethical in nature and are entirely voluntary. To claim compliance,
gm
however, firms must follow requirements and should follow recommendations, which
describe best practice. Firms may exceed the strict requirement of the standards and even
exceed recommendations in order to establish a fair and representative presentation.
@
In addition to requirements of the GIPS standards, firms must follow any additional
y
requirements established in updates, interpretations, clarifications, Q&A, and guidance
ud
statements available on the GIPS website, www.gipsstandards.org.
st
LESSON 2: FUNDAMENTALS OF COMPLIANCE
fa
LOS 32b: Explain the fundamentals of compliance with the GIPS

nc
standards, including the definition of the firm and the firm's definition of
discretion- Vol 6, pp 217- 220
ve
Only an investment firm, its subsidiary, or a division held out to clients as a distinct
ra
business entity may claim compliance. A distinct business entity must retain discretion
over managed investments, and maintain organizational separation (i.e., different legal
entity) and functional segregation (i.e., investment process, market segment, or client type).
y
ile
Firms choosing to represent themselves as GIPS-compliant must follow all GIPS

requirements and apply them throughout the firm, and must not present false or misleading
w
performance or performance-related information. This means that firms may not simply
meet the requirements for some asset classes, composites, products, or strategies. Firms
18
may not claim partial compliance, or indicate that they comply with GIPS standards
"except for" some item.
20
The definition of.firm determines the parameters for claiming total.firm assets as well
as the extent of compliance activities. Total firm assets include the aggregate fair
value of all assets under the firm's investment responsibility, regardless of whether
they are discretionary or fee paying. GIPS-compliant firms must establish, document,
and consistently apply policies and procedures related to GIPS compliance and error
correction.
©2017Wiley
Example2-1
An investment management firm has two divisions. Division A manages personal trust
accounts and Division B manages institutional accounts. The firm has one research
department that provides a list of recommended securities to both divisions, and one
trading department that helps both divisions determine security misvaluations. Portfolios
in each division may select from various style categories defined by the research
department. Each division, however, remains organizationally separate under different
om
senior personnel who report to the CEO. For purposes of defining total firm assets, these
two divisions would be most likely be considered:
l.c
A. one division.
B. two firms, because they are organizationally separate.
ai
gm
C. one firm, because they share common investment approaches and trading
strategies.
@
Solution:
y
C. A firm should define itself using the broadest, most meaningful definition.
ud
Although the two divisions may be separate legal entities run by different
senior managers, they are functionally identical as to the investment and trading
processes. These two divisions are likely to experience the same investment
st
results and should, therefore, be considered a single firm for GIPS firm
fa
definition.
nc
In general, firms may not alter historical composite results. This includes when assets
ve
comprising composites are shifted outside the firm (i.e. , when an organization's structure
changes). In addition, joint marketing efforts must distinguish between results from
ra
compliant and non-compliant firms.

y
Although following GIPS requirements is a prerequisite for claiming compliance, there are
three additional recommendations:
ile
1. Verify compliance;
w
2. Adopt the broadest definition of the firm; and

3. Provide a GIPS-compliant performance presentation to each client annually.
18
Note that adopting the broadest meaningful firm definition reduces potential confusion
20
over applicability of compliance claims among regulators and investors.
©2017Wiley @
OVERVIEW OFTHE GIDBAL INVESTMENT PERFORMANCE STANDARDS
LESSON 3: INPUT DATA
LOS 32c: Explain the requirements and recommendations of the GIPS

standards with respect to input data, including accounting policies related
to valuation and performance measurement. Vol 6, pp 220-223
Firms must maintain all data necessary to support all items of a GIPS-compliant
presentation. This will allow firms to replicate return data for clients, verifiers, and
om
regulators should a question arise.
Accrual accounting must be used for all fixed income securities and other assets that earn
l.c
interest income. Therefore, interest income earned but not yet received should be included
in return calculations, and bonds should be transacted at full value (i.e. , including accrued
ai
interest). Dividends should be accrued as of the ex-dividend date.
gm
Beginning January 1, 2005, firms must use trade date accounting. Using trade date
accounting rather than settlement date accounting reflects return from the point the
manager made a commitment to the buy or sell decision, and prevents the need for
@
comparison of trade decisions in one period that do not settle until the next reporting
period. However, recognizing assets and liabilities made within three days of the actual
y
transaction satisfies the requirement.
ud
Beginning January 1, 2011, firms must value portfolios based on the fair value of assets
st
discussed in GIPS valuation principles. Cost and book value will be relevant only for
calculating after-tax return.
fa
GIPS standards specify the frequency and timing of portfolio valuation as shown in
nc
Exhibit 3-1.
ve
Exhibit 3-1: Portfolio Valuation

ra
Period Valuation
Prior to January 1, 2001 Quarterly or more frequent.
y
Beginning January 1, 2005 Monthly or more frequent.

ile
Beginning January 1, 2006 Composites (and thus portfolios) must have consistent
beginning and ending annual valuation dates.
w
Beginning January 1, 2010 On the date of all large external cash flows (as
defined by the firm for each composite); and
18
As of each calendar month end or the last business

day of each month.
20
Note that external cash flows are cash contributions and withdrawals and that GIPS does
not define "large" for the purposes of triggering a valuation event.
Although the standards allow some flexibility in valuing portfolios, firms may not do
so more frequently than specified by policy to avoid the temptation of opportunistically
valuing assets at high levels. Composites (and thus portfolios) must be valued at calendar
year end or the last business day of the year unless a composite has a non-calendar fiscal
year.
© 2017Wiley
Additional recommendations include:
1. Using qualified independent third party valuations;

2. Valuing portfolios when all (not just large) external cash flows occur; and
3. Accruing investment management fees for net-of-fee return calculations.
Example3-1
om
A performance presentation with return shown net of fees would show gross return
reduced for:
l.c
A. investment management fees but not carried interest.
ai
B. carried interest but not investment management fees.
gm
C. both investment management fees and carried interest.
Solution:
@
C. Net-of-fee performance would include gross of fee performance less a
y
deduction for investment management fees and carried interest.
ud
LESSON 4: RETURN CALCULATION METHODOLOGIES
st
fa
LOS 32d: Discuss the requirements of the G IPS standards with respect to
return calculation methodologies, including the treatment of external cash
nc
flows, cash and cash equivalents, and expenses and fees. Vol 6, pp 223--232
ve
The GIPS standards require use of a total return methodology that accounts for realized
and unrealized gains and losses along with accrued income. Absent external cash flows,
ra
total return is based on the increase in portfolio value, including accrued income, over the
measurement period:
y
ile
Liil
w
C2-J
18
This accurately describes total return in the absence of external cash flows (e.g., investor
20
contributions and withdrawals), which are outside the control of an investment manager.
Both periodic and subperiod returns must be geometrically inked using time-weighted
returns that adjust for external cash flows. This requires using an intraperiod valuation
method with subperiod returns between external cash flows geometrically linked into a
time-weighted return:
©2017Wiley
Each subperiod return is based on a starting value for the portfolio and the intraperiod
time continues until the instant before the next external cash flow or through the end of
the valuation period, whichever occurs first. Note that this time-weighted return is not
dependent on the size of the cash flow or the length of time in the portfolio, as required
after January I , 2010.
Example4-1
om
An investor contributes $100,000 to a portfolio at the beginning of November. At the
end of the day on November 4, the portfolio value is $101,000. A cash contribution of
$6,000 is credited to the account prior to the start of trade the next day. The portfolio
l.c
value for the month ending November 30 is $108,000. The portfolio's time-weighted
periodic return based on the intraperiod valuation method will be closest to:
ai
A. 1.00%
gm
B. 1.91%
@
C. 7.00%
y
Solution:
B.
ud
The intraperiod valuation method requires geometric linking for each subperiod
st
return:
fa
, = vt - Vo = $101,000-$100,000
0.01
' V0 $100,000
nc
VI -Vo $108,000-$107,000
2
----v;- 0.0093
ve
' = $ 107,000
rtw, = (I +0.0!)(1+0.0093)- 1= 0.0194
ra
y
Valuation for the portfolio is recommended on the date of all cash flows rather than just
ile
large cash flows.
Returns adjusted for daily-weighted external cash flows may be calculated using either
w
internal rate of return or modified Dietz method calculations:

18
20
rmodDietz = ~n ( )
V0 + .£.. r=l CF; X W;
The weight W; by which each sub-period cash flow is multiplied can be calculated based
on the total number of calendar days in the period CD and D;, the number of days from the
beginning of the measurement period to the day a cash flow occurs:
CD-D
W- = - - -'
' CD
© 2017Wiley
This weighting formula asswnes cash flows occur at the end of the day, and simply represents
the percentage of days during the period each cash flow was resident in the portfolio.
Example4-2
An investor contributes $100,000 to a portfolio at the end of the day on August 31.
At the end of the day on September 4, the portfolio value is $101,000 before a cash
contribution of $6,000 is credited to the account. The portfolio value for the month
om
ending September 30 is $108,000. The portfolio's time-weighted return based on the
Modified Dietz valuation method will be closest to:
l.c
A. 1.0%
ai
B. 1.9%
gm
C. 8.0%
Solution:
@
B. The modified Dietz method calculations require first calculating the weights for
y
the cash flow:
w = CD-D; = 30 - 4 =0.8667
ud
st
' CD 30
v; - v0 -CF
fa
rmodDietz = ~n ( )
Vo+ .£..r=l CFj X wi
nc
$108,000 - $100,000 -$6,000

0.0190
$100,000 + ($6,000 x 0.8667)
ve
ra
Firms may instead choose to assume cash flows are credited at the beginning of the day
y
received. This would result in an equation similar to the weighting formula above, but with
ile
one less day for D, in the numerator (i.e., one more day of being in the portfolio during the
period):
w
The modified internal rate of return approach (i.e., modified IRR) is the return required to
grow V0 to V1 using an iterative estimation for r until a final solution occurs:
18
20
n
V1 = L [CF;(l +r)w' ]+ V0 (1 +r)
t=l
©2017Wiley
Some software algorithms use the modified Dietz method as a starting point for estimating
the final modified IRR value. However, the true IRR approach results in a money-weighted
return not acceptable for GIPS performance measurement. Applying the time weight w,
converts this to a time-weighted return.
For periods prior to January I, 2005, G!PS allows the original Dietz method, which
assumes cash flows occur at the midpoint of the measurement period:
om
V1 -V0 -CF
'Dietz= Vo +0.5CF
l.c
Intraperiod returns must be geometrically linked in calculating periodic returns.
ai
Impact of Cash Flows
gm
Cash flow timing can distort returns depending on the type of market. For example, cash
flow timing has little impact on return when the market is flat, steadily rising, or steadily
@
falling. However, cash flow timing during volatile markets can have a significant impact on
returns.
y
ud
Regardless of the market characteristics, firms must consistently apply cash flows per their
policies for a given composite. This may mean the firm considers only large external cash
st
flows or, ideally, the firm considers all external cash flows. Firms may define "large" as
a high percentage of portfolio value in a liquid market composite (e.g., developed market
fa
equity), or as a low percentage of portfolio value in an illiquid market composite (e.g.,

emerging market debt). They may define it in terms of cash/asset flow, a percentage of
nc
each portfolio's assets, or as a percentage of the composite's assets. In any case, the firm
must document and consistently apply its definitions.
ve
Cash and Cash Equivalents

ra
The GIPS standards require inclusion of cash and equivalents in total return calculations in
order to accurately assess an investment manager's ability to allocate assets to cash. Active
y
managers will often have discretion on how much cash is held up to some threshold of
ile
portfolio value (e.g., 5% of assets) while passive managers may be held to a requirement to
invest all cash as soon as possible. In any case, there will usually be some cash included in
w
a portfolio as the result of buying and selling securities.

18
High cash levels benefit portfolios in a falling market and create a drag on portfolio return
in a rising market. The return on money market instruments held in the portfolio, however,
20
has relatively little impact on the total return compared to the asset manager's cash
allocation decision.
©2017Wiley
Fees and Expenses
The GIPS standards require return calculations on values after actual rather than estimated
trading expenses. Trading expenses represent the cost of buying and selling investments
including:
Brokerage commissions;
Exchange fees and taxes; and
Internal or external trading spreads.
om
However, custody fees should not be considered part of trading expenses even if they are
charged on a per-transactions basis, because the investment manager has little control over
l.c
custodial care for the assets compared to a great deal of control over how frequently and in
what type of spread situation to trade.
ai
Where an investment manager offers a comprehensive package including bundled fees
gm
(i.e., fees for asset management, brokerage, and custody), gross-offee returns must be
reduced by the full amount of the bundled fee or the portion of the bundled fee including
trading costs. Net-affee returns must be reduced by the full amount of the bundled fee or
@
the portion of the bundled fee including trading costs and investment management fees.
y
Withholding Taxes
ud
Some countries allow foreign investors to file claims to recover a portion of taxes withheld
st
on dividends, interest, or taxable capital gains. The GIPS standards recommend the
following:
fa
Accrual of withholding taxes subject to reclamation (i.e., taxes that may be

nc
returned to the investor); and

Return calculation net of nan-reclaimable withholding taxes.
ve
ra
LOS 32e: Explain the requirements and recommendations of the GIPS

standards with respect to composite return calculations, including methods
for asset-weighting portfolio returns. Vol 6, pp 232-235
y
ile
Composite Returns
w
Composite returns show the success of firm implementation for a strategy, objective, or
investment mandate. The beginning assets method calculates composite returns as the sum
18
of the individual portfolio returns weighted by their proportionate beginning-of-period

asset value:
20
©2017Wiley
The beginning assets plus weighted cash flows method uses the individual portfolios VP in
place of V0 ,p:
om
The calculation for rp; will be the same in either formulation, although more frequent asset
weighting will give a better indication of true performance for the composite. Composites
constructed beginning January 1, 2010 must use monthly or more frequent weighting, and
l.c
the GIPS standards recommend monthly or more frequent weighting for earlier periods.
ai
Exhibit 4-1: Weighted Cash Flows
gm
Portfolios ($000)
CF Weight* I A B c D Total
Beginning assets (BA)
@
98.6 100.0 102.6 104.0 405.2
External CF date:
y
0.833 1.4 -2.6 -1.2
IO 0.667
ud 0.0
15 0.500 2.5 2.5
st
20 0.333 5.0 -2.5 2.5
fa
25 0.167 18.0 18.0

nc
30 0.000 0.0
Beginning assets + weighted CF 101.4 101.3 103.4 103.2 409.3
ve
BA % of composite BA 24.33% 24.68% 25.32% 25.67% 100.00%

ra
BA + wCF % of composite BA + wCF 24.78% 24.74% 25.27% 25.21% 100.00%

*CF weights use end-of-day crediting convention.
y
ile
The calculation for Portfolio A's beginning assets plus weighted cash flows, for example, is:
w
BA+ wCF = 98.6+(1.4x 0.833)+(5.0x0.333) = 101.4

18
A final method treats the entire composite as if it were a single portfolio by summing
20
beginning asset values and periodic cash flows. The composite return can then be
calculated using the modified Dietz method.
© 2017Wiley
LESSON 5: COMPOSITE CONSTRUCTION LESSON
The GIPS standards require all discretionary, fee-paying portfolios to be part of at least
one composite. Discretionary, non-fee-paying portfolios may be included in a composite
with appropriate disclosure. However, non-discretionary portfolios cannot be included in a
composite regardless of whether they pay fees or not. This structure results in composites
that reflect the investment manager's ability while preventing exclusion of unsatisfactory
results.
om
Qualifying Portfolios for Composites
l.c
LOS 32f: Explain the meaning of "discretionary" in the context of
composite constrnction and, given a description of the relevant facts,
ai
determine whether a portfolio is likely to be considered discretionary.
Vol 6, pp 235-238
gm
Discretionary means the investment manager can implement an intended investment
strategy (e.g., large cap growth). Clients may adopt an investment policy statement, which
@
places restrictions on a portfolio to prevent risk from, for example, lack of diversification
or unacceptable levels of interest rate and credit quality risk. Clients who impose
y
restrictions that prevent proper implementation of an intended strategy, however, render it
non-discretionary. ud
st
Examples of restrictions that potentially render an account non-discretionary include:
fa
Selling company stock;

Selling sentimental holdings;
nc
Retaining low-basis stock to avoid capital gains; and

Investing in companies that the investor finds objectionable (e.g., alcohol, tobacco,
ve
firearms, gaming, etc.).

ra
Legal restrictions may prohibit certain types of transactions in particular types of portfolios
(e.g., short sales in retirement accounts).
y
Other restrictions may be imposed by a client's contributions and withdrawals. For

ile
example, a client making withdrawals may cause an investment manager to keep greater
cash balances than indicated by strategy.
w
Only restrictions that impede implementation of the strategy, however, render the
18
portfolio non-discretionary. In some cases, the restrictions can suggest a particular

strategy (i.e., non-GMO food companies) and an investment manager may be able to
20
include several portfolios with similar restrictions in a composite (e.g., a portfolio that
excludes objectionable companies). In addition, managers may be able to segregate the
non-discretionary assets from the discretionary assets and include only the latter in the
composite. Firms may also decide to include non-discretionary assets below a materiality
threshold (i.e., constitute some non-material percentage of assets).
©2017Wiley
In any case, firms are required to document and consistently apply their definitions of
discretion.
Firms may not link simulated or model portfolios to actual results reported for a
composite; that is, only actual accounts may be included. Such results may be shown as
supplemental information, but may not be linked to composite results for actual accounts.
Firms may include their own actual proprietary account results in composites subject to the
reporting requirements related to non-fee-paying accounts.
om
Composite Definition
l.c
LOS 32g: Explain the role of investment mandates, objectives, or strategies
in the construction of composites. Vol 6, pp 238-241
ai
GIPS-compliant firms must include all portfolios meeting a composite definition in
gm
that composite. The composite definition describes a strategy, objective, or mandate
that objectively represents accounts in that composite and should enable performance
comparison with other firms using a similar style. Firms are not allowed to include
@
portfolios with different strategies, objectives, or mandates in the same composite.
y
Generic composite descriptions are not very helpful for comparing composite returns from
ud
different investment managers. Although firms are not required to define their composites
according to each level of the GIPS hierarchy, it may be useful for categorizing portfolios
st
so that they may be included in the appropriate composite:
fa
Investment mandate- Based on a summary of the strategy (e.g., small-cap

domestic equities);
nc
o Asset classes- May be further defined by region or country (e.g.,

European equities);
ve
Style or strategy-(e.g., growth vs. value, active vs. passive, sector-

based);
ra
o Benchmarks-( e.g. , managed to an index such as S&P 500);

Risk/return characteristics-Grouped by risk (e.g. , high beta;
targeted excess return).
y
ile
Firms may meaningfully categorize portfolios into a composite based on market

capitalization and style, similar to the nine-box matrix in common use among investment
w
professionals. This categorizes companies into size (i.e., small, medium, or large) and
style (i.e., growth, blend, and value). Portfolios may then be categorized based on money-
18
weighted averages of portfolio holdings.

20
Using too few composites to represent strategies employed risks disguising dispersion
of portfolio returns for the advertised strategy. Using too many composites increases
management expense and tends to create composites with too many similarities or too few
portfolios to be useful.
© 2017Wiley
A process for designating the strategy represented by a composite might include:
Determine whether the firm's organizational structure suggests existing

strategies. For example, specific research units may specialize in finding value
equity investments while another group specializes in index construction and
enhancements.
Review internal and competitor marketing materials, and RFPs (request for
proposals) for investment management services to determine how the industry
describes existing firm offerings.
om
Construct a framework similar to the GIPS hierarchy previously presented and the
GIPS guidance statement on composite definitions.
Fit existing fee-paying, discretionary portfolios into the provisional composites in
l.c
the framework. Exclude client portfolios that do not appear to fit the provisional
composites and develop new composite descriptions as required that better fit the
ai
orphaned portfolios.
gm
Provide detailed, relevant documentation to all affected parties within the
organization.
@
Firms may define composites consistent with portfolio benchmarks, especially where only
assets included in the benchmark may be included in portfolios. Of course, this applies
where the firm has no other composites that fit the same characteristics.
y
ud
LOS 32h: Explain the requirements and recommendations of the GIPS
st
standards with respect to composite construction, including switching
portfolios among composites, the timing of the inclusion of new portfolios
fa
in composites, and the timing of the exclusion of terminated portfolios from

nc
composites. Vol 6, pp 241-244

ve
Including and Excluding Portfolios

ra
Firms are required to consistently apply documented policies for including portfolios
in a composite, preferably by including them beginning with the next full performance
measurement period after receiving the funds (e.g., beginning October 1 for funds received
y
September 5). Each composite, however, may have its own deployment guidelines
ile
consistent with its strategy (e.g., guidelines that deploy assets into an illiquid market in the
least disruptive way). For example, a firm may decide that liquidity for its strategy requires
w
other than immediate deployment and may develop a guideline that fits the strategy such
as: "Funding for all new portfolios received after the 15th of a month shall be included in
18
the composite in the second month after funding."
Firms must include portfolios in composites through the last day of the last full month
20
they were managed. When a firm loses its discretion or a client terminates a relationship,
the firm must include the portfolio in composite performance through the last full month it
maintained discretion or managed the account. For example, a firm receiving notification
on November 5 that it will lose its contract effective November 30 and should immediately
cease discretionary trading would include the portfolio in composite performance
reports through October 31 rather than through November 30. Historical performance of
terminated portfolios remains with the composite.
GIPS standards also prevent switching portfolios among composites unless the composite
definition or investment characteristics have made inclusion inappropriate. Redefining an
©2017Wiley @
existing composite should be an infrequent event because the GIPS standards require a new
composite definition when strategy changes. In any case, performance results for the portfolio
prior to reassignment must remain in the composite to which it was originally assigned.
The GIPS standards define large cash flows as those that would affect performance results
if not included, and significant cash flows as those that would impede the manager's
ability to implement a strategy. The GIPS standards recommend creating a temporary new
account into which significant client-directed external cash flows are placed. Once the
strategy can be implemented for these cash flows, the temporary account can be transferred
om
into the client's main portfolio where it may be treated as an external cash flow.
Finns not possessing technology to create temporary new accounts may temporarily
l.c
remove an entire portfolio from a composite until the strategy for the cash flows can be
implemented. Firms choosing this approach must define significant for each composite
ai
before any such transfers out of a composite occur and must consistently apply the
approach for that composite.
gm
Firms may terminate portfolios from a composite based on falling below a minimum
asset level, which has been established as necessary to effectively implement the relevant
@
strategy. Firms must consistently apply the ntinimum asset level and may not apply
changes to the minimum asset level retroactively (e.g., by removing portfolios below the
y
ntinimum from the composite's history). GIPS guidance requires firms to specify ex ante
ud
(i.e., before the firm constructs composites) whether the ntinimum asset level applies to
beginning portfolio value, ending value, beginning value plus cash flows, etc.
st
GIPS guidance recommends that firms establish ntinimum threshold and time requirements
fa
for inclusion in the composite (i.e., ± 5% of the minimum for two periods to add or
nc
withdraw) in order to minintize portfolio movement in and out of composites. The GIPS
standards recommend that firms avoid showing composite performance to clients who
do not meet minimum asset requirements (i.e., with the hope their assets will grow to
ve
the ntinimum level). Historical performance for portfolios removed from a composite
must remain with the composite. Minimum asset levels may be changed prospectively
ra
(e.g., with an eye toward significant general market changes) but may not be changed
retroactively to include or exclude portfolios.
y
ile
Carve-Out Segments
w
LOS 32i: Explain the requirements of the GIPS standards for asset class
segments carved out of multi-class portfolios. Vol 6, pp 244--245
18
For periods beginning January 1, 2010, composites may not include carve-out segments
20
(i.e., asset class segments "carved out" of multi-strategy portfolios). For example, the bond
portion of a portfolio containing stocks, bonds, and cash cannot be included in a composite
of bond portfolios unless it is separately managed with its own cash balance.
Firms must disclose the method used to allocate the cash position to a carve-out
segment included in performance results for periods prior to January l, 2010. Compliant
presentations for composites that include carve outs must further disclose the percentage
of composite assets represented by carve outs for each annual period between January l,
2006 and prior to January l, 2011. Methods for allocating cash to carve outs are outside
the scope of study.
©2017Wiley
ExampleS-1
Sanderson Investment Management has separate asset managers who invest client assets
in equity, bond, and cash asset classes. A portfolio manager develops an asset allocation
strategy for each client based on individual investment policy requirements, and then
pools client assets by class with other clients. Can Sanderson's marketing group create
a composite showcasing the equity manager's talent at generating alpha for the period
ending December 31, 2014, assuming they use calendar year reporting?
om
A. No.
l.c
B. Yes, but only for annual reporting.
C. Yes, but only for quarterly reporting.
ai
gm
Solution:
A. The GIPS standards do not allow carve out segments to be included in
@
composite performance reports for periods beginning January 1, 2010 unless
the segment is separate! y managed with its own cash balance. In this case, cash
y
is not managed with the asset class in a separate account, but separately as a
pooled asset with other clients' money. ud
st
fa
LESSON 6: DISCLOSURE, PRESENTATION, AND REPORTING

nc
Disclosure
ve
LOS 32j: Explain the requirements and recommendations of the GIPS

standards with respect to disclosure, including fees, the use of leverage and
ra
derivatives, conformity with laws and regulations that conflict with the
GIPS standards, and noncompliant performance periods. Vol 6, pp 245-251
y
ile
In addition to fair representation of performance, the GIPS standards require and

recommend various types of disclosure designed to enhance the reliability and usability
w
of reported information. Firms must disclose whether the performance presented complies
with local laws in conflict with the GIPS standards and, for periods prior to January 1,
18
2000, must disclose periods of reporting not compliant with the GIPS standards. Firms are
not required to make negative assurance disclosures (e.g., "Portfolios in this composite
do not use short derivative strategies to enhance income during periods of flat or falling
20
markets").
Claims of Compliance
Firms may claim compliance with the GIPS standards upon meeting all requirements
(except as required by local law). These claims of compliance are considered disclosures
with wording dependent upon whether results have undergone third-party verification,
whether verification includes more detailed examination of a particular composite, or
whether the claim appears in advertising.
©2017Wiley
For claims of compliance not subjected to third-party verification, firms with compliant
presentations must include the following disclosure:
" [Insert name of firm] claims compliance with the Global Investment Performance
Standards (GIPS®) and has prepared and presented this report in compliance with the
GIPS standards. [Insert name of firm] has not been independently verified."
For claims of compliance subjected to third-party verification, firms with compliant

presentations must include the following disclosure in its entirety:
om
l.c
GIPS standards. [Insert name of firm] has been independently verified for the periods
[insert dates]. The verification report(s) is/are available upon request.
ai
"Verification assesses whether (1) the firm has complied with all the composite
gm
construction requirements of the GIPS standards on a firmwide basis, and (2) the
firm's policies and procedures are designed to calculate and present performance in
compliance with the GIPS standards. Verification does not ensure the accuracy of any
@
specific composite presentation."
y
For claims of compliance where the verifier has conducted a focused exantination of
ud
a particular composite, firms with compliant presentations must include the following
disclosure in its entirety:
st
"[Insert name of firm] claims compliance with the Global Investment Performance
fa
GIPS standards. [Insert name of firm] has been independently verified for the periods
nc
[insert dates].
ve
"Verification assesses whether (1) the firm has complied with all the composite
construction requirements of the GIPS standards on a firmwide basis, and (2) the
ra
firm 's processes and procedures are designed to calculate and present performance in
compliance with the GIPS standards. The [insert name of composite] composite has
y
been examined for the periods [insert dates]. The verification and exantination reports
are available upon request."
ile
Different wording must be used for claims of compliance used in advertising as opposed to
w
that above used for performance presentations:

18
Standards."
20
Firm and Composite Definitions
A disclosure defining the firm provides investors with information about the organization
managing their assets, presenting performance results, and claiming compliance with the
GIPS standards. Redefined firms must describe the redefinition, including the date and
reason for the redefinition. The GIPS standards recommend disclosing other firms defined
separate! y under the same parent.
© 2017Wiley
Each composite must include an explanation sufficient for a reasonably informed client
to understand the composite's strategy, objective, or mandate. Firms must disclose that a
list of all the firm's composite descriptions is available upon request. This allows clients to
determine whether the composite they were shown is most appropriate for their investment
needs or whether another firm composite might provide a better fit. Note here that
composite descriptions are less detailed than composite definitions .
Firms must disclose a composite's creation date, any name changes or redefinitions, and
the dates, descriptions, and reasons for redefinitions.
om
Firms should disclose if a composite includes any proprietary (i.e., firm owned) assets.
l.c
Significant Events
ai
Firms are required by the GIPS standards to disclose any significant events (e.g., portfolio
manager leaving or a research team resigning).
gm
For periods on or after January 1, 2006, firms must disclose the use of subadvisors and the
periods used, and should disclose such prior to that time. Firms must also disclose whether the
@
firm's reported performance includes performance generated by a previous firm or affiliation.
y
Valuation
ud
Firms should disclose valuation assumptions, methodologies, and procedures and disclose
st
dates for any material changes. Firms must disclose that policies for valuing portfolios,
calculating returns, and presenting performance are available upon request.
fa
Beginning January 1, 2011, firms must disclose whether they have deviated from the
nc
valuation hierarchy recommended in GIPS Valuation Principles and whether subjective

unobservable inputs were used to value investments in a portfolio. Prior to that date, firms
ve
should disclose use of subjective unobservable inputs.

ra
Firms must disclose the reporting currency for al l periods and, for periods after January 1,
2011, must disclose material differences in exchange rate sources used among portfolios,
composites, and benchmarks. Only differences in exchange rates need be disclosed for
y
prior periods, not the difference in sources for the rates.

ile
Taxes
w
Firms must disclose, if material, details of treatment for withholding tax on capital gains,
18
interest income, and dividends. If available, firms must also disclose if benchmark returns
are net of withholding taxes.
20
Benchmarks
Firms must disclose a description of the benchmark used for evaluating performance
or explain why no appropriate benchmark was avai lable for presentation. For custom
benchmarks (e.g., representing the composite's strategy or firm's investing process) or
combinations of benchmarks, firms must disclose the components, weights, and rebalancing
process. Firms must disclose the date and description of and reason for any change.
The GIPS standards recommend that firms disclose any differences between the composite
description and the strategy represented by the benchmark.
©2017Wiley
Fees
Firms must disclose the fee schedule or bundled fees applicable to performance
presentations. Firms must include a description of fees included in a bundled fee.
Performance presentations must disclose whether gross-of-fees peiformance includes any
costs other than trading expenses, and whether the net-of-fees peiformance includes any
additional costs other than management fees (which includes performance-based fees and
carried interest).
om
Measures of Dispersion
Firms must disclose the method of dispersion used (e.g., standard deviation and/or, if
l.c
applicable, any other method of describing risk) for both composite and benchmark
performance. Firms must present monthly ex post standard deviation for 36 months or
ai
disclose why it is inappropriate or not available and describe the method of dispersion used
or why no other method was used.
gm
Presentation and Reporting
@
LOS 32k: Explain the requirements and recommendations of the GIPS
y
standards with respect to presentation and reporting, including the
ud
required timeframe of compliant performance periods, annual returns,
composite assets, and benchmarks. Vol 6, pp 251-252
st
LOS 32u: Identify and explain errors and omissions in given performance
fa
presentations and recommend changes that would bring them into

compliance with GIPS Standards. Vol 6, pp 251-270
nc
Requirements
ve
lt has not been

uncommon for past
exams to include an The GIPS standards require at least five years of annual data for all compliant composite
ra
entire performance
presentation along presentations, extended each year until they present at least 10 years of data. Firms with
with questions less than five years of data on a composite must present their available performance results.
asking candidates
y
to either 1) identify
ile
presentation errors,
or 2) detennine
Core elements of a compliant presentation include:
whether specific
items have been
Composite and benchmark annual returns for each period reported;
w
correctly presented.
Benchmark total return for each period reported;
Value of assets in the composite at the end of each period;
18
Percentage the composite represents of total firm assets (or the value of total firm
assets) at the end of each period;
20
Number of portfolios for each period (if greater than five for the entire period); and
Dispersion of individual portfolio returns (if greater than five for the entire period)
for each period.
Beginning January 1, 2011 or later, firms must report performance from inception of
the composite through the first annual period end, and from the beginning of an annual
period to the composite termination date. In other words, firms must report composite
performance for the part of the annual period after inception or before termination. Annual
periods typically represent the calendar year but other annual periods are acceptable.
© 2017Wiley
LOS 32m: Evaluate the relative merits of high/low, range, interquartile

range, and equal-weighted or asset-weighted standard deviation as
measures of the internal dispersion of portfolio returns within a composite
for annual periods. Vol 6, pp 251-257
Dispersion of portfolio returns within a composite allows investors the opportunity to

detennine how well the investment manager implements the composite strategy across
om
different portfolios. Acceptable measures include but are not limited to high/low range
(i.e., difference between high and low value), and equal-weighted or asset-weighted
standard deviation.
l.c
Equal-weighted standard deviation for a composite uses a familiar calculation where
ai
r; is the return for a portfolio, re is the return for the composite, and n is the number of
portfolios in the composite. This measure answers the question of dispersion of returns for
gm
clients:
y @
Sc= ~i=~l_n___l__
ud
st
Asset-weighted standard deviation answers the question of dispersion of return for the
fa
average dollar invested, where re.aw is the asset-weighted average return for the composite,
and w; is the portfolio's percentage of assets in the composite based on beginning-a/-
nc
period value Vo:

ve
n -- 2
Sc,aw = L ('i-rc,aw) W;
ra
i"'l
w. _ Vo,;
y
i vO,i
ile
t=l
n
w
'c,aw = L wiXlf
i""I
18
Note that either n or n -I in the denominator can be theoretically supported, although the
20
above formulas are used. To detennine returns above or below a particular percentage,
apply the number of standard deviations representing the appropriate percentage to the
standard deviation for the composite (similar to hypothesis testing).
Although the GIPS standards do not specifically require a particular method, nor do they
recommend one, they do provide the foregoing as examples. Additionally, some firms may
prefer to present the interquartile range (i.e., the difference between returns in the third
and first quartiles). Stated differently, the interquartile range describes the range spanning
the middle 50% of portfolio returns and excludes relatively high and low 25 percent
returns (i.e., outliers).
©2017Wiley
By defining the yth percentile of a descending order series as the point above which y
percent of n observations fall, the observations at percentile breaks for the interquartile
range are calculated by substituting 25 and 75 for y:
om
Next, it will usually be necessary to interpolate the return between two portfolios around
the interquartile cutoff. For example, &is for a composite with 16 portfolios is 0.25 x
=
(16 + I) 4.25. The interquartile return will begin at the return of portfolio 4 less
l.c
25% of the distance between the return for portfolios 4 and 5. This can be represented
mathematically using rA for the return portfolio above the bound (i.e., portfolio 4 in this
ai
case), r 8 for the portfolio below the bound (i.e., portfolio 5 in this case), and Ly- nA,Ly
where nA,Ly is the ordinal number of the portfolio above the bound:
gm
y @
ud
Interquartile range, however, will be unfamiliar to many investors and may merit additional
disclosures such as: "Internal dispersion of portfolio returns for this composite has been
st
presented for each annual period as the interquartile spread, calculated as the difference
between returns at the 25th and 75th percentile."
fa
nc
Example6-1
ve
According to the GIPS, which of the following measures of internal dispersion is most
appropriate for a composite whose returns are not normally distributed and prone to
ra
outliers?
A. Range.
y
ile
B. Interquartile range.
w
C. Standard deviation.
18
Solution:
B. While standard deviation is the most commonly recognized measure of

20
dispersion, it is not appropriate when the composite returns are not normally
distributed. The range would be affected by outliers, making it inappropriate
for this composite. The interquartile range measures the spread of the middle
50 percent of returns (capturing the median value at its center), which is not
dependent on the returns being normally distributed nor is it heavily influenced
by outliers.
©2017Wiley
While the GIPS standards do not require any particular measure of internal dispersion
for portfolios in an annual period, it does require that firms present the three-year
annualized ex past standard deviation of monthly returns for the composite and the
benchmark beginning January I , 2011. This provides investors with some way to compare
standardized measures of a strategy's risk as implemented by various firms. In composites
where standard deviation will not meaningfully represent risk (e.g. , strategies using
derivatives or other cases with non-normal return distributions), firms must present an
appropriate risk measure for the composite and the benchmark.
om
Firms must present only compliant performance after January I, 2000, but may link
previous non-compliant periods with appropriate disclosures of the non-compliance and
the periods involved.
l.c
Firms must not annualize partial annual period results, which would be similar to
ai
forecasting results for the remainder of the annual period.
gm
Firms must present the percentage of composite assets represented by carve-outs, but only
for periods beginning January I , 2006 and prior to January I , 2011.
@
While all fee-paying discretionary accounts must be included in at least one composite,
firms must not include any non-discretionary account in a composite. Firms may, however,
y
include non-fee paying accounts in a composite with relevant disclosures as to the end-of-
ud
period percentage of such assets. This addresses the issue of management fees waived for a
charitable organization, an employee, or for proprietary accounts.
st
Firms must also disclose the end-of-period percentage of composite assets in bundled-fee
fa
portfolios, if the composite includes any.

nc
LOS 321: Explain the conditions under which the performance of a past
ve
firm or affiliation must be linked to or used to represent the historical

performance of a new or acquiring firm. Vol 6, pg 255
ra
Firms must link performance of a past firm or affiliation to represent performance for the
y
new or acquiring firm on a composite-specific basis if the following conditions are all met:
ile
All investment decision-makers from the past firm or affiliation are employed by
the new or acquiring firm;
w
The decision-making process remains independent and in place at the new or

acquiring firm; and
18
The new or acquiring firm can support the reported performance with appropriate
documentation.
20
Recommendations
Although investors actually receive returns net of all expenses and fees, the GIPS standards
recommend that firms present grass-a/Jee returns (i.e., returns reduced for trading costs
but not for investment management and administrative fees). Doing so allows investors
to compare management's strategy against an appropriate benchmark without deductions
for potentially negotiable investment management fees and potentially uncontrollable
administrative fees (i.e., all fees other than trading costs and investment management fees,
including accounting, auditing, consulting, custody, etc.).
©2017Wiley
Further, the GIPS standards recommend that firms present net-of-fee returns without
deducting administrative expenses. Therefore, the returns would ideally be represented as:
Portfolio returns
Less: Trading costs

Gross-of-fee returns
Less: Management fees
om
Net-of-fee returns
Less: Administrative expenses
Client returns
l.c
ai
The required presentation of annual returns should also be supplemented with cumulative
returns for the composite and benchmark, calculated using geometric linking of historical
gm
returns. In addition to the asset-weighted annual returns which must be presented, the GIPS
standards recommend also presenting equal-weighted mean and median returns. This will be
especially useful to clients if the internal dispersion of portfolio returns for the composite is
@
calculated on an equal-weighted basis (e.g., the standard deviation calculation).
y
Presentations should also be updated at least quarterly, with presentation of returns for
quarterly and/or monthly time periods. ud
st
While returns for partial annual periods must not be annualized, annualized composite
and benchmark returns should be presented for periods longer than one year based on a
fa
geometric mean calculation:

nc
'~• =n IT(l+r,) - l=[(l+r1 )(l+r2 )(l+r3 ) ••. (l+r.)]

11
ve
" - 1
t=l
ra
In addition to the required presentation of annualized three-year ex post standard deviation

for composite and benchmark returns, the GIPS standards also recommend:
y
ile
Same presentation for earlier annual periods;

Annualized composite and benchmark total returns and three-year ex post standard
w
deviation should be presented together; and

Firms should present relevant composite-level ex post risk measures.
18
Recommendations also include compliance with GIPS requirements for all periods rather
20
than as required for the period beginning January 1, 2000. Prior to that, firms may present
non-compliant data with appropriate disclosures. Further, firms should present more than
10 years of historical data, if applicable.
LESSON 7: REAL ESTATE, PRIVATE EQUITY, AND WRAP FEE-SEPARATELY

MANAGED ACCOUNTS
The GIPS standards contain various exceptions to the general requirements and
recommendations for real estate, private equity, and separately managed accounts with
wrap fees. Unless stated otherwise, the special GIPS provisions apply to periods beginning
January 1, 2011.
© 2017Wiley
Real Estate Provisions
LOS 32n: Identify the types of investments that are subject to the GIPS
standards for real estate and private equity. Vol 6, pg 259
Real estate investments subject to the special provisions of GIPS include:
Ownership of real property;
om
Debt with equity participation;
REIT and REOC private placement securities; and
Commingled funds, property unit trusts, and insurance company separate accounts.
l.c
However, special real estate provisions do not apply to publicly traded real estate securities
ai
(e.g., RE!Ts), mortgage-backed securities, and real estate loans (if related only to a
contractual interest rather than any participation in the underlying property dynamics). The
gm
general GIPS provisions also apply to private equity open-end and evergreen funds that
allow continuing redemption and investment.
@
LOS 320: Explain the provisions of the GIPS standards for real estate and
y
private equity. Vol 6, pp 259-265
ud
Real estate must be valued using market value (defined in the 2005 edition of GIPS) prior
st
to January I, 2011 and in accordance with the GIPS valuation principles and definition of
fair value for periods beginning January I, 2011. Fair value will be defined in more detail
fa
in the valuation principles.

nc
Real estate must be valued as follows:

ve
Prior to January 1, 2008- At least once every 12 months;

Beginning January I, 2008 but prior to January I, 2010-At least quarterly; and
ra
Beginning January 1, 2010-As of each quarter end or the last business day of
each quarter.
y
Periodic valuations must be performed by an independently certified, designated, or

ile
licensed commercial property appraiser or valuer with no ties to the firm. If no such
certified appraiser or valuer is available in the local area, firms should ensure they use
w
independent, well-qualified individuals with relevant experience.

18
The standards require third-party valuation as follows:

20
Prior to January 1, 2012- Every 36 months;

Beginning January I, 2012-Every 12 months unless client agreements stipulate
more or less frequently, but no less frequently than every 36 months.
Firms must present the percentage of composite assets as of annual period end subjected to
external valuation.
Portfolio returns after subtracting actual transactions expenses must be calculated

quarterly beginning January I , 2006. Transactions expenses include actual trading
expenses and any advisory, financial, investment banking, and legal fees related to buying/
©2017Wiley
selling or recapitalizing/restructuring portfolio investments. Gross-of-fee returns are

portfolios after transactions expenses, while net-of-fee returns are gross-of-fee returns after
investment management fees. For periods after January 1, 2011 , firms must separately
calculate income returns and capital (i.e., component) returns using geometrically linked
time-weighted returns. Firms must calculate composite and component returns at least
quarterly using asset-weighting individual portfolio returns.
Component returns can typically be divided into three types of strategies:
om
Care- Most of total return from income;
Opportunistic- Most of total return from capital gains; and
Value-added- Total return derived from both income and capital gains.
l.c
Firms may make compliant presentations by including gross-of-fee or net-of-fee total
ai
returns and component returns. Firms should, however, present the same type of total
return and component returns. Further, firms should use the same method of calculating
gm
returns for all portfolios included in a composite.
Firms must disclose the method used to internally value property (e.g. , using income
@
capitalization rates computed from recent comparable sales or directly using a method of
comparables). Firms must disclose material changes to valuation methodologies beginning
y
January 1, 2011.
ud
Firms must not link GIPS-compliant performance with non-compliant performance
st
beginning January 1, 2006. Firms must disclose periods of non-compliance prior to that
date.
fa
Firms must calculate and present a measure of internal dispersion that describes the high
nc
and low annual time-weighted return among the portfolios in a composite.

ve
Recommendations include:
ra
Valuing investments for periods prior to January 1, 2012, using independent

third-party appraisers at least annually, and preferably performing the third party
valuation at the end of each annual period;
y
Disclosing the accounting basis (i.e., U.S. GAAP, IFRS , etc.) for portfolios and
ile
explaining the differences between valuations provided for performance reporting

and financial reporting;
w
Disclose for periods prior to January 1, 2011, material changes to valuation

policies or methods;
18
Presentation of both gross- and net-of-fee returns, percentage of total portfolio

assets in a composite that are not real estate investments, and component returns
20
for the benchmark, if available.
The GIPS standards also require that closed-end funds show not only time-weighted rates
of return, but also internal rates of return since inception (SI-IRR) using quarterly or more
frequent cash flows. Similar calculations have been described elsewhere. Returns using
these quarterly calculations can then be annualized using the formula:
' ann = ( 1+'Quarterly t - 1
© 2017Wiley
The GIPS standards recommend that firms use daily cash flows to calculate SI-IRR, but
must disclose the frequency of cash flows used in the return calculation.
In addition to composite definition described in the general provisions, closed end real
estate funds must also describe the composite by vintage year and disclose how they have
defined it. The methods mentioned in the GIPS glossary for defining vintage year are the
year of:
First drawdown or capital call from investors; or
om
First committed capital from investors is closed and legally binding.
Firms must present closed-end fund composite performance net of fees for each annual
l.c
period. Beginning January 1, 2011 , firms must present non-annualized net-of-fees SI-IRR
for an initial period less than a complete annual period, as well as for periods through
ai
a composite's final liquidation date. Firms must also disclose the final liquidation date.
Although net-of-fee SI-IRR must be presented, firms may choose to also show gross-of-fee
gm
SI-IRR but must show it for all periods for which net-of-fee SI-IRR has been presented.
Benchmarks must not only reflect the composite strategy, objective, or mandate, but must
@
have the same vintage year. Firms must also present end-of-period annual SI-IRR for the
benchmark.
y
ud
At the end of each annual period, firms must present a composite's:
st
Cumulative committed capital (i.e., capital committed by investors to the
investment vehicle);
fa
Paid-in capital (i.e. , the amount of committed capital drawn down by the
investment vehicle);
nc
Distributions since inception;

Investment multiple or TVPI (i.e., total value to capital paid in since inception,
ve
where total capital can be computed as end-of-period residual value of the fund
plus since-inception distributions);
ra
Realization multiple or DPI (i.e., since-inception distributions to since-inception

paid-in capital);
y
Unrealized multiple or RVPI (i.e., residual value to since-inception paid-in capital);

ile
PIC multiple (i.e. , paid-in capital to committed capital).
Private Equity Provisions

w
Private equity investments subject to the special provisions of GIPS will typically be
18
structured as a limited partnership, which has a general partner to select and manage
investments and administer fund business, and limited partners who invest in the fund.
20
Private equity investments must be valued at least annually in accordance with the GIPS
valuation principles and definition of fair value for periods beginning January 1, 2011.
For prior periods, firms may use either the GIPS 2005 edition Private Equity Valuation
Principles or the 2010 edition GIPS valuation principles.
Firms must calculate annualized SI-IRR using daily-weighted cash flows for periods
beginning January 1, 2011 and either daily or monthly for prior periods. Firms must
include distributions of stock as cash flows valued as of the date of distribution, and must
disclose the period used for weighting for periods prior to January 1, 2011.
©2017Wiley
Firms must calculate private equity returns gross-of-fee returns after deducting actual
transactions expenses. Net-of-fees returns exclude management fees and carried interest
(i.e., the investment profits allocated to general partners). Net-of-fee returns for private
equity fund-of-funds must deduct management fees and carried interest from the fund-
of-funds and each underlying fund. Firms must disclose whether any expenses other
than transaction fees have been deducted in calculating gross-of-fee returns, and whether
any expenses other than transactions fees and management fees have been deducted in
calculating net-of-fee returns. Therefore, firms must disclose carried interest if any.
om
In addition to composite definition described in the general provisions, private equity funds
must also describe the composite by vintage year and disclose how they have defined
it. Fund-of-funds must be included in a fund-of-funds composite described by general
l.c
provisions and vintage year. Mandatory disclosures for each composite include vintage
year and method of determination, as well as final liquidation date, if applicable. Firms
ai
must disclose valuation methods and, beginning January 1, 2011, firms must disclose
gm
significant changes to those valuation methods. The GIPS standards recommend disclosing
such significant changes for prior periods. In addition to the GIPS Valuation Principles,
firms must disclose whether they use additional industry-specific valuation guidelines.
@
Firms must disclose periods of non-GIPS compliant SI-IRR presented for periods prior to
January 1, 2006. Firms must not present non-compliant performance after that date.
y
ud
Firms must disclose the method used to calculate a composite's benchmark. In PME
(public market equivalent) benchmarks, firms apply the composite's external cash flows
st
to a hypothetical capital market index. In other words, capital calls are assumed to buy the
index while distributions are assumed to be sold from the index.
fa
nc
Firms must initially present at least five years of performance as required by the general
provisions (or since inception ifless than five years) and an additional year each annual
period thereafter. Firms must present gross- and net-of-fees SI-IRR for partial periods at
ve
composite initiation or liquidation beginning January 1, 2011.

ra
Beginning January 1, 2011, fund-of-funds composites defined only by their strategy

objective, or mandate must present:
y
ile
Aggregated, gross-of-fee SI-IRR for underlying investments as of the most recent

period end; and
w
A benchmark that reflects the composite strategy and vintage year of the
underlying investments. The GIPS standards recommend but do not require that
the percentage of direct investments included in composites of fund-of-fund assets
18
be presented for earlier periods.

20
The GIPS standards also recommend but do not require that beginning January l, 2011,
fund-of-funds composites defined only by their vintage year present gross-of fees SI-IRR
for underlying investments grouped by strategy, objective, or mandate. This is in addition
to the other performance measures.
Beginning January l , 2011, fund of funds composites are also required to separately report
the percentage of assets invested in direct investments and in fund vehicles. The GIPS
standards recommend reporting these percentages in earlier periods.
©2017Wiley
For all private equity composites, firms must report for each annual period the cumulative
committed capital, paid-in capital since inception, and distributions since inception. Firms
must also present the TVPI, DPI, PIC, and RVPI multiples defined earlier.
Recommendations for private equity investments also include:
Quarterly or more frequent valuation;

SI-IRR calculation using daily external cash flows for periods before January I ,
2011; and
om
Disclosing and explaining differences between valuations provided for
performance reporting and financial reporting.
l.c
Wrap Fee/Separately Managed Account (SMA) Provisions
ai
LOS 32p: Explain the provisions of the GIPS standards for wrap fee/
gm
separately managed accounts. Vol 6, pp 268-270
Separately managed accounts (SMAs) involve a portfolio of subaccounts, often managed
@
by third-party sub-advisors. The SMA sponsor charges a wrap fee that bundles together
complex charges for trading, custody, investment management, and administration.
y
Thus, SMAs are often known as "wrap fee accounts." The GIPS SMA provisions apply
ud
to presentations beginning January 1, 2006, but only when a sponsor stands between the
client and an investment manager of a subaccount claiming GIPS compliance and not to
st
other types of bundled fees. The provisions only apply to model or overlay portfolios when
the investment management firm for the overlay has discretionary management.
fa
SMA provisions of GIPS require firms to include bundled-fee portfolios in at least one
nc
composite in accordance with their inclusion policies, or define separate composites to

include/exclude SMA portfolios. Alternatively, firms may redefine themselves into a
ve
separate division or firm that manages SMA portfolios. SMA portfolios are subject to the
same verification and reporting requirements as other portfolios with some exceptions.
ra
An SMA sponsor will often rely on investment management firms to present GIPS
compliant performance data to its prospects and clients. An investment management
y
firm's compliant presentation must include composites that contain SMA portfolios, and
ile
must disclose the percentage of composite assets represented by bundled fee portfolios.
Although including non-SMA and SMA portfolios may increase the assets under
w
management for a composite and increase the investment manager's stature, including
SMA portfolios that reduce performance by the entire bundled fee (rather than just
18
transactions costs) also reduce the gross-of-fee and net of fee performance of the strategy
presented to clients and could result in a competitive disadvantage.
20
To avoid this problem, subadvisors may either rely on sponsor data (a potentially dubious
prospect) or maintain a separate set of accounting records for investment performance
reporting (i.e., shadow accounting) on portfolios managed for an SMA.
Investment managers may wish to provide sponsor-specific composites (i.e. , apply only
to the sponsor's clients). Firms must disclose the sponsor's name and, if the presentation
is designed to solicit new business and does not include performance net of bundled fees,
must indicate that the presentation is only for the sponsor's use. However, sponsors must
©2017Wiley
present composite performance to SMA prospects and clients net of the entire wrap fees
applied.
If a composite currently contains but did not always contain SMA portfolios, firms
must disclose periods when it did not contain SMA portfolios. Firms may not link non-
compliant results for periods after January I , 2006 with compliant results, but may link
pre-2006 non-compliant results with compliant periods after January I , 2006 and may only
present compliant performance for periods beginning with 2006.
om
LESSON 8: VALUATION PRINCIPLES AND ADVERTISING GUIDELINES
GIPS VALUATION PRINCIPLES
l.c
LOS 32q: Explain the requirements and recommended valuation hierarchy
ai
of the GIPS Valuation Principles. Vol 6, pp 270--273
gm
Beginning January I, 2011, the GIPS standards require firms to determine/air value for
assets, defined as the amount exchanged in a current transaction between willing, unrelated
@
parties acting in their own interests with knowledge and prudence. If available, firms must
use the objective, observable, unadjusted market price quoted on the measurement date
y
in an active market. If not available, firms must use their best estimate of market value,
ud
including any accrued income, and disclose use of subjective, unobservable inputs if
material to composite performance.
st
Private equity, real estate, and private agreements among counterparties (e.g., swaps) are
fa
examples of assets for which market value may be problematic.

nc
The valuation hierarchy involves:

ve
Objective, observable, unadjusted market price.

Quoted prices for identical or similar investments in markets that are not active
ra
(i.e., non-current prices, few transactions for the investment, or widely varying
quotations among market makers).
Observable market-based inputs for the investment other than quoted prices.
y
Subjective, unobservable inputs.

ile
The GIPS standards require firms to document valuation policies, methods, and
w
hierarchies, and recommend that firms develop hierarchies specific to assets in the
composite. Firms must make these valuation policies available to clients upon request.
18
Firms should also list risk-adjusted cash flows and discount rates used.
20
Real Estate
Firms are required to periodically subject assets to external valuation by third parties
who adhere to the standard setting body governing their conduct. Firms may not provide
incentive compensation that could potentially inflate the appraiser's estimate of value.
The GIPS standards further recommend that the external appraiser be rotated every three to
five years, and that the value estimate be presented as a single value (rather than as a range
of values).
© 2017Wiley
Private Equity
In addition to previously mentioned requirements, appraisers must use the facts and
circumstances of the investment to determine the most appropriate valuation method.
These considerations may include but may not be limited to:
Data quality and reliability used for each method;

Comparability of firms and transactions; and
Additional considerations unique to the valuation target.
om
GIPS ADVERTISING GUIDELINES
l.c
LOS 32r: Determine whether advertisements comply with the GIPS
ai
Advertising Guidelines. Vol 6, pp 273-275
gm
Advertising includes written or electronic materials disseminated to one or more clients
or prospective clients. These guidelines do not apply to presentations to individuals or
@
multi-individual entities making a single investment decision (i.e., investment committees
or boards of directors), nor do they apply to advertisements that do not mention the GIPS
standards.
y
ud
In order to claim compliance with the GIPS standards, firms must either include a
compliant performance presentation in advertising, or comply with the GIPS Advertising
st
Guidelines (referred to as "the Guidelines" in this section). Following the Guidelines
does not exempt the firm from other areas of compliance, or from presenting a compliant
fa
presentation, but allows it to reduce the advertising space required.

nc
All advertising claiming GIPS compliance must include a definition of the firm, and
instructions for obtaining a list of composite descriptions and a compliant presentation
ve
for the composite. Compliant advertising that includes performance information must
additionally include:
ra
The composite description;

y
Indication of presentation gross- or net-of-fees;

ile
Currency used to express returns; and

One of the following sets of total returns:
w
o One-, three-, and five-year annualized composite returns through the most
recent period;
o Period-to-date composite returns in addition to the annualized returns
18
above, for the same time period as the compliant presentation; or

o Period-to-date composite returns in addition to five years of annual returns,
20
for the same time period as the compliant presentation.
Whichever alternative performance is presented, returns for less than one year must not
be annualized and period end dates must be provided. Return since inception must be
provided for composites in existence less than five years. For example, under the first
option, annualized returns for a composite in existence four years would be provided for
one, three, and four years.
Advertising performance requires firms to disclose, if material, the nature and extent of
derivatives, leverage, and short positions with a description sufficient to identify risks.
©2017Wiley
Other GIPS compliant information may be presented as long as it does not receive greater
prominence in the advertising than the required information.
Advertisements must include the same benchmark provided in the compliant presentation,
and must be presented for the same periods as composite performance. Firms must
disclose why no benchmark is presented.
LESSON 9: VERIFICATION AND OTHER ISSUES
om
Verification
l.c
LOS 32s: Discuss the purpose, scope, and process of verification.
Vol 6, pp 275-280
ai
Verification is the process of a third-party assessment of a firm 's compliance with the
gm
GIPS standards for constructing composites and calculating and presenting composite
performance. While verification cannot insure the accuracy of any particular composite
presentation, it can provide additional confidence in the firm's claim of compliance with
@
the GIPS standards.
y
The GIPS standards recommend but do not require verification. If undertaken, verification
ud
must be performed by an independent third party. A firm must not state that it has been
verified unless the verifier has issued a verification report indicating that it has met the
st
GIPS requirements for constructing composites and calculating and presenting composite
performance.
fa
Verifiers
nc
In performing verification, verifiers may rely on the verifier's own work, the work of other
ve
verifiers, or on the work of qualified, independent third parties. The principal verifier must,
however, document the competency, objectivity, qualifications, and reputation of the third
ra
party.
Reports
y
ile
A verification report attests to firmwide compliance; a verification report cannot be issued

for some subset of the firm's composites. Therefore, the GIPS standards prohibit firms
w
from claiming that a particular composite has been verified. However, firms may choose
to have a detailed examination performed for a specific composite and can state that
18
composite has been examined if they receive an examination report for the composite.
20
The verification report must indicate that required verification procedures have been
followed. A verifier finding fault with the firm's composite descriptions, method of
calculating and presenting performance, or data gathering and retention, must provide a
statement denying a verification report.
Scope
GIPS standards recommend that a firm undergo verification of all periods for which it
claims compliance. The minimum period is one year or since inception, if less than one
year.
© 2017Wiley
Verifiers may use sampling as the basis for firmwide verification with the sample size
dependent on:
Assets under management;

Number and type of composites;
Number of portfolios in composites;
The method of calculating performance;
Use of third-party software to construct and maintain composites and calculate
performance;
om
Use of external performance measurement services; and
Internal control structure.
l.c
Verification Procedures
ai
Verifiers must be satisfied that the firm meets fundamental requirements. In order to
accomplish that, verifiers must understand the requirements and the firm, as well as
gm
complete the procedures for verification.
Pre-Verification
@
Verifiers must understand the GIPS standards and updates, interpretations and
y
clarifications, Guidance Statements, and Questions & Answers published by CFA Institute
ud
and the GIPS Executive Committee. Verifiers must understand applicable laws and
regulations and differences between these and the GIPS standards.
st
Next, verifiers must learn about firm operations and how the firm complies with GIPS
fa
requirements and implements recommendations. Verifiers must understand the firm's

GIPS-related procedures and compliance policies, especially with regard to performance
nc
calculations, and ensure they are documented.

ve
Verification
ra
Verifiers must detennine that the firm has met fundamental requirements of the GIPS
standards:
y
Consistent previous and current firm definition;

ile
Consistent application of policies and procedures to ensure existence and

ownership of client assets;
w
Appropriate calculation and disclosure of total firm assets;

Composites are appropriately defined and maintained;
18
Policies for creating and maintaining composites have been consistently applied;
The firm's list of composite descriptions is complete;
20
All fee-paying, discretionary portfolios have been included in at least one

composite and portfolios have not been excluded from the appropriate composite;
The firm has consistently applied its definition of discretion; and
Composite benchmarks reflect the strategy, objective, or mandate.
For a sample of portfolios, verifiers must:
Detennine consistent firm treatment for data related to accounting treatment and
classification of portfolio flows (e.g., external cash flows , income, fees , and taxes);
Ensure appropriate valuation methodologies for investments;
©2017Wiley
Recalculate rates of return, taking into account proper recognition of fees and
expenses;
Validate the discretionary status of portfolios; and
Determine whether they have been appropriately included in at least one
composite, including appropriate movement among composites (if applicable).
For a sample of composites, verifiers must:
Validate applicability of and calculations for composite and benchmark dispersion
om
and risk;
Validate applicability of the benchmark as a comparison for the composite;
Sample custom benchmark data to ensure correct calculation and compliance with
l.c
the required benchmark disclosure; and
Ensure that they include all required information and disclosures.
ai
Verifiers must document their judgments and conclusions regarding compliance. Toward
gm
that end, verifiers must obtain a representation letter from the firm assuring consistent
application of the firm's policies and procedures during the examination period. The letter
must also contain other representations made to the verifier during the verification process.
y @
AFfER-TAX RETURN CALCULATION CHALLENGES
ud
LOS 32t: Discuss challenges related to the calculation of after-tax returns.
st
Vol 6, pp 280--283
fa
The GIPS standards do not require firms to present after-tax returns for composites.
nc
However, many firms manage investment portfolios for and market tax-aware strategies to
individuals and institutions subject to taxation. The GIPS Executive Committee has opted
to remove its Guidance Statement for country-specific tax issues in favor of transferring
ve
responsibility to GIPS country sponsors.

ra
Effective January I , 2011, compliant presentations will include after-tax performance as

supplemental information subject to the Guidance Statement on the Use of Supplemental
y
Information.
ile
Methods
w
Pre-Liquidation Method
18
A pre-liquidation calculation recognizes taxes actually incurred or accrued during the

period, but does not consider the liability or benefit embedded in unrealized gains or
20
losses. Not all potential gains will be realized by the portfolio because they may be offset
with losses. However, the investment manager has no idea precisely what the ex ante net
effect will be. Therefore, the pre-liquidation method completely disregards prospective
capital gains and losses.
Mark-to-Liquidation Method
Mark-to-liquidation assumes taxes on unrealized gains are payable at the end of the report
period. This method not only ignores future changes in valuation that may increase or
© 2017Wiley
decrease tax liability, but also ignores the additional future gains that may accrue to the as
yet untaxed gain.
Estimated Liquidation Method
This method estimates the timing and amount of taxable liquidations over some extended
period. This requires a method of estimating future returns and tax outcomes. No
universally accepted method has been developed.
om
Tax Rate Challenges
Different tax rates apply to different types of securities and return periods. In addition,
l.c
client tax rates vary based on income, wealth, or other factors specific to the tax code to
which they are subject.
ai
Benchmarks
gm
After-tax benchmarks should have all the attributes of pre-tax benchmarks and, in addition,
reflect client tax liability. However, the rates used for various types of income or gain
@
cannot adequately reflect every possible client tax situation. Although some benchmark
providers have published benchmarks net of dividend withholding tax, little attention
y
has been paid to other types of tax. In addition to considering dividends, interest, and
ud
price changes, firms would have to develop simplifying assumptions that could reflect
the provider's rules for constructing and rebalancing the index, turnover of securities that
st
generates tax liability, stock splits, and other corporate actions.
fa
Mutual funds and ETFs benchmarked to capital indexes are imperfect because of their fees
and deviation from benchmark. External cash flows and investment manager transactions
nc
affect mutual fund tax liability. ETFs may be somewhat better suited, however, because
they do not experience turnover or reflect other investor actions.
ve
Non-Discretionary Tax Events

ra
Managers may have to liquidate securities to satisfy customer withdrawal requests. While
using time-weighted returns minimizes the impact of these non-discretionary external cash
y
flows, they generate taxes that will impact after-tax return. Managers who could otherwise
ile
time discretionary trading to consider tax liabilities must have a method of adjusting for
non-discretionary tax events, such as simply removing non-discretionary capital gains
w
by adding back tax on hypothetical realized gains. However, that method introduces
the potential incentive for managers to liquidate assets with the greatest embedded
18
capital gain. This can be solved by adding back gains tax hypothesized from selling a
proportionate share of all securities in the portfolio.
20
Non-discretionary tax loss harvesting will tend to improve after-tax returns. Firms should
disclose net harvested tax losses.
Until other methods are developed, portfolio tax efficiency measures presented with
performance can assist tax paying clients in selecting investments.
©2017Wiley

CFA 2017 Level III - Study Guide Vol 5

Uploaded by

Document Information

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

CFA 2017 Level III - Study Guide Vol 5

Uploaded by

Copyright:

Available Formats

20

Published by John Wiley & Sons, Inc., Hoboken, New Jersey.

Published simultaneously in Canada.

Required CFA® Institute disclaimer:

following is the copyright disclosure for these materials:

Lesson 3: Standard Ill: Duties to Clients 46

Lesson 4: Standard IV: Duties to Employers 70

Lesson 6: Standard VI: Conflicts of Interest 97

Study Session 2: Ethical and Professional Standards in Practice

Lesson 2: Ethical and Professional Standards in Practice, Part 2: Pearl Investment

Lesson 1: Asset Manager Code of Professional Conduct 121

Study Session 3: Behavioral Finance

Reading 7: Behavioral Finance and Investment Processes 165

Lesson 3: Types of Investment Accounts and Taxes and Investment Risk 31

Reading 10: Domestic Estate Planning: Some Basic Concepts 39

Lesson 1: Basic Estate Planning Concepts 39

Lesson 3: Transferring Excess Capital 46

Study Session 5: Private Wealth Management (2)

Reading 11 : Concentrated Single-Asset Positions 59

Lesson 2: General Principles of Managing Concentrated Single-Asset Positions 60

Lesson 4: Managing the Risk of Private Business Equity 71

Study Session 6: Portfilio Management for Institutional Investors

Lesson 6: Economic Analysis, Part 3: Economic Forecasting 30

Lesson 1: Estimating aJustified P/ERatio and Top-Down and Bottom-Up Forecasting 39

Reading 17: Asset Allocation 53

Lesson 1: What Is Asset Allocation? 54

Lesson 3: Selection of Asset Classes 61

Lesson 5: Mean Variance Optimization (MVO) and Other Modelling Techniques 71

Reading 19: Market Indexes and Benchmarks 105

Study Session 10: Fixed-Income Portfolio Management (1)

Lesson 2: Derivative-Enabled Strategies 157

Lesson 3: International Bond Investing 166

Study Session 12: Equity Portfolio Management

Reading 23: Equity Portfolio Management 175

Lesson 2: Passive Equity Investing 176

Lesson 3: Active Equity Investing 182

Lesson 5: Managing aPortfolio of Managers 196

Lesson 7: Distressed Securities 201

Wiley Study Guide for 2017 Level Ill CFA Exam

Volume 4: Alternative Investments, Risk Management, & Derivatives

Study Session 13: Alternative Investments for Portfolio Management

Lesson 5: Hedge Funds 21

Study Session 14: Risk Management

Lesson 2: Interest Rate Option Strategies

Reading 28: Risk Management Applications of Swap Strategies 121

Lesson 4: Strategies and Applications Using Swaptions 153

Wiley Study Guide for 2017 Level Ill CFA Exam

& Global Investment Performance Standards

Study Session 16: Trading, Monitoring, and Rebalancing

Reading 29: Execution of Portfolio Decisions

Lesson 2: The Costs ofTrading 10

Study Session 17: Performance Evaluation

READING 29: EXECUTION OF PORTFOLIO DECISIONS

Time to complete: 1.5 to 2.5 hours

This lesson will provide you with the tools to understand:

Principal trade-The broker commits capital to execute a trade quickly, often at a

trade and can be executed at a favorable cost.

LOS 29c: Compare alternative market structures and their relative

advantages. Vol 6, pp 9-17

. [ . . (Bid price+ Ask price)]

execution price for a sale.

Transaction Bid Ask

2(21.30-21.26) = 0.04 and 2(21.16-21.15) = 0.02

Average effective spread is (0 + 0.04 + 0.02)/3 = 0.02.