Financial Income Markets (MFM854)

Portfolio Management

Leben Johnson
4th Dec. 2019
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 Investment Management Process
• Decide Investment Objectives: Based on Business
– Pension Fund: Generate cash flow
– Life Insurance: Meet obligation, generate profit
– Banks: Return higher than Cost of Capital
• Establish Investment Policy
– Distribution of funds in asset classes, eg. Equities, Bonds, Real Estate, Cash, Gold etc.
– Within regulatory or charter constraints
– Tax benefits
• Select a Portfolio Strategy
– Active Portfolio Management
• Decide governing factors and target expectations with forecasted dividends, P/E, interest rate
– Passive Portfolio Management
• Indexing
– Enhanced Indexing or Indexing Plus
• Partly Indexed or Passive rest Active.
• Structured portfolio strategies to meet benchmarks
• Immunization
• Select Assets
– Deciding on securities, misprices secutiries
• Measure and Evaluate Portfolio Performance
– Compare to benchmark

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 Tracking Error or Active Risk
Defined as the standard deviation of the portfolio’s return relative to the
return of the benchmark index.

Calculating Tracking Error

- Return of the portfolio for each period
- Return of the benchmark index for same periods
- Difference between the returns, called active return.
- Calculate Standard Deviation of the active returns – Tracking Error

Tracking error is for the period calculated, ie monthly or weekly.

To annualize tracking error: Monthly tracking error *
or Weekly tracking error *

Ex-Post / Backward Tracking Error: Historical

Ex-Ante /Forward Tracking Error: Predicting based on multi-factor risk models

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 Multi Risk Factors
Multi-Risk
Factors

Non-
Systemic
Systemic

Term Non-Term Issuer Issue

Structure Structure Specific Specific

Sector
Quality
Optionality
Coupon
MBA Sector Risj
MBS Volatility
MBS Prepayment

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 Active Portfolio Strategies
- Expectations Strategy
- Interest-rate expectation strategy
- Yield Curve Strategies
- Types of Yield Curve Shifts
- Parallel Shift Upward, Downward
- Flattening Twist , Steepening Twist
- Negative Butterfly, Positive Butterfly

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 Yield Curve Shifts

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 Yield Curve Strategies

• Bullet Strategy
• Barbell Strategy
• Ladder Strategy

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 Value at Risk (VaR)

• VaR identifies the worst case

scenario loss of a portfolio, with
a certain degree of confidence,
within a given period of time.
– Three methods to calculate
• Historical Method
• Variance-Covariance
Method
• Monte Carlo Simulation
Method
– VaR Annualized =
VaR (Period) *

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