# Portfolio Management Flashcards

Authorized participants

(APs) A special group of institutional investors

who are authorized by the ETF issuer to

participate in the creation/redemption process.

APs are large broker/dealers, often market

makers.

Creation basket

The list of securities (and share amounts) the

authorized participant (AP) must deliver to the

ETF manager in exchange for ETF shares.

The creation basket is published each

business day.

Creation/redemption

The process in which ETF shares are

created or redeemed by authorized

participants transacting with the ETF

issuer.

Creation units

Large blocks of ETF shares transacted

between the authorized participant (AP) and

the ETF manager that are usually but not

always equal to 50,000 shares of the ETF.

iNAVs

ndicatedÓ net asset values are

intraday Öfair value estimates of an

ETF share based on its creation

basket.

Redemption basket

The list of securities (and share amounts) the

authorized participant (AP) receives when it

redeems ETF shares back to the ETF manager.

The redemption basket is published each

business day.

Describe factors affecting ETF bid–ask spreads.

ETF spreads are positively related to the cost of creation/redemption, the spread on the underlying securities, the risk premium for carrying trades until close of trade, and the APs’ normal profit margin. ETF spreads are negatively related to the probability of completing an offsetting trade on the secondary market. Creation/redemption fees and other trading costs can influence spreads as well.

Describe sources of ETF premiums and discounts to NAV.

ETF premium (discount) % = (ETF price – NAV) / NAV

Sources of premium or discount include timing difference for ETFs with foreign securities traded in different time zones and stale pricing for infrequently traded ETFs.

Describe types of ETF risk.

Risks of investing in ETFs include counterparty risk (common for ETNs), fund closures, and expectation-related risk.

Describe costs of owning an ETF.

ETF costs include trading cost and management fees. Short-term investors focus on lower trading costs while longer-term, buy-and-hold investors seek lower management fees. Trading costs tend to be lower for more-liquid ETFs. Liquidity is evaluated using the ratio of average dollar volume to average assets (higher is better).

Explain the creation/redemption process of ETFs and the function of authorized participants.

Authorized participants (APs) can create additional shares by delivering the creation basket to the ETF manager. Redemption is similarly conducted by tendering ETF shares and receiving a redemption basket. These primary market transactions are in kind and require a service fee payable to the ETF issuer, shielding the nontransacting shareholders from the costs and tax consequences of creation/redemption. The creation/redemption process ensures that market prices of ETFs stay within a narrow band of the NAV.

Describe sources of tracking error for ETFs.

Tracking error is the annualized standard deviation of the daily tracking difference. Sources of tracking error include fees and expenses of the fund, sampling, and optimization used by the fund, the fund’s investment in depository receipts (DRs) (as opposed to the underlying shares directly), changes in the index, regulatory and tax requirements, fund accounting practices, and asset manager operations.

Identify and describe portfolio uses of ETFs.

Portfolio uses of ETFs include the following:

- Efficient portfolio management, including liquidity management, portfolio rebalancing, portfolio completion, and transition management.
- Asset class exposure management, including core exposure to an asset class or sub-asset class as well as tactical strategies.
- Active investing, including smart beta, risk management, alternatively weighted ETFs, discretionary active ETFs, and dynamic asset allocation.

Describe how ETFs are traded in secondary markets.

ETFs are traded just like other shares on the secondary markets. Market fragmentation may widen the quoted spreads for European ETFs.

Active factor risk

The contribution to active risk squared

resulting from the portfolio different-than

benchmark exposures relative to factors

specified in the risk model.

Active return

The return on a portfolio minus

the return on the portfolio

benchmark.

Active risk

The standard deviation of

active returns.

Active risk squared

The variance of active returns;

active risk raised to the second

power.

Active specific risk

The contribution to active risk squared

resulting from the portfolio active weights on

individual assets as those weights interact

with assetsÖ residual risk.

Arbitrage

(1) The simultaneous purchase of an undervalued asset or portfolio and sale of an overvalued but equivalent asset or portfolio in order to obtain a riskless profit on the price differential. Taking advantage of a market inefficiency in a

risk-free manner.

(2) The condition in a financial market in which equivalent

assets or combinations of assets sell for two different prices, creating an opportunity to profit at no risk with no commitment of money. In a well functioning financial market, few arbitrage opportunities are possible.

(3) Arisk-free operation that earns an expected positive net profit but requires no net investment of money.

Arbitrage opportunity

An opportunity to conduct an arbitrage; an

opportunity to earn an expected positive net

profit without risk and with no net

investment of money.

Arbitrage portfolio

The portfolio that exploits an

arbitrage opportunity.

Company fundamental factors

Factors related to the company internal performance, such as factors relating to earnings growth, earnings variability, earnings momentum, and financial leverage.

Company share-related factors

Valuation measures and other factors related to share price or the trading characteristics of the shares, such as earnings yield, dividend yield, and book-to market value.

Factor

A common or underlying element

with which several variables are

correlated.

Factor portfolio

Pure factor portfolio portfolio with

sensitivity of 1 to the factor in

question and a sensitivity of 0 to all

other factors.

Factor price

The expected return in excess of the risk

free rate for a portfolio with a sensitivity of 1

to one factor and a sensitivity of 0 to all

other factors.

Factor risk premium

The expected return in excess of the risk

free rate for a portfolio with a sensitivity of

to one factor and a sensitivity of 0 to all

other factors. Also called factor price.

Fundamental factor models

A multifactor model in which the factors are

attributes of stocks or companies that are

important in explaining cross-sectional

differences in stock prices.

Information ratio

(IR) Mean active return divided by

active risk; or alpha divided by the

standard deviation of diversifiable

risk.

Macroeconomic factor model

A multifactor model in which the factors

are surprises in macroeconomic

variables that significantly explain equity

returns.

Macroeconomic factors

Factors related to the economy, such

as the inflation rate, industrial

production, or economic sector

membership.

Priced risk

Risk for which investors demand

compensation for bearing (e.g., equity risk,

company-specific factors, macroeconomic

factors).

Pure factor portfolio

A portfolio with sensitivity of 1 to

the factor in question and a

sensitivity of 0 to all other factors.

Security selection risk

Active specific riskThe contribution to active

risk squared resulting from the portfolio

active weights on individual assets as those

weights interact with assetsÖ residual risk.

Standardized beta

With reference to fundamental factor models, the

value of the attribute for an asset minus the average

value of the attribute across all stocks, divided by

the standard deviation of the attribute across all

stocks.

Statistical factor model

A multifactor model in which statistical

methods are applied to a set of historical

returns to determine portfolios that best

explain either historical return covariances or

variances.

Systematic risk

Risk that affects the entire market or

economy; it cannot be avoided and is

inherent in the overall market. Systematic

risk is also known as non-diversifiable or

market risk.

Tracking error

The standard deviation of the differences

between a portfolio returns and its

benchmarkÖs returns; a synonym of active

risk. Also called tracking risk.

Tracking risk

The standard deviation of the differences

between a portfolio returns and its

benchmarkÖs returns; a synonym of active

risk. Also called tracking error.

Define arbitrage opportunity and determine whether an arbitrage opportunity exists.

An arbitrage opportunity is defined as an investment opportunity that bears no risk and has no cost, but provides a profit. Arbitrage is conducted by forming long and short portfolios; the proceeds of the short sale are used to purchase the long portfolio. Additionally, the factor sensitivities (betas) of the long and short portfolios are identical and, hence, our net exposure to systematic risk is zero. The difference in returns on the long and short portfolios is the arbitrage return.

Describe uses of multifactor models and interpret the output of analyses based on multifactor models.

Multifactor models can be useful for risk and return attribution and for portfolio composition. In return attribution, the difference between an active portfolio’s return and the benchmark return is allocated between factor return and security selection return.

In risk attribution, the sum of the active factor risk and active specific risk is equal to active risk squared (which is the variance of active returns):

active risk squared = active factor risk + active specific risk

active factor risk = active risk squared − active specific risk

Multifactor models can also be useful for portfolio construction. Passive managers can invest in a tracking portfolio, while active managers can go long or short factor portfolios.

A factor portfolio is a portfolio with a factor sensitivity of 1 to a particular factor and zero to all other factors. It represents a pure bet on a single factor and can be used for speculation or hedging purposes. A tracking portfolio is a portfolio with a specific set of factor sensitivities. Tracking portfolios are often designed to replicate the factor exposures of a benchmark index like the S&P 500.

Describe the potential benefits for investors in considering multiple risk dimensions when modeling asset returns.

Multifactor models enable investors to take on risks that the investor has a comparative advantage in bearing and avoid the risks that the investor is unable to absorb.

Models that incorporate multiple sources of systematic risk have been found to explain asset returns more effectively than single-factor CAPM.

Explain sources of active risk and interpret tracking risk and the information ratio.

Active return is the difference between portfolio and benchmark returns (RP − RB), and active risk is the standard deviation of active return over time. Active risk is determined by the manager’s active factor tilt and active asset selection decisions:

active risk squared = active factor risk + active specific risk

The information ratio is active return divided by active risk

Calculate the expected return on an asset given an asset’s factor sensitivities and the factor risk premiums.

Expected return = risk-free rate + ∑(factor sensitivity) × (factor risk premium)

Describe and compare macroeconomic factor models, fundamental factor models, and statistical factor models.

A multifactor model is an extension of the one-factor market model; in a multifactor model, asset returns are a function of more than one factor. There are three types of multifactor models:

Macroeconomic factor models assume that asset returns are explained by surprises (or shocks) in macroeconomic risk factors (e.g., GDP, interest rates, and inflation). Factor surprises are defined as the difference between the realized value of the factor and its consensus expected value.

Fundamental factor models assume asset returns are explained by the returns from multiple firm-specific factors (e.g., P/E ratio, market cap, leverage ratio, and earnings growth rate).

Statistical factor models use multivariate statistics (factor analysis or principal components) to identify statistical factors that explain the covariation among asset returns. The major weakness is that the statistical factors may not lend themselves well to economic interpretation.

Describe arbitrage pricing theory (APT), including its underlying assumptions and its relation to multifactor models.

The arbitrage pricing theory (APT) describes the equilibrium relationship between expected returns for well-diversified portfolios and their multiple sources of systematic risk. The APT makes only three key assumptions: (1) unsystematic risk can be diversified away in a portfolio, (2) returns are generated using a factor model, and (3) no arbitrage opportunities exist.

Active share

A measure of how similar a portfolio is to its

benchmark. A manager who precisely replicates the

benchmark will have an active share of zero; a

manager with no holdings in common with the

benchmark will have an active share of one.

Conditional VaR (CVaR)

The weighted average of all loss outcomes in the

statistical (i.e., return) distribution that exceed the VaR

loss. Thus, CVaR is a more comprehensive measure

of tail loss than VaR is. Sometimes referred to as the

expected tail loss or expected shortfall.

Convexity

A measure of how interest rate

sensitivity changes with a change

in interest rates.

Delta

The relationship between the option price and the

underlying price, which reflects the sensitivity of the

price of the option to changes in the price of the

underlying. Delta is a good approximation of how an

option price will change for a small change in the

stock.

Duration

A measure of the approximate

sensitivity of a security to a change in

interest rates (i.e., a measure of interest

rate risk).

Ex ante tracking error

A measure of the degree to which the

performance of a given investment portfolio

might be expected to deviate from its

benchmark; also known as relative VaR.

Expected shortfall

A measure of the degree to which the

performance of a given investment portfolio

might be expected to deviate from its

benchmark; also known as relative VaR.

Expected tail loss

Conditional VaR

Gamma

A measure of how sensitive an option delta is to a

change in the underlying. The change in a given

instrumentÖs delta for a given small change in the

underlyingOs value, holding everything else

constant.

Historical simulation method

The application of historical

price changes to the current

portfolio.

Incremental VaR (IVaR)

A measure of the incremental effect of an asset on the

VaR of a portfolio by measuring the difference

between the portfolio VaR while including a specified

asset and the portfolios VaR with that asset

eliminated.

Lookback period

The time period used to

gather a historical data set.

Marginal VaR (MVaR)

A measure of the effect of a small change in a position size on portfolio VaR.

Maximum drawdown

The worst cumulative loss ever sustained by an asset

or portfolio. More specifically, maximum drawdown is

the difference between an asset or a portfolioÔs

maximum cumulative return and its subsequent

lowest cumulative return.