1.Cfa三级强化段总复习1 Jcy 金程教育标准版

Behavioral
Finance
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Jcy CFA/AQF/FRM/RFP
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Topic in CFA Level III
Session Content
Study Session 1 BEHAVIORAL FINANCE
Study Session 2 CAPITAL MARKET EXPECTATIONS
Study Session 3 ASSET ALLOCATION AND RELATED DECISIONS IN PORTFOLIO MANAGEMENT
Study Session 4 DERIVATIVES AND CURRENCY MANAGEMENT
Study Session 5-6 FIXED-INCOME PORTFOLIO MANAGEMENT (1)&(2)
Study Session 7-8 EQUITY PORTFOLIO MANAGEMENT (1)&(2)
Study Session 9 ALTERNATIVE INVESTMENTS FOR PORTFOLIO MANAGEMENT
Study Session 10-11 PRIVATE WEALTH MANAGEMENT (1)&(2)
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Study Session 12 PORTFOLIO MANAGEMENT FOR INSTITUTIONAL INVESTORS

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Study Session 13 TRADING, PERFORMANCE EVALUATION, AND MANAGER SELECTION

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Study Session 14 CASES IN PORTFOLIO MANAGEMENT AND RISK MANAGEMENT

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Study Session 15-16 ETHICS & PROFESSIONAL STANDARDS (1)&(2)
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Framework SS1: Behavioral Finance
R1 The Behavioral Biases of

Individuals
Behavioral Finance
R2 Behavioral Finance and
Investment Processes
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Reading
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The Behavioral Biases of Individuals

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Behavioral biases Conservatism bias
Confirmation bias
Representativeness bias
Belief perseverance
Illusion of control bias
Hindsight bias
Cognitive errors
Anchoring & adjustment
Mental accounting bias
Information-
processing biases Framing bias
Availability bias
Behavioral
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biases
Loss aversion bias
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Overconfidence bias
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Self-control bias
Emotional biases Status quo bias
Endowment bias
Regret-aversion bias
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2111(1)
Cognitive Errors and Emotional Biases

Cognitive errors are due primarily to faulty reasoning and could arise
from a lack of understanding proper statistical analysis techniques,
information processing mistakes, faulty reasoning, or memory errors.
Cognitive errors are more easily corrected for because they stem
from faulty reasoning rather than an emotional predisposition.
Cognitive errors can be further classified into two categories:
belief perseverance biases: related to cognitive dissonance.

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information-processing biases: information being processed

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and used illogically or irrationally.

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Cognitive Errors and Emotional Biases
Emotional biases stem from impulse or intuition; emotional biases tend
to result from reasoning influenced by feelings.
Emotional biases are harder to correct for because they are based
on feelings, which can be difficult to change.
Most cognitive biases can be moderated. To moderate a bias is to

recognize the bias and to attempt to reduce or even eliminate the bias
within the individual.
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It may only be possible to recognize an emotional bias and adapt it. To

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adapt to a bias is to recognize and accept the bias and to adjust for the
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bias rather than to attempt to moderate the bias.
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2012(1)
1.1 Cognitive Errors: Belief Perseverance Biases

Conservatism bias: People maintain their prior views or forecasts by
inadequately incorporating new information. It causes individuals to
overweight initial beliefs and under-react to new information.
Consequences: Maintain or be slow to update a view, forecast or belief,

even when presented with new information and data.
Overcoming: FMPs should react decisively to new information and

avoid retaining old forecasts by disregarding new information.
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2012(1)

Confirmation bias: People tend to look for and notice what confirms their
beliefs, and to ignore or undervalue what contradicts their beliefs.
Consequences:
Consider only the positive information about an existing investment.
Develop screening criteria and ignore information that refutes the

validity of the screening criteria.
Under-diversify portfolios, leading to excessive exposure to risk.

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Hold a disproportionate amount of investment assets in employing

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company’s stock.
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Overcoming: Actively seeking out information that challegenges your

beliefs. Another step it to get corroborating support for an investment
decision.
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Representativeness bias: People tend to classify new information based on
past experiences and classifications. FMPs may underweight the base rates and
overweight the new information.
Base-rate neglect: the base rate or probability of the categorization is not

adequately considered. FMPs rely on stereotypes when making investment
decisions without incorporating the base probability of the stereotype
occuring.
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Sample-size neglect(law of small numbers): FMPs incorrectly assume

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that small sample sizes are representative of populations, they overweight

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the information in the small sample.

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Representativeness bias.
Consequences:
Adopt a view or forecast base almost exclusively on new information or

a small sample. This may also result in high investment manager
turnover as the investor changes investment managers based on short-
term results.
Update beliefs using simple classifications rather deal with the mental
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stress of updating beliefs given complex data.

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Overcoming: Ask the following question: “What is the probability that X

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(the investment) belongs to Group A (the group it resembles or is

considered representative of) versus Group B (the group it is statistically
more likely to belong to)?”
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Illusion of control bias: People tend to believe that they can control or
influence outcomes when, in fact, they cannot.
Consequences:
Trade more than is prudent.
Lead investors to inadequately diversify portfolios.
Overcoming: Investors need to recognize that successful investing is a

probabilistic activity, they should also seek contrary viewpoints and keep
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records.
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Hindsight bias: People may see past events as having been predictable and
reasonable to expect, they may remember their own predictions of the future as
more accurate than they actually were. I know it all along
Consequences:
Overestimate the degree to which they predicted an investment

outcome, thus giving them a false sense of confidence.
Cause FMPs to unfairly assess money manager or security performance.

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FMP needs to carefully record and examine their investment decisions

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to avoid repeating past investment mistakes.
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2.1 Cognitive Errors: Information Processing
Anchoring and adjustment bias: When estimating a value with unknown
magnitude, people begin by envisioning some initial default number (anchor)
which they then adjust up or down to reflect subsequent information and
analysis, but they tend to adjust their anchors insufficiently and produce end
approximations that are biased.
Consequences: FMPs may stick too closely to original estimates when new
information is learned.
Overcoming: Remember that past prices, market levels, and reputation
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provide little information about an investment’s future potential and should

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not influence investment decisions to any great extent.

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Mental accounting bias: People treat one sum of money differently from
another equal-sized sum based on which mental account the money is assigned
to. Mental accounts are based on the source of the money or the planned use
of money. BPT - Behavioral Portfolio Theory
-> diff. layers
Consequences:
Neglect opportunities to reduce risk by combining assets with low
correlations.
Irrationally distinguish between returns derived from income and
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capital appreciation.
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Overcoming:
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FMPs should focus on total return rather than treat investment income
and capital appreciation differently.
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Framing bias: A person answers differently based on the way in which it is
asked (framed).
Consequences:
Misidentify risk tolerance because of how questions about risk
tolerance were framed.
Choose suboptimal investments based on how information about the
specific investment is framed.
Focus on short-term price fluctuations, may result in excessive trading.
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Overcoming: Be as neutral as possible and open-minded as possible when

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interpreting investment-related situations.

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Availability bias: People take a heuristic approach to estimating the probability
of an outcome based on how easily the outcome comes to mind. Easily recalled
outcomes are of often perceived as being more likely than those that are harder
to recall or understand. e.g. Advertisment / TV
Sources of availability bias:
Retrievability
Categorization
Narrow range of experience
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Resonance
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2108(1)

Availability bias:
Consequences:
Choose an investment, investment adviser, or mutual fund based on
advertising rather than on a thorough analysis of the options.
FMPs may limit their investment opportunity set.
Fail to diversify.
Fail to achieve an appropriate asset allocation.
Overcoming: Develop an appropriate investment policy strategy, carefully
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research and analyze investment decisions before making them, and focus
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on long-term results.
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2012(1)
3.1 Emotional Biases

Loss aversion: People tend to strongly prefer avoiding losses as opposed to
achieving gains. It leads to risk avoidance when people evaluate a potential gain
Consequences:
Hold investments in a loss position longer than justified by fundamental
analysis. Sell investments in a gain position earlier than justified by
fundamental analysis
Limit the upside potential of a portfolio by selling winners and holding
losers.
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Trade excessively as a result of selling winners.

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Hold riskier portfolios than is acceptable.

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Overcoming: A disciplined approach to investment based on fundamental

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analysis
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2111(1)

Overconfidence bias: people demonstrate unwarranted faith in their own
intuitive reasoning, judgments, and/or cognitive abilities, this may be the result
of overestimating knowledge levels, abilities, and access to information.
Self-attribution bias: people take credit for successes (self-enhancing)
and assign responsibility for failures (self-protecting).
Illusion of knowledge: People believe that they are smarter and more
informed than they actually are.
Prediction overconfidence: The confidence intervals that FMPs assign
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to their investment predictions are too narrow.

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Certainty overconfidence: The probabilities that FMPs assign to

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outcomes are too high because they are too certain of their judgments
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2111(1)

Overconfidence bias:
Consequences:
Underestimate risks and overestimate expected returns.
Hold poorly diversified portfolios.
Trade excessively.
Experience lower returns than those of the market.
Overcoming:
FMPs should review their trading records, identify the winners and
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losers, and calculate portfolio performance over at least two years.

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Be objective when making and evaluating investment decisions.

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perform post-investment analysis on both successful and unsuccessful

investments
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2108(1)

Self-control bias: people fail to act in pursuit of their long-term goals because
of a lack of self-discipline.
Conflict of Utility Theory (most efficient)
Consequences:
Save insufficiently for the future.
Accept too much risk in their portfolios in an attempt to generate
higher returns.
Cause asset allocation imbalance problems.
Overcoming: FMPs should ensure that a proper investment plan is in place
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and should have a personal budget.

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Status quo bias: people choose to do nothing (i.e.,maintain the “status quo”)
instead of making a change (inertia). If one choice is the default choice, people
will let that choice stand rather than making another choice.
Consequences:
Unknowingly maintain portfolios with risk characteristics that are
inappropriate for their circumstances.
Fail to explore other opportunities.
Overcoming: FMPs should quantify the risk-reducing and return-enhancing
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advantages of diversification and proper asset allocation

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Endowment bias: People value an asset more when they hold rights to it than
when they do not. FMPs may irrationally hold on to inherited or purchased
securities they already own.
Consequences:
Fail to sell off certain assets and replace them with other assets.
Maintain an inappropriate asset allocation.
Continue to hold classes of assets with which they are familiar.
Overcoming:
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When financial goals are in jeopardy, emotional attachment must be

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moderated; it cannot be accepted and adapted to

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Regret-aversion bias: People tend to avoid making decisions that will result in
action out of fear that the decision will turn out poorly.
Consequences:
Be too conservative in their investment choices as a result of poor
outcomes on risky investments in the past.
Engage in herding behavior.
Overcoming: FMPs should quantify the risk-reducing and return-enhancing
advantages of diversification and proper asset allocation
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Reading
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Behavioral Finance and Investment Processes

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1. Barnewall Two-Way Behavioral Model
Barnewall distinguishes two relatively simple investor types: passive
and active.
Passive investors are defined as those investors who have become

wealthy passively.
Active investors are individuals who have been actively involved in

wealth creation through investment, and they have risked their own
capital in achieving their wealth objectives. Active investors have a
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higher tolerance for risk than they have need for security.
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2. BB&K Five-Way Model
Adventurer
Individualist May hold highly undiversified
Independent and confident portfolios
Like to make their own decisions but only Confident and willing to take
after careful analysis chances
Pleasant to advise because they will listen Makes their own decisions
and process information rationally. Makes them reluctant to take
advice
Challenge for an investment
Straight Arrow adviser.
Sensible and secure
Willing to take on some
risk in the expectation of
earning a commensurate
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Guardian return. Celebrity

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Cautious and concerned Like to be the center of

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attention
May seek advice from
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May hold opinions about some

those they perceive as things but to a certain extent
being more knowledgeable
recognize their limitations
than themselves
May be willing to seek and take
advice about investing.
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3. Pompian Behavioral Model: BITs and Biases
General type Passive Active
Risk tolerance Low High
Investment Conservative Moderate Growth Aggressive
style
Bias types Emotional Cognitive Cognitive Emotional
BITs Passive Preserver Friendly Independent Active
(PP) Follower Individualist (II) Accumulator
(FF) (AA)
Emotional bias Endowment Regret Overconfidence Overconfidence
Loss aversion aversion and self-attribution Self-control
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Status quo
Regret aversion
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Cognitive bias Mental accounting Availability Conservatism Illusion of

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Anchoring and Hindsight Availability control

adjustment Framing Confirmation
Representativeness
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2012(1)
3. Pompian Behavioral Model: BITs

Passive Preserver, place a great deal of emphasis on financial security and
preserving wealth rather than taking risks to grow wealth.
They gained wealth without risking their own capital, thus may not be
financially sophisticated. E.g. Concerned; Anxious; Worried
The focus is on family and security, PP biases tend to be emotional

rather than cognitive.
Advising PP:
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PPs are more receptive to “big picture” advice rather than details such
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as standard deviation and sharpe ratio.

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Advisers should focus on what the money will accomplish.

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PPs need to be persuaded about the soundness of advisers’ general

philosophy first, and then PPs will respond to advice and take action.
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Friendly Follower are passive investors with a low to medium risk
tolerance who tend to follow leads from their friends, colleagues, or
advisers when making investment decisions.
They often want to be in the latest, most popular investment.
They often overestimate their risk tolerance.
They generally comply with professional advice.
Advising FFs: Quantitive method

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FFs are likely to say yes to advice that makes sense to them without
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adequately considering the risk involved.

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Education on benefits of portfolio diversification is the best course.
Offering education in clear, unambiguous ways.
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Independent Individualist is an active investor with medium to high risk
tolerance who is strong-willed and an independent thinker.
They are self-assured and “trust their gut” when making decisions.
They made an investment without consulting anyone.
They enjoy investing and are comfortable taking risks, but often resist
following a financial plan.
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They are usually willing to listen to sound advice when it is presented in

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a way that respects their intelligence.

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A good approach is to have regular educational discussions during

client meetings
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2111(2) 2105(1) 2108(1)

Active Accumulator is the most aggressive behavioral investor type. These
clients are usually entrepreneurial and want to be heavily involved in the
investment decision-making process.
AAs often have high portfolio turnover rates.
AAs are quick decision makers but may chase higher risk investments
that their friends or associates are suggesting.
Some AAs do not accept or follow basic investment principles such as

diversification and asset allocation
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Advising AAs: Big picture, principle

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They may be the most difficult clients to control.

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The best approach to dealing with these clients is to take control of the
situation Show your competence
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Limitations of Classifying Investors into BITs
Individuals may exhibit both cognitive errors and emotional biases;
Individuals may exhibit characteristics of multiple investor types;
Individuals will likely go through behavioral changes as they age;
Individuals are likely to require unique treatment even if they are classified
as the same investor type because human behavior is so complex;
Individuals act irrationally at different times and without predictability.

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4. Portfolio Construction – Individual Investors
Inertia and Default(status quo bias)
Most DC plan participants show inertia and tend not to change their
asset allocations through time, even though their tolerance for risk and
other circumstances would be changing .
Inertia leads plan participants to stick with default options which will
be cash or money market funds, with low risk but also low rates of
return.
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Target date funds can counteract the inertia, they automatically switch
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from risky assets to fixed-income assets as the plan member nears the
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intended retirement date.

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Naive diversification—dividing contributions equally among available
funds irrespective of the underlying composition of the funds.
Naïve diversification may be the result of framing bias.
Participants may follow a conditional 1/n strategy, by allocating
equally among their chosen subset of funds. Once they have selected
their funds, they allocate the invested amount equally among the
chosen funds.
Regret may play a role in explaining naïve diversification strategies.
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Compony stock(investing in the familiar)
Familiarity and overconfidence effects: Employees underestimate risk
because of familiarity with the employer and overconfidence.
Naïve extrapolation of past returns: Plan participants at companies
whose stock has done well in the past may expect this performance to
continue. Representative Bias
Framing and status quo effect of matching contributions:

Employees may be taking the company’s decision to contribute stock to
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their plan as implicit advice.

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Loyalty effects: Employees may be willing to hold employer’s stock to

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assist the company. Emotional

Financial incentives
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Excess trading: investors trade too much(damaging returns) and tend to
sell winners and hold on to losers(the disposition effect).
Home bias: Familiarity with a country may lead investors to own high
concentrations of domestic assets.
Behavioral portfolio theory: mental accounting bias
Portfolios are formed as layered pyramids in which each layer is aligned
with an objective, and behavioral investors do not consider the
correlation between the layers.
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Investors have multiple attitudes toward risk depending on which part

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of their wealth is being considered.

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5.1 Overconfidence in Forecasting Skills
Overconfidence bias: people demonstrate unwarranted faith in their own
intuitive reasoning, judgments, and/or cognitive abilities.
Illusion of knowledge bias: people generally do a poor job of estimating
probabilities but believe they do it well because they believe that they are
smarter and more informed than they actually are;
Illusion of control bias: a tendency of analysts to try to control what
cannot be controlled;
Self-attribution bias: people take credit for successes and assign
responsibility for failures;
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Representativeness: analysts judge the probability of a forecast being

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correct by considering how much the outcome resembles overall available

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data;
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Availability bias: which involves individuals giving undue weight to more

accessible, readily recalled information.
Hindsight bias(I knew it all along): ego defense mechanism
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5.1 Overconfidence in Forecasting Skills
Remedial actions for overconfidence and related biases:
Prompt and accurate feedback combined with a structure that rewards

accuracy can help analysts to re-evaluate their processes.
Appraisal by colleagues, supervisors, or systems ran help calibrate forecasts

and control overconfidence.
Well-structured feedback can also reduce hindsight bias.
Provide at least one counterargument in the report to reduce overconfidence.

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Ensuring that a search process includes only comparable data is also helpful
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to reducing overconfidence.
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Analysts should incorporate additional information with a Bayesian approach

to calculate probabilities and recognize underlying base rates.
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5.2 Influence by Company Management
Company management is also susceptible to behavioral biases.
Framing is a cognitive bias in which the same problem is assessed

differently depending on how information or a question is presented;
Anchoring means that the framework for interpreting and analyzing

the available information can be influenced disproportionately by an
initial, default position or “anchor”. Adjustments from the anchor tend
to insufficiently incorporate new information;
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Availability is a cognitive bias that involves individuals giving undue

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weight to more accessible, readily recalled information.

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Analysts should also recognize the possibility of a self-attribution bias

in company executives.
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2111(1) 2105(1)
5.3 Analyst Biases in Conducting Research

The gamblers’ fallacy is a misunderstanding of probabilities in which
people wrongly project reversal to a long-term mean. It reflects a faulty
understanding about the behavior of random events, expecting reversals to
occur more frequently than actually happens.
Conjunction fallacy
Combining the probabilities of the events inappropriately to support

the manager’s belief
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6. BF vs Committee Decision Making
Social proof is a bias in which individuals are biased to follow the beliefs
of a group. Analysts may wrongly favor the judgment or endorsement of
others, often without being fully aware that they are doing so.
Group environment may amplify individual behavioral biases.
The committee may merely acted to support the judgment of the chair.
Committees are often made up of individuals with similar backgrounds
who are likely to approach decisions in a similar way.
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2108(1)
6. BF vs Committee Decision Making

Techniques for Structuring and Operating Committees to Address
Behavioral Factors :
A committee is made up of members from diverse backgrounds;
Members are independent enough to express and support their own
views rather than falling into line with the views of others;
The chair should actively encourage alternative opinions so that all
perspectives are covered.
Teams that are diverse in skills, experience, and culture may be less
prone to social proof bias.
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7. Market Anomolies
Efficient markets should not deliver abnormal returns.
Anomalies: persistent abnormal returns that differ from zero and are
predictable in direction.
Some apparent anomalies may be explained by the small samples involved,
a statistical bias in selection or survivorship, or data mining that
overanalyzes data for patterns and treats spurious correlations as relevant.
Markets can present temporary disequilibrium behavior, unusual features
that may survive for a period of years but ultimately disappear.
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January effect, weekend effect

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Momentum
Momentum or trending effects: future price behavior correlates with that of the
recent past.
Typically in the short term, up to two years, there is a positive correlation.
There is evidence of price reversals, or a mean reversion, at longer periods of

three to five years.
Herding occurs when a group of investors trade on the same side of the market
in the same securities, or when investors ignore their own private information and
act as other investors do.
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Momentum can be partly explained by short-term underreaction to relevant

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Investors’ bias to sell winners reflects anchoring on the purchase price.
Recency effect: the tendency to recall recent events more vividly and give them
undue weight
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Momentum
Regret is the feeling that an opportunity has been missed, and is typically an
expression of hindsight bias.
Trend-chasing effect: investors have a bias to buy investments they wish

they had owned the previous year.
Disposition effect encourage investors to hold on to losers, causing an

inefficient and gradual adjustment to deterioration in fundamental value.
An irrational belief in short-term mean reversion in the form of a price

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recovery (gamblers’ fallacy)

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Bubbles and Crashes
Periods of significant overvaluation or undervaluation can persist for more
than one year, rather than rapidly correcting to fair value;
Bubbles and crashes appear to be panics of buying and selling;
A continuous rise in an asset price is fuelled by investors‘ expectations of

further increase; asset prices become decoupled from economic
fundamentals.
Bubbles and crashes are periods of unusual positive or negative asset

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returns because of prices varying considerably from or reverting to their

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intrinsic value.
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2108(1)
Bubbles and Crashes - Biases

Investor behavior in bubbles:
overconfidence; overtrading, underestimation of risks, failure to diversify,
and rejection of contradictory information;
The overconfidence and excessive trading that contribute to a bubble are
linked to confirmation bias and self-attribution bias;
Hindsight bias : individuals can reconstruct prior beliefs and deceive
themselves that they are correct more often than they truly are.
Investors would be better off not trading on all the available information,
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The disposition effect recognizes that investors are more willing to sell
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winners, which can encourage excess trading.

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There can also be a confirmation bias to select news that supports an

existing decision or investment.
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Value and Growth
Value stocks are typically characterized by low price-to earnings ratios,
high book-to-market equity, and low price-to-dividend ratios.
Growth stock characteristics are generally the opposite of value stock

characteristics.
The halo effect extends a favorable evaluation of some characteristics to

other characteristics.
A company with a good growth record and good previous share price
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performance might be seen as a good investment, with higher

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expected returns than its risk characteristics merit.

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The home bias : portfolios exhibit a strong bias in favor of domestic

securities in the context of global portfolios.
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It’s not an end but just the beginning.
"There are only two creatures," says a proverb, "who can surmount the
pyramids-the eagle and the snail.“
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: Asset Allocation
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Session Content
ASSET ALLOCATION AND RELATED DECISIONS IN PORTFOLIO
Study Session 3
MANAGEMENT
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Framework SS3: Asset Allocation and Related
Asset Allocation and Decisions in Portfolio Management

Related Decisions in R5: Overview of Asset Allocation
Portfolio Management R6: Principles of Asset Allocation
R7: Asset Allocation with Real-
World Constraints
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Reading
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Overview of Asset Allocation

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1. The Portfolio Management Process
Develop capital market
Identify and articulate the expectations for the
asset owner’s objectives. planning horizon.
Synthesize Input to
Structure Portfolio strategic
Revise expectations
Document objective Strategic asset allocation asset
Revise objectives
and constraints in the Input Active risk budgets allocation

investment policy Manager and /or individual
statement. security selection
Execution of portfolio
decisions
Rebalance
Revise IPS Rebalancing
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Identify changes in asset

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owner’s economic Investment Process

Monitor prices and markets.
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balance sheet, objectives, results feedback

or constraints
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Evaluate progress toward achieving objectives and compliance with IPS
Investment Governance
Initial flows Feedback flows 5-90
1. The Portfolio Management Process
Initial Flows
Identify and articulate the asset owner's objectives.
Document objective and constraints in the investment policy statement.
Develop capital market expectations for the planning horizon.
Structure Portfolio.
Evaluate progress toward achieving objectives and compliance with IPS.
Feedback Flows
Identify changes the asset owner's economic balance sheet, objectives,
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or constraints.
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Monitor prices and markets.

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2. Investment Governance
A common governance structure in an institutional investor context will
have three levels within the governance hierarchy:
Governing investment committee
Investment staff
Third-party resources
Effective investment governance models:
1. Establish long-term and short-term investment objectives.
2. Allocate rights and responsibilities within the governance structure.
3. Specify processes for creating an investment policy statement (IPS).
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4. Specify processes for creating a strategic asset allocation and

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rebalancing policy.
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5. Apply a reporting framework to monitor the investment program’s

stated goals and objectives.
6. Periodically perform a governance audit.
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2.2 Allocation of Rights and Responsibilities
Allocation of Rights and Responsibilities

Investment Investment Investment Staff Third-Party
Activity Committee Resource
Mission Draft and approve n/a n/a
Investment policy Approve Draft Consultants
statement provide input
Asset allocation Approve with Draft with input Consultants
policy input from staff from consultants provide input
and consultants
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Selection of Delegate to Research, Consultants

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investment investment staff: evaluation, and provide input

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manager and Approval authority selection of

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other service retained for investment

providers certain providers managers and
service providers
8-90

Portfolio Delegate to Execution if assets Execution by
construction outside managers are managed in- independent
(individual asset or to staff if house investment
selection) sufficient internal managers
resources exist
Monitoring asset Delegate to staff Assure that the Consultants and
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portfolio the investment portfolios equals input

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rebalancing policy statement the desired overall

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portfolio
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positioning;
approve and
execute
rebalancing
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Risk management Approve principles Create risk Investment
and conduct management manager manages
oversight infrastructure and portfolio within
design reporting established risk
guidelines;
consultants may
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Investment Oversight Ongoing Consultants and

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manager assessment of custodian provide

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monitoring managers input
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Performance Oversight Evaluate Consultants and
evaluation and manager’s custodian provide
reporting continued input
suitability for
assigned role;
analyze sources of
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Governance audit Commission and Respond and Investment

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assess correct Committee

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contracts with an
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independent third
party for the audit
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2.4 Strategic Asset Allocation
The investment committee, which is the highest level of the governance
structure, will typically approve the strategic asset allocation decision.
A proposed asset allocation will be developed after (1) the IPS is
constructed, (2) investment results are simulated over the appropriate
time horizon(s), and (3) the risk and return attributes of all possible asset
allocation strategies are considered.
In addition to approving the asset allocation, good governance should
also specify rebalancing decisions and responsibilities.
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3. Economic Balance Sheet
Economic balance sheet
Conventional/Financial assets and liabilities
Additional/Extended assets and liabilities
Relevant in making asset allocation decisions but not appear on
conventional balance sheets
Assets Liabilities and Net worth

Financial assets Financial liabilities
Domestic equity Short-term borrowing
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Extended assets Extended liabilities

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PV of expected future income PV of expected future expense

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Economic Net worth

Economic net worth
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Extended portfolio assets
For individual investors
Human capital (The PV of future earnings)
The PV of pension income
The PV of expected inheritances
For institutional investors
Underground mineral resources
The PV of future intellectual property royalties
Extended portfolio liabilities
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For individual investors

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The PV of future consumption

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For institutional investors

The PV of prospective payouts for foundations
Grant payable appear as conventional liabilities
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The Laws have worked their entire careers at Whorton Solutions (WS), a
multinational technology company and they have two teenage children
who will soon begin college.
The Laws have an investment portfolio consisting of $800,000 in
equities and $450,000 in fixed-income instruments. 80% of the equity
portfolio consists of shares of WS. The Laws also own real estate valued
at $400,000, with $225,000 in mortgage debt. The Laws’ pre-retirement
earnings from WS have a total present value of $1,025,000, and their
future expected consumption expenditures have a total present value
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of $750,000.
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The Laws express a very strong desire to fund their children’s college
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education expenses, which have an estimated present value of

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$275,000. The Laws also plan to fund an endowment at their alma

mater in 20 years, which has an estimated present value of $500,000.
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Using the economic balance sheet approach, the Laws’ economic net
worth is closest to:
A. $925,000
B. $1,425,000
C. $1,675,000
Solution: A.
Assets Liabilities and Net worth
Financial assets Financial liabilities
:
Fixed income 450,000 Mortgage debt 225,000

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Real estate 400,000 Extended liabilities

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Equity 800,000 Children’s education 275,000

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Extended assets Endowment funding 500,000

Human capital 1,025,000 PV of consumption 750,000
Economic Net worth 925,000
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2105(1) 2108(1)
4. Approaches to Asset Allocation
Three broad approaches to asset allocation
Asset-only: Mean–variance optimization (MVO)
Focus solely on the asset side of the investor’s balance sheet
Global market-value weighted portfolio should be considered as a
baseline asset allocation in an asset-only approach.
Liability-relative: Funding liabilities
Provide for the money to pay liabilities when they come due
Liability-driven investing (LDI) is an investment industry term that
generally encompasses asset allocation that is focused on funding
an investor’s liabilities
Goals-based: Achieving the goals
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For individuals and families, specify asset allocations for sub-

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portfolios, each of which is aligned to specified goals ranging from

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supporting lifestyle needs to aspirational financial objective.

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The sum of all sub-portfolio asset allocations results in an overall

SAA for total portfolio.
Asset allocation focused on investor’s goals is also known as Goals-
based investing (GBI)
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4.1 Relevant Objectives
Asset Relation to
Typical Typical Uses and Asset Owner
Allocation Economic
Objective Types
Approach Balance Sheet
Does not Maximize Liabilities or goals not defined
explicitly Sharpe ratio and/or simplicity is important
Asset-only model for acceptable Some foundations, endowments
liabilities or level of Sovereign wealth funds
goals volatility Individual investors
Fund Penalty for not meeting liabilities
Models legal liabilities and high
Liability-
and quasi- invest excess Banks
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liabilities assets for Defined benefit pensions

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growth Insurers
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Achieve goals
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with specified
Goals-
Models goals required Individual investors
based
probabilities
of success
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4.2 Relevant Risk Concepts
Asset-only
Primary measure of risk: volatility (standard deviation) of portfolio return
Other risk sensitivities:
Risk relative to benchmarks: tracking risk (tracking error)
Downside risk
semi-variance
peak-to-trough maximum drawdown
measures focusing on the extreme (tail) segment of the downside:
Value at risk (VaR)
Liability-relative
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Shortfall risk
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Volatility of contributions needed to fund liabilities

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Measure of risk: standard deviation of the surplus (main driver of risk:

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different characteristics – e.g. interest rate sensitivity, sensitivity to inflation)

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Goal-based
Maximum acceptable probability of not achieving a goal
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2105(1)
4.3 Asset Class
Three “super classes” of assets:
Capital assets
Consumable/transformable assets
Store of value assets
Criteria for specifying asset classes for the purpose of asset allocation
1. Assets within an asset class should be relatively homogeneous;
2. Asset classes should be mutually exclusive;
3. Asset classes should be diversifying;
Low pairwise correlation
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4. The asset classes as a group should make up a preponderance of

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world investable wealth;

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5. Asset classes selected for investment should have the capacity to

absorb a meaningful proportion of an investor’s portfolio.
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Example
In reviewing a financial plan written by the Laws’ previous adviser, Raye
notices the following asset class specifications.
Equity: US equities
Debt: Global investment-grade corporate bonds and real estate
Derivatives: Primarily large-capitalization foreign equities
The previous adviser’s report notes the asset class returns on equity
and derivatives are highly correlated. The report also notes the asset
class returns on debt have a low correlation with equity and derivative
returns.
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Raye believes the previous adviser’s specification for debt is incorrect

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given that, for purposes of asset allocation, asset classes should be:
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A. diversifying.
B. mutually exclusive.
C. relatively homogeneous.
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4.4 Risk Factor
Asset-based asset allocation
Modeling using asset classes as the unit of analysis tends to obscure the
portfolio’s sensitivity to overlapping risk factors;
Use multifactor risk models have been labeled “factor-based asset
allocation” can be used for asset allocation by creating factor portfolios.
How risk factor exposures can be achieved by long and short positions
or use existing instrument.
Inflation. Going long nominal Treasuries and short inflation-linked
bonds isolates the inflation component.
Real interest rates. Inflation-linked bonds provide a proxy for real
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US volatility. VIX (Chicago Board Options Exchange Volatility Index)

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futures provide a proxy for implied volatility.

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Credit spread. Going long high-spread credit bond and short

Treasuries/government bonds isolates credit exposure.
Duration. Going long 10+ year Treasuries and short 1–3 year Treasuries
isolates the duration exposure being targeted.
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5. Optimal Asset Allocation
Strategic asset allocation / Policy portfolio
an asset allocation that is expected to be effective in achieving an asset
owner’s investment objectives, given his or her investment constraints
and risk tolerance, as documented in the investment policy statement
Optimal asset allocation
Maximize W0 , wi , asset class return distributions,
E U WT =f
by choice of asset class weights wi degree of risk aversion
subject to 𝑛
𝑖=1 𝑤𝑖 = 1 𝑎𝑛𝑑 𝑎𝑛𝑦 𝑜𝑡ℎ𝑒𝑟 𝑐𝑜𝑛𝑠𝑡𝑟𝑎𝑖𝑛𝑡𝑠 𝑜𝑛 𝑤𝑖
Utility function
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Mean-variance utility: U = E rp − 2 λσ2p
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Optimal allocation to the risky asset

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1 μ − rf
w∗ =
λ σ2
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Example
An investment adviser is counseling a client who recently inherited
€1,200,000 and who has above-average risk tolerance (λ = 2). The
exhibit below shows three alternative strategic asset allocations.
Investor’s Forecasts
Asset Allocation Expected Return Standard Deviation of Return
A 10.00% 20%
B 7.00% 10%
C 5.25% 5%
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Based only on Goddard’s risk-adjusted expected returns for the asset

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allocations, which asset allocation would she prefer?

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Example
Solution:
1 1
Using the utility function U E (rp ) 2
p =E (rp ) 2 2
p =E (rp ) 2
p
2 2
The client’s utility for Asset Allocations A, B, and C are as follows:
UA=10.0%-(20%)2=6.0%
UB=7.0%-(10%)2=6.0%
UC=5.25%-(5%)2=5.0%
The client would be indifferent between A and B based only on their
common perceived certainty-equivalent return of 6%.
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6. Strategic implementation choices
Two dimensions of passive/active choices
Passive/active management of the strategic asset class weights;(whether
to deviate from the SAA tactically or not);
Passive and active management of allocations to asset classes.
(1) Passive/Active Management of Asset Class Weights
Tactical asset allocation (TAA): involves deliberate short-term deviations
from the strategic asset allocation;
Deviation restricted by risk budgets or rebalance range
Risk budget: address which risk to take and how much of each to
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Tradeoff between potential outperformance and tracking error

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Key limitation: additional trading, monitor cost and CG tax.

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Dynamic asset allocation (DAA): a strategy incorporating deviations

from the SAA that are motivated by longer-term valuation signals or
economic views;
26-90
6. Strategic implementation choices
(2) Passive/Active Management of Allocations to Asset Classes
Passive: investor insights or expectation do not impact the composite of
the portfolio.
Active: will respond to changing CME or insights, resulting in changes to
portfolio composition;
Passive/Active Spectrum
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7. Strategic considerations in rebalancing
Rebalancing is the discipline of adjusting portfolio weights to more closely
align with the strategic asset allocation.
Approaches to rebalancing
Calendar rebalancing
Percent-range rebalancing (range-based rebalance)
Frequency of the portfolio valued
The narrower corridor, the more frequent rebalance
The more frequent the monitoring, the greater the precision in
implementation
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More frequent rebalancing, higher cost

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Fully or partially correcting

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Rebalance back to target weights

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Rebalance to range edge

Rebalance halfway between the range-edge trigger point and the target
weight
28-90
Strategic considerations
Considerations Rebalancing ranges

Transaction costs Higher costs, wider ranges
Risk-aversion More risk-averse, narrower ranges
Less correlated, narrower ranges in case further
Asset class correlation
divergence
Beliefs in momentum Beliefs in momentum, wider ranges; Mean reversion,
favor/ mean reversion narrower ranges
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Illiquid investments, typically associated with larger

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Liquidity
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trading costs, encourage wider ranges

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Higher volatility makes divergences from the strategic

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Volatility
asset allocation more likely, thus narrower ranges
Encourage asymmetric and wider rebalancing ranges,
Taxes
for example, 25%->(24%,28%)
29-90
Disciplined rebalancing has tended to reduce risk while incrementally
adding to returns. Empirical finding include following:
Rebalancing earns a diversification return.
The compound growth rate of a portfolio is greater than the
weighted average compound growth rates of the component
portfolio holdings (given positive expected returns, positive asset
weights, and sufficiently low transaction costs).
Rebalancing earns a return from being short volatility.
In the case of a portfolio consisting of a risky asset and a risk-free
asset, the return to a rebalanced portfolio can be replicated by
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creating a buy-and-hold position in the portfolio, writing out-of-

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the-money puts and calls on the risky asset, and investing the
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premiums in risk-free bonds.

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As the value of puts and calls is positively related to volatility, such a

position is called being short volatility (or being short gamma, by
reference to the option Greeks).
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Reading
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Principles of Asset Allocation

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31-90
1. Developing asset-only asset allocations
• MVO
Framework • Addressing the Criticisms of MVO
Add constraints
Resampled MVO, Reverse optimization,
Black-Litterman Model
Non-normal optimization
Liquidity consideration
Factor-Based Asset Allocation
MCS
2. Developing liability-relative asset allocation
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• Surplus Optimization
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• Hedging\Return-seeking portfolio
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• Integrated Asset-Liability Approach

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3. Developing goals-based asset allocations

4. Heuristics and other approaches
5. Risk budgeting and Risk Parity
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2012(1)
1.1 Asset-Only: MVO
Mean-variance optimization (MVO)
It assumes investors are risky averse, so they prefer more return for the
same level of risk.
Given an opportunity set of investable assets, their expected returns and
variances, as well as the pairwise correlations between them, MVO
identifies the portfolio allocations that maximize return for every level of
risk.
If the MVO analysis includes all investable risky assets, the result is the
familiar “efficient frontier”. 𝑅𝑃
:
Efficient Frontier
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Global Minimum
Variance Portfolio
𝜎𝑃
33-90
1.1 Asset-Only: MVO
MVO requires three sets of inputs: returns, risks (standard deviations),
and pair-wise correlations for the assets in the opportunity set, and the
objective function expressed as follows:
Um = E R m − 0.005λσ2m
There are some issues to consider:

Common constraints;
The simplest optimization places no constraints on asset class
weights except the budget constraint that weights sum to 1.
The non-negativity constraint leads to corner-portfolio EF.
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Only risky asset vs separating out cash and cash equivalent as risk-free
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asset (non-constraint).
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Cash is treated as risky asset → risky-asset EF

Cash and cash equivalent are treated as risk-free assets → linear EF
(CML)
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2108(1)
1.1 Asset-Only: MVO
Under non-negativity constraint
With short sale restrictions, the frontier changes from a smooth curve to one
with corner portfolios
A corner portfolio is formed when the weights of an asset go from zero
to positive or vice versa
No negative weights
We can approximate the standard deviation for an efficient portfolio given
those of adjacent corner portfolios
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1.1 Asset-Only: MVO——Examples
An endowment's return objective is 7%, which includes a spending rate
of 3%
Given the corner portfolio returns on the next slide and assuming no
short sales, determine the standard deviation and asset weights for the
portfolio that will meet their objective
Corner Sharpe Asset A Asset B Asset C

E(R) σ
Portfolio Ratio Weight Weight Weight
1 9% 16% 0.436 100% 0% 0%
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2 7.5% 11.5% 0.478 80% 20% 0%

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3 5.5% 7.7% 0455 0% 40% 60%

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4 5.3% 7.6% 0.434 0% 0% 100%
36-90
Estimating the Standard Deviation
The approximate standard deviation of the portfolio is a weighted
average of the standard deviations of Corner Portfolios 2 and 3:
σP= 0.75(0.115) + 0.25(0.077)
σP= 0.1055 = 10.55%
Note that the estimate is an upper it to the true standard deviation
Does not account for diversification (correlation)
Asset Class Contributions
:
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and C, use the 75/25 weights in Corner Portfolios 2 and 3:

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Corner Portfolio 2 has weights 80/20/0 in Assets A, B, and C

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Corner Portfolio 3 has weights 0/40/60 in Assets A, B, and C
37-90
Introducing a Risk-Free Asset
If there is a risk-free asset available, combining it with the corner
portfolio with the highest Sharpe ratio can increase the investor's
utility
This is equivalent to combining the risk-free asset with the
tangency portfolio
In capital market theory, the market portfolio (i.e., the tangency
portfolio) has the highest available Sharpe ratio of any
portfolio on the efficient frontier
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corner portfolio and the risk free asset

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If its return is less than the required return, borrow at the risk-free
rate to lever up the return
This assumes no restrictions on leverage
38-90
Calculating the Portfolio Weights
In our example, Corner Portfolio 2 has the highest Sharpe ratio
Given a return objective of 7%, risk-free rate of 2%, solve for the
weights of Corner Portfolio 2 and RF:
0.07 = 0.075w2 + 0.02(1 - w2)
w2 = 0.909; wRF = 0.091
Put 90.9% of the value of the portfolio in Corner Portfolio 2 and 9.1
% in the risk-free asset
:
Calculating the Standard Deviation

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the portfolio standard deviation is determined as follow:

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σP = 0.909(0.115)+0.091(0)
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σP = 0.1045 = 10.45%
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2111(2)
1.1 Asset-Only: MVO

Strengths
Most common and widely used
Basis for more sophisticated approaches
Weaknesses
The asset allocations tend to be highly concentrated in a subset of the available
asset classes; (add constraints)
The outputs (asset allocations) are highly sensitive to small changes in the inputs;
(Resampled MVO, Reversed MVO and Black-Litterman Model)
Investors are often concerned with characteristics of asset class returns such as
skewness and kurtosis that are not accounted for in MVO; (Non-normal
optimization approaches)
:
The MVO may ignore the effect of illiquidity (Three additional methods)
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While the asset allocations may appear diversified across assets, the sources of risk
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may not be diversified; (Risk budgeting and Factor-based model)

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MVO is a single-period framework that does not take account of trading/

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rebalancing costs and taxes;(MCS method)

MVO allocations may have no direct connection to the factors affecting any liability
or consumption streams;
40-90
1.2 Adding Constraints
There are two primary reasons (advantage) practitioners typically apply
additional constraints:
To incorporate real-world constraints into the optimization problem ;
To help overcome some of the potential shortcomings of mean–variance
optimization elaborated above (highly concentrated allocations).
Disadvantage: If a very large number of constraints are imposed, one is no
longer optimizing but rather specifying an asset allocation through a series
of binding constraints.
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1.2 Adding Constraints
When running an optimization, in addition to the typical budget constraint
and the non-negativity constraint, one can impose additional constraints.
Specify a set allocation to a specific asset
30% to real estate or 45% to human capital
Specify an asset allocation range for an asset
The emerging market allocation must be between 5% and 20%.
Specify an upper limit, due to liquidity considerations
Such as private equity or hedge funds
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The allocation to emerging market equities must be less than the

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allocation to developed equities

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1.3 Resampled MVO
Resampled mean–variance optimization combines Markowitz’s mean–
variance optimization framework with Monte Carlo simulation and, all
else equal, leads to more-diversified asset allocations.
Resampling uses MCS to estimate a large number of potential capital
market assumptions for MVO, which lead to an equal number of MVO
frontiers, also referred to as simulated frontiers.
The resulting asset allocations, or portfolio weights, from these
simulated frontiers are saved and averaged (using a variety of methods),
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and, eventually, for the resampled frontier. make optimization results

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less sensitive to changes in input variables

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Resampling can also be used to address the highly concentrated

issues.
43-90
1.3 Resampled MVO
Criticisms including the
following:
Some frontiers have
concave “bumps” where
expected return
decreases as expected
risk increases;
The “riskier” asset
allocations are over-
diversified;
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The asset allocations

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inherit the estimation

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errors in the original

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inputs; and Efficient Frontier Asset Allocation Area Graph, Returns with
Resampling
The approach lacks a
foundation in theory.
44-90
1.4 Reverse optimization
Reverse optimization takes as its inputs a set of asset allocation weights of global market
portfolio that are assumed to be optimal and with additional inputs of covariance and the
risk aversion coefficient, solves for expected returns (also called implied returns).
Reverse optimization is a powerful tool that helps explain the implied returns associated
with any portfolio. stable implied returns —> stable weightings
Weights of an existing IPS of the client is also possible
Derived return already reflect a highly diversified portfolio
Improve the return estimate (forward-looking)
Some practitioners will find the link between reverse optimization and CAPM equilibrium
elegant.
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First, use the weights associated with the asset classes (or various indexes) to form a
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working version of the global market portfolio;

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And use the beta of each asset relative to our working version of the global market
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portfolio;
Then to infer what expected returns would be if all assets were priced by the CAPM
according to their market beta.
Run a new MVO
45-90
2105(1)
1.5 Black-Litterman model
The Black–Litterman model has helped make the MVO framework more
useful. It enables investors to combine their unique forecasts of expected
returns with reverse optimized returns in an elegant manner.
Starts with excess returns (in excess of the risk-free rate) produced from
reverse optimization;
And then provides a technique for altering reverse-optimized expected
returns in such a way that they reflect an investor’s own distinctive
views. Adjusted return = wi * implied return + (1-wi) * Forecast Return
A new MVO is run.
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Black-Litterman model helped make the MVO more useful.

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Enable investor to combine their unique forecasts

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Asset allocation grounded in market capitalization, reflect market

expectation (highly diversified portfolio, avoid concentration)
46-90
2105(1)
1.6 Non-normal optimization
A normal distribution is fully explained by the first two moments because the
skewness and (excess) kurtosis of the normal distribution are both zero.
Unfortunately, variance or standard deviation is an incomplete measure of risk
when returns are not normally distributed. Investor preferences may go beyond
the first two moments (mean and variance) of a portfolio’s return distribution.
The third and fourth moments are, respectively, skewness and kurtosis.
Skewness measures the degree to which return distributions are
asymmetrical
Kurtosis measures the thickness of the distributions’ tails (i.e., how
frequently extreme events occur)
A number of variations of these more sophisticated optimization techniques
:
have been put forth, most of them consider the non-normal return
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distribution characteristics and use a more sophisticated definition of risk,

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such as: X MVO

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Mean–semivariance optimization
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Mean–conditional value-at-risk optimization

Mean–variance-skewness optimization
Mean–variance-skewness-kurtosis optimization
47-90
1.7 Liquidity considerations
Definition
Liquid asset classes: such as publicly listed equities and bonds.
Less liquid asset classes: such as direct real estate, infrastructure, and private
equity.
When make asset-allocation decisions, there are two problems for the less
liquid asset classes:
Due to the lack of accurate indexes, it is more challenging to make capital
market assumptions for these less liquid asset classes
Even if there were accurate indexes, there are no low-cost passive
investment vehicles to track them.
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In addressing asset allocation involving less liquid asset classes, practical

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(1) Exclude less liquid asset classes from the asset allocation decision and
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then consider real estate funds, infrastructure funds, and private equity
funds as potential implementation vehicles when fulfilling the target
strategic asset allocation.
48-90
1.7 Liquidity considerations
(2) Include less liquid asset classes in the asset allocation decision and
attempt to model the inputs to represent the specific risk characteristics
associated with the likely implementation vehicles.
(3) Include less liquid asset classes in the asset allocation decision and
attempt to model the inputs to represent the highly diversified characteristics
associated with the true asset classes.
Use listed real estate indexes, listed infrastructure, and public equity
indexes that are deemed to have characteristics similar to their private
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equity counterparts to help estimate the risk of the less liquid asset
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classes and their correlation with the other asset classes in the
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opportunity set. Using proxies
49-90
1.8 Factor-based Model
Factor-based asset allocation also requires three sets of inputs: returns, risks
(standard deviations), and pair-wise correlations for these factors in the
opportunity set, in order to get an optimized solution.
MVO and more sophisticated approaches that overcome some of the
limitations or weaknesses of as applied to an opportunity set consisting
of traditional, non-overlapping asset classes.
An alternative approach used by some practitioners is to move away
from an opportunity set of asset classes to an opportunity set consisting
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1.8 Factor-based Model
The factors are typically similar to the fundamental (or structural) factors in
widely used multi-factor investment models. Typical factors used in asset
allocation include size, valuation, momentum, liquidity, duration (term), credit,
and volatility.
Returns can be combined from shorting large-cap stocks and going long
small-cap stocks, for an example, “Size factor return = Small-cap stock return
– Large-cap stock return”.
Constructing factors in this manner removes most market exposure
from the factors because of the short positions that offset long positions.
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Pair-wise correlations between factors are smaller than that of asset classes.
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The factor represents what is referred to RequiredReturn RF ( Rmkt RF )

mkt,j
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as a zero (dollar) investment, or self-

financing investment, in which the SMB,j ( Rsmall Rbig )
underperforming attribute is sold short to ( RHBM RLBM )
HML,j
finance an offsetting long position in the
better-performing attribute.
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1.9 Monte Carlo simulation
Monte Carlo simulation complements MVO by addressing the limitations of
MVO as a single-period framework.
MCS can help paint a realistic picture of potential future outcomes,
including the likelihood of meeting various goals, the distribution of the
portfolio’s expected value through time, and potential maximum drawdowns.
Monte Carlo simulation can effectively grapple with a range of practical
issues that are difficult or impossible to formulate analytically.
Rebalancing and taxes: In the multi-period world, rebalancing triggers
the realization of capital gains and losses. Given a specific rebalancing
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rule, different SAAs will result in different patterns of tax payments.

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Path dependent: Investors save/deposit money in and spend money

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out of their portfolios; thus, in the more typical case, terminal wealth is
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path dependent because of the interaction of cash flows and

returns.
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• MVO
Add constraints
MCS
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2012(1)
2. Liability-relative Asset Allocations
Liability-relative asset allocation is aimed at the general issue of rendering
decisions about asset allocation in conjunction with the investor’s liabilities.
Liability-relative investors view assets as an inventory of capital, which is
available to achieve goals and to pay future liabilities.
Were developed in an institutional investor context, but these ideas
have also been applied to individual investors.
Because many large institutional investors possess legal liabilities
and operate in regulated environments in which an institution’s
inability to meet its liabilities with current capital has serious
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consequences.
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Liability-relative Asset Allocations Methods include:

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1. Surplus optimization
2. Hedging/Return-seeking Portfolio Approach
3. Integrated asset-liability Approach
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2.1 Surplus optimization
It involves adapting asset-only mean–variance optimization to an efficient
frontier based on the volatility of surplus by substituting surplus return
for asset return over any given time horizon, all else equal.
Is a straightforward extension of the asset-only portfolio model
The objective function is U LRm E (R s ,m ) 0.005 2
(R s ,m )
Where, Surplus Return = (Change in asset value – Change in liability

value)/(Initial asset value)
Expected returns and variances of liabilities
We assume that the liabilities have the same expected returns and
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volatilities as US corporate bonds;

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An alternative approach is to deploy a set of underlying factors that

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drive the returns of the assets.
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Asset liability management (ALM) considers the allocation of assets with
respect to a given liability or set of liabilities.
The ALM approach maximize the difference (the surplus) between assets
and liabilities at each level of risk (much like the efficient frontier represents
the maximum return at each level of risk).
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The comparison between the two asset mixes ( asset-only and surplus ):
The asset mixes are very different on the conservative side of the two
frontiers.
The most conservative mix for the surplus efficient frontier consists
mostly of the US corporate bond index because it results in the
lowest volatility of surplus over the one-year horizon.
In contrast, the most conservative mix for the asset-only efficient
frontier consists chiefly of cash.
The two asset mixes (asset-only and surplus) become similar as the
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degree of risk aversion decreases, and they are identical for the most
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aggressive portfolio (private equity).

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Bonds disappear from the frontier about halfway between the most
conservative and the most aggressive mixes.
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2111(1)
2.2 Hedging/Return-seeking Portfolio Approach

In this approach, the liability-relative asset allocation task is divided into two
parts, thus this approach is also called two-portfolio approach.
We distinguish as “basic” the two-portfolio approach in the case in
which there is a surplus
In the basic case, the first part of the asset allocation task consists
of hedging the liabilities through a hedging portfolio. In the
second part, the surplus (or some part of it) is allocated to a return-
seeking portfolio, which can be managed independently of the
hedging portfolio (e.g. using MVO).
And as “variants” the approach as applied when there is not a positive
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surplus
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A partial hedge, whereby capital allocated to the hedging portfolio

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is reduced in order to generate higher expected returns

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And dynamic versions whereby the investor increases the allotment

to the hedging portfolio as the funding ratio increases.
Funding ratio: PV of plan assets/PV of plan liability
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Compared to basic approach
These variants do not hedge the liabilities to the full extent possible
given the assets and thus are less conservative than the basic approach
discussed above.
Still, there can be benefits to a partial hedge when the sponsor is able to
increase contributions if the funding ratio does not increase in the
future to 1 or above.
An essential issue involves the composition of the hedging portfolio
The designated cash flows can be hedged via cash flow matching,
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duration matching, or immunization, e.g. frozen DB pension plan.

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What’s the most important is the hedging portfolio must include assets
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whose returns are driven by the same factors that drive the returns of
the liabilities.
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Limitations and ways of addressing these problems:
First, if the funding ratio is less than 1, the investor cannot create a fully
hedging portfolio unless there is a sufficiently large positive cash flow
(contribution).
In this case, the sponsor might increase contributions enough to
generate a positive surplus.
Or applications of variants of the two-portfolio approach are possible,
such as partial hedge variant.
A second barrier occurs when a true hedging portfolio is unavailable. An
example involves losses due to weather-related causes, such as hurricanes or
:
earthquakes.
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In these cases, the investor might be able to partially hedge the

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portfolio with instruments that share some of the same risks. The
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investor has “basis risk” when imperfect hedges are employed.

As an aside, the investor might be able to set up a contract with
someone who, for a fee, will take on the liability risk that cannot be
hedged. Insurance contracts have this defining characteristic.
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2.3 Integrated asset-liability Approach
The approach, integrating the liability portfolio with the asset portfolio,
requires a formal method for selecting liabilities and for linking the asset
performance with changes in the liability values.
The previous two approaches are most appropriate when asset
allocation decisions are made after, and relatively independently of,
decisions regarding the portfolio of liabilities.
However, the integrated asset-liability approach integrates and jointly
optimizes asset and liability decisions.
Loss in stress scenarios in banks
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This approach can be implemented in a factor-based model, linking the

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assets and liabilities to the underlying driving factors.

It has the potential to improve the institution’s overall surplus.
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3 Comparing the approaches
Surplus optimization and the hedging/return-seeking portfolio
The surplus optimization approach links assets and the present value of
liabilities through a correlation coefficient. The two-portfolio model does not
require this input.
Implementation of the basic two-portfolio approach depends on having an
overfunded plan. A variant of the two-portfolio approach might be applied,
however.
Surplus optimization does not require an overfunded status. Both
approaches address the present value of liabilities, but in different ways.
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• MVO
Add constraints
MCS
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3. Goals-based Asset Allocations
Process:
Disaggregates the investor’s portfolio into a number of sub-portfolios,
each of which is designed to fund an individual goal (or “mental
account”) with its own time horizon and required probability of success.
Two fundamental parts
The first centers on the creation of portfolio modules;
While the second involves identifying client goals and matching
each of these goals to the appropriate sub-portfolio of a suitable
asset size.
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• MVO
Add constraints
MCS
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4. Heuristic and Other Approaches
“120 minus your age” rule.
120 – Age = Percentage allocated to stocks, which leads directly to an
age-based stock versus fixed income split
The heuristic lines lack some of the nuances of the various glide path
lines, but it would appear that an age-based heuristic leads to asset
allocations that are broadly similar to those used by target-date funds.
60/40 stock/bond heuristic. Norwaian Sovereign Fund
An asset allocation consisting of 60% equities and 40% fixed income.
:
Equity allocation: supplying a long-term growth foundation; fixed-

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income allocation: risk reduction benefits

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There is some evidence that the global financial asset market portfolio is
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close to this prototypical 60/40 split.
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4. Heuristic and Other Approaches
Endowment model (Yale model)
High allocations to non-traditional assets
A commitment to active management
Seeks to earn illiquidity premiums
Endowments with long time horizons are well positioned to capture.
1/N rule
In empirical studies comparing approaches, however, the 1/N rule has
been found to perform considerably better, based on Sharpe ratios and
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certainty equivalents, than theory might suggest. One possible

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explanation is that the 1/N rule sidesteps problems caused by

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optimizing when there is estimation error in inputs.

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• MVO
Add constraints
MCS
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2012(1) 2105(3) 2108(1) 2111(1)
5. Risk Budgeting and Risk Parity
A risk budget is simply a particular allocation of portfolio risk. The goal of risk
budgeting is to maximize return per unit of risk—whether overall market risk
or active risk.
The risk budgeting process is the process of finding an optimal risk budget.
The marginal contribution to total risk (MCTR) identifies the rate at which
risk would change with a small (or marginal) change in the current weights.
MCTRi i p
:
The absolute contribution to total risk (ACTR) for an asset class measures
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how much it contributes to portfolio return volatility.

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ACTR wi MCTR wi
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i p
Excess return=expected return - risk-free rate
Sometimes, it is based on reverse-optimized returns.
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An asset allocation is optimal when the ratio of excess return (over the
risk-free rate) to MCTR is the same for all assets and matches the
Sharpe ratio of the tangency portfolio.
Ratio of excess return to MCTR=(Expected return – Risk-free

rate)/MCTR
Critically, beta takes account not only of the asset’s own volatility
but also of the asset’s correlations with other portfolio assets.
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in the pursuit of return. A risk budget specifies the total amount of risk and
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how much of that risk should be budgeted for each allocation.
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Risk parity
Risk parity portfolio
A risk parity asset allocation is based on the notion that each asset
(asset class or risk factor) should contribute equally to the total risk
of the portfolio for a portfolio to be well diversified.
𝟏 𝟐 𝟏
𝝎𝒊 × 𝑪𝒐𝒗 𝒓𝒊 , 𝒓𝒑 = 𝝈
𝒏 𝒑
𝐴𝐶𝑇𝑅 = 𝝎𝒊 𝜷𝒊 𝝈𝒑 = 𝝈
𝒏 𝒑
Construct the overall portfolio

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Deriving a risk parity–based asset allocation (risk parity portfolio)

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Borrow or to lend so that the overall portfolio corresponds to the

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investor’s risk appetite.

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Risk parity
Advantage
The sources of risk are diversified (asset classes)
Back tests of levered risk parity portfolios have produced promising
results
Disadvantage
It ignores expected returns
The contribution to risk is highly dependent on the formation of the
opportunity set (fixed-income vs equity)
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Dependent on the ability to use extremely large amounts of

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leverage at low borrow rates (which may not have been feasible)
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Reading
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Asset Allocation with Real-World Constraints

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1. Constraints on asset allocation.
Framework 2. Tax considerations in asset allocation.

3. Revisions to asset allocation.
4. Short-term shifts in asset allocation.
5. Behavioral biases and the methods of
overcome them.
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Constraints in Asset Allocation
Economies and diseconomies of scale
Assets size
Regulatory restrictions
Assets owner (liquidity need)

Liquidity needs
Assets classes (characteristics)
Constraints
Changing human capital
Time horizon
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Changing character of liabilities

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Insurance companies
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Pension Funds
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Regulatory or other considerations

Endowments and foundations
Sovereign wealth funds

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Assets Size
The disadvantages subject to large assets are:
The illiquidity occurred when invest in small-cap stocks, either buy
or sell;
Invest in small-cap stock will cause the market wildly fluctuate;
Capital inflow may cause active investment managers to pursue
ideas outside of their core investment thesis;
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Organizational hierarchies may slow down decision making and

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reduce incentives.
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The advantages subject to large assets are:

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Have sufficient size to build a diversified portfolio of investment

strategies.
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Assets Size
The disadvantages subject to small assets are:
Insufficient amount to meet the minimum requirement for some
investments;
Lower governance capacity-sophistication and manpower resource-
to develop the required knowledge base for complex asset classes
and investment vehicles;
Higher internal management cost;
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Many capital markets impose local legislation, restricting investment

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in some assets with a given level of capital;

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Too small to diversify across the range of asset classes.

Notice that the large and small are not rigidly defined
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Asset Allocation for the Taxable Investor
2.1 After-Tax Portfolio Optimization
The return will be affected by the tax:
rat = rpt(1 – t)
• rat = the expected after-tax return
• rpt = the expected pre-tax (gross) return
• t = the expected tax rate
If the expected return composed by different integral:
rat = pdrpt(1 – td) + parpt(1 – tcg)
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• pd = the proportion of rpt attributed to dividend income

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• pa = the proportion of rpt attributed to price appreciation

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• td = the dividend tax rate

• tcg = the capital gains tax rate
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After-Tax Portfolio Optimization
As the tax and tax loss carry forward exist, the expected volatility of will
be reduced as well.
σat = σpt(1 – t)
• σat = the expected after-tax standard deviation
• σpt = the expected pre-tax standard deviation
As the expected return and after-tax standard deviation differ from the
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original data, the optimal portfolio would change as well.

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2111(1)

Taxes and Portfolio Rebalancing
As the after-tax volatility would be reduced by tax, and the correlations
of asset classes will remain after the charge of tax, the asset class
movements should be larger for a taxable investor than an otherwise
equal tax-exempt investor to remain a same risk portfolio.
In another words, the rebalancing ranges for a taxable portfolio can
be wider than those of a tax-exempt portfolio with a similar risk
profile:
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Rat =Rpt/(1 – t)
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Where
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Rat=the after-tax rebalancing range

Rpt= the pre-tax rebalancing range
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Example
Consider a portfolio with a 50% allocation to equity, where equity
returns are subject to a 25% tax rate. A tax-exempt investor may
establish a target allocation to equities of 50%, with an acceptable
range of 40% to 60% (50% plus or minus 10%). What the range should
be for a taxable investor who would like to achieve the same target
equity allocation.
Correct answer:
10% 1-25% =13.3%
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50% 13.3%
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A taxable investor with the same target equity allocation can

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achieve a similar risk constraint with a range of 37% to 63% (50%

plus or minus 13%).
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Strategies to Reduce Tax Impact
Tax loss harvesting refers to sell securitizes in loss statue along with
the selling of profitable securitizes when realize profit.
Strategic asset location refers to placing less tax-efficient assets in

accounts with more favorable tax treatment.
As a general rule, the portion of a taxable asset owner’s assets that

are eligible for lower tax rates and deferred capital gains tax
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treatment should first be allocated to the investor’s taxable

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accounts. ( tax deferred account,

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taxable account)
One important exception to this general rule regarding asset

location applies to assets held for near-term liquidity needs.
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Aggregating assets across accounts with differing tax treatment requires
modifying the asset value inputs to the portfolio optimization.
The after-tax value of assets in a tax-deferred account is defined by
vat = vpt(1 – ti)
where
vat = the after-tax value of assets
vpt = the pre-tax market value of assets

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ti = the expected income tax rate upon distribution

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Short-Term Shifts in Asset Allocation
Two major approaches to TAA
TAA Approaches
（Discretionary, 酌情判断）（persistence、predictable、proved)

Discretionary TAA Systematic TAA
Discretionary TAA is predicated on Using signals, systematic

the existence of manager skill in TAA attempts to capture
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predicting and timing short-term

anomalies that have been
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Definitions market moves away from the

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shown to have some

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expected outcome for each asset predictability and

class that is embedded in the SAA persistence.
policy portfolio.
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Discretionary TAA Valuations
Term and credit spreads
Central bank policy

Data points provide relevant
GDP growth
information
Earnings expectations
Inflation expectations
Leading economic indicators

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Discretionary Economic sentiment Consumer Consumer

TAA indicators confidence spending
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Margin borrowing
Market sentiment indicators Short interest
Volatility index
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Systematic TAA
Value factors
Value and momentum factors
Momentum factors
Dividend yield; cash flow yield,

Value ratios
and earnings yield
Systematic TAA Carry in currencies
Carry in commodities
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Signals of other asset classes

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Yields-to-maturity
and term premiums
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Trend positively
Trend following
Trend negatively
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Dealing with Behavioral Biases
How to deal with behavior biases
Loss-aversion: In goals-based investing, loss-aversion bias can be
mitigated by framing risk in terms of shortfall probability or by funding
high-priority goals with low-risk assets.
Illusion of Control: The illusion of control can be mitigated by using
the global market portfolio as the starting point in developing the asset
allocation.
Mental Accounting: Goals-based investing incorporates mental
accounting directly into the asset allocation solution. Each goal is
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aligned with a discrete sub-portfolio, and the investor can specify the
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acceptable level of risk for each goal. Provided each of the sub-
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portfolios lies along the same efficient frontier, the sum of the sub-
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portfolios will also be efficient.
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2111(1)
Dealing with Behavioral Biases

How to deal with behavior biases
Representative Bias: The strongest defenses are an objective asset

allocation process and a strong governance framework.
Framing Bias: The framing effect can be mitigated by presenting the

possible asset allocation choices with multiple perspectives on the
risk/reward trade-off.
Availability Bias: Familiarity bias (a bias stems from availability bias) can
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be mitigated by using the global market portfolio as the starting

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point in developing the asset allocation, where deviations from this

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baseline portfolio must be thoughtfully considered and rigorously

vetted.
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The failures and reverses which await men - and one after another
sadden the brow of youth - add a dignity to the prospect of human life,
which no Arcadian success would do. -- Henry David Thoreau.
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/ /
eg.202205CFA
:
academic.support@gfedu.net
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Alternative
Investments
for Portfolio
Management
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Session Content

:

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Framework SS9: Alternative Investments
for Portfolio Management

Alternative Investments
• R19 Hedge Fund Strategies
• R20 Asset Allocation to
Alternative Investments
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Reading
19
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Hedge Fund Strategies

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Overview of Hedge Fund Strategies 2012(1)
Key features of hedge funds

Lower regulatory and legal constraints (Lack of transparency).
Flexible mandates: Flexibility to use short selling and derivatives.
A larger investment universe.
Aggressive investment exposures.
Comparatively free use of leverage.
Liquidity constraints for investors.
Higher cost structures.
Types of hedge fund
:
Single-manager fund
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One portfolio manager invests in one strategy or style.

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Multi-manager fund
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Multi-strategy fund, in which teams of portfolio managers trade

and invest in multiple different strategies within the same fund.
FOFs
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Classifications of Hedge Fund Strategies
At the single manager and single strategy level, hedge fund strategies can
be classified in various ways.
Hedge fund strategies are categorized based on the kinds of securities
they invest in, the trading strategy used, and the kinds of risk
exposures taken.
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Categorization
Long/short equity
O-Chart
Equity strategies Dedicated short selling and short-biased
Equity market neutral
Merger arbitrage
Event-driven strategies
Distressed securities
Fixed-income arbitrage
Relative value strategies
Hedge Fund Convertible bond arbitrage
Strategies
Global macro strategies
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Opportunistic strategies
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Volatility trading
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Specialist strategies
Reinsurance/life settlements
Fund-of-funds
Multi-manager strategies
Multi-strategy hedge funds
7-84
Equity Strategies
Equity-related hedge fund strategies focus primarily on stock markets.
Equity hedge fund strategies invest primarily in equity and equity-
related instruments.
Types of equity-related hedge fund
The size and sign of equity market exposure often dictate the
classification of equity hedge fund strategies.
The main risk: equity-oriented risk.
Equity-related hedge fund strategies
Long/short equity;
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Dedicated short bias;

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Equity market neutral.

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Long/Short Equity
Strategy Implementation
Identify overpriced and underpriced stocks.
Purchases (long positions) stocks that will rise in value;
Sells (short positions) stocks that will fall in value.
Sector-specific focus (specialist L/S fund managers)
Search for single-name shorts for portfolio alpha and added
absolute return.
Generalist L/S managers
Use index-based short hedges to reduce market risk.
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Use index funds to achieve a desired exposure.

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Long/Short Equity
Characteristic
Varies strategies.
Return profiles are typically aimed to achieve average annual returns
roughly equivalent to a long-only approach but with a standard
deviation 50% lower than a long-only approach.
This strategy can typically be handled by both limited partner and
mutual fund-type vehicles.
Leverage Usage:
Variable: The more market-neutral or quantitative the strategy
approach, the more levered the strategy application tends to be to
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Role in portfolio
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Liquid, diverse, with mark-to-market pricing driven by public market

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quotes;
Added short-side exposure typically reduces beta risk and provides an
additional source of potential alpha and reduced portfolio volatility.
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Dedicated Short Selling and Short-Biased
Poorly managed companies, firms in declining market segments, or even
firms with deceitful accounting.
Dedicated short-selling funds
Short-biased
Activist short selling
One major challenge : markets inevitably rise over time, which creates a
tendency toward negative returns for shorts.
Strategy Implementation
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Take a bottom-up approach by scanning the universe of potential sell

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targets to uncover and sell short.

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Methods: Altman Z-score & Beneish M-score.
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Dedicated Short Selling and Short-Biased
Characteristics
Lower return but with a negative correlation benefit.
More volatile than a typical L/S equity hedge fund given short beta
exposure.
Managers have some ability to add alpha via market timing of portfolio
beta tilt, but it is difficult to do with consistency or added alpha.
This strategy is typically handled best in a limited partnership because
of difficult operational aspects of short selling.
Leverage Usage
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Role of portfolio
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Liquid, negatively correlated alpha to that of most other strategies, with

mark-to-market pricing from public prices.
But historic returns generally disappointing.
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Equity Market Neutral 2012(1)
Equity market-neutral (EMN)

Take opposite (i.e., long and short) positions in similar or related equities
that have divergent valuations.
The overall goal of EMN funds: 1) to generate alpha, 2) to be immune to
movements in the overall market
Types of EMN
Pairs trading.
Stub trading.
Multi-class trading.
Strategy implementation
:
1) to include only tradable securities with sufficient liquidity and

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2) to analyze for buy and sell opportunities using fundamental models

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and/or statistical and momentum-based models

3) to maintain market risk neutrality
4) to consider the availability and cost of leverage in terms of desired
return profile and acceptable potential portfolio drawdown risk
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Equity Market Neutral
Characteristics
Relatively modest return profiles
High levels of diversification and liquidity and lower standard deviation
Shorter horizons and more active trading
High leverage
Not to meet regulatory leverage limits for mutual fund vehicles
Role in portfolio
EMN strategies are especially attractive during periods of market
vulnerability and weakness, since their sources of return and alpha do
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not require accepting beta risk.

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Example 2012(1)
Ling Chang, a Hong Kong-based EMN manager, has been monitoring

PepsiCo Inc. (PEP) and Coca-Cola Co. (KO), two global beverage
industry giants. After examining the Asia marketing strategy for a new
PEP drink, Chang feels the marketing campaign is too controversial and
the overall market is too narrow. Although PEP has relatively weak
earnings prospects compared to KO, 3-month valuation metrics show
PEP shares are substantially overvalued versus KO shares (relative
valuations have moved beyond their historical ranges). As part of a
larger portfolio, Chang wants to allocate $1 million to the PEP versus
KO trade and notes the historical betas and S&P 500 Index weights, as
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shown in the following table.

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Stock Beta S&P 500 Index Weight

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PEP 0.65 0.663

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KO 0.55 0.718
Discuss how Chang might implement an EMN pairs trading strategy.
15-84
Example
Solution:
Chang should take a short position in PEP and a long position in KO with
equal beta-weighted exposures. Given Chang wants to allocate $1 million
to the trade, she would take on a long KO position of $1 million. Assuming
realized betas will be similar to historical betas, to achieve an equal beta-
weighted exposure for the short PEP position, Chang needs to short
$846,154 worth of PEP shares [= –$1,000,000 / (0.65/0.55)].
Only the overall difference in performance between PEP and KO shares

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would affect the performance of the strategy because it will be insulated

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from the effect of market fluctuations. If over the next 3 months the
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valuations of PEP and KO revert to within normal ranges, then this pairs
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trading EMN strategy should reap profits.
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Event-Driven Strategies 2012(1)
To attempt to profit from predicting the outcome of corporate events

Types of event-driven approach
Soft-catalyst event-driven approach
Hard-catalyst event-driven approach
The main risk: event risk.
Merger Arbitrage;
Distressed Securities.
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Merger Arbitrage 2012(1) 2105(1)
Cash-for-stock
Stock-for-stock acquisition
Merger arbitrage is comparable to writing insurance on an acquisition.
If the acquisition is completed as planned, the hedge fund earns an
insurance premium.
If the transaction fails, the hedge fund stands to lose money.
Cross-border merger and acquisition (M&A) where two countries and
two regulatory authorities are involved are more risky.
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Merger Arbitrage
Characteristics
Relatively liquid strategy
Market sensitivity and left-tail risk attributes (if the deals fail)
Insurance-like plus a short put option
Limited-partnership vehicle
Leverage Usage (high)
Role in portfolio
Relatively high Sharpe ratios with typically low double-digit returns and
mid–single digit standard deviation (depending on specific levels of
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leverage applied), but left-tail risk is associated with an otherwise steady

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return profile.
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Distressed Securities
To focus on firms that either are in bankruptcy, facing potential bankruptcy,
or under financial stress
Firms face these circumstances for a wide variety of reasons.
Waning competitiveness,
Excessive leverage,
Poor governance,
Accounting irregularities,
Outright fraud.
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Outcomes of bankruptcy process
In liquidation, the priority of claims
Senior secured debt (high),
Junior secured debt,
Unsecured debt,
Convertible debt,
Preferred stock,
Common stock (finally).
In re-organization, a firm’s capital structure is re-organized and terms
for current claims are negotiated and revised.
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In a liquidation situation, the focus is on determining the recovery value

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for different classes of claimants.

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In a reorganization situation, the focus is on how the firm’s finances will

be restructured and on assessing the value of the business enterprise
and the future value of different classes of claims.
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Characteristics
More variability
Usually long-biased
Relatively high levels of illiquidity
Role in portfolio
Returns tend to be “lumpy” and somewhat cyclical.
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Relative Values Strategies
To exploit valuation differences between securities
Relative values strategies
Fixed-Income Arbitrage;
Convertible Bond Arbitrage.
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Fixed-Income Arbitrage
To exploit pricing inefficiencies by taking long and short positions
across a range of debt securities
Arbitrage opportunities sources
Duration
Credit quality
Liquidity
Optionality
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Most common types of fixed-income arbitrage strategies

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The payoff profile of this fixed-income arbitrage strategy resembles a

short put option.
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Fixed-Income Arbitrage
Characteristics
High correlations found across different securities
Very liquid
High leverage usage
Role in portfolio
A function of correlations between different securities, the yield spread
available, and the high number and wide diversity of debt securities
across different markets.
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Convertible Bond Arbitrage
A combination of straight debt plus a long equity call option with an
exercise price equal to the strike price times the conversion ratio
(conversion value).
Buy the relatively undervalued convertible bond
Take a short position in the relatively overvalued underlying stock
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Convertible Bond Arbitrage
Characteristics
To extract and benefit from this structurally cheap source of implied
volatility by delta hedging and gamma trading short equity hedges
against their long convertible holdings
Liquidity issues surface for convertible arbitrage strategies in two ways:
1) naturally less-liquid securities
2) availability and cost to borrow underlying equity for short selling
High levels of leverage
Role in portfolio
Convertible arbitrage works best during periods of high convertible
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Opportunistic Hedge Fund Strategies
To profit from investment opportunities across a wide range of markets and
securities using a variety of techniques
Categorization methods
1) The type of analysis and approach that drives the trading strategy.
2) How trading decisions are implemented (discretionary or systematic).
3) The types of instruments and/markets in which they trade.
Opportunistic hedge fund strategies
Global macro strategies;
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Managed futures.
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Global Macro Strategies
To focus on global relationships across a wide range of asset classes and
investment instruments
Top-down and a range of macroeconomic and fundamental models
A mixture of positions
Individual securities,
Baskets of securities,
Index futures,
Foreign exchange futures/forwards,
Precious or base metals futures,
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Agricultural futures,
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Fixed-income products or futures,

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Global Macro Strategies
Characteristics
The use of leverage
The key source of returns revolves around correctly discerning and
capitalizing on trends in global markets.
Role in portfolio
Global macro can be very useful over a full market cycle in terms of
portfolio diversification and alpha generation.
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Managed Futures
Take long and short positions in a variety of derivatives contracts
Futures development
Gaining in size and liquidity;
Trading sector and industry index futures as well as more exotic
contracts.
Time-series momentum (TSM) trend following
Cross-sectional momentum (CSM) strategies
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Managed Futures
Characteristics
Highly liquid
More systematic approach
Somewhat cyclical and more volatile end of the spectrum of hedge
fund strategies (with volatility positively related to the strategy’s time
horizon)
High leverage
Role in portfolio
Returns of managed futures strategies typically exhibit positive right-
:
tail skewness in periods of market stress, which is very useful for

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portfolio diversification.
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Specialist Strategies
To require highly specialized skill sets for trading in niche markets.
The main risk : often unique
Specialist strategies
Volatility trading;
Reinsurance/life settlements.
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Volatility Trading
The goal is to source and buy cheap volatility and sell more expensive
volatility while netting out the time decay aspects normally associated with
options portfolios.
Type of relative value volatility trading
Time-zone arbitrage
Cross-asset volatility trading
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Volatility trading
1) To extract an outright long volatility view
2) To implement the volatility trading strategy using OTC options.
3) To migrate to the use of VIX Index futures (or options on VIX futures)
4) To purchase an OTC volatility swap or a variance swap from a
creditworthy counterparty
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Volatility Trading
Characteristics
Positive convexity
Liquidity varies across the different instruments
Outsized gains with very little up-front risk.
Role in portfolio
A useful source of portfolio return alpha across different geographies
and asset classes.
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Reinsurance/Life Settlements
Types of insurance contracts sold by insurance providers
Vehicle and home insurance,
Life insurance,
Catastrophe insurance
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The hedge fund would look for the following policy characteristics:
1) the low surrender
2) the low ongoing premium payments
3) the relatively high probability that the designated insured person
is indeed likely to die within a certain period of time
On finding the appropriate , to pay a lump sum (via a broker) to the
policyholder(s)
Valuation methods for catastrophe insurance may require the hedge
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Characteristics
Life insurance protects the policyholder’s dependents in the case of
his/her death.
A hedge fund strategy focusing on life settlements involves analyzing
pools of life insurance contracts being offered for sale.
Organized markets for catastrophe bonds and catastrophe risk futures
continue to develop.
Role in portfolio
A very appealing feature of insurance investments in a portfolio is that
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the risk inherent in these strategies is almost entirely uncorrelated with

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market risks and business cycles.

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Multi-Manager Strategies
Three main approaches:
1) Creating one’s own mix of managers by investing directly into
individual hedge funds running different strategies;
2) Fund-of-funds;
3) Multi-strategy funds.
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Fund-of-Funds
To aggregate investors’ capital and allocate it to a portfolio of separate,
individual hedge funds following different, less correlated strategies
1) To become acquainted with different hedge fund managers via the
use of various databases and introductions at prime broker-sponsored
capital introduction events
2) With both quantitative and qualitative top-down and bottom-up
approaches, to initiate the formal manager selection process
3) To review the fund’s Offering Memorandum and Limited Partnership
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Agreement
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4) To move into the ongoing monitoring and review phases

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2111(1)
Fund-of-Funds
Characteristics
To be important for smaller high-net-worth investors and smaller
institutions
Levered capital to FoFs.
Other attractive features
More diverse strategy mix but with less transparency and slower tactical
reaction time
Role in portfolio
By combining different and ideally less correlated strategies, a FoF
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portfolio should provide more diversification, less extreme risk

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exposures, lower realized volatility, and generally less single

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manager tail risk than direct investing in individual hedge fund

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strategies.
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2111(1)
Multi-Strategy Hedge Funds
To combine multiple hedge fund strategies under the same hedge fund
structure
Characteristics
To generally outperform with more variance and occasional large losses
often related to their higher leverage
To offer potentially faster tactical asset allocation and improved fee
structure (netting risk handled at strategy level) but with higher
manager-specific operational risks
To impose investor-level or fund-level gates on maximum redemptions
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allowed per quarter

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To be somewhat more prone to left-tail blow-up risk in stress

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periods
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More resilient
Role in portfolio
The multi-strategy manager can react faster to different real-time
market impacts.
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Conditional Factor Risk Model
A linear factor model can provide insights into the intrinsic characteristics
and risks in a hedge fund investment.
𝑅𝑒𝑡𝑢𝑟𝑛 𝑜𝑛 𝐻𝐹𝑖 𝑡 = 𝛼𝑖 + 𝛽𝑖,1 𝐹𝑎𝑐𝑡𝑜𝑟 1 𝑡 + 𝛽𝑖,2 𝐹𝑎𝑐𝑡𝑜𝑟 2 𝑡 + ⋯ +
𝛽𝑖,𝐾 𝐹𝑎𝑐𝑡𝑜𝑟 𝐾 𝑡 + 𝐷𝑡 𝛽𝑖,1 𝐹𝑎𝑐𝑡𝑜𝑟 1 𝑡 + 𝐷𝑡 𝛽𝑖,2 𝐹𝑎𝑐𝑡𝑜𝑟 2 𝑡 + ⋯+
𝐷𝑡 𝛽𝑖,𝐾 𝐹𝑎𝑐𝑡𝑜𝑟 𝐾 𝑡 + 𝑒𝑟𝑟𝑜𝑟 𝑖,𝑡
The following four factors for measuring risk exposures:

1. Equity risk (SNP500).
2. Currency risk (USD).
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3. Credit risk (CREDIT).

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4. Volatility risk (VIX).

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Empirical Results: Risk-adjusted Measure
The Sharpe ratio is one risk-adjusted measure of performance.
The Sortino ratio is a similar risk-adjusted measure of performance.
Comparatively higher Sharpe and Sortino ratios:
Systematic futures.
Global macro.
Event-driven hedge fund strategies.
Not significantly enhance risk-adjusted performance:
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Fund-of-funds.
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Multi-strategy.
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Empirical Results: Risk measure-S.D.
The lowest standard deviations of returns for the overall portfolio:
Dedicated short-biased.
Bear market neutral.
Notably low standard deviations:
Systematic futures.
FoF: macro/systematic.
Little positive impact on reducing standard deviations of the overall
portfolio include:
Event-driven: distressed securities.
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Relative value: convertible arbitrage.

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Empirical Results: Risk measure-Drawdown
Drawdown is defined as the peak-to-trough decline for a portfolio.
The smallest maximum drawdowns:
Global macro.
Systematic futures.
Merger arbitrage.
Not to mitigate the traditional portfolio’s maximum drawdown:
L/S equity.
Event-driven: distressed securities.
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Relative value: convertible arbitrage.

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Reading
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Asset Allocation to Alternative

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Investments
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2111(1)
Roles in Multi-Asset Portfolios - Alternatives
Overall, the goal of adding alternative investments to a portfolio is most
often to improve the portfolio’s risk and returns profile.
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Private equity.
For a portfolio of public equity securities, limited diversification
potential
The main function is to increase expected returns.
Hedge funds.
To somewhat reduce a portfolio’s overall equity beta but mainly to
increase returns through their managers’ security selection skill
To be less correlated with traditional asset classes.
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2012(1)
Roles in Multi-Asset Portfolios
Real assets.
Assets such as commodities, farm and timberland, and infrastructure
protect against inflation risk.
Commodity holdings (futures) can target particular subsets of inflation
risk.
Infrastructure investments require a longer time horizon and their
correlation with inflation may be limited.
Commercial real estate.
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Real estate investments can hedge inflation risk.

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Private credit.
This class of alternative investments include both direct lending and
distressed debt.
Direct lending : income-producing investment.
Distressed debt : more like equity securities
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Diversifying Equity risks: Short Time Horizon
For a short investment horizon, the primary risk is returns volatility.
To be biased downward for a number of reasons:
Appraisal-based valuations
Sampling biases, such as survivorship bias and backfill bias
Low correlations of returns with each other
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Diversifying Equity risks: Long Time Horizon
With a long time horizon, the primary risk is the failure of achieving a
minimum required rate of return over time.
Alternative investments can be a better choice for diversification.
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Investment Opportunity Set
Traditional approaches to defining the investment opportunity set include
classifying asset groups by liquidity or by how they perform over
economic cycles.
A liquidity-based approach
Fixed Income Equity Other Assets

More Liquid Cash Public Equity Commodity Futures
Gov. Bond L/S Equity REITs
Corp. Bond Hedge funds

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Private Real Estate

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Less Liquid Private Credit Private Equity

Private Real Assets
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Traditional approach
Classify assets by how they are expected to perform under different
scenarios for economic growth and inflation.
Negative/Low Growth High Growth

Deflation Non-Indexed Bonds
Public Equity
Moderate
Private Equity
Inflation
Private Credit
Indexed Bonds Commodities
High Inflation
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2111(1)
A risk factor based approach to defining asset classes involves statistically
estimating their sensitivities to risk factors identified by the manager.
Economic growth and inflation;
Interest rates and credit spreads;
Currency values;
Liquidity;
Capitalization;
Value-versus-growth.
Characteristics of a risk factor based approach
:
With respect to alternative investments, a risk factor analysis may show

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that some alternative investment classes are similar to traditional asset

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classes in terms of factor sensitivity.

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private equity returns ≈ public equity;

private credit ≈ publicly traded high yield bonds.
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Pros and cons of a risk factor based approach
Identifying sources of risk that are common across asset classes
Allowing a manager to analyze multiple dimensions of portfolio risk
To be sensitive to the period used for analysis
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Traditional approach
Advantages
Easy to communicate.
Relevance for liquidity management and operational considerations.
Limitations
Over-estimation of portfolio diversification.
Obscured primary drivers of risk.
Risk-based approach
Advantages
Common risk factor identification.
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Integrated risk framework.

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Limitations
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Sensitivity to the historical look-back period.

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Implementation hurdles.
Determining which risk factors to use and how these factors are
measured can be subjective.
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Investment Considerations
Many operational and practical complexities must be considered before
finalizing a decision to invest.
Properly defining risk characteristics;
Establishing return expectations;
Selection of the appropriate investment vehicle;
Operational liquidity issues;
Expense and fee considerations;
Tax considerations (applicable for taxable entities);
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Build vs. Buy.

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Risk consideration
Several characteristics of alternative investments limit the usefulness of
mean-variance optimization as a tool for determining their appropriate
portfolio allocations.
Illiquidity and valuation issues, option-like return patterns
A portfolio’s less effective allocation to the asset class
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Expected return
Setting return expectations is made more difficult by their short history
relative to other asset classes and by the limited validity of the data
that are available.
A suggested approach to
estimate each of its risk factor exposures,
add the expected returns from these exposures to the risk-free
rate.
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Investment Vehicles
A typical structure for an alternative investment vehicle is a limited
partnership.
Investing directly in a limited partnership is appropriate for large
investors.
Investing through a fund-of-funds may be appropriate for investors
that lack the needed expertise.
Benefit : to provide access to this asset class to investors who
otherwise would not have it
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charged by the underlying limited partnerships

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Investment Vehicles
Separately managed accounts (SMAs, funds of one)
Some open-ended mutual funds and “undertakings for collective
investment in transferable securities” (UCITS)
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Liquidity Concerns: Liquidity risks associated with investment vehicle
More strict
Subscriptions
Limited partners commit a stated amount of capital
Redemptions
To distribute capital over its life
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Liquidity Concerns: Drawdown Structure
The following illustrates a time line of cash flows that might occur for a
$10 million commitment to a private equity fund. Fund
LP commits terminates
$10 million Distributions
$4 m $5 m $3 m
0 1 2 3 4 5 6 7 8 9 10
-$3 m -$4 m -$2 m
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Calldown period
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Note in the figure that only $9 million of the limited partner’s capital
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was called. A general partner is not required to call the full amount of
committed capital.
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Liquidity Concerns: Drawdown Structure
Neither capital calls nor distributions occur on a predetermined
schedule.
Limited partners must also consider the opportunity cost of their
committed capital during the calldown period.
whether they are consistent with the fund’s redemption terms
Equity-oriented hedge fund
Relative value funds
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Expenses, Fees
Many alternative investments involve significant fees and expenses.
Funds with calldown structures charge management fees on the
amount of committed capital, regardless of how much of it has been
called down.
Taxes
Investors must ensure that their investments, and the investment
vehicles used to invest, are consistent with their tax situations.
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Other considerations: Intermediaries or In-House Programs
Large investors may consider developing their own program for
implementing alternative investments directly rather than using
intermediaries such as funds of funds.
An in-house program may be appropriate for an investor that needs
highly customized solutions, desires close control over its investment
program, or wishes to implement co-investments with general partners.
A successful program must be able to identify and invest with the best
fund managers.
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with whom they wish to invest.

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Suitability Considerations
Investment Horizon
To be generally suitable only for investors with long time horizons
Expertise
Based on the premise that skilled managers (large investors) can
create value through active management
Governance
To have a formal investment policy with clear objectives, put decision-
making power in the hands of experts, and have a reliable reporting
framework.
Transparency
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Approaches to Asset Allocation
A suggested approach to including alternative investments in an asset
allocation decision is to do it in two stages:
First with only the traditional asset classes;
Then also considering alternative investments.
The second process can be assisted by statistical tools such as:
Monte Carlo simulation.
Mean-variance optimization.
Risk factor based optimization.
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Challenges in modeling the risk and return properties of alternatives
Because asset valuations for many alternative investments are based on
appraisals, returns data are likely to be artificially smoothed and are
often stale.
The distribution of returns is also known to be non-normal, exhibiting
skew and excess kurtosis to a greater extent than traditional asset
classes.
Incorporate non-normality into analyses.
use empirically observed asset returns instead of working with the
normal distribution (small-sample and time-period biases)
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One method for modeling a distribution with fat tails (positive excess
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kurtosis) is to define risk and return properties for two or more distinct
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market environments.
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Monte Carlo simulation
1) To simulate risk factor or asset return scenarios that exhibit the
skewness and kurtosis commonly seen in alternative investments.
2) To illustrate simulation-based risk and return analytics over a long
time horizon in a broad asset allocation context.
Steps of model construction process
1. Decide between asset class returns or risk factors as the variables
to be simulated
2. Establish the quantitative framework
3. To translate them to asset class returns (based on risk factors)
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4. To use the resulting asset class return scenarios to develop

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meaningful outputs
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Optimization techniques
Mean–variance optimization (MVO) typically over-allocates to
alternative asset classes, because:
risk is underestimated because of stale or infrequent pricing;
the underlying assumption that returns are normally distributed.
Practitioners usually address this bias towards alternatives by
establishing limits on the allocations to alternatives.
Optimization methods that incorporate downside risk (mean–CVaR
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optimization) or take into account skew may be used to enhance the

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asset allocation process.

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Limitation
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Small changes in the inputs may generate significant changes in

optimal asset allocations.
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Risk factor based optimization
Risk factor based optimization is similar to MVO, but instead of
modeling asset classes by their return and risk characteristics, the
investor models risk factors and factor return expectations.
A risk factor based approach requires the additional step of translating
the optimized risk exposures to an asset allocation to achieve them.
Limitations
Asset classes’ return sensitivity to some risk factor exposures might
not be stable over time.
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Correlations among risk factors may behave like correlations

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among asset class returns and increase during periods of financial

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stress.
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Liquidity Planning
A portfolio must be managed in a way that meets its capital commitments
while still providing required liquidity.
Here we will explore the challenges with private investment liquidity
planning with three primary considerations:
1 How to achieve and maintain the desired allocation.
2 How to handle capital calls.
3 How to plan for the unexpected.
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Liquidity Planning
Achieve and maintain the desired allocation
Cash flows for a typical private investment partnership are capital calls in
the early years and distributions in the later years.
A simple model (estimate the cash flows to and from a fund)
Capital Contribution = Rate of Contribution (Capital
Commitment – Paid-in-Capital)
Capital contribution (C) in year t;
PIC denotes the already paid-in capital.
Distributions from a fund can be modeled as percentages of its net
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asset value.
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Distributions in period t = percentage to be distributed in period t

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× [NAV in period t -1 × (1+growth rate)]

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growth rate = IRR of its investments

NAV in period t = NAV in period t-1 × (1 + growth rate) +
contributions in period t – distributions in period t
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Liquidity Planning
Achieve and maintain the desired allocation
Liquidity forecasting is also important for managing how a portfolio
reaches and maintains its target asset allocations.
Combined with the cash flow forecasting approach described previously
for a particular fund, an investor can project the capital commitments
needed over a span of years to reach the target allocation, and forecast
the need to reinvest future distributions to maintain the target.
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Liquidity Planning
Managing the capital call
A crucial aspect of liquidity planning is having cash available to meet
capital calls.
A suggested approach is to invest it in publicly traded securities that
may be viewed as proxies for the private investments to which they are
committed.
Preparing for the unexpected
Capital calls, distributions, growth rates, and even fund lifetimes may
turn out significantly different than expected.
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Monitoring Programs
Overall Investment program monitoring
Its performance should be evaluated in the context of return, risk,
income, and safety, rather than simply measured against a benchmark.
One reason that measuring against a benchmark or peer group can be
misleading is the difficulty of selecting a representative one.
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Considerations in Monitoring Programs
Performance Evaluation
Monitoring of alternative investments can be challenging because their
performance reporting can be infrequent and come with significant
time lags.
A further complication with private investments is that they often report
internal rates of return rather than time-weighted rates of return.
IRR is influenced by the timing of capital calls and distributions, and
therefore, may be subject to manipulation.
Investors may prefer to monitor a private fund’s multiple on invested
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capital (MOIC).
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If capital is returned quickly (thereby possibly producing extraordinarily

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high IRRs), the investor may want to put greater emphasis on the MOIC
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measure. Similarly, funds that return capital more slowly than

expected might want to put greater weight on the IRR measure.
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Considerations in Monitoring Programs
Monitoring the Firm and the Investment Process
A fund’s “key persons” are typically specified in its documents.
The manager’s interests should be aligned with the investor’s
interests.
Style drift
Risk Management
Client/asset turnover
A large or unexpected increase in new investors may make more
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capital available to a manager than he has attractive opportunities to

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use.
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A fund should have reliable auditors, custodians, and other third-party

service providers.
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Search for knowledge, read more, sit on your front porch

and admire the view without paying attention to your
needs.
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Private
Wealth
Management
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Session Content
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Study Session 15-16 ETHICAL AND PROFESSIONAL STANDARDS (1)&(2)
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SS10: Private Wealth
Framework Management (1)
Private Wealth • R21 Overview of Private Wealth
Management
Management • R22 Topics in Private Wealth
Management
SS11: Private Wealth
management (2)
• R23 Risk Management for
Individuals
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Reading
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Overview of Private Wealth Management

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1. Private Clients versus Institutional Clients
Framework 2. Understanding Private Clients

3. Investment Planning
4. Investment Policy Statement
5. Portfolio Construction and Monitoring
6. Ethical and Compliance Considerations in
Private Wealth Management
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Private Clients versus Institutional Clients
Summary Private clients Institutional clients
diverse investment specific, clearly defined
Investment
objectives (may not be investment objectives
objectives
clearly defined or quantified)
Time horizon a shorter time horizon theoretically infinite
Scale smaller (more limitations ) larger
Constraints
taxable income may be more
Taxes significant and complex favored by a tax-exempt
institution
Investment less formal governance
formal governance structure
Governance structure
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Investment a higher degree (more

Other emotional
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Sophistication investment resources)

Distinctions
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Regulation separate regulators or shared regulatory structure

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Uniqueness Similar financial and Similar objective , similar

and objective, different strategies
Complexity investment strategies
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Understanding Private Clients
Information Needed in Advising Private Clients
Personal Information
Financial Information
Private Client Tax Considerations
Client Goals
Private Client Risk Tolerance
Technical and Soft Skills for Wealth Managers
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Personal Information
• The client’s family situation; Private Client Tax Considerations
• Proof of client identification; • Taxes on income.
• Employment and career information; • Wealth-based taxes.
• The sources of a client’s wealth; • Taxes on consumption/spending.
• Investment background;
• Return objective (liquidity preferences or ESG);
• Financial objectives and risk tolerance.
Financial Information
Assets Liabilities
• Cash and deposit accounts
• Consumer debt, such as credit card
• Brokerage accounts
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• Retirement accounts
Automobile loans
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• Other employee benefits
Student loans
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• Ownership interests (stock) in private businesses
Property-related loans
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• Cash-value life insurance
• Margin debt in brokerage accounts
• Real property, including residences, rental
property, and land
• Other personal assets
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Private Client Tax Considerations--Basic Tax Strategies
Tax avoidance.
Some countries allow investors to contribute limited amounts to certain
accounts that permit tax-free earnings and future withdrawals. Another
example of tax avoidance involves various wealth transfer techniques.
Tax reduction.
tax-exempt bonds; tax-efficient asset classes
Tax deferral.
By deferring the recognition of certain taxes until a later date, clients
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can benefit from compounding portfolio returns that are not diminished
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by periodic tax payments.

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Some investors in a progressive tax system may also seek to defer taxes
because they anticipate lower future tax rates.
limit portfolio turnover.
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Client Goals
Financial goals are not always apparent, defined, or measurable: they may be
expressed by clients as wishes, desires, or aspirations.
Planned Goals: Planned goals are those that can be reasonably estimated or
quantified within an expected time horizon.
Retirement. Maintaining a comfortable lifestyle beyond their working years
is a goal for most clients.
Specific purchases. Client goals may focus on specific purchases, which tend
to be a function of the level of wealth and/or stage of life.
Education. Clients often wish to fund their children’s education.
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Family events.(e.g. weddings)

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Wealth transfer. When clients have a definite amount of inheritance that

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they wish to transfer, this goal may need to be prioritized over other goals.
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Philanthropy. Clients often wish to make charitable donations during or

after their lifetime.
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Client Goals
Unplanned Goals: Unplanned goals are those related to unforeseen
financial needs.(difficult to estimate the timing and the amount of
funding needed)
Property repairs. Although households may be insured against
losses or catastrophes, clients may face additional spending needs if
insurance does not fully cover such events.
Medical expenses. Private client households normally have medical
insurance for illness or hospitalization, but health insurance may not
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cover all medical expenses. A related issue in some locations is the

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potential cost of elder care for oneself or one’s family members.

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Other unforeseen spending.

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When establishing client goals, private wealth managers consider goal

quantification, goal prioritization, and goal changes.
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Private Client Risk Tolerance 2020(12)
Key terms for a set of risk-related concepts:

Risk tolerance refers to the level of risk an individual is willing and able
to bear. Risk tolerance is the inverse of risk aversion.
Risk capacity is the ability to accept financial risk. The key difference
between risk capacity and risk tolerance is that risk capacity is more
objective in nature, while risk tolerance relates to an attitude.
Risk perception is an individual’s subjective assessment of the risk
involved in an investment decision’s outcome.
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How a client perceives the riskiness of an investment decision or the

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investment climate—depends on the circumstances involved.

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Private Client Risk Tolerance
Wealth managers often utilize questionnaires to assess clients’ risk
tolerance.
The result of a risk tolerance questionnaire, typically a numerical score, is
often used as an input in the investment planning process.
Risk Tolerance Conversation enable the wealth manager to educate a
client about investment risk.
clients often have multiple goals or objectives, their risk tolerance may
vary for different goals.
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a low risk tolerance with respect to near-term goals but a higher risk
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tolerance when it comes to longer-term goals.

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Technical and Soft Skills for Wealth Managers
Technical Skills
Technical skills represent the specialized knowledge and expertise necessary to provide
investment advice to private clients.
Capital markets proficiency.
Portfolio construction ability.
Financial planning knowledge.
Quantitative skills.
Technology skills.
Language fluency.
Soft Skills (non-technical)

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Soft skills typically involve interpersonal relationships—that is, the ability to effectively
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Communication skills.
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Social skills.
Education and coaching skills.
Business development and sales skills.
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Investment planning
After developing an understanding of their clients, wealth managers begin
the process of helping clients meet their objectives.
Capital Sufficiency Analysis
Retirement Planning
Investment policy statement
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Methods for Evaluating Capital Sufficiency
Deterministic Forecasting Method
Portfolio growth in a deterministic model occurs in a “straight-line”
manner.
Inputs: a portfolio return assumption, the current value of the
portfolio, anticipated future contributions to the portfolio, and cash
flows from the portfolio that represent client needs (according to
the client’s goals).
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While simple to understand, the deterministic method is typically

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unrealistic with respect to the variability in potential future

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outcomes.
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Methods for Evaluating Capital Sufficiency
Monte Carlo simulation allows a wealth manager to model the
uncertainty of several key variables and, therefore, the uncertainty or
variability in the future outcome. Monte Carlo simulation generates
random outcomes according to assumed probability distributions
for these key variables.
Inputs: Some Monte Carlo simulation software requires separate
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asset class assumptions—such as simple average return, standard

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deviation, and correlation with other portfolio asset classes—rather

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than assumptions at the overall portfolio level.
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Capital Sufficiency Analysis 2012(1) 2105(1)
Interpreting Monte Carlo Simulation Results

Monte Carlo Simulation Results
Year 10 Year 15 Year 20
Percentile
Portfolio Value Portfolio Value Portfolio Value
5th $3,519,828 $3,651,264 $3,647,328
25th $1,981,861 $1,698,449 $1,530,372
50th $1,239,837 $843,820 $569,974
75th $765,821 $305,126 ($249,205)
95th $197,179 ($264,048) ($1,402,608)
Successful Trials 98% 88% 69%
The table also shows the percentage of trials at a given horizon in which the
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client successfully achieved her objective.

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Wealth managers tend to guide clients toward a 75%–90% probability of

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success, although no industry standard range exists.
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Interpreting Monte Carlo Simulation Results
When the probability of success falls below an acceptable range,
potential solutions include the following:
Increasing the amount of contributions toward a goal
Reducing the goal amount
Delaying the timing of a goal (e.g., retiring a few years later than
originally planned)
Adopting an investment strategy with higher expected returns,
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albeit within the client’s acceptable risk tolerance and risk capacity
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Retirement Planning
Retirement Stage of Life
During the education stage, an individual is typically developing human
capital rather than financial capital.
Human capital is an implied asset that represents the net present value
of an investor’s future expected labor income;
Financial capital represents the tangible and intangible assets
(excluding human capital) owned by an individual or household.
Analyzing Retirement Goals
Wealth managers may use several different methods to analyze a client’s
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retirement goals.
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Three common methods

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mortality tables
Annuities
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Mortality Tables
A mortality table indicates individual life expectancies at specified ages.
In practice, a wealth manager can use a mortality table to estimate the
present value of a client’s retirement spending needs by assigning
associated probabilities based on life expectancy to annual expected
cash outflows.
One potential drawback to using mortality tables is that an individual
client’s probability of living to a certain age may exceed that of the
general population.
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Plan Year Client Age Life Expectancy Survival Probability

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0 72 12.0 100%
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1 73 11.4 97%
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2 74 10.8 93%
3 75 10.2 90%
4 76 9.7 86%
5 77 9.1 82%
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Annuities
Annuities provide a series of fixed payments, either for life or for a specified
period, in exchange for a lump sum payment. A relatively simple way of
calculating the present value of a client’s desired retirement spending is by
pricing an annuity.
Two basic forms are the immediate annuity and the deferred annuity.
With an immediate annuity, an individual (called the “annuitant”) pays an
initial lump sum, typically to an insurance company, in return for a guarantee
of specified future monthly payments—beginning immediately—over a
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specified period of time.

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With a deferred annuity, the specified future monthly payments begin at a

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later date.
Life annuities are those in which the income stream continues as long as
the annuitant lives. Life annuities help to mitigate longevity risk.
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Monte Carlo Simulation
Advantages of Monte Carlo Simulation
its applicability to the client’s actual asset allocation.
aggregating the results of many trials of probability-based estimates of
key variables, the overall probability of meeting retirement needs is
generated, and it can flexibly model different scenarios and explore
issues that are important to clients.
Limitations of Monte Carlo Simulation
It is only a method of estimation; it cannot predict the future.
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the output from Monte Carlo simulation can be highly sensitive to

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small changes in input assumptions.

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Monte Carlo output includes the probability of reaching a goal (or

goals) but not necessarily the “shortfall magnitude.”
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Behavioral Considerations in Retirement Planning
Heightened loss aversion. Some studies suggest that retirees are much
more loss-averse than younger investors.
Consumption gaps. Due to loss aversion and uncertainty about future
financial needs, many retirees spend less than economists would predict,
resulting in a gap between actual and potential consumption.
The “annuity puzzle.” While annuities can help to mitigate longevity risk
and, in some cases, may improve the probability of retirees meeting their
spending objectives, individuals tend not to prefer to invest in annuities.
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2105(1)
The investment policy statement (IPS) is a written planning document that
describes a client’s investment objectives and risk tolerance over a relevant
time horizon, along with the constraints that apply to the client’s portfolio.
The IPS is also an operating manual, listing key ongoing management
responsibilities.
Advantages
One advantage is that the IPS encourages investment discipline and
reinforces the client’s commitment to follow the strategy.
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Background and Investment Objectives
Investment objectives should be detailed and quantified whenever
possible.
Sometimes, clients have difficulty assigning specific amounts to future
objectives. When this is the case, the wealth manager can create a more
general objective, with the understanding that he will continue to work
with the client to determine an achievable specific objective.
The wealth manager should also include in this section of the IPS other
cash flows that are linked to investment objectives and that will
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therefore affect the capital sufficiency analysis.

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In a situation involving multiple objectives, the wealth manager should note

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which of the objectives is primary.
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Background and Investment Objectives
The investment objective, when linked to the client’s asset allocation and
the wealth manager’s capital market assumptions, should provide the
basic inputs to a capital sufficiency analysis.
Whenever the capital sufficiency analysis does not support the
investment objective, the wealth manager must work with the client to
establish a revised objective that the manager judges to be achievable.
The IPS should include the market value of the portfolio and of the
accounts that make up the portfolio。
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The background and investment objectives section should describe any

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other investment assets the client may have outside of the portfolio and
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any cash flows from external sources.
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Investment Parameters
Risk Tolerance. Wealth managers should consider the client’s ability and
willingness to withstand portfolio volatility.
Investment Time Horizon. A client’s investment horizon is indicated in this
section, but often as a range rather than a specific number of years.
e.g. exceeds 15 years, less than 10 years.
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Asset Class Preferences
The IPS should indicate the asset classes that will comprise a client’s
portfolio.
Alternatively, the wealth manager may list the asset classes that the
client has not approved.
Some wealth managers include a short narrative about the importance
of asset allocation and the process that the wealth manager used to
educate the client about asset class risk and return characteristics.
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The narrative captures in written form the risk–return trade-off that the
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Other Investment Preferences
This section may contain a general comment about or specific criteria
about for these ESG preferences.
Other investment preferences described in this section might be a
“legacy” holding that the client wishes to retain or a non-recommended
investment that the client wishes to make.
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Liquidity Preferences. If the client has liquidity needs that are not
established in the background and investment objectives section, those
needs should be noted here(e.g. a cash reserve).
If the client’s liquidity preference constrains asset class selection
decisions or implementation decisions, that constraint should be listed
here.
Constraints. Some clients have constraints that restrict the wealth manager
from implementing certain investments or strategies.
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investment options in certain accounts(e.g. employer-sponsored

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defined contribution retirement plan account)

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large unrealized capital gains

ESG-related constraints
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Portfolio Asset Allocation
This section contains the target allocation for each asset class in the
client’s portfolio.
Wealth managers who use a strategic asset allocation approach
typically define a target allocation for each asset class as well as upper
and lower bounds.
Wealth managers who use a tactical asset allocation approach may list
asset class target “ranges” rather than specific target allocation
percentages.
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Portfolio Management
Discretionary Authority
Discretionary authority refers to the ability of the wealth manager to act
without having to obtain the client’s approval.
Full discretion means that the wealth manager is free to implement
rebalancing trades and replace fund managers without prior client
approval.
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Rebalancing
Some wealth managers use a “time-based” rebalancing policy, whereby
client portfolios are rebalanced at a certain time interval regardless of
the difference between current asset class weights and target asset class
weights.
It is more common for wealth managers to use a “threshold-based”
rebalancing policy, whereby the manager initiates rebalancing trades
when asset class weights deviate from their target weights by a pre-
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The rebalancing section also sets expectations for how frequently the
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opportunities.
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Tactical Changes
If target allocation ranges have been established in the portfolio asset
allocation section, this section indicates whether—as well as under what
circumstances and to what degree—the wealth manager is permitted
to go outside those ranges when executing a tactical change.
Note that a wealth manager who uses only a strategic asset
allocation approach would likely not include this section in the IPS.
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Implementation
This section includes information about the investment vehicles the
wealth manager recommends to clients.
third-party money managers ⇒ due diligence process; frequency;
quantitative screens used in the due diligence process; qualitative
criteria that influence the manager selection and retention decisions;
proprietary investment;
This section indicates whether the wealth manager prefers to invest in
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mutual funds, exchange-traded funds (ETFs), or individual securities.

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Duties and Responsibilities
Wealth Manager Responsibilities
Formulating and reviewing the IPS, including frequency of review.
Recommending or selecting investment options and constructing the investment
portfolio’s asset allocation.
Monitoring and rebalancing the portfolio.
Monitoring portfolio implementation costs.
Monitoring the third-party service providers.
Reporting portfolio performance.
Reporting taxes and financial statements.
Voting proxies.
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The wealth manager sets expectations for how frequently the client and wealth
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As part of this review, it is important for the client to affirm that the investment
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objectives remain accurate.

Likewise, it is important for the wealth manager to confirm that the strategy remains
likely to meet those objectives.
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IPS Appendix
Modeled Portfolio Behavior
Modeled portfolio behavior describes a range of possible
performance outcomes over various holding periods and can provide
more value to the client than merely stating the return objective or the
“expected compound return.”
Capital Market Expectations
Capital market expectations include the wealth manager’s modeled
portfolio statistics—that is, the expected returns and standard
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deviations of asset classes, as well as modeled correlations between

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asset classes.
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2121(1)
Portfolio Construction and Monitoring
Portfolio Construction
Traditional Approach
Goals-Based Investing Approach
Portfolio Reporting and Review
Portfolio Reporting
Portfolio Review
Evaluating the Success of an Investment Program
Goal Achievement
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Process Consistency
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Portfolio Performance
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Definitions of Success
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Traditional Approach
Constructing portfolios for private clients involves several key steps:
1) Identify asset classes.
2) Develop capital market expectations.
3) Determine portfolio allocations.
4) Assess constraints.
5) Implement the portfolio.
6) Determine asset location.
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Goals-Based Investing Approach
The manager then performs mean–variance optimization for each
goal “portfolio” rather than at the overall portfolio level.
Goal portfolios are optimized either to a stated maximum level of
volatility or to a specified probability of success.
An advantage of the goals-based investing approach is that it may be
easier for clients to express their risk tolerance on a goal-specific basis
rather than at the overall portfolio level.
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A disadvantage is that the combination of goal portfolio allocations

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portfolio.
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The following steps are the same as Traditional Approach：

asset classes, implementing the portfolio, and determining asset.
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Portfolio Reporting and Review
Portfolio Reporting Portfolio Reporting
Portfolio reporting involves periodically Portfolio reviews provide an opportunity for

providing clients with information about their the wealth manager to revisit the client’s
investment portfolio and performance. investment plan and reinforce the
• Reflect strategic asset allocation targets; appropriateness of the strategy.
• Detailed performance report; • Revisit the client’s investment plan and
• Historical performance report; reinforce the appropriateness of the
• Contribution and withdrawal report; strategy;
• Purchase and sale report; • Inquires about any changes in the client’s
• Currency exposure report; objectives, risk tolerance, or time horizon;
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• Goals-based investing → focus on the

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client’s progress toward a goal; The key difference between portfolio

• Benchmark reports. reporting and portfolio review is that the
wealth manager is more actively engaged
in a review.
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Evaluating the Success of an Investment Program
Goal Achievement.
A successful investment program for a private client is one that achieves
the client’s goals/objectives with an acceptable amount of risk.
The client should remain likely to meet his or her long-term
objectives without meaningful adjustments to the plan.
Process Consistency.
Portfolio Performance.
absolute or relative
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benchmark
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Definitions of Success.
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Ethical Considerations
Fiduciary Duty and Suitability.
Fiduciary duty.
Suitability.
Know Your Customer (KYC).
Confidentiality.
Conflicts of Interest.
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Private Client Segments
Summary
Asset service
Segments Characteristics
Level personnel
Robo- less Robo-advisors low-cost; small portfolio; MVO; ETF; mutual
advisors $250,000 fund;
Mass $250,000 to professional build their portfolio; financial planning needs;
Affluent $1 million wealth non-customized;
manager
High-Net- $1 million to specialized more customized strategies; tax planning;
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Worth $50 million advisers wealth transfer issues;

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Ultra- over $50 a wider range complex tax situations, estate planning, bill
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High-Net- million of service payment, concierge services, travel planning,

Worth needs and advice on acquiring high-end assets; family
office.
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Reading
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Topics in Private Wealth Management

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1. Tax Issues
Framework 2. Managing Concentrated Positions

3. Wealth Transfer planning
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2007 AM Q1Q2 2008 AM Q1 2009 AM Q1Q2
2010 AM Q1 2011 AM Q2Q3 2012 AM Q1Q2
1.1 Basic concepts of taxation

General categories of taxes Interest, Dividends, and Withholding Taxes
• Income Tax • Double taxation
• Gains Tax (Step-up on death) • Qualified dividends (at least 60 days, unhedged)
• Wealth or Property Tax • Withholding taxes (cross-border)
• Stamp Duties
• Wealth Transfer Tax
Tax Efficiency of investments
Tax Jurisdiction Tax efficiency Tax inefficiency

• Tax haven Equity Alternatives,
• Territorial tax systems Derivatives
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• Worldwide tax systems Lower-yield Higher-yield

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Residence rules Lower-turnover Higher-turnover

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Tie-breaker rules
“style box” approach
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1.2 Measuring Tax Efficiency
1) After-tax holding period return: Returns are adjusted for the tax liability generated in
the period.
After-tax holding period returns can be geometrically linked and annualized in the
normal way.
Value − Value0 + income
R=
Value0
R = pre-tax holding period return ′
tax
R =R−
Value − Value0 + income − tax Value0
R′ =
Value0
R’ = after-tax holding period return n
After-tax returns are calculated monthly tax = transactioni × t i

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𝑅𝐺′ = [ 1 + 𝑅1′ 1 + 𝑅2′ … (1 + 𝑅𝑛′ )]1/𝑛 −1

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𝑅𝐺′ =cumulative after-tax return

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It assumes that when capital losses are realized, sufficient capital gains from other
investments exist so that the investor may deduct the losses in full.
If there are no gains, the deductibility of investment losses can result in an after-tax
return that is higher than the pre-tax return.
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2) After-tax post-liquidation return: Post-liquidation returns assume that
the portfolio is liquidated at the end of a hypothetical investment horizon
(usually 1, 3, 5, and 10 years) and the taxes are paid on those gains.
The post-liquidation measure allows an investor to consider the impact
of the embedded tax liabilities (i.e., the unrealized capital gains) on
ending wealth.
This is especially useful in the evaluation of commingled funds, such as
mutual funds.
liquidation tax 1/n
R PL = [ 1 + R′1 1 + R′2 … 1 + R′n − ] −1
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liquidation tax = (final value − tax basis) × capital gains tax rate
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3) After-tax excess returns: Similar to regular returns, after-tax returns can
be compared against a benchmark, helping an investor understand whether
the tax drag is eroding the return benefits of a strategy.
x = pre-tax excess return = R − B
x’ = after-tax excess return = R’ − B’
R and B = portfolio and benchmark pre-tax return, respectively
R’ and B’ = after-tax returns for the portfolio and benchmark,
respectively
The tax alpha isolates the benefit of tax management by subtracting
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αtax = tax alpha = x ′ − x

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4) Tax-efficiency ratio: This ratio is the after-tax annualized total return
divided by the pre-tax annualized total return.
𝑅′
𝑇𝐸𝑅 =
𝑅
Note that the tax-efficiency ratio is not as useful when returns are
negative.
For example, if a portfolio had a −10% pre-tax return and −12%
after-tax return, the ratio would be 120% (−0.12/−0.10).
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1.3 Tax-Aware Approaches to Planning
Examples of Tax-Aware Approaches to Planning
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2121(2)
1.4 Impact of taxes on capital accumulation
Value of a tax-exempt account
𝐹𝑉 = (1 + 𝑅)n
R = pre-tax annual return
Value of a taxable account

𝐹𝑉 = (1 + 𝑅′)n
𝑅′ = after-tax annual returns
Value of a tax-deferred account

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Pays tax only when assets are withdrawn from the account.
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Withdrawals are taxed at the applicable income tax rates.

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1.5 Asset Location
Asset location: the process for determining whether the assets will be held
in a taxable, tax-deferred, or tax-exempt account.
Rule of thumb:
Tax-efficient assets in the taxable account;
Tax-inefficient assets in the tax-exempt or tax-deferred account.
For example:
Taxable bonds should be held in a tax-exempt account and that
equities (given the preferential tax rate applied to capital gains) should
be held in the taxable account.
Investors with a long investment horizon or that have higher
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An asset location strategy cannot be rigidly employed.

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The client may have a different goal and time horizon for each account
type and may have multiple goals for the assets held within a single
account.
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1.6 Decumulation Strategies for a Retirement Account
Since retirement accounts are tax-exempt or tax-deferred, they compound
at a higher rate than taxable accounts.
A common rule of thumb suggests that it is better to make withdrawals
from the taxable account first and allow the retirement account to
continue to compound.
Under progressive tax regimes (jurisdictions where tax rates rise as the
level of income rises), a more tax-efficient strategy may be to withdraw
from the retirement account until the lowest tax brackets have been fully
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Any additional withdrawals would then be taken from the taxable

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1.7 Tax Management Strategies
The manager of a private wealth portfolio is tasked with the additional
complexity of minimizing the tax drag on returns.
selection of the investment vehicle (i.e., whether the assets are held in
a partnership, fund, or separate account),
tax lot accounting,
tax loss harvesting,
tax deferral,
quantitative tax management.
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1.7.1 Selection of the investment vehicle
Tax Characteristics of Investment Vehicles
1) Partnership: Tax liabilities are passed through to partners.
2) Mutual fund: Tax liabilities are influenced by co-investors.
When new shareholders buy into the fund, they are also buying a share
of the unrealized capital gains accrued in prior periods.
For example, a redemption by one shareholder can trigger a capital
gains tax liability for all shareholders.
Potential Capital Gain Exposure (PCGE) is an estimate of the
percentage of a fund’s assets that represents gains and measures how
much the fund’s assets have appreciated.
:
net gains (losses) gains − distributions − losses

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PCGE = =
total net assets starting assets + (gains − distributions − losses)
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3) Exchange-traded fund (ETF): Tax liabilities can be reduced or eliminated

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basket of stock；in-kind transactions

4) Separate account: Realized losses and gains can be aggregated across
all of the client’s accounts.
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1.7.2 Tax lot accounting
Tax lot accounting: Keeping track of how much you paid for an investment
and when you bought it—is crucial for understanding how much tax you
might owe.
The tax lot method is the rule for prioritizing the realization of losses and
gains.
FIFO: first in, first out (default, least tax efficient)
LIFO: last in, first out
HIFO: highest in, first out
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The specified-lot method (in which the portfolio manager identifies

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1.7.3 Tax Loss Harvesting
Tax Loss Harvesting: Sell securities that are below their acquisition price in
order to realize a loss that can be used to offset gains or other income.
To avoid the wash sale rule in the United States, you must hold cash or
some other security for 31 days. There are two issues:
Cash drag.
Selling the placeholder and switching back to the original security
after 31 days can create its own tax burden if a short-term capital
gain is realized when the placeholder is sold.
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strategy.
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1.8 Quantitative methods
A quantitative approach to tax management can be used to minimize tax-
drag and investment risk.
Tracking error can be used to measure risks.
Optimization algorithm
• minimizes tracking error risk Quantitative methods
• maximizes realized losses; • Transitions
• minimizes realized gains; • Tax-optimized loss harvesting
• minimizes trading costs; and • Gain-loss matching optimization
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2. Managing Concentrated Positions
Three major types of concentrated positions commonly encountered in
managing private client assets are:
1) publicly traded stocks
2) a privately-owned business
3) commercial or investment real estate
Concentrated position is used to describe a holding that due to its low tax
basis or personal association with the client inhibits the development of an
efficient, diversified portfolio.
Four risk and tax-related considerations relevant to concentrated single-asset
positions:
1) The company-specific risk inherent in the concentrated.
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3) The liquidity risk inherent in a privately-held or outsized publicly-held

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security.
4) The risk of incurring an outsized tax bill that diminishes return if one
were to sell part of the concentrated position in an attempt to reduce the
other risks.
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The key factors for a diversify strategy Mitigate the risks
• Degree of concentration • Sell and diversify
• Volatility and downside risk of the position • Staged diversification
• Tax basis • Hedging and monetization strategies
• Liquidity • Tax-free exchanges
• Tax rate of the investor • Charitable giving strategies
• Time horizon of the investor • Tax-avoidance and tax-deferral strategies
• Restrictions on the investor
• Emotional attachment and
other non-financial considerations
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2121(1)
For public equities For private equities
• Staged Diversification and Completion Portfolios • Initial public offering (IPO)
Sell and diversify • Sale to a third-party investor
Staged diversification • Sale to an insider
Completion portfolio • Divestiture of non-core assets
• Tax-Optimized Equity Strategies • Personal line of credit
Equity monetization Leveraged Recapitalization
Collar • Employee stock ownership plan
Covered call
• Tax-Free Exchanges
• Charitable Remainder Trust
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• Mortgage financing
• Charitable trust or donor-advised fund(DAF).
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2121(1)
3. Wealth Transfer planning
Estate planning terminology Objectives of Wealth Transfer planning

• Estate planning • Maintaining sufficient income and liquidity
• Will (testament) • Deciding on control over the assets
• Testator • Asset protection
• Probate • Transferring assets in a tax-aware manner
• Trust • Preservation of family wealth
• Lifetime gifts • Business succession
• Bequest • Achieving charitable goals
Forced heirship
Charitable gratuitous transfers
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2121(1)
3.1 Gift vs Bequest
1) Tax-free Gift
FV𝐺𝑖𝑓𝑡 [1 + 𝑟𝑔 (1 − 𝑡𝑔 )]𝑛
RV𝑇𝑎𝑥 𝐹𝑟𝑒𝑒 𝐺𝑖𝑓𝑡 = =
FV𝐵𝑒𝑞𝑢𝑒𝑠𝑡 1 + 𝑟𝑒 1 − 𝑡𝑒 𝑛 (1 − 𝑇𝑒 )
𝑟𝑔 : the expected pre-tax returns to the beneficiary
𝑡𝑔 : the effective tax rate on gift returns
𝑛: the expected time until the donor’s death
𝑟𝑒 : the expected pre-tax returns to the estate
𝑡𝑒 : the effective tax rate on estate returns
𝑇𝑒 : the estate tax rate
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If the pre-tax return and effective tax rates are equal for both the recipient
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and donor, the relative value of the tax-free gift:

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FV𝐺𝑖𝑓𝑡 1
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RV𝑇𝑎𝑥 𝐹𝑟𝑒𝑒 𝐺𝑖𝑓𝑡 = =

FV𝐵𝑒𝑞𝑢𝑒𝑠𝑡 (1 − 𝑇𝑒 )
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3.1 Gift vs Bequest
2) Taxable Gift (gift tax is paid by the recipient)
FV𝐺𝑖𝑓𝑡 [1 + 𝑟𝑔 (1 − 𝑡𝑔 )]𝑛 (1 − 𝑇𝑔 )
RV𝑇𝑎𝑥𝑎𝑏𝑙𝑒 𝐺𝑖𝑓𝑡 = =
FV𝐵𝑒𝑞𝑢𝑒𝑠𝑡 1 + 𝑟𝑒 1 − 𝑡𝑒 𝑛 (1 − 𝑇𝑒 )
𝑇𝑔 : the gift tax rate
If the pre-tax return and effective tax rates are equal for both the recipient
and donor, the relative value of the taxable gift:
FV𝐺𝑖𝑓𝑡 (1 − 𝑇𝑔 )
RV𝑇𝑎𝑥𝑎𝑏𝑙𝑒 𝐺𝑖𝑓𝑡 = =
FV𝐵𝑒𝑞𝑢𝑒𝑠𝑡 (1 − 𝑇𝑒 )
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3.2 Estate Planning Tools
Control
Asset protection
Tax-related considerations
Estate Planning Tools

• Trust
Revocable trust vs. Irrevocable trust
Fixed trust vs. Discretionary trust
• Foundations
• Life insurance
• Companies
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allows the donor to retain control

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current income tax deduction

favorable tax treatment of investment returns
protection of assets from estate tax
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Reading
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Risk Management for Individuals
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2011 AM Q5C
Human capital, asset allocation, and insurance

Human capital = sum of the present value of earned Assumptions regarding
income. (i.e., income generated by the individual’s labor)
Passive income generated by investments is considered the number, size and
financial income. uncertainties of future
Social security and employer-related pension payments cash flows could be
are considered human capital. Thus, an individual’s wrong.
human capital may maintain a positive value at
retirement. Assumptions regarding
In addition to an amount of human capital at time t, the human capital and
each individual has an amount of financial capital,
defined as the total value of financial assets owned. financial capital curve
could be wrong.
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Earnings risk
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Mortality risk
Longevity risk
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2121(1) 2012(1) 2105(1)
Human capital
we can estimate human capital by discounting the expected future cash
flows generated from wages or other income sources.
𝑁 𝑤𝑡
HC0 = 𝑡=1 (1+𝑟)𝑡
Where,
HC0 , estimate the value of an individual’s human capital today, at Time 0;
𝑤𝑡 , the income from employment in year t;
r, the appropriate discount rate;
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Human capital 2105(1)
The income from different professions can vary significantly. The risk
adjustment should consider the inherent stability of the income stream as
well as the possibility that the income stream will be interrupted by job loss,
disability, or death that may be completely unrelated to the type of
employment. Additionally, we incorporate mortality.
𝑁
𝑝(𝑆𝑡 )𝑤𝑡−1 (1 + 𝑔𝑡 )
HC0 =
(1 + 𝑟𝑓 + 𝑦)𝑡
𝑡=1
Where,
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𝑤𝑡−1 (1 + 𝑔𝑡 ), where we define the wage in time period t as a product of the

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wage in period t – 1 and the sum (1 + 𝑔𝑡 );

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1 + 𝑟𝑓 + 𝑦, modify the discount rate to be the sum of the nominal risk-free

rate 𝑟𝑓 and a risk adjustment 𝑦 based on occupational income volatility;
𝑝(𝑆𝑡 ), where 𝑝(𝑆𝑡 ) is the probability of surviving to a given year (or age).
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Earnings risk, Mortality risk, Longevity risk
Earnings risk
Risk of getting unemployed, disabled, or unable to work
Increase savings rate
Minimize correlation between human and financial capital — e.g. not concentrate
investments in employer’s stock.
Offset risk of human capital with financial capital — the more exposed to earnings
risk, the less aggressive financial portfolio.
Mortality risk
Risk of sudden, unexpected loss of human capital caused by premature death.
The most commonly used hedge is life insurance which has a perfect negative
correlation with human capital.
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Longevity risk
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Inability of your assets to meet your retirement living expenses because you live longer
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than expected of your financial capital has experienced an unexpected, severe drop in
value.
The most common remedy is life-time payout annuity.
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Asset allocation policy & Life insurance payout
Human capital could be equity-like (e.g. a financial industry employee) or
fixed income-like (e.g. a tenured university professor)
When preparing IPS, the human capital should also be taken into
consideration
--e.g. for a tenured professor (with bond-like human capital ), besides
his pure risk tolerance, he is actually more equipped to invest in equities.
The relative amount of financial and human capital could have a significant
impact on the asset allocation.
Financial wealth and demand for life insurance (negative)

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Note: lower volatility (bond-like) →aggressive financial investment →life

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insurance demand increase

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Risk aversion and demand for life insurance (positive)

Probability of death and demand for life insurance (positive)
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Annuities as hedge against longevity
The fixed annuity pays a set nominal amount each period for the life of the investor.
In contrast, variable annuities are indexed to some underlying investment.
Both provide a lifetime cash flow.
Fixed annuities. Although fixed annuities provide a predictable, stable lifetime cash flow, they
have several drawbacks:
Since the cash flows are stated in constant nominal terms, the real values of the cash
flows fall over time.
The fixed cash flows are based on a current interest rate. If interest rates are historically
low when the annuity is purchased, the investor is locked into a low lifetime return.
The annuity is typically illiquid. The investor usually cannot get out of the contract.
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Variable annuities.
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Cash flows received on a variable pay annuity are based on the performance of an
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individual bond or stock fund or a mix of bond and stock funds selected by the investor.
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Since the payout is based on investment performance, the investor naturally receives
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variable cash flows.

In some periods the funds perform well and provide high returns, easily meeting the
individual’s inflation-adjusted spending needs. In other periods, however, the payments
might fail to meet the investor’s needs or may even be zero if the funds lose money.
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2012(1) 2105(2) 2108(1)
Individual Risk Exposures
Human capital and Financial capital (current assets, personal assets and
investment assets)
Net worth consists of the difference between traditional assets and
liabilities. Net wealth extends net worth to include claims to future assets
that can be used for consumption, such as human capital and the present
value of pension benefits.
Evaluate risks and select appropriate methods to manage the risks.
Risk avoidance, Risk reduction, Risk transfer (insurance), Risk retention
(self-insurance)
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The Financial Stages of Life for an Individual: Education phase, Early

career, Career development, Peak accumulation, Pre-retirement, Early
retirement, Late retirement.
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Individual Risk Exposures
Risk Exposures: Types of Life Insurance
Earnings risk (insure with Temporary life insurance
disability insurance) provides insurance for a
premature death risk (insure with certain period of time
life insurance) specified at purchase (term
Longevity risk (insure with life insurance).
annuities) Permanent life insurance
Property risk (insure with provides lifetime coverage,
property insurance) assuming the premiums are
Liability risk (insure with liability paid over the entire period.
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Whole life insurance
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remains in force for an

insurance)
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insured’s entire life .

Disability income insurance is
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Universal life insurance

designed to mitigate earnings
is constructed to provide
risk
more flexibility than
whole life insurance.
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Life Insurance 2012(1)
Three key considerations in the Build-up of cash value in a whole

pricing of life insurance: life insurance policy
Mortality Expectations： Policy
The net premium of a life face
insurance policy represents the value
discounted value of the future
death benefit.
CASH VALUE
A probability of 0.15% of Insurance value
dying within the year, death
benefit $100,000, discount
rate 5.5%. Net premium =
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(0.15%×$100,000 + 99.85%
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× $0)/1.055= $142.18 Cash value

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The gross premium adds a

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load to the net premium, Age at AGE Age at

allowing for expenses and a Issue Endowment
projected profit for the
insurance company.
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2105(1) 2108(1)
Life Insurance Costs
Net premium cost index (per $1000 of face value, per year)
FV of premium
premium …… premium
-FV of dividend
t=N = FV of net payment
t=0
dividend …… dividend CPT PMT
PMT
Net premium cost index =
coverage/1000
Surrender cost index (per $1000 of face value, per year)
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-cash value
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t=N = FV of net payment

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t=0
dividend …… dividend CPT PMT
PMT
Surrender cost index =
coverage/1000
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2105(1) 2108(1)
Annuities
Deferred Variable Annuities Relative advantages and disadvantages of
Deferred Fixed Annuities fixed and variable annuities
Immediate Variable Volatility of Benefit Amount
Annuities Flexibility
Immediate Fixed Annuities Future Market Expectations
Advanced Life Deferred Inflation Concerns
Annuities Payout Methods
Annuity Benefit Taxation
Appropriateness of Annuities
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Fees
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Implementation of Risk Management
For Individual
The effect of human capital on asset allocation policy:
For equity-like human capitals : less aggressive portfolio.
For bond-like human capitals : more aggressive portfolio.
For younger : more equities.
For older : more bonds.
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It’s not the end but just beginning.
Your life can be enhanced, and your happiness enriched, when you choose
to change your perspective. Don't leave your future to chance, or wait for things
to get better mysteriously on their own. You must go in the direction of your
hopes and aspirations. Begin to build your confidence, and work through
problems rather than avoid them. Remember that power is not necessarily
control over situations, but the ability to deal with whatever comes your way.
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Trading,
Performance
Evaluation, and
Manager
Selection
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Session Content

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SS13: Trading, Performance
Framework Evaluation, and Manager Selection
Trading, Performance • R25 Trade Strategy and Execution
Evaluation, and • R26 Portfolio Performance

Evaluation
Manager Selection
• R27 Investment Manager
Selection
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Reading
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Trade Strategy and Execution

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4-99
1. Motivations to Trade
Framework 2. Trading Strategies and Strategy Selection

• Trade Strategy Inputs
• Reference Prices
• Trade Strategies
3. Trade Execution (Strategy Implementation)
• Trade Implementation Choices
• Algorithmic Trading
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• Comparison of Markets
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4. Implementation Shortfall
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5. Evaluating Trade Execution

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6. Trade Governance
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Motivations to Trade 2111(1)
Portfolio managers need to trade their portfolio holdings to ensure

alignment with the fund’s underlying investment strategy and objectives.
Profit seeking
Trade urgency
Alpha decay
Risk management/hedging needs
Remain at targeted risk levels or risk exposures (risk management)
Hedge risks when they do NOT have an investment view
Cash flow needs
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High or low trade urgency

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To minimize cash drag on a portfolio

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Corporate actions/index reconstitutions/margin calls

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Corporate actions and operational needs

For index tracking portfolios
Margin or collateral calls
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Trading Strategies and Strategy Selection
Trade Strategy Inputs
Order Characteristics
Security Characteristics
Market Conditions
User-Based Considerations: Trading Cost Risk Aversion
Market Impact and Execution Risk
Reference Prices
Pre-Trade Benchmarks
Intraday Benchmarks
Post-Trade Benchmarks
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Price Target Benchmarks

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Trade Strategies
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Short-Term Alpha Trade

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Long-Term Alpha Trade

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Risk Rebalance Trade

Client Redemption Trade
New Mandate Trade
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Side
Order Characteristics Size
Relative size (% of ADV)
Execution risk is the risk of
an adverse price movement
Security type occurring over the trading
Short-term alpha horizon owing to a change
Security Characteristics
Price volatility in the fundamental value of
Security liquidity the security or because of
trading-induced volatility. ★
Liquidity crises
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Market Conditions
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Market volatility and liquidity are dynamic

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Market risk
User-Based Considerations: Trading Cost Risk Aversion
Urgency
8-99
Market impact is the adverse price impact in a security
caused from trading an order and can represent one of
the largest costs in trading.
Market Impact and
Execution Risk
Execution risk is the adverse price impact resulting
from a change in the fundamental value of the security
and is often proxied by price volatility.
Trader’s dilemma. Trading too fast results in too much market impact, but
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The goal in selecting a trading strategy is to choose the best price–time

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trade-off given current market conditions and the unique characteristics of

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the order.
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Reference Prices 2012(1) 2108(1)
Reference prices, also referred to as price benchmarks, are used in

determining trade prices for execution strategy and in calculating actual
trade costs for post-trade evaluation purposes.
Categories of reference prices
Pre-trade benchmarks
Intraday benchmarks
Post-trade benchmarks
Price target benchmarks
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2105(1)
Reference Prices
Decision price
Quantitative portfolio managers
Previous close
Fundamental portfolio managers
Pre-trade benchmarks No overnight risk★
Opening price
Not suitable for transactions during
opening auction
Arrival price Goal: transact at or close to current
market prices
Greater trade urgency
Managers without
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price movements
VWAP Rebalancing their portfolios over the
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Intraday Benchmarks day and have both buy and sell orders
Exclude potential trade outliers ★

TWAP
The order may not be fully filled
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Reference Prices
Advantage: minimizes potential tracking error. ★
Post-trade Benchmarks
(Closing price)
Disadvantage: not known until after trading is
completed. ★
Seeking short-term alpha

Price target Benchmarks
More favorable price.
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Trade Strategies
The primary goal of a trading strategy is to balance the expected costs,
risks, and alpha associated with trading the order in a manner consistent
with the portfolio manager’s trading objectives, risk aversion, and other
known constraints. Trading strategies involving equities, fixed income,
currency, and derivatives are explained as follows:
Short-term alpha: short-term alpha-driven equity trade (high trade
urgency).
Long-term alpha: long-term alpha-driven fixed-income trade (low
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Cash flow driven: client redemption trade to raise proceeds.

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Cash flow driven: cash equitization (derivatives) trade to invest a new

client mandate.
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2108 (1)
Trade Execution (Strategy Implementation)

Trade Implementation Choices
Algorithmic Trading
Execution Algorithm Classifications
Scheduled (POV, VWAP, TWAP)
Liquidity seeking
Arrival price
Dark strategies/liquidity aggregators
Smart order routers
Comparison of Markets
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Equities
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Fixed Income
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Exchange-Traded Derivatives
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Over-the-Counter Derivatives
Spot Foreign Exchange (Currency)
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Trade Execution (Strategy Implementation)
Higher-touch Principal trades → quoted spread

Approaches
Agency trades → as an agent only
Trade Trading in large blocks of securities

Implementation requires a higher-touch approach★
Choices
Alternative trading systems (ATS),
multilateral trading facilities (MTF)
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Direct market access (DMA)

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strategies
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Dark pools
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2111(1) 2012(1) 2105(1)
Execution Algorithm Classifications★
Advantage Automatically take advantage of
increased liquidity conditions
POV May incur higher trading costs
Disadvantage
May not complete the order within
the time period specified
Scheduled
Time slicing schedule
VWAP U-shaped curve may not complete the
algorithms may not be optimal order in cases where
for illiquid stocks volumes are low
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TWAP Time slicing schedule

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algorithms Equal-weighted time schedule

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VWAP Advantage: ensures the specified number of shares are executed

& within the specified time period
TWAP Disadvantage: will not take advantage of increased liquidity
conditions
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Take advantage of market Liquidity sweeping
liquidity across multiple venues by Sweeping the book
Liquidity-seeking
trading faster when liquidity exists Dark pools
algorithms
at a favorable price
(opportunistic
algorithms) Appropriate for large orders → execute quickly without
having a substantial impact ★
Seek to trade close to current market prices

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Arrival price Front-loaded strategy★

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Suitable for traders who believe prices are likely to move

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unfavorably during the trade horizon
unfavorably movement → urgency trading → front-loaded strategy
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Less transparent
Dark strategies
liquidity aggregators
For traders concerned about information leakage
1) Order size is large relative to the market
appropriate for 2) Relatively illiquid or wide bid–ask spreads
3) Does not need to execute the order in its entirety
Highest probability of executing the limit order and

the venue with the best market price
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Smart order routers

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Continuously monitor market conditions in real time

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Market orders
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appropriate for
Limit orders
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Comparison of Markets
Large trades → high-touch agency approach
Equities
Small trades → electronic trading algorithms
Urgent trades → principal trades
Fixed Income
Non-urgent trades → agency trades
Large, urgent → sweep the book

Exchange-Traded Derivatives Large, non-urgent → electronic trading algorithms
Small trades → direct market access (DMA)
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Large, urgent → broker risk trades (principal trades)

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Large, non-urgent → high-touch agency trade

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Large, urgent → RFQs

Spot Foreign Exchange(Currency) Large, non-urgent → high-touch agency trade
Small trades → direct market access (DMA)
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Summary
Trade implement choice
High-touch
Principal: Large, urgent
Agency: Large, non-urgent
Automated Execution
ATS/MTF: Non-exchange
DMA: Buy-side, small trade, exchange-traded derivatives, non-
urgent(原版书）, Urgent
Dark pool: large relative, illiquidity, do not need to execute all
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orders, non-urgent, information leakage

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Scheduled(POV, VWAP, TWAP): not concerned about adverse price

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movement, non-urgent, greater risk-tolerance, relatively small,

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relatively liquidity
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Summary
Automated Execution
Liquidity seeking: execute quickly without substantial impact
Arrival price: more aggressively trading, 担心adverse movement,
urgent, high-level of risk averse, relatively liquidity, relatively small or
medium
SORs: 同时监控lit & dark, sufficiently small;
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Trade Evaluation
Trade Cost Measurement
Implementation Shortfall
Expanded Implementation Shortfall
Evaluating Trade Execution
Arrival price
VWAP
TWAP
Market on Close
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Market-adjusted Cost
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Added Value
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The implementation shortfall measure is the standard for measuring the
total cost of the trade. IS compares a portfolio’s actual return with its
paper return (where transactions are based on decision price).
The paper return shows the hypothetical return that the fund would
have received if the manager were able to transact all shares at the
desired decision price and without any associated costs or fees (with
no friction).
IS = Paper return – Actual return
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Expanded Implementation Shortfall

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Expanded IS = Delay cost + Trading cost + Opportunity cost + Fees
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Paper return = 𝑷𝒏 − 𝑷𝒅 𝑺 = 𝑺 𝑷𝒏 − 𝑺 𝑷𝒅
S represents the total order shares
S > 0 indicates a buy order
S < 0 indicates a sell order
𝑃𝑑 represents the price at the time of the investment decision
𝑃𝑛 represents the current price
Actual return = ( s𝒋 )( 𝑷𝒏 ) − s𝒋 p𝒋 − 𝑭𝒆𝒆𝒔
s𝑗 and p𝑗 represent the number of shares executed and the transaction
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price of the jth trade

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s𝑗 represents the total number of shares of the order that were

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executed in the market

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“Fees” includes all costs paid by the fund to complete the order
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2111(1) 2012(1) 2105(1)
IS = s𝑗 p𝒋 − 𝑠𝑗 𝑃𝒅 + 𝑺 − 𝑠𝑗 𝑷𝒏 − 𝑷𝒅 + 𝑭𝒆𝒆𝒔
Execution cost Opportunity cost
Expanded IS =
( 𝑠𝑗 )𝑃𝟎 − ( 𝑠𝑗 ) 𝑃𝒅 + 𝑠𝑗 𝑝𝒋 − 𝑠𝑗 𝑃𝟎 + 𝑺 − 𝑠𝑗 𝑷𝒏 − 𝑷𝒅 + 𝑭𝒆𝒆𝒔
Delay cost Trading cost Opportunity cost

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Execution cost
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𝑃0 represents the arrival price

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Example
On Monday, the shares of Impulse Robotics close at £10.00 per share.
On Tuesday, before trading begins, a portfolio manager decides to buy
Impulse Robotics. An order goes to the trading desk to buy 1,000 shares of
Impulse Robotics at £9.98 per share or better, good for one day. The
benchmark price is Monday’s close at £10.00 per share. No part of the
limit order is filled on Tuesday, and the order expires. The closing price on
Tuesday rises to £10.05.
Additional: The buy-side trading desk releases the order to the market
30 minutes after receiving it, when the price is £10.03.
On Wednesday, the trading desk again tries to buy Impulse Robotics by
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entering a new limit order to buy 1,000 shares at £10.07 per share or better,
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good for one day. During the day, 700 shares are bought at £10.07 per
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share. Commissions and fees for this trade are £14. Shares for Impulse
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Robotics close at £10.08 per share on Wednesday.

No further attempt to buy Impulse Robotics is made, and the remaining
300 shares of the 1,000 shares the portfolio manager initially specified are
canceled.
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Example
Solution:
We can break this IS down further, as follows:
Delay cost Trading cost Fixed costs

#700@10.07
Monday Tuesday Wednesday

£10.00 £10.03 £10.05 £10.08
Paper portfolio
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#1000@$10.00 Opportunity cost

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Delay cost, which reflects the adverse price movement associated

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with not submitting the order to the market in a timely manner and
is based on the amount of shares executed in the order: (700
£10.03) – (700 £10.00) = £7,021 – £7,000 = £21.
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Example
Trading cost, which reflects the execution price paid on shares
executed: (700 £10.07) – (700 £10.03) = £7,049 – £7,021 =
£28.
Opportunity cost, which is based on the amount of shares left
unexecuted and reflects the cost associated with not being able to
execute all shares at the decision price: (1,000 shares – 700 shares)
(£10.08 – £10.00) = £24.
Fixed fees, which are equal to total explicit fees paid: £14.
Therefore, expanded implementation shortfall (£) = £21 + £28 +
£24 + £14 = £87.
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The expanded IS provides further insight into the causes of trade

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costs. The delay cost is £21, which accounts for 24.1% (£21/£87) of
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the total IS cost, whereas the opportunity cost of £24 accounts for
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27.6% (£24/£87) of the total IS cost. Quite often, delay cost and
opportunity cost account for the greatest quantity of cost during
implementation. These costs can often be eliminated with proper
transaction cost management 28-99
techniques.
Improving Execution Performance
Delay costs can be reduced by having a process in place that provides
traders with broker performance metrics.
In theory, the delay cost component should have an expected value
of zero.
Portfolio managers can use IS to help determine appropriate order
size for the market within the portfolio manager’s price range and to
minimize the opportunity cost of the order.
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Opportunity cost is not mean zero and often represents a cost to

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the fund. This is due to two reasons:

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adverse price movement

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illiquidity
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Trade evaluation measures the execution quality of the trade and the
performance of the trader, broker, and/or algorithm used.
Various techniques measure trade cost execution using different
benchmarks (pre-trade, intraday, and post-trade).
Trade cost analysis enables investors to better manage trading costs and
understand where trading activities can be improved through the use of
appropriate trading partners and venues.
Trade cost calculations are expressed such that a positive value indicates
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underperformance and represents underperformance compared with the

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benchmark. A negative value indicates a savings and is a better

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performance compared with the benchmark.

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Cost in total dollars ($)
𝐶𝑜𝑠𝑡 $ = 𝑆𝑖𝑑𝑒 × (𝑃 − 𝑃∗ ) × 𝑆ℎ𝑎𝑟𝑒𝑠
Cost in dollars per share ($/share)
𝐶𝑜𝑠𝑡 $/𝑠ℎ𝑎𝑟𝑒 = 𝑆𝑖𝑑𝑒 × (𝑃 − 𝑃∗ )
Cost in basis points (bps)
(𝑃 − 𝑃∗ )
𝐶𝑜𝑠𝑡 𝑏𝑝𝑠 = 𝑆𝑖𝑑𝑒 × × 10,000 𝑏𝑝𝑠
𝑃∗
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Side: +1 Buy order ; -1 Sell order

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𝑃 = Average execution price of order

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𝑃∗ = Reference price
Shares = Shares executed
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Arrival Price
The arrival price benchmark measures the difference between the
market price (P0) at the time the order was released to the market and
the actual transaction price for the fund.
This benchmark is used to measure the trade cost of the order
incurred while the order was being executed in the market.
(𝑃 − 𝑃0 )
Arrival cost (bps) =𝑆𝑖𝑑𝑒 × × 104 𝑏𝑝𝑠
𝑃0
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VWAP
Portfolio managers use the VWAP benchmark as a measure of whether
they received fair and reasonable prices over the trading period.
Since the VWAP comprises all market activity over the day, all buying
and selling pressure of all other market participants, and market noise, it
provides managers with a reasonable indication of the fair cost for
market participants over the day.
(𝑃 − 𝑉𝑊𝐴𝑃)
VWAP cost (bps) =𝑆𝑖𝑑𝑒 ×
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× 104 𝑏𝑝𝑠
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𝑉𝑊𝐴𝑃
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TWAP
The TWAP benchmark is an alternative measure to determine whether
the fund achieved fair and reasonable prices over the trading period
and is used when managers wish to exclude potential trade price
outliers.
(𝑃 − 𝑇𝑊𝐴𝑃)
TWAP cost (bps) =𝑆𝑖𝑑𝑒 × × 104 𝑏𝑝𝑠
𝑇𝑊𝐴𝑃
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Market on Close
The closing benchmark, also referred to as an MOC benchmark, is used
primarily by index managers and mutual funds that wish to achieve
the closing price on the day and compare their actual transaction prices
with the closing price.
Doing so ensures that the benchmark cost measure will be
consistent with the valuation of the fund.
The closing price benchmark is also the benchmark that is
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consistent with the tracking error calculation.

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(𝑃 − 𝐶𝑙𝑜𝑠𝑒)
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Close (bps) =𝑆𝑖𝑑𝑒 × × 104 𝑏𝑝𝑠

𝐶𝑙𝑜𝑠𝑒
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Market-Adjusted Cost
The market-adjusted cost is a performance metric used by managers
and traders to help separate the trading cost due to trading the order
from the general market movement in the security price.
The market-adjusted cost is calculated by subtracting the market cost
due to market movement adjusted for order side from the total arrival
cost of the trade.
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Market-adjusted cost (bps)=Arrival cost (bps) – β × Index cost (bps)

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Where,
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β represents the stock’s beta to the underlying index

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(𝐼𝑛𝑑𝑒𝑥 𝑉𝑊𝐴𝑃 − 𝐼𝑛𝑑𝑒𝑥 𝑎𝑟𝑟𝑖𝑣𝑎𝑙 𝑝𝑟𝑖𝑐𝑒)

Index cost (bps) =𝑆𝑖𝑑𝑒 × × 104 𝑏𝑝𝑠
𝐼𝑛𝑑𝑒𝑥 𝑎𝑟𝑟𝑖𝑣𝑎𝑙 𝑝𝑟𝑖𝑐𝑒
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2105(1) 2108(1)
Market-Adjusted Cost

𝑆𝑖𝑑𝑒 × × 104 𝑏𝑝𝑠
𝑃 − 𝑃0 )
𝑆𝑖𝑑𝑒 × × 104 𝑏𝑝𝑠
𝑃0
𝑃0 : Market price
Market-adjusted cost (bps)=Arrival cost (bps) – β × Index cost (bps)
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β represents the stock’s beta to the underlying index

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Example
A portfolio manager executes a sell order at an average price of $29.50.
The arrival price at the time the order was entered into the market was
$30.00. The selected index price at the time of order entry was $500,
and market index VWAP over the trade horizon was $495. The stock has
a beta to the index of 1.25.
1. Calculate arrival cost.
2. Calculate index cost.
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3. Calculate market-adjusted cost.

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Example
Solutions:
1. Calculate arrival cost.
(𝑃 − 𝑃0 )
Cost bps = Side × × 10,000 bps
𝑃0
$29.5 − $30.00
= −1 × × 10,000 bps
$30.00
= 166.7 bps
In this example, the arrival cost is calculated to be +166.7 bps,
indicating that the order underperformed the arrival price.
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Although this is true, much of the adverse prices were likely due to
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market movement rather than inferior performance from the

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broker or algorithm.
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This sell order was executed in a falling market, which resulted in

an arrival cost of 166.7 bps for the investor.
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Example
Solution:
2. Calculate index cost.
Cost bps = Side × × 10,000 bps
$495 − $500
= −1 × × 10,000 bps
$500
= 100 bps
3. Calculate market-adjusted cost.
Market-adjusted cost (bps) = Arrival cost (bps) – β Index cost (bps)
= 166.7 bps – 1.25 100 bps
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= 166.7 bps – 125 bps

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= 41.7 bps
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However, an estimated 125 bps of this cost was due to market

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movement, which would have occurred even if the order had not traded
in the market.
Thus, the market-adjusted cost for this order is 41.7 bps.
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Added Value
Another methodology used by investors to evaluate trading
performance is to compare the arrival cost of the order with the
estimated pre-trade cost.
This metric helps fund managers understand the value added by their
broker and/or execution algorithms during the execution of the order.
Added value (bps) = Arrival cost (bps) – Est. pre-trade cost (bps)
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Example
Consider the following facts. A portfolio manager executes a buy order
at an average price of 𝑃 = $50.35. The arrival price at the time the
order was entered into the market was P0 = $50.00. Prior to trading, the
buy-side trader performs pre-trade analysis of the order and finds that
the expected cost of the trade is 60 bps, based on information available
prior to trading. The pre-trade adjustment is calculated as follows:
Solutions
(𝑃−𝑃0 )
Arrival cost (bps) =𝑆𝑖𝑑𝑒 ×
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× 104 𝑏𝑝𝑠
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𝑃0
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(50.35−50)
=+1× × 104 𝑏𝑝𝑠=70bps
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Added value = Arrival cost - Est. pre-trade cost
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=70-60=10bps
The pre-trade adjusted cost in this example is 10 bps, indicating
that the fund underperformed pre-trade expectations by 10 bps.
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Trade Governance
Major regulators mandate that asset managers have in place a trade policy
document that clearly and comprehensively articulates a firm’s trading
policies and escalation procedures.
The objective of a trade policy is to ensure the asset manager’s execution
and order-handling procedures are in line with their fiduciary duty owed
to clients for best execution.
A trade policy document needs to incorporate the following key aspects:
Meaning of best execution;
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Factors determining the optimal order execution approach;

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Handling trading errors;

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Listing of eligible brokers and execution venues;

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A process to monitor execution arrangements.
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Trade Governance
Meaning of Best Order Execution within the Relevant Regulatory
Framework
execution price
trading costs
speed of execution
likelihood of execution and settlement
order size
nature of the trade
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Rather than simply trying to obtain the best price at the lowest possible
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trading cost, best execution involves identifying the most appropriate

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trade-off between these aspects.

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Trade Governance
Factors Used to Determine the Optimal Order Execution Approach
Urgency of an order
Characteristics of the securities traded
Characteristics of the execution venues used
Investment strategy objectives
Rationale for a trade
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Trade Governance
List of Eligible Brokers and Execution Venues
Quality of service
Financial stability
Reputation
Settlement capabilities
Speed of execution
Cost competitiveness
Willingness to commit capital
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Trade Governance
Process Used to Monitor Execution Arrangements
Checkpoints for trade execution monitoring include the following:
Trade submission
What was the execution quality of a trade relative to its benchmark?
Is there an appropriate balance between trading costs and opportunity
costs?
Could better execution have been achieved using a different trading
strategy, different intermediaries, or different trading venues?
Trading records and the evaluation of those records
Address client concerns
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Address regulator concerns

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Monitor the parties involved in trading/order execution

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These policies and procedures should be outlined in a comprehensive

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document and reviewed regularly (for example, quarterly) and when the
need arises.
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Reading
26
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Portfolio Performance Evaluation

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1. The Components of Performance Evaluation
Framework 2. Performance Attribution

• Approaches to Return Attribution
• Risk Attribution
• Return Attribution Analysis at Multiple
Levels
3. Benchmarking Investments and Managers
4. Performance Appraisal
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The Components of Performance Evaluation
Performance evaluation includes three primary components, each
corresponding to a specific question we need to answer to evaluate a
portfolio’s performance:
Performance measurement provides an overall indication of the
portfolio’s performance, typically relative to a benchmark.
what was the portfolio’s performance?
Performance attribution builds on performance measurement to
explain how the performance was achieved.
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how was the performance achieved?

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Performance appraisal leverages both returns and attribution to infer

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the quality of the investment process.

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was the performance achieved through manager skill or luck?
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Performance Attribution
Easiest method
Not use the underlying holdings → least accurate
Returns-based
Most vulnerable to data manipulation ★
Suitable for the portfolios that are difficult to obtain the
underlying holdings
Fails to capture the impact of any transactions ★

The shorter time intervals, the more accuracy
Holdings-based
Residual → timing or trading effect
Suitable for investment strategies with little turnover★
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Uses both holdings and transactions★

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Weights and returns reflect all transactions

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Transactions-based Most accurate, most difficult and time-consuming

The underlying data must be complete, accurate, and
reconciled from period to period
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Approaches to Return Attribution
Return attribution is a set of techniques used to identify the sources of
excess return of a portfolio against its benchmark, quantifying the
consequences of active investment decisions.
Arithmetic attribution approaches
Arithmetic difference = R – B.
R=portfolio return
B=benchmark return
Arithmetic approaches are straightforward for a single period.
However, when combining multiple periods, the sub-period
attribution effects will not sum to the excess return.
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Geometric attribution approaches extend the arithmetic approaches

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by attributing the geometric excess return (G), as defined below:

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1+𝑅 𝑅−𝐵
𝐺= −1=
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1+𝐵 1+𝐵
In a geometric attribution approach, the attribution effects will
compound (multiply) together to total the geometric excess return.
Works across multiple periods.
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Return Attribution
Equity
The Brinson Model
Brinson–Hood–Beebower (BHB) Model
Brinson–Fachler (BF) Model
The BF model is more widely used in performance attribution
today.
Factor-Based Return Attribution (Carhart four-factor model)
Fixed Income
Exposure decomposition—duration based
:
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Yield curve decomposition—duration based

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Yield curve decomposition—full repricing based

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Equity Return Attribution
Brinson–Hood–Beebower (BHB) Model
𝑹𝒊
Selection Effect Interaction Effect
𝑆𝑖 = 𝑊𝑖 𝑅𝑖 − 𝐵𝑖 𝐼𝑖 = (𝑤𝑖 − 𝑊𝑖 )(𝑅𝑖 − 𝐵𝑖 )
𝑩𝒊
Allocation Effect
𝐴𝑖 = 𝑤𝑖 − 𝑊𝑖 𝐵𝑖
:
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𝟎
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𝟎 𝑾𝒊 𝒘𝒊
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Brinson–Fachler (BF) Model
𝑹𝒊
Selection Effect Interaction Effect
𝑆𝑖 = 𝑊𝑖 𝑅𝑖 − 𝐵𝑖 𝐼𝑖 = (𝑤𝑖 − 𝑊𝑖 )(𝑅𝑖 − 𝐵𝑖 )
𝑩𝒊
Allocation Effect
𝐴𝑖 = 𝑤𝑖 − 𝑊𝑖 (𝐵𝑖 −𝐵)
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𝑩
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Factor-Based Return Attribution (Carhart four-factor model)
𝑅𝑝 − 𝑅𝑓 = 𝑎𝑝 + 𝑏𝑝1 RMRF + 𝑏𝑝2 SMB + 𝑏𝑝3 HML + 𝑏𝑝4 WML + 𝐸𝑝
where
𝑅𝑝 = the return on the portfolio
𝑅𝑓 = risk-free rate of return
𝑎𝑝 = “alpha” or return in excess of that expected given the
portfolio’s level of systematic risk (assuming the four factors capture
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𝑏𝑝 = the sensitivity of the portfolio to the given factor

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Carhart four-factor model
RMRF = the return on a value-weighted equity index in excess of
the one-month T-bill rate
SMB = small minus big, a size (market-capitalization) factor (SMB
is the average return on three small-cap portfolios minus the
average return on three large-cap portfolios)
HML = high minus low, a value factor (HML is the average return
on two high-book-to-market portfolios minus the average return on
two low-book-to-market portfolios)
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WML = winners minus losers, a momentum factor (WML is the

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return on a portfolio of the past year’s winners minus the return on

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a portfolio of the past year’s losers)

𝑬𝒑 = an error term that represents the portion of the return to the
portfolio, p, not explained by the model
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2108 (1)
Fixed-Income Return Attribution

Fixed-income portfolios are driven by very different sources of risk,
requiring attribution approaches that attribute returns to decisions made
with respect to credit risk and positioning along the yield curve.
All three approaches can be applied to single-currency and multi-currency
portfolios.
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Exposure decomposition is a top-down attribution approach,
including portfolio duration bets, yield curve positioning or sector
bets, each relative to the benchmark.
Exposure decomposition relates to the decomposition of portfolio
risk exposures by means of grouping a portfolio’s component bonds
by specified characteristics.
Duration based relates to the typical use of duration to represent
interest rate exposure decisions.
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Exposure decomposition using duration segments portfolios by their

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market value weight and assigns securities to duration buckets (i.e.,

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exposure to different ranges of duration) based on the security’s

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maturity. (similar to Brinson model)

The exposure decomposition approach is used primarily for marketing
and client reports.
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The duration-based yield curve decomposition approach to fixed-
income attribution can be either executed as a top-down approach or
built bottom-up from the security level.
This approach is applied to both the portfolio and the benchmark to
identify contributions to total return from changes in the yield to
maturity (YTM).
% Total return = % Income return + % Price return
where % Price return ≈ – Duration × Change in YTM
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Yield curve decomposition approach require more data points to

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calculate the separate absolute attribution analyses for the portfolio and
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the benchmark.
Yield curve decomposition approach is typically used when preparing
reports for analysts and portfolio managers.
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Instead of estimating price changes from changes in duration and yields
to maturity, bonds can be repriced from zero-coupon curves (spot rates).
This bottom-up security-level repricing can then be translated into a
contribution to a security’s return and aggregated for portfolios,
benchmarks, and active management.
This full repricing attribution approach provides more precise pricing
and allows for a broader range of instrument types and yield changes.
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This approach is complex nature can make it more difficult and costly
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(more data-intensive) to administer operationally and can make the

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results more difficult to understand.

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The full repricing approach is used primarily for fixed-income

professionals.
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Exposure Decomposition
Bucket Duration
Short Less than or equal to 5
Mid Greater than 5 and less than or equal to 10
Long Greater than 10
Exhibit 4 Sample Exposure Decomposition: Relative Positions of Portfolio and Benchmark

Portfolio Contribution to
Portfolio Weights Portfolio Duration
Duration
Short Mid Long Total Short Mid Long Total Short Mid Long Total
Government 10.00% 10.00% 20.00% 40.00% 4.42 7.47 10.21 8.08 0.44 0.75 2.04 3.23
Corporate 10.00% 20.00% 30.00% 60.00% 4.40 7.40 10.06 8.23 0.44 1.48 3.02 4.94
Total 20.00% 30.00% 50.00% 100.00% 4.41 7.42 10.12 8.17 0.88 2.23 5.06 8.17
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Benchmark Contribution to
Benchmark Weights Benchmark Duration
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Duration
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Government 20.00% 20.00% 15.00% 55.00% 4.42 7.47 10.21 7.11 0.88 1.49 1.53 3.91
Corporate 15.00% 15.00% 15.00% 45.00% 4.40 7.40 10.06 7.29 0.66 1.11 1.51 3.28
Total 35.00% 35.00% 30.00% 100.00% 4.41 7.44 10.14 7.19 1.54 2.60 3.04 7.19
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Portfolio Contribution to
Portfolio Weights Portfolio Returns
Return
Government 10.00% 10.00% 20.00% 40.00% –3.48% –5.16% –4.38% –4.35% –0.35%–0.52% –0.88% –1.74%
Corporate 10.00% 20.00% 30.00% 60.00% –4.33% –6.14% –5.42% –5.48% –0.43%–1.23% –1.63% –3.29%
Total 20.00% 30.00% 50.00% 100.00% –3.91% –5.81% –5.00% –5.03% –0.78%–1.74% –2.50% –5.03%
Benchmark Contribution to
Benchmark Weights Benchmark Returns
Return
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Government 20.00% 20.00% 15.00% 55.00% –3.48% –5.16% –4.38% –4.34% –0.70%–1.03% –0.66% –2.39%
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Corporate 15.00% 15.00% 15.00% 45.00% –4.33% –6.14% –5.86% –5.44% –0.65%–0.92% –0.88% –2.45%
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Total 35.00% 35.00% 30.00% 100.00% –3.84% –5.58% –5.12% –4.83% –1.35%–1.95% –1.54% –4.83%
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From Exhibit 4, we can make the following inferences regarding the manager’s
investment decisions:
With a higher duration than the benchmark (8.17 compared with 7.19 for the
benchmark), the manager likely expected the rates to fall and took a bullish
position on long-term bonds (interest rates) by increasing exposure to the
long end of the interest rate curve (e.g., investing 50% of the portfolio in the
longest-duration bucket versus 30% for the benchmark).
Based on the overweight in the corporate sector (60% versus the 45%
benchmark weight), the manager likely expected credit spreads to narrow.
:
Notice that this bet increases the 4.94 contribution to duration of the
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corporate sector in the portfolio compared with the 3.28 contribution to

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duration for the benchmark. This allocation makes the portfolio more
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exposed to market yield fluctuations in the corporate sector.

The total portfolio return is –5.03%, relative to a total benchmark return of –
4.83%, showing an underperformance of –0.20% over the period.
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Exhibit 5 Sample Exposure Decomposition: Attribution Results
Total
Duration Duration Curve Interest Sector Bond
Sector Total
Bucket Effect Effect Rate Allocation Selection
Allocation
Government 0.00% 0.00%
Short Corporate 0.04% 0.00% 0.04%
Total 0.04% 0.12% 0.52% 0.04% 0.00% 0.56%
Mid Corporate –0.05% 0.00% –0.05%
Total 0.23% 0.03% 0.26% –0.05% 0.00% 0.21%
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Long Corporate –0.22% 0.13% –0.09%

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Total –1.25% 0.37% –0.88% –0.22% 0.13% –0.97%

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Total –0.62% 0.52% –0.10% –0.23% 0.13% –0.20%
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Using the results from Exhibit 5, we can draw the following conclusions about
the investment decisions made by this manager:
The portfolio underperformed its benchmark by 20 bps.
62 bps were lost by taking a long-duration position during a period when
yields increased (benchmark returns were negative in each duration bucket).
52 bps were gained as a result of changes in the shape of the yield curve.
Given the manager’s overweighting in the long-duration bucket, we can
infer that the yield curve flattened.
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23 bps were lost because the manager overweighted the corporate sector
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during a period when credit spreads widened (the benchmark corporate

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returns in each duration bucket were less than the government returns in
those same duration buckets).
13 bps were added through bond selection.
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Yield-Curve Decomposition
Exhibit 6 Yield Curve Decomposition—Duration Based: Active Return Contribution
Curva
Bond Yield Roll Shift Slope Spread Specific Residual Total
-ture
Gov’t. 5% 30 June 21 –0.19% –0.04% 0.43% 0.01% 0.15% 0.00% 0.00% –0.01% 0.35%
Gov’t. 7% 30 June 26 –0.22% –0.03% 0.71% 0.04% 0.04% 0.00% 0.00% –0.03% 0.52%
Gov’t. 6% 30 June 31 0.12% 0.01% –0.48% 0.05% 0.09% 0.00% 0.00% –0.01% –0.22%
Corp. 5% 30 June 21 –0.11% –0.02% 0.21% 0.05% 0.05% 0.04% 0.02% –0.02% 0.22%
Corp. 7% 30 June 26 0.12% 0.01% –0.35% –0.02% –0.02% –0.07% 0.00% 0.02% –0.31%
Corp. (B) 6% 30 June 31 –0.39% –0.03% 1.41% –0.26% –0.11% 0.30% 0.00% –0.04% 0.88%
Corp. (P) 6% 30 June 31 0.78% 0.06% –2.82% 0.52% 0.33% –0.60% 0.15% –0.05% –1.63%
Total 0.11% –0.04% –0.89% 0.39% 0.53% –0.33% 0.17% –0.14% –0.20%
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Time: 0.08% Curve Movement: 0.03%

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Note: There may be minor differences due to rounding in this table.

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Using the data from Exhibits 4 and 6, we can infer the following about the
portfolio investment process over this period:
Yield: The portfolio overweighted corporate bonds and longer-term
maturities relative to the benchmark (from Exhibit 4), which generally
offer higher yield than government bonds and short-term maturities.
This decision contributed 11 bps to the excess return (from Exhibit 6).
Roll: The portfolio overweighted longer maturities (from Exhibit 4).
Because of the shape of the yield curve, bonds with longer maturities
generally sit on a flatter part of the yield curve, where the roll return is
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limited. The overweighting of the longer maturities reduced the

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portfolio roll return by 4 bps.

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Shift: The portfolio overall duration of 8.17 is greater than the

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benchmark duration of 7.19 (from Exhibit 4), which, given the increase in
yield of +1%, reduced the portfolio return by 89 bps.
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Slope: The slope flattening caused the long-term yields to increase less than yields on
shorter terms to maturity. The overweight at the long end of the curve contributed 39
bps to the excess return.
Curvature: The reshaping of the yield curve resulted in a larger yield increase at the
five-year maturity point. The manager underweighted that part of the yield curve. This
decision contributed 53 bps to the excess return.
Spread: The manager overweighted the corporate sector, which resulted in a 33 bps
reduction in return because corporate spreads widened.
Specific spread: Looking at the bond-specific spreads in Exhibit 6, the corporate 5%
30 June 2021 bond added 2 bps of selection return and the corporate (P) 6% 30 June
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2031 bond added 15 bps of selection return. These decisions added a total of 17 bps
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to active return.
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Residual: A residual of –0.14% is unaccounted for because duration and convexity can
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only estimate the percentage price variation. It is not an accurate measure of the true
price variation. The residual becomes more important during large yield moves, which
is the case here, with a +1% yield shift.
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Risk Attribution
Risk attribution identifies the sources of risk in the investment process.
For absolute mandates, it identifies the sources of portfolio volatility.
For benchmark-relative mandates, it identifies the sources of tracking
risk.
Risk attribution should reflect the investment decision-making process.
In all cases, risk attribution explains only where risk was introduced into the
portfolio. It needs to be combined with return attribution to understand the
full impact of those decisions.
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Risk Attribution 2012(1)
Selecting the Appropriate Risk Attribution Approach

Type of Attribution Analysis
Investment Decision-
Relative (vs. Benchmark) Absolute
Making Process
Position’s marginal contribution Position’s marginal
Bottom up
to tracking risk contribution to total risk
Attribute tracking risk to relative
Top down
allocation and selection decisions Factor’s marginal
Factor’s marginal contribution to contribution to total risk
Factor based tracking risk and active specific and specific risk
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risk
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2111 (1) 2012(1) 2108(1)
Return Attribution Analysis at Multiple Levels
Macro attribution Micro attribution
Fund sponsor Individual portfolio manager

VS.
Strategic asset allocation Tactical deviations
𝑹𝒊
Selection Interaction
𝑊𝑖 𝑅𝑖 − 𝐵𝑖 (𝑤𝑖 − 𝑊𝑖 )(𝑅𝑖 − 𝐵𝑖 )
𝑩𝒊
Brinson–Fachler
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approach Allocation Effect

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𝑤𝑖 − 𝑊𝑖 (𝐵𝑖 −𝐵)
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B
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2111 (1) 2108(1)
Benchmarks
Properties of a valid benchmark Benchmark types
•Specified in advance • Absolute return
•Appropriate • Broad market indexes
•Measurable • Style indexes
•Unambiguous • Factor-model-based
•Reflective of current investment opinions • Returns-based
•Accountable • Manager universes (peer groups)
•Investable • Custom security-based (strategy)
Broad Factor- Custom

Manager Style Returns-
summary Absolute Market Model- Security-
Universes Indices Based
Indices Based Based
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Specified in
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√ × √ √ √
advance
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Appropriate √ √ √ √
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Measurable √ √ √ √ √ √
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Unambiguous × × √ √ × √ √
Investable × × √ √ × √ √
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Benchmarks 2020(12)
P: a portfolio’s return
Benchmark
E = (P – M) S A B: appropriate benchmark return
M: market index return
M B P
S: style return
A: active management return
S=0
E = (P – M): difference between the portfolio and
Broad market index A=0 the broad market index
P=M
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Evaluating Benchmark Quality

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• A good benchmark should not reflect these systematic biases, where the correlation
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between A and S should not be statistically different from zero. 𝛒(𝐀,𝐒)=𝟎

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A good benchmark will have a statistically significant positive correlation coefficient between
S and E. 𝛒(𝐒,𝐄)>𝟎
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Benchmarking Alternative Investments
Survivorship bias
Hedge Fund★ Backfill bias
Self-reported
Subset → not fully representative of the asset class
Performance is likely to be highly correlated with the returns
of the largest fund data contributors
Based on manager-reported performance ★
Real Estate Emphasis on the most expensive cities and asset types
Based on appraisal data ★
Benchmark returns are unleveraged or leveraged ★
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Do not reflect the high transaction costs, limited transparency,

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and lack of liquidity ★

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Different valuation methodology

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IRR can be meaningfully influenced by an early loss or an early

Private Equity win ★
Funds at different stages of development cannot be compared ★
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Benchmarking Alternative Investments
Use of derivatives to represent actual commodity assets ★
Commodity Varying degrees of leverage
Discretionary weighting of exposures
The benchmarks are typically specific to a single strategy

Managed Stale pricing ★
Derivatives Survivorship bias ★
Backfill bias ★
Illiquid and non-marketable → difficult to find suitable benchmarks
Distressed
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Securities Stale pricing

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2111 (1) 2105(1) 2108(1)
Performance Appraisal
Sharpe ratio Treynor ratio Information ratio
RA − r𝑓 𝑅𝐴 − 𝑟𝑓 E(rP ) − E(rB )
SA = TA = IR =
σA σ(rP − rB )
βA
α Jensen’s alpha Capture ratios

Appraisal ratio AR = =
σε SEE
UC m, B, t
𝑛
− 𝑌𝑖 )2 𝑛 2 CR mB, t =
𝑖=1(𝑌𝑖 𝑖=1 𝜀𝑖 𝑆𝑆𝐸 DC m, B, t
SEE = = = , df = n − 2
𝑛−2 𝑛−2 𝑛−2
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E 𝑟𝑝 − 𝑟𝑇 t=1 min(𝑟𝑡 − 𝑟𝑇 , 0)2
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Sortino ratio SR D = σD =
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𝜎𝐷 𝑁
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Drawdown 𝑉(𝑚, 𝑡) – 𝑉(𝑚, 𝑡 ∗)

𝑀𝑎𝑥𝑖𝑚𝑢𝑚 𝐷𝐷(𝑚, 𝑡) = min( , 0)
Drawdown duration 𝑉(𝑚, 𝑡 ∗)
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Example: Performance Appraisal Measures
1. Portfolio Y delivered an average annualized return of 9.0% over the
past 60 months. The annualized standard deviation over this same time
period was 20.0%. The market index returned 8.0% per year on average
over the same time period, with an annualized standard deviation of
12.0%. Portfolio Y has an estimated beta of 1.40 versus the market
index. Assuming the risk-free rate is 3.0% per year, the appraisal ratio is
closest to:
:
A. ‒0.8492.
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B. ‒0.0922.
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C. ‒0.0481.
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Example: Performance Appraisal Measures
Solution to 1:
B is correct. Jensen’s alpha is –1.0%: 𝛼𝑝 = 9.0% – [3.0% + 1.40(8.0% –
3.0%)] = –1.0% = –0.01. Non-systematic risk is 0.011776: 𝜎𝜀𝑝 2 =
0.202 – 1.402 (0.122 ) = 0.011776. The appraisal ratio is approximately
–0.0922:
−0.01
AR = = – 0.0922
0.011776
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Example: Drawdown
Cumulative Cumulative
Month R(m) Drawdown Comments
R(m) Drawdown
January 2011 2.37% 2.37% 0.00%
February 2011 3.43% 5.88% 0.00%
March 2011 0.04% 5.92% 0.00%
April 2011 2.96% 9.06% 0.00%
May 2011 ‒1.13% 7.83% ‒1.13% ‒1.13% Drawdown begins
June 2011 ‒1.67% 6.03% ‒1.67% ‒2.78%
July 2011 ‒2.03% 3.87% ‒2.03% ‒4.75%
August 2011 ‒5.43% ‒1.77% ‒5.43% ‒9.93%
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September 2011 ‒7.03% ‒8.67% ‒7.03% ‒16.26% Maximum drawdown

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October 2011 10.93% 1.31% ‒7.11% Recovery begins

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November 2011 ‒0.22% 1.09% ‒0.22% ‒7.31%

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December 2011 1.02% 2.12% ‒6.36%

January 2012 4.48% 6.69% ‒2.17%
February 2012 4.32% 11.30% 0.00% Recovery begins
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Example: Drawdown
Consider the return on the S&P 500 Index from January 2011 to
February 2012. The drawdown is 0% until May 2011, when the return is
–1.13% and the drawdown continues to grow, reaching a maximum of
–16.26% in September 2011. The strong returns from October 2011 to
February 2012 reverse the drawdown. The total duration of the
drawdown was 10 months, with a 5-month recovery period.
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Reading
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Investment Manager Selection

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1. Manager Selection Process
Framework 2. Type I and Type II Errors in Manager Selection

3. Quantitative Elements of Manager Search and
Selection
• Style Analysis
• Capture Ratios and Drawdowns
4. Qualitative Elements of Manager Due Diligence
:
• Investment Philosophy
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• Investment Personnel
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• Investment Decision-Making Process

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• Operational Due Diligence
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Manager Selection Process
Due diligence is the analysis and investigation in support of an investment
decision, action, or recommendation.
Due diligence on investment managers must emphasize the sources and
reasons behind the actual returns generated in the past.
The manager search and selection process has three broad components: the
universe, a quantitative analysis of the manager’s performance track
record, and a qualitative analysis of the manager’s investment process.
Manager Universe
:
Quantitative Analysis
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Qualitative Analysis
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Manager Universe
The manager selection process begins by defining the universe of
feasible managers, those managers that potentially satisfy the
identified portfolio need.
The manager universe consists of only those managers who are suitable
for the portfolio in terms of the objectives and constraints of the IPS,
invest in the relevant style (e.g., value, growth, mixed) desired by the
client, and will manage the portfolio with the appropriate balance
between active versus passive approaches.
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The IPS and the reason for the manager search largely determine the
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universe of managers considered and the benchmark against which they

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are compared.
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The benchmark can be determined using one or more of: third-

party categorization, returns-based style analysis, holdings-based
style analysis, and manager experience.
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2012(1)
Hypothesis
H0 : the manager adds no value.
Ha : the manager adds positive value.
Type I: Hiring or retaining a manager who subsequently underperforms
expectations. (worry more)
Type II: Not hiring or firing a manager who subsequently outperforms, or
performs in line with, expectations.
:
Type I and Type II Errors

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Realization
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Below expectations At or above expectations

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(no skill) (skill)

Hire/Retain Type I Correct
Decision
Not Hire/Fire Correct Type II
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Manager Selection Process 2111(1)
The cost of errors is driven by the size, shape, mean, and dispersion of the
return distributions of the skilled and unskilled managers within the universe.
The smaller the difference in sample size and distribution mean and
the wider the dispersion of the distributions, the smaller the expected
cost of the Type I or Type II error.
The extent to which markets are mean-reverting also has a bearing on
the cost of Type I and Type II errors.
If performance is mean reverting, firing a poor performer (or hiring
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a strong performer) only to see a reversion in performance results is

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a Type I error.
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A Type II error would be not trimming strong performers and

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avoiding hiring managers with weaker short-term track records,

which can be costly.
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2012(1) 2108(1)
Quantitative Elements of Manager Search and Selection

Style Analysis
Returns-based style analysis (RBSA)
Holdings-based style analysis (HBSA)
Capture Ratios and Drawdowns in Manager Evaluation
upside capture ratio (UC)
downside capture ratio (DC)
capture ratio (CR)
maximum drawdown
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drawdown duration
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Approaches to Manager Analysis
Meaningful
Accurate
Style Analysis
Consistent
Timely Does not require a large amount of data
Advantage Can be estimated even for complicated
strategies
Returns-based
Top-down Based on a static portfolio → inaccuracy
Disadvantage
Illiquid securities, stale prices
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Advantage Estimation of current risk factors → accuracy

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Holdings-based
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Additional computational effort

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Bottom-up Accuracy may be compromised by stale

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Disadvantage pricing and window dressing

Uses a point in time analysis format that may
not be useful in projecting into the future
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RBSA & HBSA
Holdings-based style analysis
Portfolio Characteristics for GF Active Equity Strategy Based on Current-Period
Data
Active Equity Benchmark
Number of stocks 50 1,000
Market value $180 billion $4,400 billion
Weighted average market capitalization $4.0 billion $4.1 billion
Dividend yield 3.00% 2.00%
Price/Earnings 8× 12×
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Returns-based style analysis

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Return Correlations between GF’s Active Equity Approach and Benchmarks Based
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on 36 Months of Historical Data

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Value Blend Growth

Coefficient of determination 0.39 0.45 0.65
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Qualitative Elements of Manager Due Diligence
The goal of manager due diligence is to weigh the potential risks that may
arise from entering into an investment management relationship and
entrusting assets to a firm.
Investment Philosophy
Investment Personnel
Investment Decision-Making Process
Signal Creation (Idea Generation)
Signal Capture (Idea Implementation)
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Monitoring the Portfolio

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Operational Due Diligence

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Firm
Investment Vehicle
Evaluation of the Investment’s Terms
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Qualitative Elements of Manager Due Diligence
Behavioral inefficiencies are mispricings caused by other
Clear investors and their behavioral biases (e.g., trend-following).
Investment Concise
The mispricings are very short-term in nature.
Philosophy Consistent
Structural inefficiencies occur because of laws and
2020(12) Appropriate
regulations, which can make them long-term in nature.
Sufficient expertise and experience

Investment key person risk
Personnel Agreements & incentives
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Turnover of firm personnel

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Investment Decision-Making Process
Unique
Signal Creation Timely
Interpreted differently
The repeatability of process and its congruence with the

Signal Capture investment philosophy
The determination and approval of the investment position
Risk management methodology

Consistent with the investment philosophy and process
Long and short positions → paired or separated
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AUM will likely increase over time

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Hard stop losses & soft stop losses

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Liquidity → determined whether is a net supplier or

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demander of liquidity
Monitoring External considerations

the Portfolio Internal considerations
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Operational Due Diligence
Performance appraisal assumes that reported returns are accurate and fully
reflect the manager’s risk profile. Unfortunately, as we have seen, this
assumption is not always true.
Operational due diligence analyzes the integrity of the business and seeks
to understand and evaluate these risks by examining and evaluating the
firm’s policies and procedures.
Firm
Investment Vehicle
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Investment Vehicle
The advantages of SMA vehicles include the following:
Ownership: In an SMA, the investor owns the individual securities
directly.
Customization: SMAs allow the investor to potentially express
individual constraints or preferences within the portfolio.
Tax efficiency: SMAs offer potentially improved tax efficiency because
the investor pays taxes only on the capital gains realized and allows the
implementation of tax-efficient investing and trading strategies.
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Transparency: SMAs offer real-time, position-level detail to the investor,

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providing complete transparency and accurate attribution to the

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investor.
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Investment Vehicle
If the SMA is customized, additional investment due diligence may be
required to account for differences in security selection or portfolio
construction. Disadvantages include:
Cost: Separate accounts represent an additional operational burden on
the manager, which translates into potentially higher costs for the
investor.
Tracking risk: Customization of the strategy creates tracking risk
relative to the benchmark, which can confuse attribution because
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performance will reflect investor constraints rather than manager

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decisions.
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Investor behavior: Transparency, combined with control and

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customization, allows for potential micromanagement by the investor—

that is, the investor attempting to manage the portfolio.
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There are three basic forms of performance-based fees:
A symmetrical structure in which the manager is fully exposed to both
the downside and upside
Computed fee = Base + Sharing of performance
A bonus structure in which the manager is not fully exposed to the
downside but is fully exposed to the upside
Computed fee = max (Base, Base plus sharing of positive
performance)
A bonus structure in which the manager is not fully exposed to either
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the downside or the upside

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Computed fee = max (Base, Base plus sharing of performance,

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to a limit)
Fee structures must be designed carefully to avoid favoring one party over
the other.
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Sample Performance-Based Fee Schedule
A simple performance-based fee, specifies a base fee below which the
computed fee can never fall. In this case, the manager is protected against
sharing for performance below 25 bps. To make the result symmetrical
around the commonplace 50 bps fee, the manager does not share in active
performance beyond 2.75%.
Panel A. Sample Fee Structure
Standard fee 0.50%
Base fee 0.25%
Sharing* 20%
Breakeven active return 1.50%
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Maximum annual fee 0.75%

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Panel B. Numerical Examples for Annual Periods

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Active Return
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≤ 0.25% 1.00% 1.50% 2.00% ≥ 2.75%

Billed fee 0.25% 0.40% 0.50% 0.60% 0.75%
Net active return ≤ 0.00% 0.60% 1.00% 1.40% ≥ 2.00%
* On active return, beyond base fee.
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Call Option
Bonus-style fees are the close equivalent of a manager’s call option on a
share of active return, for which the base fee is the strike price.
The graph illustrates three fee components: a 25 bps base fee, plus a
long call option on active return with a strike price equal to the
minimum (base) fee, minus another (less valuable) call option with a
strike price equal to the maximum fee.
Payoff Line of Sample Performance-Based Fee Schedule

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It’s not the end but just beginning.
By training your thoughts to concentrate on the bright side of
things, you are more likely to have the incentive to follow through on
your goals. You are less likely to be held back by negative ideas that
might limit your performance.
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Behavioral

Study Session 12 PORTFOLIO MANAGEMENT FOR INSTITUTIONAL INVESTORS

Study Session 13 TRADING, PERFORMANCE EVALUATION, AND MANAGER SELECTION

Study Session 14 CASES IN PORTFOLIO MANAGEMENT AND RISK MANAGEMENT

Study Session 15-16 ETHICS & PROFESSIONAL STANDARDS (1)&(2)

R1 The Behavioral Biases of

The Behavioral Biases of Individuals

Cognitive Errors and Emotional Biases

Cognitive errors can be further classified into two categories:

belief perseverance biases: related to cognitive dissonance.

information-processing biases: information being processed

and used illogically or irrationally.

Most cognitive biases can be moderated. To moderate a bias is to

It may only be possible to recognize an emotional bias and adapt it. To

bias rather than to attempt to moderate the bias.

1.1 Cognitive Errors: Belief Perseverance Biases

Consequences: Maintain or be slow to update a view, forecast or belief,

Overcoming: FMPs should react decisively to new information and

1.2 Cognitive Errors: Belief Perseverance Biases

Consider only the positive information about an existing investment.

Develop screening criteria and ignore information that refutes the

Under-diversify portfolios, leading to excessive exposure to risk.

Hold a disproportionate amount of investment assets in employing

Overcoming: Actively seeking out information that challegenges your

Base-rate neglect: the base rate or probability of the categorization is not

Sample-size neglect(law of small numbers): FMPs incorrectly assume

that small sample sizes are representative of populations, they overweight

the information in the small sample.

Adopt a view or forecast base almost exclusively on new information or

stress of updating beliefs given complex data.

Overcoming: Ask the following question: “What is the probability that X

(the investment) belongs to Group A (the group it resembles or is

Trade more than is prudent.

Lead investors to inadequately diversify portfolios.

Overcoming: Investors need to recognize that successful investing is a

Overestimate the degree to which they predicted an investment

Cause FMPs to unfairly assess money manager or security performance.

FMP needs to carefully record and examine their investment decisions

to avoid repeating past investment mistakes.

provide little information about an investment’s future potential and should

not influence investment decisions to any great extent.

Overcoming: Be as neutral as possible and open-minded as possible when

interpreting investment-related situations.

2.4 Cognitive Errors: Information Processing

3.1 Emotional Biases

Trade excessively as a result of selling winners.

Hold riskier portfolios than is acceptable.

Overcoming: A disciplined approach to investment based on fundamental

3.2 Emotional Biases

to their investment predictions are too narrow.

Certainty overconfidence: The probabilities that FMPs assign to

3.2 Emotional Biases

losers, and calculate portfolio performance over at least two years.

Be objective when making and evaluating investment decisions.

perform post-investment analysis on both successful and unsuccessful

3.3 Emotional Biases

and should have a personal budget.

advantages of diversification and proper asset allocation

When financial goals are in jeopardy, emotional attachment must be

moderated; it cannot be accepted and adapted to

Behavioral Finance and Investment Processes

Passive investors are defined as those investors who have become

Active investors are individuals who have been actively involved in

1.Cfa三级强化段总复习1 Jcy 金程教育标准版

1.Cfa三级强化段总复习1 Jcy 金程教育标准版