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CFA3 > Portfolio Management > Flashcards

Portfolio Management Flashcards

Asset allocation, PM topics.

1
Q

Pro and con of a goals-based investment plan

A

An emotionally-biased client can see how a higher priority goal is less impacted by market declines so a higher chance the client will remain invested. It leads to suboptimal total asset allocations.

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2
Q

What are six criticisms of MVO?

A

Outputs are sensitive to inputs, assumes a normal distribution, does not account for liabilities, concentrated portfolios in only a few asset classes, considers market risk but not factor risk , and single period framework.

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3
Q

How does RMVO and BL improve MVO?

A

Inputs are world market weights, correlations and s.d., put through optimiser to get implied returns. (BL may come in here to adjust implied returns based on manager views, rerun optimisation). MVO is then run with the implied returns to get an AA.

Pro is that the derived returns already reflect a highly diversified portfolio and you avoid the tendency for MVO to output high concentrated allocations in a few asset classes.

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4
Q

What is resampled MVO and one criticism?

A

Recognizes that inputs may be incorrect (subject to sampling error), it combines MVO and MCS to aggregate different samples of data (returns and variances) to find an average to then be used in the optimiser. Riskier assets are overdiversified.

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5
Q

What are the MCTR and ACTR equations?

A

MCTR = beta x portfolio sd.
ACTR = MCTR x weight.

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6
Q

What are the three criteria for evaluating an investment programme?

A

Goal achievement - does the plan remain likely to meet goals without material changes. Process consistency - did the manager stick to the IPS. Performance - has it met its absolute or relative performance target.

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7
Q

What are strategies to manage concentrated positions in public equities?

A

Monetisation with a zero-cost collar (sell calls and buy puts) or a covered call.
Tax-free exchange where many investors with different positions combine to get a slice of a diversified fund and do not pay tax.
Irrevocable donation to a charitable remainder trust that sells shares, reinvests in a diversified portfolio paying no tax and pays out income to beneficiaries and then to a charity once they die.

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8
Q

What are three strategies to free up capital for a business owner and what are the tax and ownership impacts?

A

Personal line of credit secured on company shares: retain control and no taxable event.
Leveraged recap (ext firm takes equity, organizes debt, owner gets cash. Taxable and losses control.
ESOP (sell shares to the ESOP and on to employees. May not be taxable but loses control.

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9
Q

What are non-selling strategies to manage concentrated positions in real estate?

A

Mortgage refinancing and charitable trusts.

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10
Q

What are the three insurance pricing factors?

A

Mortality expectations - chance of insured dying within the term of the policy. Discount rate - firm expected returns. Loading.

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11
Q

Standard mission and objective of a II?

A

Mission is to maintain purchasing power into perpetuity while supporting…
Investment objective is to achieve a real rate of return (after inflation) of at least the annual spending rate with reasonable risk.

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12
Q

What is whole of life and universal permanent life insurance?

A

Whole of life stays in force for insured person’s life and universal stays in place as long as premiums are paid.

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13
Q

What is a non-forfeiture whole of life insurance policy clause?

A

Insured receives some benefit if premiums are missed.

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14
Q

What is a waiver of rider whole of life insurance policy clause?

A

Future premiums are waived if the insured becomes disabled.

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15
Q

What is a guaranteed insurability rider whole of life insurance policy clause?

A

The insured can purchase more insurance at predetermined intervals.

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16
Q

What is an indemnity plan in life insurance contracts?

A

Insured can visit any provider but pays a fee.

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17
Q

What is an preferred provider organisation plan in life insurance contracts?

A

Insured can visit a network of providers for a low fee.

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18
Q

What is a health maintenance organisation in life insurance contracts?

A

Insured can visit a network of providers for little to no cost with the aim of health prevention outcomes.

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19
Q

How do the treatment of shortfall risk and longevity risk differ for DC and DB pension schemes?

A

Both risks falls on the employee in DC schemes. Shortfall risk falls on the employer in DB and longevity risk is reduced through pooling mortality risk.

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20
Q

What is the spending mandate for foundations?

A

5% of assets pa + investment expenses + 100% donations.

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21
Q

How does the Yale spending rule work?

A

Makes spending more predictable by adding a smoothing and counter cyclical element.

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22
Q

What is the equation for equity duration

A

D(A/E) – D(A/E – 1)(Δi/Δy).

(Δi/Δy) is change in yield of liabilities for a 1% change in yield of assets.

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23
Q

What is the equation for equity volatility?

A

σ^2 = σ^2(A/E)^2 + σ^2(A/E–1)^2 – 2(A/E)(A/E–1) ρ σ σ

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24
Q

What are two pros and a con of MCS in retirement planning specifically?

A

Quantify the probability of having sufficient assets to last for person’s expected lifetime i.e., assess probability of ruin.
It can incorporate path dependency issues because it’s a multi-time horizon model e.g., inflation, taxes, investment returns.

Output only as good as inputs.

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25
Q

What is a VWAP and TWAP algorithm, a pro and con, and when would you choose TWAP over VWAP?

A

VWAP carves up orders and sends to market based on historical intraday volumes. TWAP do the same but make sure an even number of shares is traded each time period. Pro is ensure a specific number of shares is executed in a specific time period. Con is forcing trades in low liquidity and not trading enough in times of high liquidity. Use TWAP to mitigate impact of outliers or with markets with unpredictable trade volumes.

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26
Q

What is a scheduled trading algorithm and when is it used?

A

Trades passively throughout the day (POV, VWAP, TWAP). High liquidity and low order size, low urgency because low market impact concerns.

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27
Q

What is a liquidity seeking algorithm and when is it used?

A

Aims to take advantage of favorable liquidity conditions in the market. Use for large orders in less liquid assets with high urgency but a desire to reduce market impact.

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28
Q

What is a arrival price algorithm and when is it used?

A

Small/med (~10% ADV) trades in liquid markets with fast execution to capture alpha (mispricing).

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29
Q

What is a dark aggregator algorithm and when is it used?

A

Large (20%+) orders in illiquid markets with high market impact where full execution is not needed.

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30
Q

What is a smart order routing algorithm and when is it used?

A

Sends small orders (<10%) to markets with best market prices. “market price” so not ideal for large orders.

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31
Q

How are fixed income trades implemented?

A

Urgent trades use broker/principle approach and non-urgent use agency approach.

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32
Q

How are exchange traded derivatives trades implemented?

A

Large and urgent trades sweep the book, large and non-urgent use algorithms, and small trades use DMA.

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33
Q

How are OTC derivatives trades implemented?

A

Urgent use broker/principle approach and non-urgent use agency approach.

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34
Q

How are Spot FX trades implemented?

A

Urgent trades use dealers, non-urgent use algorithms, and small trades use DMA.

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35
Q

What is the equation for implementation shortfall?

A

Opportunity cost + execution cost + fees

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36
Q

What is the equation for execution costs?

A

executed shares (execution price - decision price)

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37
Q

What is the equation for delay costs?

A

executed shares (arrival price - decision price)

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38
Q

What is the equation for trading costs?

A

executed shares (execution price - arrival price)

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39
Q

What is the equation for opportunity costs (trading)?

A

unexecuted shares (closing price - decision price)

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40
Q

What is the equation for market-adjusted cost? What is the equation for index cost?

A

market-adjusted cost = arrival cost - β × index cost.

index cost = (index VWAP - index arrival price) / index arrival price

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41
Q

What are the four elements that a manager’s trading policy should set out?

A

Meaning of best execution, factors that determine the optimal trading approach, list of approved brokers and venues, and a monitoring process.

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42
Q

What are the BHB model allocation, security selection and interaction effect equations that make up excess return?

A

Allocation = BM return (portfolio weight - BM weight).

Security selection = BM weight (portfolio return - BM return).

Interaction = difference in weight × difference in return.

43
Q

What is the allocation effect equation for the BF model?

A

(portfolio weight - BM weight)(BM return - total BM return)

44
Q

What are the seven tests of BM quality?

A

Unambiguous (securities and weights are identifiable), investable (tradable), measurable (returns are published), appropriate (consistent with manager style), reflective of current investment opinion (consistent with manager process), specified in advance, and accountable (manager constraints shouldn’t limit accountability).

45
Q

Equation for the Treynor ratio?

A

portfolio return - risk free / systematic risk

46
Q

Equation for the appraisal ratio?

A

alpha/SQRT(non-systematic risk)

Non-systematic risk = residual risk = unexplained portion of regression x total sd

47
Q

Equation for the Sortino ratio?

A

portfolio risk - risk free / downside risk

48
Q

What are the components of a manager selection processes universe assessment?

A

suitability of the IPS, appropriate style, and active vs. passive approach.

49
Q

What are the components of a manager selection processes quantitative assessment?

A

attribution and appraisal, capture ratio, and drawdown.

50
Q

What are the components of a manager selection processes qualitative assessment?

A

Investment due diligence: philosophy, process, people, and portfolio construction.

Operational due diligence: process and procedure, firm, investment vehicles, terms, and monitoring.

51
Q

What is a type 1 and type 2 error with respect to manager selection?

A

Type 1 is hiring a manager that underperforms.

Type 2 is failing to hire a manager that outperforms.

52
Q

What is and a pro and con of a returns-based style analysis?

A

Regression approach against a bunch of indices to see which coefficient is the highest i.e., the most explanatory power. Doesn’t need holdings data and easy to be applied in excel. Slower to detect style drift and it’s backward looking meaning it may not detect that relationships have changed. Good for hedge funds.

53
Q

What is and a pro and con of a holdings-based style analysis?

A

Aggregates the properties of each stock in the portfolio to conclude overall style. More accurate than RBSA and detects style drift faster. Requires availability of portfolio properties and subject to window dressing. Good for low turnover/passive strategies.

54
Q

Compare SMAs and pooled investment vehicles in terms of transparency, liquidity, investor behavior, cost, tax efficiency, and tracking error.

A

SMAs have high transparency (real time data), liquidity (shielded from demands of co-investors), and are more tax efficient.
Pooled shielded from investor behavior (micromanagement), lower cost, and lower tracking error (less customization).

55
Q

What is a pro and con of a AUM-based fee?

A

Lower fees in a growing market. Managers are not incentivised to maximise returns.

56
Q

What is a pro and con of a performance-based fee?

A

Aligns interests. May result in perverse incentives like chasing ST gains.

57
Q

What are three generic reasons to support a fund increasing its risk profile?

A

Current risk is lower than peers, expected returns are expected to be lower going forward, higher risk decreases chance of purchasing power erosion over the LT.

58
Q

What are five tools for managing liquidity risk?

A

Liquidity profiling and time-to-cash tables, rebalancing strategies (systematic and automatic adjustment), stress testing, derivatives, and cashflow forecasting.

59
Q

What is a pro and a con of a cash market transaction for rebalancing?

A

Better for permanent and large allocation shifts. High cash drag (timing delays and active manager impact).

60
Q

What is 4 pros and 2 cons of a derivative market transaction for rebalancing?

A

Quick implementation. Flexibility to tactically adjust exposure and quickly reverse it. Ability to leave external managers in place. High levels of liquidity.
High tracking error. Operational burden.

61
Q

What are the steps in the human life value method?

A

After-tax income + employee benefits - expenses. Re-tax. Find PV due and subtract from any existing insurance to find additional insurance needed.

62
Q

What are the three main risks to II’s and how can they be miitgated?

A

Uncertain cash flows - cash flow modelling. Stale pricing - use public market proxies or remove serial correlation of returns. Unable to rebalance to the SAA - maintain regular rebalancing via policies.

63
Q

What is a pro and a con of direct investment?

A

Lower fees and more certain cash flows. Requires dedicated in-house team and can increase concentration risk.

64
Q

What type of trade BM would a ST alpha seeking manager use?

A

Pre-trade arrival price.

65
Q

What type of trade BM would a quantitative manager use?

A

Pre-trade previous close.

66
Q

What type of trade BM would a LT fundamental manager use?

A

Pre-trade opening price.

67
Q

What type of trade BM would a index tracking manager use?

A

post-trade closing price.

68
Q

What does a high arrival cost and low market-adjusted cost indicate?

A

That most of the expense is from buying in a rising market as opposed to buying pressure induced from the order itself.

69
Q

What risk attribution approach should be used for a bottom-up process and a relative or absolute manager?

A

Positions marginal contribution to tracking error.

70
Q

What risk attribution approach should be used for a top-down process and a relative or absolute manager?

A

Attribute tracking error to relative allocation and selection decisions.

71
Q

What risk attribution approach should be used for a factor process and a relative or absolute manager?

A

Factors marginal contribution to tracking and active specific risk or total risk and specific risk.

72
Q

What is capital sufficiency and what are two methods?

A

A process to determine whether a client has or is likely to accumulate enough money to meet objectives. Deterministic forecasting and MCS.

73
Q

What is a pro and con of deterministic forecasting?

A

Easy to understand and implement. Use of a single return assumption is not representative of the actual market volatility.

74
Q

What is the denominator effect?

A

Where AUM falls by a larger amount than the repricing of illiquid assets, resulting in a higher allocation to illiquid assets.

75
Q

What is a discretionary and fixed trust, and when would one be used over the other?

A

Fixed trusts the disbursements are specified in the trust documents. Discretionary trusts the trustee can decide when and how much to disburse to the beneficiaries. Discretionary trusts are used to protect the trust assets from the creditors of the beneficiaries.

76
Q

What is the relative value of a gift vs. a bequest?

A

[1+r(1-tax of receiver)]^n (1-gift tax) / [1+r(1-tax of gifter)]^n (1-estate tax)

77
Q

TDA and TEAs have the same economic benefit if what is factored in?

A

Pre-tax contributions vs. after-tax contributions.

78
Q

Why do dark pools have a high risk of non-execution?

A

Because there is no market maker to absorb excess order flow.

79
Q

What are the areas to cover for a ‘prepare the investment objectives section of an IPS’?

A

Purpose: goals and any prioritisation given.
Expected annual costs.
Expected annual inflows.
Anything other purchases.
How the manager can assist (helping with prioritisation/quantification).

80
Q

What is the net payment cost index calculations? How does this differ from surrender cost index? What do these methods do? What is the single assumption of each?

A

FVdue(premiums) - FV(dividends) then find PMT using the first part as FVdue.
Surrender cost index subtracts cash value in first step.
Methods are used to compare the cost of policies.
Net payment index assumes death at end of policy and surrender assumes insured ends contract and receives cash.

81
Q

What is a behavioural inefficiency relating to active management strategies?

A

Mispricing caused by other market participants that are temporary.

82
Q

What is a structural inefficiency relating to active management strategies?

A

Mispricing created by external regulations and are long-lived.

83
Q

What impact do incentive fees and management fees have on volatility?

A

Incentive fees decrease volatility. Management fees have no impact but reduce returns.

84
Q

What is the potential capital gain exposure equation and what is it used for?

A

net gains / total net assets. PCGE can be used to gauge the amount of tax liability embedded in a fund.

85
Q

What is the after-tax post-liquidation return equation and what is it used for?

A

Used to show embedded tax liabilities in an investment.
a. (1+r)(1+k) = x
b. x - (%embedded gain x tax rate) = y
c. y^(1/k) = answer

86
Q

What is the theoretical equation for a illiquidity premium?

A

illiquid asset price = marketable asset price - put price.
Put strike = theoretical market price.

87
Q

What are the three steps before looking for an external manager?

A

Decide if outside support it needed, develop an IPS, and decide AA.

88
Q

What are the steps in calculating implementation costs of a unlevered ETF vs. derivatives strategy?

A

Leverage cost = (notional x % borrowed x rate) / notional
Add this on to unlevered cost.
Note 3x leverage would be 2/3 % borrowed.

89
Q

What is the standard equation for evaluating trade execution?

A

(execution price - BM price) / BM price

90
Q

What is a POV algorithm and a pro and con?

A

Send orders to market according to a volume participation schedule. Pro is auto exploit increased liquidity when available. Con is will continue to trade at any (potentially adverse) price.

91
Q

Explain contributions and benefits paid for a DC and DB scheme?

A

Contributions
- DB paid by employer and depend on funded status.
- DC a function of employee salary and employer contributions.
Benefits
- DB certain and a function of salary and years served. Must vest.
- DC uncertain and a function of contributions and investment returns. Vested immediately.

92
Q

What is an execution and a profit-seeking algorithm?

A

Execution focus on how to trade manager orders. Profit-seeking use real time market data to decide what securities to trade and to implement them as efficiency as possible.

93
Q

Factors to look at when deciding an endowments risk tolerance?

A

Percent of college operating budget it supports and access to debt markets increases ability to tolerate risk.

94
Q

What is and a pro and con of staged diversification and portfolio completion?

A

Strategies to reduce concentrated positions in public stock. SD is selling down over time and reinvesting proceeds in a diversified portfolio. Pro is tax liability is spread out con is concentration is not reduced immediately. PC is adding an index-based portfolio to the existing position to create an overall diversified portfolio. Pro is the concentrated position doesn’t need to be sold con is it is complex as requires optimisation.

95
Q

Can ETFs and mutual funds be sold short or bought on margin? Which has larger taxable event?

A

ETFs can but not mutual funds. ETFs have smaller taxable event because of in-kind transfers between ETF manager and APs.

96
Q

What are the client/advisor segment types and the net worth bands?

A

Robo-advisor is low worth
Mass affluent is 250k-1m
High net worth is 1m-50m
Ultra high net worth is 50m+

97
Q

What is a mortality table?

A

Columns are client age, life expectancy, and survival probability. Used to weight expected annual cash flows to determine PV retirement spending needs.

98
Q

What is a revocable and irrevocable trust, and when would one be used over the other?

A

Revocable is where the settlor remains the right to revoke the trust and regain control of the trust assets. Irrevocable is where the settlor cannot claim back assets. Use irrevocable to protect trust assets from creditors of the settlor. Use revocable trust if need to call back assets (longevity risk) outweighs claims against settlor.

99
Q

Ability to take on risk is a function of what?

A

Time horizon, liquidity, and priority.

100
Q

What are the steps to think about with goal prioritisation?

A

Is there clear prioritization? If not, state there are a number of competing goals and the manager will need to work with the client to decide what goals are most important. Use capital sufficiency to asses likelihood of achieving goals given portfolio. If not likely, reassess goals so they are supported by capital sufficiency.

101
Q

How are vested and unvested pension benefits treated (HC or FC)?

A

Unvested is HC and vested is FC.

102
Q

What is the utility function equation?

A

E(R) – 0.005 λ σ^2

Enter as percentages.

103
Q

What kind of portfolios should you use a Treynor ratio to compare performance?

A

Diversified portfolios because it uses systematic risk.

CFA3 (8 decks)

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