PAPER NO.15 ADVANCED PORTFOLIO MANAGEMENT
UNIT DESCRIPTION
This paper is intended to equip the candidate with the knowledge, skills and attitudes that will enable him/her to apply advanced financial techniques and methods in portfolio management.
LEARNING OUTCOMES
A candidate who passes this paper should be able to:
• Develop investment policy statement for individual and institutional investors
• Construct a portfolio using different asset classes
• Analyse different strategies used to manage a portfolio of different asset classes
• Apply trade execution decisions and techniques in portfolio management
• Undertake portfolio monitoring and rebalancing processes
• Evaluate the performance of a portfolio.
CONTENT
1. Capital market forecasts
1.1 The application framework
1.1.1 Overview of capital market forecasts and approaches
1.1.2 Role of and a framework for capital market forecasts in the portfolio management process, challenges in developing capital market forecasts exogenous shocks and their effect on economic growth
1.1.3 Application of economic growth trend analysis to the formulation of capital market forecasts, approaches to economic forecasting, effect of business cycles affects short- and long-term forecasts, relationship of inflation to the business cycle and the implications of inflation for cash, bonds, equity, and real estate returns
1.1.4 Monetary and fiscal policy effects on business cycles, macroeconomic, interest rate, and exchange rate linkages between economies
1.2 Forecasting asset class returns
1.2.1 Approaches to setting forecasts for fixed-income returns, risks faced by investors in emerging market fixed-income securities and the country risk analysis techniques used to evaluate emerging market economies;
1.2.2 Approaches to setting forecasts for equity investment market returns, risks faced by
1.1.3 Economic and competitive factors effect on forecasts for real estate investment markets and sector returns;
1.1.4 Forecasting exchange rate volatility;
1.1.5 Changes in the component weights of a global investment portfolio based on trends and expected changes in macroeconomic factors
2 Managing individual investor portfolios and institutional investors Portfolio:
2.1 Individual investors:
2.1.1 Overview of investor characteristics: situational profiling (source of wealth, measure of wealth, stage of life); psychological profiling (traditional finance, behavioural finance, personality typing)
2.1.2 Investment policy statement for an individual investor
2.1.3 Strategic asset allocation for an individual investor: Monte Carlo simulation in personal retirement planning
2.2 Institutional investors:
2.2.1 Overview of pension funds: defined-benefit and defined-contribution plans; pension fund risk tolerance; defined benefit and defined contribution investment policy statement; risk management considerations; hybrid pension plans; employee share ownership plans
2.2.2 Other institutional investors: Foundations, endowments, Insurance industry (life and non-life insurance companies), banks, investment intermediaries and other institutional investors; their background and investment setting
3 Asset allocation
3.1 Overview of asset allocation: role of asset allocation in portfolio management, governance structures, articulation of investment objectives, allocation of rights and responsibilities, governance audit, strategic versus tactical asset allocation; importance of asset allocation in portfolio performance; steps involved in establishing an appropriate asset allocation
3.2 Asset allocation and investors and return objectives: dynamic versus static asset allocation; factors affecting asset allocation policy (loss aversion; mental accounting; fear of regret); return and risk objectives in relation to asset allocation, economic balance sheet and asset allocation
3.3 Selection of asset classes: criteria for specifying asset classes; inclusion of international assets (developed and emerging markets)
3.4 Optimisation approaches to asset allocation: mean-variance approach (Its application when adding an asset class in an existing portfolio); resampled efficient frontier; experience-based approaches; asset only, asset/liability management (ALM);); Black – Letterman approach: Monte-Carlo Simulation
3.5 Nondomestic equities and bonds: Their associated risks, costs and opportunities
3.6 Conditional return correlations: their importance when evaluating the diversification effects of nondomestic investments
3.7 Integrating a segmented market with a global market: expected effects on share prices expected returns, and return volatilities
3.8 Formulation and justification of minimum-variance frontier given investment policy statement and capital market expectations.
3.9 Asset allocation with practical constraints
4 Fixed income portfolio management
4.1 Use of liability as a benchmark and use of bond index as a benchmark with respect to investment objectives
4.2 Managing funds against a bond market: classification of strategies (pure bond indexing/full replication approach, enhanced indexing and active investing, full- blown); selection of a benchmark bond index and factors to consider (market value risk, income risk, liability framework risk); use of bond market indices
4.3 Techniques used to align the risk exposures of the portfolio with those of the benchmark bond index: duration matching technique, key rate durations technique
4.4 Assessment of the risk and return characteristics of a proposed trade: total return analysis, scenario analysis
4.5 Bond immunisation strategy: its formulation and evaluation under various interest rate scenarios
4.6 Spread duration and its importance
4.7 Extension of classical immunisation theory: introduction of contingent immunisation
4.8 Risks associated with managing a portfolio against a liability structure: interest rate risk, contingent claim risk, cap risk
4.9 Immunisation strategies for single liability, multiple liabilities and general cash flows: their advantages and disadvantages
4.10 Immunised portfolios: risk immunisation and return maximisation
4.11 Cash flow matching: its use in funding a fixed set of future liabilities; its advantages and disadvantages
5 International and emerging market fixed-income portfolio management strategies
5.1 Effect of leverage on portfolio duration and investment returns
5.2 Use of repurchase agreements (repos) to finance bond purchases: Factors affecting the repo rate
5.3 Measures of fixed income portfolio risk: standard deviation, target semi variance, shortfall risk and value at risk (VaR)
5.4 Use of futures instead of cash market instruments to alter portfolio risk
5.5 Formulation and evaluation of an immunisation strategy based on interest rates
5.6 Use of interest rate swaps and options to alter portfolio cash flows and exposure to interest rate risk; use of credit derivative instruments to address default risk, credit spread risk and downgrade risk in the context of fixed income portfolio
5.7 Potential sources of excess return for an international bond portfolio
5.8 Effect of change in value for a foreign bond when domestic interest rates change, and the bond’s contribution to duration in domestic portfolio, given the duration of the foreign bond and the country beta
5.9 Hedging currency risk in international bond markets; break even spread analysis in seeking yield advantages across international bond market; investing in emerging market debt
6 Equity portfolio management
6.1 Role of equity in the overall portfolio
6.2 Equity investment universe; segmentation by size and style, segmentation by geography, segmentation by economic activity.
6.3 Equity investment approaches: passive approach; active approach; semi-active (enhanced-index) approach; their relevance with respect to expected active return and tracking risk
6.4 Weighting schemes used in the construction of major equity market indices and the biases associated with each
6.5 Passive equity investing: alternative methods for establishing passive exposure to an equity market; indexed separate or pooled accounts, index mutual funds, exchange-traded funds, equity index futures and equity total return swaps
6.6 Approaches to constructing an indexed portfolio: full replication, stratified sampling and optimisation
6.7 Active equity investing: equity investment–styles classifications and risks associated with each; techniques for identifying investment styles; equity style indices; equity style box analysis and style drift; long–short and long-only investment strategies; ‘equitised’ market-neutral and short-extension portfolios; sell disciplines/trading of active investors
6.8 Semi-active equity investing (enhanced-index): derivatives-based and stock- based enhanced indexing strategies
6.9 Managing a portfolio of managers: core-satellite approach to portfolio construction; effect of adding a completeness fund to control overall risk exposures
6.10 Components of total active return (“true” active return and “misfit” active return) and their associated risk measures; alpha and beta separation as an approach to active management;
6.11 Identifying, selecting, and contracting with equity managers
6.12 Structuring equity research and security selection: top-down and bottom-up approaches to equity research
7 Alternative investments portfolio management
7.1 Introduction to alternative investments portfolio management
7.2 Selection of active managers of alternative investment scheme
7.3 Alternative investment benchmarks: construction and interpretation; benchmark bias
7.4 Return enhancement and risk diversification effects of adding an alternative investment to a reference portfolio (for instance a portfolio of bonds and equity only)
7.5 Venture capital: Major issuers and suppliers; purpose of venture capital; buyout funds; use of convertible preferred stock in direct venture capital investment
7.6 Private equity fund: Typical structure and timelines; formulating private equity investment strategy
7.7 Commodity investments: Direct and indirect commodity investment; components of return for commodity futures contracts; role of commodities in a portfolio
7.8 Hedge funds: Typical structure; high water- mark provisions; fund-of-funds; performance and evaluation
7.9 Managed futures: Trading strategies; role in a portfolio
7.10 Distressed securities: Risks associated with investing in distressed securities including event risk, market liquidity risk, ‘J-factor’ risk
8 Currency portfolio management
8.1 Effects of currency movements on portfolio risk and return
8.2 Strategic choices in portfolio management
8.3 Active currency trading strategies based on economic fundamentals, technical analysis, curry trade and volatility trading
8.4 Adjusting the hedge ratio using forward contracts and foreign exchange (FX) swaps
8.5 Trading strategies used to reduce hedging costs and modify the risk return characteristics of a foreign currency portfolio
8.6 Portfolios exposed to multiple foreign currencies: use of cross-hedges ratio, macro-hedges ratio, minimum-variance-hedge ratio
8.7 Challenges for managing emerging market currency exposures
9 Execution of portfolio decisions
9.1 The context of trading: market microstructure: order types and their price and execution uncertainties, their effective spread and their quoted bid ask spread; types of markets and their quality; roles of brokers and dealers
9.2 Costs of trading: transaction costs components (explicit and implicit costs); implementation shortfall and volume weighted average price (VWAP) as measures of transaction costs; use of econometric methods/models in pre-trade analysis to estimate implicit transaction costs
9.3 Major types of traders: their motivation to trade, time versus price preferences and preferred order types; major trading tactics; algorithmic trading strategies and determining factors including order size, average daily trading volume, bid– ask spread and the urgency of the order
9.4 Trade execution decision and tactics: meaning and criteria of best execution; firm’s investment and trading procedures, including processes, disclosures and record keeping with respect to best execution
9.5 Role of ethics in trading
10 Portfolio monitoring and rebalancing
10.1 Monitoring: Fiduciary’s responsibilities in monitoring an investment portfolio; monitoring of investor circumstances, market/economic conditions and portfolio holdings; revisions to an investor’s investment policy statement and strategic asset allocation, given a change in investor circumstances
10.2 Rebalancing: Benefits and costs of rebalancing a portfolio to the investor’s strate- gic asset allocation; calendar rebalancing; percentage-of-portfolio rebalancing; optimal corridor width of an asset class; target portfolio rebalancing versus allowed range portfolio rebalancing; rebalancing strategies (linear, concave, and convex rebalancing strategies); constant mix, buy-and-hold, and constant proportion portfolio insurance (CPPI) rebalancing strategies
11 Evaluating portfolio performance
11.1 Importance of performance evaluation from the perspective of fund sponsors and the perspective of investment managers
11.2 Components of performance evaluation: performance measurement, performance attribution and performance appraisal
11.3 Performance measurement: total, time-weighted, money-weighted rates of return, linked internal rate of return and annualized return
11.4 Benchmarks: concept of a benchmark; properties of a valid benchmark; types; steps involved in constructing a custom security-based benchmark; validity of using manager universes as benchmarks; tests of benchmark quality; hedge funds and hedge fund benchmarks
11.5 Performance attribution: inputs for micro and macro attribution; use of macro and micro performance attribution methodologies to identify the sources of investment performance; use of fundamental factor models in micro performance attribution
11.6 Performance appraisal: risk-adjusted performance measures, including (in their ex post forms) alpha, information ratio, Treynor measure, Sharpe ratio and Modigliani-Modigliani measure (M2); incorporation of portfolio’s alpha and beta into the information ratio, Treynor measure, and Sharpe ratio; use of performance quality control charts in performance appraisal
11.7 Practice of performance evaluation: noisiness of performance data; manager continuation policy decisions
11.8 Investment manager selection; framework for investment manager search and selection, type I and type II errors in manager selection, elements of manager search and selection, capture ratios and drawdown in manager evaluation, qualitative elements of manager due diligence, investment personnel investment decision-making process
12 Performance Standards
12.1 Introduction to the Performance Standards; objectives, key characteristics, and scope, benefits to prospective clients and investment managers; fundamentals of compliance with the performance standards, requirements and recommendations of the performance standards with respect to input data, accounting policies related to valuation and performance measurement;
12.2 Role of performance standards with respect to return calculation methodologies, treatment of external cash flows, cash and cash equivalents, and expenses and fees
12.3 Performance standards and composite return calculations, methods for asset- weighting portfolio returns; composite construction and portfolio management, role of investment mandates, objectives, or strategies in the construction of composites, role of performance standards and composite construction; switching portfolios among composites, timing of the inclusion of new portfolios in composites, and the timing of the exclusion of terminated portfolios from composites;
12.4 Performance standards requirements for asset class segments carved out of multi-class portfolios, performance standards and disclosure requirements, including fees, the use of leverage and derivatives, conformity with laws and regulations that conflict with the global standards, and noncompliant performance periods; performance standards presentation and reporting (timeframe of compliant performance periods, annual returns, composite assets, and benchmarks)
12.5 Merits of high/low, range, interquartile range, and equal-weighted or asset- weighted standard deviation as measures of the internal dispersion of portfolio returns within a composite for annual periods
12.6 Investments that are subject to performance standards for real estate and private equity; provisions of performance standards for real estate and private equity;
12.7 Performance standards for Wrap fee/ valuation hierarchy of the performance standards principles
12.8 Advertisements compliance with the performance standard guidelines
Sample study and reference material
1. Brentani, C. (2004). Portfolio Management in Practice. Amsterdam: Butterwort-Heineman.
2. Fischer, D. E., Jordan, R. J., & Pradhan, A. K. (2018). Security Analysis and Portfolio Management (7th edition). New Delhi: Prentice Hall India.
3. Reilly, F. K., & Brown, K. C. (2018). Investment Analysis and Portfolio Management (11th edition). Australia: South-Western Cengage Learning.
4. Leibowitz, M. L., Emrich, S., & Bova, A. (2009). Modern Portfolio Management: Active Long/Short 130/30 Equity Strategies. New Jersey: John Wiley and Sons.
5. Kasneb e-learning resources (link on the Kasneb website)
6. Kasneb approved study packs.