PAPER NO. 7 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 relevant investment methods and techniques in portfolio management.
LEARNING OUTCOMES
A candidate who passes this paper should be able to:
• Prepare investment policy statements
• Construct optimal portfolios and illustrate the theory and empirical applications of asset pricing models
• Apply portfolio management concepts and techniques to their specific business problems
• Use documents within the Investment sector
• Apply behavioural finance concepts in portfolio management
CONTENT
1. Overview of Portfolio Management
1.1 Portfolio perspectives in investments and its importance
1.2 Portfolio management and strategies
1.3 Types of investors, their distinctive characteristics and specific needs
1.4 Investment Vehicles; Pooled investment products (mutual funds, exchange traded funds, separately managed accounts, hedge funds, buyout funds/private equity funds and venture capital funds)
1.5 Portfolio Diversification: Avoiding disaster
1.6 Steps in the Portfolio Management Process: Planning Step; Understanding the client’s needs, Investment Objectives, Preparation of an investment policy statement (IPS), Major components of Investment policy statement. Execution Step; Asset Allocation – Asset Allocation Concepts, Types of Asset Allocation, Security Analysis, Portfolio Construction. Feedback Step; Portfolio Monitoring and Rebalancing, Performance Measurement and Reporting
1.7 Introduction to Performance Standards
2. Introduction to Portfolio Risk and Return
2.1 Measures of Portfolio risks and estimates: Standard Deviation, Variance and Coefficient of Variation
2.2 Measures of Portfolio return, their calculation, interpretation, and uses: holding period return (HPR), average returns (arithmetic average return, geometric average), time-weighted return, money weighted return, gross return, pre-tax nominal return, after tax nominal return, real return, leveraged return
2.3 Determinants of Required Rates of Return
2.4 Assessing the relationship between Risk and Returns
2.5 Historical Risk Return Characteristics of different asset classes
2.6 Characteristics of major asset classes used to construct portfolios
2.7 Portfolio selection; concept of risk aversion; utility theory
7.8 The effect of the number of assets in a multi asset portfolio on the diversification benefits
3. Capital Market Theory
3.1 Modern Portfolio Theories; Risk Return Framework, Efficient Market Hypothesis,
3.2 Portfolio Theory, Capital Assets Pricing Model (CAPM), Arbitrage Pricing Theory (APT)
3.3 Implications of combining a risk-free asset with a portfolio of risky assets
3.4 Capital allocation line (CAL) and capital market line (CML)
3.5 Systematic and non-systematic risks
3.6 Return generating models and their uses
3.7 Capital asset pricing model (CAPM): assumptions; applications; practical limitations; implications
3.8 Security market line (SML) and its application, the beta coefficient, market risk premium
3.9 Market model: predictions with respect to market returns, variances and co- variances
3.10 Adjusted beta and historical beta: their use as predictors of future betas
3.11 Minimum variance frontier: importance and problems related to its instability
3.12 Arbitrage pricing theory (APT): underlying assumptions and its relation to multifactor models, estimation of expected return on an asset given its factor sensitivities and factor risk premiums, determination of existence of an arbitrage opportunity and how to utilise it
3.13 Understanding and interpretation of active risk, tracking error, tracking risk, information ratio, factor portfolio and tracking portfolio
4. Portfolio Planning and Construction
4.1 Definition of portfolio planning
4.2 Investment objectives: risk and return objectives for a client
4.3 Investors financial risk tolerance: investors ability (capacity) to bear risk and willingness to take risk
4.4 Investment constraints: liquidity, time horizon, tax issues, legal and regulatory factors, unique circumstances, and their effect to the choice of a portfolio
4.5 Ethical responsibilities of a portfolio manager
4.6 Introduction to asset allocation: Theory and practice, mean – variance model, asset assumptions, alpha and beta, diversified asset allocation, consolidated asset allocation
4.7 Factors affecting asset allocation: Goals factors, risk tolerance and time horizon
4.8 Strategies for asset allocation: Age based asset allocation, life cycle funds asset allocation, constant weight asset allocation, tactical asset allocation, insured asset allocation, Dynamic asset allocation
5. Active Portfolio Management
5.1 Definition of active portfolio management
5.2 Alpha and information ratio (IR): post ante and ex ante definitions
5.3 Relationship between information ratio and alphas T-statistic
5.4 The concept of the value added (VA) and the objective of active portfolio management in terms of value added
5.5 The optimal level of residual risk to be assumed with respect to manager ability and investor risk aversion
5.6 Relationship between the choice of a particular active strategy and investor risk aversion
5.7 The ‘Fundamental law of active management’: Definition; assumptions; relationship between the optimal level of residual risk, information coefficient, and breadth; relationship between the value added, information coefficient, and breadth
5.8 Information coefficient (IC) and breadth (BR) as used in determining information ratio
5.9 Market timing versus security selection in relation to breadth and investment skill
5.10 Effect of augmenting original investment strategy with other investment strategies or information changes
6. Documentation of the Investment Sector
6.1 Investment documents
6.2 Objectives of documentation
6.3 Document classification systems
6.4 Types of internal documentation
6.5 Types of external documentation
6.6 Document management
7. Evaluating Portfolio Performance
7.1 Dollar weighted rates of return
7.2 Time weighted rates of return
7.3 Other performance measures
7.4 Risk- adjusted performance measures: Sharpe, Treynor, Jensen, risk- adjusted return on capital, return over maximum drawdown, and the Sortino ratio
7.5 Value at risk (VaR): its role in measuring overall and individual position market risk.
7.6 Methods for estimating VaR: The analytical (variance–covariance), historical and Monte Carlo methods
7.7 Extensions of VaR: Cash flow at risk, earnings at risk, and tail value at risk
7.8 Stress testing and its alternative types
7.9 Use of VaR and stress testing in setting capital requirements
8. Behavioural Finance
8.1 Introduction to behavioural finance: definition; traditional finance versus behavioural finance
8.2 Behavioural Biases: Overconfidence and individual investors, Overconfidence and professional investors, Disposition effect, Risk perceptions, Prospect theory, Decision frames, Mental accounting, Familiarity and representativeness. Behavioural portfolio management; Herding, Social interaction, Emotions and investment decisions
8.3 Expected utility versus prospect theories of investment decision
8.4 Effect of cognitive limitations and bounded rationality on investment decision making
8.5 Behavioural biases of individuals: cognitive errors versus emotional biases; commonly recognised behavioural biases for financial decision making and their implications; individual investor’s behavioural biases; the effects of behavioural biases on investment policy and asset allocation decisions, and how these effects could be mitigated
8.6 Behavioural finance and investment process: Uses and effects of classifying investors in personality types; effects of behavioural factors on advisor client interactions; the influence of behavioural factors on portfolio construction; application of behavioural finance on portfolio construction process; effects of
behavioural factors on an investment analyst forecasts and investment committee decision making: mitigation of these effects
9. Private Wealth Management
9.1 Introduction to wealth management
9.2 The wealth management process
9.3 Taxes: local taxation regimes as in relation to the taxation of dividend, income, interest income, realised capital gains, and unrealised capital gains, impact of different types of taxes and tax regimes on future wealth, computation of accrual equivalent tax rates and after-tax returns, tax profiles of different types of investment accounts and explain how taxes and asset allocation relate.
9.4 Estate planning: purpose of estate planning and the basic concepts of domestic estate planning, forms of wealth transfer taxes and impact of important non tax issues such legal system, a family’s core capital and excess capital
9.5 Wealth Management products and services: alternative investments, hedge funds, setting up trusts, equity, fixed income and structured products
10. Contemporary issues and emerging trends
10.1 Investing in International Markets
10.2 Stock lending
10.3 Program trading
10.4 Case studies on the application of portfolio management
Sample reading and reference materials
1. Levin, G., & Wyzalek, J. (2015). Portfolio Management: A Strategic Approach. Florida: CRC Press.
2. Hunt, P., & Kennedy, J. (2004). Financial Derivatives in Theory and Practice (Revised edition). London: John Wiley & Sons.
3. Kevin, S. (2006). Security Analysis and Portfolio Management. New Delhi: Prentice Hall India.
4. Kasneb e-learning resources (link on the kasneb website).
5. Kasneb approved study packs.