Last Revised: 08/19/2021

Level III - Section 5

Readings Page

Portfolio Management for Institutional Investors 2

Trade Strategy and Execution 22

Portfolio Performance Evaluation 37

Investment Manager Selection 57

Case Study in Portfolio Management: Institutional 68

Case Study in Risk Management: Private Wealth 77

Integrated Cases in Risk Management: Institutional 83

Reviews 93

OID100851170.

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 Last Revised: 08/19/2021

Portfolio Management for Institutional Investors

a. discuss common characteristics of institutional investors as a group;

b. discuss investment policy of institutional investors;

c. discuss the stakeholders in the portfolio, the liabilities, the investment time
horizons, and the liquidity needs of different types of institutional investors;

d. describe the focus of legal, regulatory, and tax constraints affecting different
types of institutional investors;

e. evaluate risk considerations of private defined benefit (DB) pension plans in

relation to 1) plan funded status, 2) sponsor financial strength, 3) interactions
between the sponsor’s business and the fund’s investments, 4) plan design,
and 5) workforce characteristics;

f. prepare the investment objectives section of an institutional investor’s

investment policy statement;

g. evaluate the investment policy statement of an institutional investor;

h. evaluate the investment portfolio of a private DB plan, sovereign wealth

fund, university endowment, and private foundation;

i. describe considerations affecting the balance sheet management of banks

and insurers.
OID100851170.

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 Last Revised: 08/19/2021

PM for Institutional Investors

- Common characteristics: LOS a

1/ Scale (size): small < $25M → may be unable to access -discuss
Pg-1
certain investments that require minimum investment
- more likely to rely on external managers
and investment consultants
large → scale benefits → access to investments can
attract internal asset managers
very large > $10B → diseconomies of scale VC/PE

- unable to access niche investments sm. cap. g.

- positions would be too small
- typically pushed into private assets, infrastructure assets
2/ Long-term investment horizon: long inv. horizons + low liquidity needs

allow for holdings of alternative investments

- banks/insurance → perpetual horizon but typically short
maturity holdings

- Common characteristics: LOS a

3/ Regulatory frameworks: ➝ legal, regulatory, tax, accounting -discuss
Pg-2
– differ by national jurisdiction
Key drivers: investor protection, safety/soundness of financial
institutions, integrity of financial markets
4/ Governance framework → BoD + investment committee

• establish investment policy (SAA), define risk appetite,

set investment strategy, monitor investment performance
OID100851170.

implemented through an investment office

- can be internal or external ➝ PF, SWF, E/F
↓
banks/insurance
5/ Principal-agent issues
- agents may be internal or external e.g. → high base fee
interests not regardless of
aligned - managed through highly developed performance
governance models, high levels of
accountability

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LOS b
➝ Investment Policy/ key document → IPS -discuss
• mission → investment objectives → within guidelines Pg-3
• return target • level of risk

within
SAA designed and implemented
Implementation approaches:
1/ Norway model: traditional style, 60/40 equity/FI allocation, very few AI,
largely passive, tight error tracking limits
+/ low cost, transparent, suitable for large scale, easy to understand
–/ limited value-added potential
2/ Endowment model: high AI exposure, active mgmt., outsourcing
(externally managed assets)
- suitable for: long-term inv. horizon, low
liquidity needs, skill in sourcing AI
+/ high value-added potential
–/ expensive, difficult to implement for very large funds/small funds

LOS b
➝ Investment Policy/ key document ➝ IPS
-discuss
Implementation approaches: Pg-4
3/ Canada model: high AI exposure, active mgmt., insourcing
+/ high value-added potential, development of internal capabilities
–/ potentially expensive, difficult to manage
OID100851170.

4/ Liability-Driven Investing (LDI) model: focus on hedging liabilities

and interest rate risk by using duration-matched FI exposure
- may also include a growth component
+/ explicit recognition of liabilities as part of the investment process
–/ certain risks (longevity, inflation) may not be hedged

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Pension Funds (1/6)

LOS c
Background/ designed to provide for the financial
-discuss
needs of retirees Pg-5
- DB & DC (Exhibit 2 – summary)
DB DC
Benefit payments - defined by contract - determined by investment
performance
Contributions - primarily employer (may - primarily employee (may
involve employee also) involve employer also)
Investment decision making - pension fund determines - employee determines how
how much to save and what much to save and what to
to invest in invest in
Investment risk - employer bears the risk - employer bears the risk
Mortality/Longevity risk - mortality risk is pooled - employee bears longevity
- employee has no longevity risk
risk

Stakeholders/ DB:/ LOS c

-discuss
➝ employer (plan sponsor) → benefits are company liabilities
Pg-6
employer/employee contributions
- funded from 2 sources:
return on plan assets

- employer contributions vary depending on funded status

- may want to minimize contributions, minimize volatility of the surplus
(may be at odds
with desires of emp./ret.)
OID100851170.
➝ employees & retirees (plan beneficiaries)
➝ CIO & investment staff → must make decisions for (within IPS)
➝ governments
➝ unions
➝ shareholders → shortfalls are liabilities, contributions reduce net income
DC:/ ➝ plan beneficiaries offer suitable investments
➝ the employer – still has fiduciary responsibility employer contributions
education (straight or
➝ the board – select default investment option
matching)
➝ government

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- Liabilities and Investment Horizon/ LOS c

-discuss
DB/ liability = PV of all future payments
years of service Pg-7
depends on final salary
life expectancy
- requires assumptions about:
- future salary increases, expected vesting, life expectancy
- also requires a discount rate: typically, a market rate
e.g./ gov’t. yields, IG corporate yields, swap rates (Libor)
∴ most pension funds have adopted an LDI approach
- in some cases, increases in expected returns will result in
(pg. 19 - box) a higher discount rate being used

- main objective: sufficient assets to cover future benefit payments

funded ratio = FV (plan assets)/PV (benefit obligation)
- shortfall = balance sheet liability → may encourage more risk
- surplus = balance sheet asset taking

LOS c
- Liabilities and Investment Horizon/
-discuss
DB/ - investment Pg-8
horizon: ➝ plan assets & liabilities small relative to
sponsor balance sheet → higher risk tolerance (longer IH)
➝ core business correlation with plan assets low → higher risk
tolerance (longer IH)
(∴ plan assets correlation with liabilities high)
➝ volatility of contributions tolerable → longer IH
➝ active/retired mix → lower retired portion → longer IH
OID100851170. ➝ younger the active lives → longer IH

DC/ Liability → equal to the contribution (for the sponsor)

Investment
horizon: each beneficiary will be at a different life stage
∴ different risk tolerance & time horizon
- life-cycle options or target-date options

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LOS c
- Liabilities and Investment Horizon/
-discuss
• Liquidity needs driven by: Pg-9
a) proportion of active to retired – more mature plans have
higher liquidity needs

b) age of workforce – older work force = higher liquidity needs

c) plan funded status – surplus = lower employer contributions

∴ higher liquidity needs

d) participant switching/withdrawals → if allowed → higher liquidity

needs
Investment time horizon interaction: low liquidity needs - can hold
larger balances in illiquid assets (AI), equities,
and corporate bonds
Example #1/

LOS d
➝ External Constraints/ -describe
Pg-10
Legal & Regulatory/ varies by country

- similar themes: ➝ reporting & transparency

➝ funding requirements
➝ discount rates

Tax & Accounting/ restrictions on plan design, governance and

investment activities in order to qualify
for favourable tax treatment
OID100851170.

DB/ – typically tax exempt

DC/ – typically tax deferred (contributions are pre-tax)

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LOS e
➝ Risk Considerations (DB):
-evaluate
1/ Plan funded status → higher funded status → greater risk Pg-11
tolerance
(fully-funded) • LDI, duration-mgmt., cash-flow matching
• grow assets at a higher rate than liabilities - involves more
(under-
• invest in more defensive assets to reduce investment risk
funded)
funded status variability – plan sponsor is willing to make
higher contributions over time

2/ Sponsor financial strength: lower financial strength → higher future

contribution risk
• high debt ratios
• low current & expected profitability

lower risk tolerance

- relative size of plan assets/liabilities to the size of
the sponsor: high → lower risk tolerance

LOS e
➝ Risk Considerations (DB):
-evaluate
3/ Sponsor and pension fund common risk exposures: Pg-12
- limitation of fund holding equity of sponsor
- correlation of sponsor operating results with pension
asset returns high → lower risk tolerance
4/ Plan design: provision for early retirement reduce duration of plan
provision for lump-sum distributions liabilities = lower risk
tolerance
OID100851170. 5/ Workforce characteristics:
• older workforce higher liquidity requirement
• higher ratio of retired lives = lower risk tolerance

• lower workforce turnover → higher vesting rate → higher liability

- lower funded status = lower risk tolerance (PBO)

• retired workers → longevity risk for sponsor → increased life

expectancy
(example #2) = higher PBO

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➝ Investment objectives/ LOS f

-prepare
Risk objectives: may be stated in terms of pension
Pg-13
surplus volatility or in terms of shortfall
• funded status of 100% w.r.t. PBO
e to • funded status above some level to avoid reporting
relativ
s
liabilitie a pension liability
• funded status above some regulatory threshold
• minimize year-to-year volatility of future contribution
e to
relativ payments
ut ion s
contrib • minimize probability of having to make future contributions

• may also state absolute risk objectives

➝ Investment Objectives/ LOS f

-prepare
Return objectives: achieve returns that adequately fund
Pg-14
its pension obligation on an inflation-adjusted basis
- achieve a long-term rate of return on plan assets that
exceeds the assumed discount rate
∴ return requirement = discount rate used to calculate PVliabilities

- return objective may be related to

a) future pension contributions – make future contributions = 0
b) pension income ➝ maintain or increase pension income
(a well funded plan can generate negative expense)
OID100851170. Note: objectives may differ for the active lives portion vs. the retired lives

DC/
- prudently grow assets that will support spending needs in retirement
- outperform policy benchmark or/ outperform other DC plans
(pg. 30 – samples)

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LOS h
➝ Investment portfolio/ -evaluate
- asset allocations Pg-15
1/ Equities - growth role, inflation hedge
- allocation to equity has been decreasing over time
(57% - 47%, 97/2017)
2/ Fixed income - defensive role, hedge interest rate risk
- holdings may have a regulatory minimum
- reduces volatility of funded ratio
3/ Alternatives - low or even negative correlations with traditional
asset classes
- can act as an inflation hedge
- allocations have been increasing (4% to 25% → 97/2017)
(example #3)

Sovereign Wealth Funds (2/6)

LOS c-h
- state-owned investment funds (invest in real or Pg-16
financial assets)
5 broad types:
1/ Budget stabilization funds – insulate the budget and economy from
commodity price volatility and external shocks
2/ Development funds – allocate resources to socio-economic projects,
typically infrastructure
3/ Savings funds – to share wealth across generations by transforming
OID100851170. non-renewable assets into diversified financial assets
4/ Reserve funds – reduce the negative carry costs of holding reserves
or to earn a higher return on ample reserves
5/ Pension reserve funds – meet future outflows (shortfalls) w.r.t. pension
liabilities

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➝ Stakeholders/ LOS c–h

➝ current and future citizens Pg-17
➝ government
➝ external asset managers, SWF mgmt., investment committee
➝ Liabilities and Investment Horizon
- do not generally have clearly defined liabilities
➝ Budget stabilization ➝ uncertain liabilities, relatively short IH
- avoid assets that are highly correlated with the main source of
- mainly invest in gov’t. bondsv gov’t. revenue
➝ Development ➝ uncertain liabilities, medium to long-term IH
➝ Savings ➝ long-term liabilities and IH
- risky and illiquid assets, but avoid assets highly correlated with
the non-renewable resource it is diversifying from
➝ Reserve ➝ liabilities are the CB, monetary stabilization bonds, long IH
➝ Pension reserve ➝ liability is future pension-related obligations, long-term
- accumulation phase/decumulation phase IH
- equity, AI ➝ property, infrastructure, PE

➝ Liquidity needs/ LOS c–h

Pg-18
- budget stabilization – high level of liquidity
- assets that have a low risk of loss over short periods
(cash, liquid IG, fixed income)
- development – low liquidity needs
- savings – low liquidity needs
- reserve – lower than stabilization, higher than savings
- pension reserve – accumulation phase → low liquidity needs
OID100851170.
- decumulation phase v→ high liquidity needs
➝ External constraints/
• Legal & Regulatory – established by national legislation
• Tax & Accounting – tax-free status by legislation
➝ Investment Objectives/
- budget stabilization – capital preservation
- returns in excess of inflation with a low probability
of a negative return in any given year

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Investment Objectives/ LOS c–h

- development – achieve a real rate of return in excess of real GDP Pg-19

or productivity growth
- savings – maintain purchasing power of the assets in perpetuity while
achieving investment returns sufficient to sustain the spending
necessary to support ongoing gov’t. activities
- reserve – achieve a rate of return above the return the gov’t. must
v
pay on its monetary stabilization bonds
- pension reserve – earn sufficient returns to maximize the likelihood
of being able to meet future unfunded pension, social security
and/or health care liabilities of plan participants as they arise
(example #4)
➝ Asset allocation
- budget stabilization – fixed income and cash

➝ Asset allocation LOS c–h

Pg-20
- savings – growth assets (equities, AI)
- reserve – equity, FI, AI
- pension reserve – large equity, ~ 10 – 15% AI

B C

PE/HF
vE C - private debt
B
OID100851170.

E B

Infrastructure, PE,
E B private debt, HF
typically follow
endowment model

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Endowments/Foundations (4/6)

➝ University endowments/ long-term investment portfolios LOS c–h

of universities Pg-21
- not subject to a specific legally required spending level
- typically the principal amount of any donation must be
preserved in perpetuity
➝ Foundations/ grant-making institutions funded by gifts and investment assets

4 types
1. Community foundations – make social/educational grants for the benefit
v
of a local community

2. Operating foundations – operate a not-for-profit business for charitable

purposes

3. Corporate foundations – established by businesses, funded from profits

4. Private grant-making foundations – established by individual donors/families

to support specific types of charities

Endowments/ LOS c–h

➝ Stakeholders ➝ current & future students Pg-22

➝ alumni – typically the donors (general or restricted support)

➝ current & future faculty/administrators – payouts support
operating budgets
➝ Investment Horizon: perpetual (maintain long-term purchasing power)
➝ Liabilities: future stream of payouts to the university based on a
OID100851170.
spending policy
v
1/ Constant growth rate – Fixed income × (1 + infl.)
- typically floor at 4%, cap at 6% of assets
inflation = higher education inflation
2/ Market Value Rule - %’age of moving average (3-5 yrs.) of asset value
- tends to be procyclical
3/ Hybrid Rule – weighted average of 1 & 2 (Yale spending rule)
𝐒𝐩𝐞𝐧𝐝𝐢𝐧𝐠 𝐭"𝟏 = 𝐰[𝐒𝐩𝐞𝐧𝐝𝐢𝐧𝐠 𝐭 × (𝟏 + 𝐢𝐧𝐟𝐥. )] + (𝟏 − 𝐰)(𝐒𝐩𝐞𝐧𝐝𝐢𝐧𝐠 𝐫𝐚𝐭𝐞 × 𝐀𝐔𝐌)
w = 0 → Market value rule w = 1 → Constant growth rate

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Endowments/ LOS c–h

➝ Liabilities: since the aim is to maintain purchasing Pg-23
power, target real return ≥ spending rate
(5% - 5.5%)
- other issues/
1/ gifts and donations – offset spending rate
2/ %’age of operating budget supported → lower → higher risk tolerance
3/ ability to issue debt – creates a defined liability, but also
allows for more illiquid investments
➝ Liquidity needs – annual net spendingv→ 2% to 4% after gifts and donations
- low liquidity needs, high risk tolerance, perpetual IH

significant allocation to illiquid investment classes

➝ Foundations/
➝ Stakeholders ➝ founding family
➝ donors
➝ grant recipients
➝ broader community

LOS c–h
➝ Foundations/
Pg-24
➝ Investment Horizon – very long-term/perpetual, except for limited life
➝ Liabilities ➝ U.S., legal requirement to spend 5% of AUM + investment fees

or face tax penalty

➝ must also spend any donation in the yr. received
(flow-through)

OID100851170.
- may be able to issue debt → creates a defined liability
→ increases risk tolerance
v
(pg. 50 – box–top)
- foundations rely on investment returns to support operating budgets
∴ less illiquid investments vs. endowments
(pg. 50 – box–bottom)
➝ Liquidity needs – relatively low, annual net spending of at least 5%
➝ External constraints/
Legal & Regulatory – typically 1) invest on a total return basis
2) exercise a duty of care when making
investment decisions

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LOS c–h
➝ External constraints/
Pg-25
• Tax & Accounting gifts/donations usually tax-deductible for donor
investment income tax-exempt
payouts are tax-exempt if the receiving institution
is exempt from tax
➝ Investment Objectives: Endowment/
primary: - maintain purchasing power of assets into perpetuity
v
- generate investment returns sufficient to sustain the
level of spending necessary to support the university budget
- total real rate of return of 5% with expected volatility 10-15%
over the long-term (inflation = higher education inflation)
3-5 years
secondary: outperform a long-term policy benchmark (pg. 53 – examples)
(example #5)
tertiary: outperform a set of pre-defined peers
(pg. 55 – IPS)

➝ Investment Objectives: private foundations LOS c–h

primary: generate a total real return of 5% (inflation = CPI) plus Pg-26
investment expense with volatility 10-15% over a 3-5 yr. period
real return + inv. expense + CPI = nominal return
secondary: outperform the policy benchmark within some specified
tracking error
(pg. 57 - examples)
➝ Asset allocation/ University endowments – most large endowments
follow the ‘endowment’ model

end of June/2017
v

OID100851170.
larger size = larger AI allocation

smaller size = larger FI allocation

smaller size = larger U.S. equity

allocation
(home bias)

(example #6)

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LOS c–h
➝ Asset allocation/ private foundations
Pg-27
end of YR. 2016
Recall/· foundations support
an entire budget, universities
have other financing sources

· foundations are mandated to

v
payout 5% of AUM to remain
tax-exempt (no further gifts
or donations can add to the
fund)

smaller size → lower AI allocation

(pg. 64 – Welcome Trust)
→ higher vs. equity allocation
largest → very low FI allocation

Banks/Insurance (6/6)
➝ Stakeholders: Banks/ LOS c–h
Pg-28
• External: shareholders, creditors, customers, credit rating
agencies, regulators
• Internal: employees, mgmt., BoD
- balance sheet approach:
Liabilities → Depositors (indiv., corp., gov’t.), derivative counterparties,
creditors
Assets → retail commercial borrowers
➝ Liabilities: Bank/
OID100851170. v
- originate assets (loans), liabilities/deposits, derivatives, FI securities in
the normal course of business
largest asset → loans (≥ 50%), then debt securities (≥ 25%)
largest liability → deposits (≥ 50% of T.L.)
time deposits (term deposits) e.g. CDs – specified
demand deposits - assumed short duration
duration
+ wholesale funding, long-term debt (10-15% of T.A.), securities payable
and repos. (10-20% of T.A.)
➝ Investment Horizon: Banks – perpetual life
But// - short to medium term maturity A/L

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➝ Liquidity needs: Banks/ LOS c–h
- short duration deposits, potential need for increased liquidity in adverse Pg-29
market conditions → banks must maintain mandated liquidity coverage ratios
(LCRs) and net stable funding ratios (NSFRs)
- commercial banks → higher cost of funds, lower liquidity
- retail banks → lower cost of funds, better liquidity
➝ Stakeholders: Insurance/
External → shareholders, derivative counterparties, policyholders, creditors,
regulators, rating agencies
v
Internal → employees, mgmt., BoD
2 forms: stock companies with shareholder ownership
mutual companies with policyholder ownership (shrinking)

Life insurers,
main investment
risk bearers

LOS c–h
➝ Liabilities and Investment Horizon: Insurers/
Pg-30
- business line determines the nature and structure of liabilities
- liabilities are identified with their predictability
Life/ long-term liabilities, high predictability using actuarial analysis
on large portfolios, one-time payout, subject to mortality risk
Investment horizon ➝ long-term, 20-40 yrs. (perpetual life however)
Annuities/ ongoing payouts with shorter duration, subject to longevity risk
v
Property/Casualty: shorter duration liability stream, higher uncertainty
OID100851170.
Investment horizon ➝ shorter than life (perpetual life however)
➝ Liquidity needs: Insurers/
- vary based on line of business
Life: ➝ disintermediation: when rates rise, liquidity requirements rise
P/C: ➝ ample liquidity due to uncertain value & timing of outflows
- high proportions of cash & short-term FI securities
- marketable gov’t. bonds of various maturities (laddered)

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➝ Liquidity needs: Insurers/ LOS c–h

- investment portfolios segmented into 2 major components Pg-31

1/ Reserve portfolio ➝ meet policy liabilities (highly liquid, low risk)

2/ Surplus portfolio ➝ intended to realize higher returns (may have AI)
➝ External constraints/
Legal/Regulatory: complex and vary by jurisdiction
- regulators focus on 1) capital adequacy attempt to
v mitigate systemic
2) liquidity
3) leverage or contagion risk
Capital adequacy ➝ lowering the risk of assets through regulation
- require diversification, specific levels of asset
quality, maintaining specified levels of liquidity
- requirements on liabilities ➝ funding sources diversified
over time and among different groups
- limit size and concentration of potential policy claims

➝ External constraints/ LOS c–h

Tax/Accounting: 3 types of accounting systems Pg-32

1) standard financial accounting - IFRS, GAAP

2) statutory accounting - imposed by regulators
- subtraction of intangible assets, acceleration of certain
expenses, recognition of additional reserves
- results in lower earnings, lower equity capital
v
3) true economic accounting - mark-to-market all A/L
- results in most volatile earnings
OID100851170.
- Banks, Insurance companies are taxable
➝ Investment Objectives/ Bank
primary: manage bank’s liquidity and risk position relative to non-securities
assets, derivative positions, liabilities & sh. capitalization (pg. 75 - box)
- asset/liability management committee ➝ sets the IPS, has the
ability to mandate adjustments on the A or L side of the BS

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➝ Investment Objectives/ Bank LOS c–h

Pg-33
- objectives in managing securities portfolio:
1/ manage overall interest rate risk - securities are an adjustment
2/ manage liquidity mechanism for interest rate risk
3/ produce income
4/ manage credit risk
- below average risk tolerance w.r.t.v securities portfolio
Insurance Companies/
- manage investment portfolios with a focus on liquidity
- grow surplus over time (sensitive to any loss of principal or any
significant interruption of investment income)
- mismatches in DA & DL may erode surpluses with
interest rate volatility
(pg. 76 - IPS)

Balance Sheet Mgmt. ➝ Banks/Insurers

LOS i
➝ Investment Strategy/ need is to fund deposits, policy
-describe
claims, derivatives payoff, debtholders Pg-34
- underlying investment strategy is mainly LDI
1. A = L + E
𝐀 𝐋
2. ∆𝐀 = ∆𝐋 + ∆𝐄 ➝ × @ 𝐀 & 𝐋
B , 𝐭𝐡𝐞𝐧 ÷ 𝐛𝐲 𝐄
∆𝐄 ∆𝐀 𝐀 ∆𝐋 𝐋
3. 𝐄
∙ 𝐀
@𝐄B − e.g. 70 = 63 + 7 → increase A by 1%
𝐋
@𝐄B
A = L + E
𝟕𝟎 𝟔𝟑
70.7 = 63 + 7.7
𝟏𝟎% = 𝟏% @ 𝟕 B − 𝟎% @𝟕𝟎B v equity ↑ 10%
OID100851170.
10%10%

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∆𝐄 ∆𝐀 𝐀 ∆𝐋 𝐋
LOS i
3. 𝐄
∙ 𝐀
@𝐄B − 𝐋
@𝐄 B ÷ yields -describe
Pg-35
∆𝐄 ∆𝐀 𝐀 ∆𝐋 𝐋 𝑷𝑽! / 𝑷𝑽" ∆𝑷𝑽
4. 𝐄∆𝐲
= 𝐀∆𝐲
@𝐄B − 𝐋∆𝐲
@𝐄B 𝑴𝒐𝒅𝑫𝒖𝒓 = 𝟐∆𝒚𝑷𝑽𝟎
= ∆𝒚𝑷𝑽𝟎

𝐀 ∆𝐋 𝐋
𝐃𝐄 = 𝐃𝐀 R S − R S ➝ interest rates on liabilities may
𝐄 𝐋∆𝐲 𝐄
not change by same magnitude
∆𝐋 ∆𝐢 𝐋 as yields @×
∆𝐢
B
R SR S v ∆𝐢
𝐋∆𝐢 ∆𝐲 𝐄

𝑨 ∆𝒊 𝑳
𝑫𝑬 = 𝑫𝑨 R S − 𝑫𝑳 R S R S ➝ over modest yield changes, the
𝑬 ∆𝒚 𝑬
volatility of equity capital is a
mod.dur mod.dur
of assets degree of of
function of degree of leverage,
leverage
liab. mod.dur of A & L, correlation of changes
liab. in yields of A & L
𝝆∆𝒊,∆𝒚

LOS i
-describe
Pg-36
liab.

v
OID100851170.

· moderate differences between DA & DL can imply durations

for equity that can be sizable in either a pos. or neg. direction
(regulators do not want large DA/DL mismatches)
- the higher the leverage, more critical it is to have DA = DL

20
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➝ to lower DA ➝ hold cash, deposits at CB, foreign reserves, LOS i

-describe
or other zero duration assets
Pg-37
➝ make business loans with floating rates
➝ credit card balances, real estate loans - adjustable rates
➝ fixed rate mortgages ➝ securitized and sold off
➝ to raise DL ➝ issue intermediate/long-term debt
➝ use subordinated capital securities (CoCo bonds)
➝ perpetual preferred v
➝ futures, swaps
(example #7)

∆𝐄 ∆𝐀 𝐀 ∆𝐋 𝐋
3. = # $ − # $ ➝ expressed as volatilities:
𝐄 𝐀 𝐄 𝐋 𝐄
recall
𝛔𝟐𝐩 = 𝐰𝟏𝟐 𝛔𝟐𝟏 + 𝒘𝛔𝟐𝟐 − 𝟐𝐰𝟏 , 𝐰𝟐 𝛒𝛔𝟏 𝛔𝟐
𝐀 𝟐 𝐋 𝟐 𝐀 𝐋 𝛔∆𝐀 𝛔∆𝐋
4. 𝛔𝟐∆𝐄 = @ 𝐄 B 𝛔𝟐∆𝐀 + @𝐄B 𝛔𝟐∆𝐋 − 𝟐 @ 𝐄 B @𝐄B 𝝆 𝑨 𝑳
𝐄 𝐀 𝐋

𝐀 𝟐 𝐋 𝟐 𝐀 𝐋 𝛔∆𝐀 𝛔∆𝐋 LOS i

4. 𝛔𝟐∆𝐄 = @ 𝐄 B 𝛔𝟐∆𝐀 + @𝐄B 𝛔𝟐∆𝐋 − 𝟐 @ 𝐄 B @𝐄B 𝝆 𝑨 𝑳 -describe
𝐄 𝐀 𝐋
Pg-38

- if ρ = 1, 𝛔𝟐∆𝐄 shrinks to minimal

𝐄
amounts, even for
high leverage

v
- as correlations between assets
and liabilities drop, as leverage
OID100851170. increase, 𝛔𝟐∆𝐄 ↑
𝐄

(Exhibit #27)
(Example #8)
(Example #9)

21
 Last Revised: 08/19/2021

Trade Strategy and Execution

a. discuss motivations to trade and how they relate to trading strategy;

b. discuss inputs to the selection of a trading strategy;

c. compare benchmarks for trade execution;

d. recommend and justify a trading strategy (given relevant facts);

e. describe factors that typically determine the selection of a trading algorithm

class;

f. contrast key characteristics of the following markets in relation to trade

implementation: equity, fixed income, options and futures, OTC derivatives,
and spot currency;

g. explain how trade costs are measured and determine the cost of a trade;

h. evaluate the execution of a trade;

i. evaluate a firm’s trading procedures, including processes, disclosures, and

record keeping with respect to good governance.

OID100851170.

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 Last Revised: 08/19/2021

Trade Strategy and Execution

➝ Motivations to Trade/ LOS a

1/ Profit seeking ➝ active managers -discuss
Pg-1
➝ trading is based on information not fully reflected
in prices
➝ transact in securities believed to be mispriced
· will take steps to hide their trades ➝ prevent information leakage
- execute in multiple, or less transparent, venues
· trade-off: lit ➝ better execution likelihood
dark ➝ less transparency, but higher likelihood
of going unfilled
- short-term profit opportunity ➝ trade urgency is high
➝ execute orders at prices nearer to the market
➝ when alpha decay is high

expected alpha is likely to be rapidly acted on

LOS a
➝ Motivations to Trade/
-discuss
1/ Profit seeking ➝ short-term ➝ may be possible in more liquid Pg-2
markets only
(equities, forex, exch.-traded derivatives)
2/ Risk management/hedging needs - may involve derivatives or just
trades in the underlying securities
- liquid derivatives more cost efficient (illiquid derivatives negate
this advantage)
- investment mandate may not allow derivatives
- use ETFs or the underlying security
OID100851170.
3/ Cash flow needs ➝ may involve high or low trade urgency
- collateral/margin calls ➝ high
- redemption ➝ low
(outflows)
- inflows ➝ may be equitized using ETFs/futures - until next rebalance
➝ minimize cash drag or underlying positions
can be established

23
 Last Revised: 08/19/2021

➝ Motivations to Trade/ LOS a

3/ Cash flow needs – client redemptions are based on NAV -discuss
Pg-3
- NAV based on closing prices
∴ trading at the closing price reduces redemption price risk
- investing or raising cash ➝ trade size and liquidity will determine
what to buy/sell from a risk/return or cost perspective
4/ Corporate Actions/Index Reconstitution/Margin Calls
- cash dividends/coupons need to be reinvested
- margin or collateral calls have high levels of trade urgency
- index tracking portfolios ➝ trades usually done ‘on close’ to
minimize tracking error
- active managers with a benchmark may choose to
rebalance with index reconstitution (in-text question)

➝ Trade Strategy Inputs/ ➝ affect trade urgency, expected costs LOS b

and risks of the trade -discuss
Pg-4
1/ Order characteristics/
a) side of the order - if buying in a rising market or selling in
a falling market ➝ market risk exposure
order may take longer to execute, or cost more
b) size of the order - large order sizes create market impact
(i.e. adverse price movement in a security as a result of
trading an order)
OID100851170. - larger orders take longer to trade
- will usually be traded with lower trade urgency
to reduce market impact
(size best evaluated in terms of % of ADV)

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 Last Revised: 08/19/2021

➝ Trade Strategy Inputs/ LOS b

2/ Security characteristics -discuss
a) security type - liquidity and trading costs will vary by exchange Pg-5

e.g./ gaining EM exposure may be easier/cheaper using ADRs/GDRs

b) short-term alpha - the expected movement in the security price
over the trading horizon (i.e. appreciation, depreciation, reversion)
- alpha decay ➝ results from price movement in the direction of the
trade forecast
➝ if information is reflected in prices quickly, decay is fast
- requires faster trading
c) price volatility - affects execution risk ➝ risk of an adverse price
movement over the trading horizon

➝ Trade Strategy Inputs/ LOS b

2/ Security characteristics -discuss
Pg-6

d) security liquidity - greater liquidity ➝ lower execution risk &

trading costs
- bid-ask spreads will indicate both costs and market depth
- larger trades ➝ broken down, traded more slowly
3/ Market conditions - during market events or crisis ➝ volatility increases
and liquidity decreases
- security liquidity will change because of changes in market
liquidity
OID100851170.
- lower market liquidity ➝ longer trading horizon
but/ - higher volatility may heighten trade urgency
- longer trading horizons increase execution/market risk

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 Last Revised: 08/19/2021

➝ Trade Strategy Inputs/ LOS b

4/ Individual risk aversion - high level of risk aversion, more -discuss
concern about market risk, trade with greater urgency Pg-7

· Market Impact and execution risk

· temporary market impact cost - temporary, short-lived impact
on security price from trading
- usually price reversion after the order is complete
· permanent component of price change associated with trading
is the market impact caused by the information content of the trade
- minimize information leakage ➝ hide trades
· execute over different venues using a mix of order types
· use dark venues

➝ Trade Strategy Inputs/ LOS b

-discuss
· Market Impact and execution risk
Pg-8
· execution risk lowers with faster trading
- trade too fast ➝ increased market impact
- trade too slow ➝ increased execution risk/market risk (in-text question)
LOS c
⇒ Reference Prices/ (a.k.a. price benchmarks) -compare
- can be specified prices, price-based calculations, or price targets
- used in calculating actual trade costs for post-trade evaluation
1/ pre-trade benchmarks - known before the start of trading
a) decision price - security price at the time the PM made
the decision to buy/sell the security

OID100851170.

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 Last Revised: 08/19/2021

⇒ Reference Prices/ LOS c

1/ pre-trade benchmarks -compare
b) previous close - often specified by quantitative PMs Pg-9

c) opening price - used by PMs who trade from the open

(not ‘on the open’ as the trade itself will affect the
opening price)
- used as the ‘decision price’ by fundamental PMs
- opening price does not have overnight risk (all subsequent
events are priced into the opening price)
d) arrival price - price of the security at the time the order
is entered into the market for execution
- typically used by short-term alpha traders
- goal is to transact at or close to current
market prices

⇒ Reference Prices/ LOS c

2/ Intraday benchmarks - for funds that trade passively over the -compare
day, seek liquidity, or rebalancing Pg-10

- do not expect the security to exhibit any short-term

price momentum
a) VWAP - volume-weighted average price - of all trades executed over
the day or trading horizon
- usually when PM wants to participate with volume
patterns
- works well when PM is executing buy and sell orders
b) TWAP - time-weighted average price - average price of trades
OID100851170.

executed over the trading day or trading horizon

- used when outlier trades make VWAP unreliable
i.e. large buy orders at the day’s low or large sell
orders at the day’s high

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 Last Revised: 08/19/2021

LOS c
⇒ Reference Prices/
-compare
3/ Post-trade benchmarks - most common is closing price Pg-11
- funds valued at end of day (NAV) will ‘buy on close’
to minimize tracking error
- typically used by index & mutual funds
4/ Price-target benchmarks
- PMs seeking short-term alpha
- purchase shares at or below some target price
LOS d
➝ Trade Strategies/ - motivation to trade, risk aversion, -select
trade urgency, order size, market conditions -justify

· all determine trade strategy

➝ Trade Strategies/ LOS d

-select
· short-term alpha
-justify
· long-term alpha Pg-12
· risk rebalance
client
· cash flow driven
equitization

➝ Trade Execution (Strategy Implementation) LOS e

· higher touch approach - involves human interaction -describe

- large block trades ➝ urgent

- principal trade or broker risk trades
- dealer is the counterparty
- buy/sell from their own inventory
OID100851170.
- if the security is less active, dealer will
quote a wider bid-ask spread
- called quote-driven, OTC or off-exchange markets

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 Last Revised: 08/19/2021

➝ Trade Execution (Strategy Implementation) LOS e

-describe
· higher touch approach
Pg-13
- large block trades ➝ non-urgent or very illiquid ➝ agency trade
- dealer attempt to arrange trades as a broker
- attempt a cross ➝ matching with other client orders
- then open market ➝ split order up
· RFQ - request for quote ➝ PM requests quotes from dealers
- liquid, standardized securities with order-driven markets
- trading done electronically w/ multiple venues
- for trades other than large orders
- large orders, liquid, standardized ➝ algorithmic trading (DMA)
- high-touch generally inefficient
- subject to front-running

LOS e
➝ Trade Execution (Strategy Implementation)
-describe
· Algorithmic Trading/ slice orders into smaller pieces and Pg-14
trade across venues and over time to reduce the
price impact of an order
- 2 purposes ➝ execution - PM determines what to buy/sell
➝ profit seeking - algorithm determines what to buy/sell
· Execution algorithm classifications/
1/ Scheduled:
a) POV - percent of volume (a.k.a. participation algorithms)
OID100851170.
- as volume increases, algorithm trades more
- trader specifies a participation rate
e.g./ 10%, for every 10K shares traded, algorithm trades 1000

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 Last Revised: 08/19/2021

➝ Trade Execution (Strategy Implementation) LOS e

· Execution algorithm classifications/ -describe
Pg-15
b) VWAP/TWAP
- VWAP ➝ follows a time slicing schedule based on historical volume profiles
- higher percentage traded at the open and close
- may not be optimal for illiquid stocks (may not complete order)
- TWAP ➝ follows an equal-weighted time schedule
- same number of shares per time period
· scheduled algos. appropriate for:
- PM has no expectations of momentum (adverse price moves)
- PM has greater risk tolerance for longer execution time periods
- minimizing market impact
- relatively small order size (5%-10% of expected volume)
- relatively liquid or balanced buy/sell orders

➝ Trade Execution (Strategy Implementation) LOS e

-describe
· Execution algorithm classifications/
Pg-16
2/ Liquidity seeking (opportunistic algorithms)
- trade faster when liquidity shows up across multiple venues
- will use exchanges, ATS and dark pools (for larger quantities)
· appropriate for · large orders with high trade urgency while avoiding
market impact
· printing limit orders would reveal information (minimizes
information leakage)
· less liquid, thinly-traded, or when liquidity is episodic
OID100851170.
3/ Arrival price - trade more aggressively at beginning of order
- called front-loaded strategy
- used when momentum is expected in prices

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 Last Revised: 08/19/2021

➝ Trade Execution (Strategy Implementation) LOS e

· Execution algorithm classifications/ -describe
Pg-17
3/ Arrival price - appropriate for · PM who are risk adverse and
wish to trade more quickly to reduce execution risk
- security is relatively liquid, order is not out-sized (i.e. < 15%
4/ Dark Strategies/liquidity aggregators expected
volume)
- used to avoid any information leakage
- order size is relatively large and may have significant market impact
appropriate for: illiquid securities
· wide bid-ask spreads
· PM does not require full execution (low trade urgency)

➝ Trade Execution (Strategy Implementation) LOS e

· Execution algorithm classifications/ -describe
Pg-18
5/ Smart order routers (SORs)
- SOR determines destination with the highest probability
of executing a limit order
- used with small market or limit orders that will have no
market impact
- best used for orders that require immediate execution or for
limit orders for which printing the order will not leak information
- appropriate for · securities traded on multiple markets
(in text question)

➝ Comparison of Markets/ LOS f

OID100851170. 1/ Equities - exchanges and dark pools (ATS or MTF – multilateral -contrast
trading facilities) Pg-19

- most trades are electronic, algo. trading is common

large & urgent trades ➝ high touch (especially illiquid securities)
large & non-urgent ➝ trading algorithms
small trades - electronic trading
2/ Fixed Income - primarily OTC, quote-driven
- sourcing liquidity relies heavily on dealers
- except for on-the-run U.S. Treasuries, bond/interest rate futures
- small trades and large urgent trades ➝ principal trades
- large, non-urgent ➝ agency trades

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 Last Revised: 08/19/2021

➝ Comparison of Markets/ LOS f

3/ Exchange-Traded Derivatives -contrast
Pg-20
- electronic trading widespread
non-urgent trades
- algo.-trading ➝ mostly futures
- large, urgent trades ➝ liquidity seeking algos.
4/ OTC Derivatives – dealer market, trade sizes usually large
- large, urgent trades ➝ principal trades
- non-urgent ➝ agency trades
5/ Spot forex (currency)
- primarily electronic trading
- large, urgent trades ➝ RFQ

➝ Trade Cost Measurement/ LOS g

-explain
· Implementation shortfall - measures total costs associated
Pg-21
with implementing the investment decision
IS = Paper return - Actual Return
where: Paper return = (𝐏𝐧 −𝐏𝐝 ) 𝐒 Pn = current price
Actual return = ^∑𝐬𝐣 a(𝐏𝐧 ) − ∑𝐬𝐣 𝐩𝐣 − 𝐅𝐞𝐞𝐬 Pd = decision price
S = total shares desired
- IS decomposes total cost into
S > 0 = buy, S < 0 = sell
1/ Execution cost ∑𝐬𝐣 𝐩𝐣 − ∑𝐬𝐣 𝐩𝐝
sj = number of shares
- shares that were transacted executed
- market impact + price drift pj = transaction prices
2/ Opportunity cost ^𝐒 − ∑𝐬𝐣 a(𝐏𝐧 −𝐏𝐝 ) – unexecuted shares
OID100851170.
3/ Fixed Fees – explicit fees

32
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LOS g
➝ Trade Cost Measurement/
-explain
· Implementation shortfall Paper portfolio
Pg-22
e.g./ Monday close = £10 (Pd) 1,000 (10.08 - 10.00) = 80
Tuesday ➝ buy 1000 shares (S) Actual Portfolio
➝ Limit 9.98 1/ Execution costs
- no fills, close = £10.05 ∑𝐬𝐣 𝐩𝐣 − ∑𝐬𝐣 𝐩𝐝
Wednesday ➝ buy 1000 shares = 700(10.07) – 700(10)
➝ Limit 10.07 (Pj) = 7049 – 7000 = 49
- 700 filled, order cancelled 2/ Opportunity costs
(sj) close = £10.08 (Pn) ^𝐒 − ∑𝐬𝐣 a(𝐏𝐧 −𝐏𝐝 ) = 𝟑𝟎𝟎 (𝟏𝟎. 𝟎𝟖 − 𝟏𝟎) = 𝟐𝟒
- commissions/fees .02/sh. 3/ Fixed Fees 700 × .02 = 14
IS = 49 + 24 + 14 = 87
𝟖𝟕
or (𝟏𝟎𝟎𝟎 × 𝟏𝟎) = 𝟖𝟕 𝐛𝐩𝐬

➝ Trade Cost Measurement/ LOS g

-explain
· Expanded IS ➝ execution cost divided into delay
Pg-23
and trading cost
where
(∑𝐬𝐣 )𝐩𝟎 − ^∑𝐬𝐣 a𝐩𝐝 + ∑𝐬𝐣 𝐩𝐣 − (∑𝐬𝐣 )𝐩𝟎
P0 = price when
order is placed
delay trading
- the time from receiving
the order from the PM to actually placing the order
- often resulting from time required to determine the trading
OID100851170. strategy (broker or algorithm choice)
previous example/order placed at P0 = £10.03
delay = 700 (10.03 – 10) = 21
𝟐𝟖
trading cost = 700 (10.07 – 10.03) = 𝟒𝟗

33
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➝ Trade Cost Measurement/ LOS g

· Improving execution performance -explain
Pg-24
· have a process in place that provides traders with broker
performance metrics (reduce delay)
· determine proper order size for the market
- rather than typing up funds/time trying to fill a difficult trade,
reduce the size and concurrently trade something else
(reduce lost opportunity)

typically the result of adverse price

movement and/or illiquidity
(in-text question)

➝ Evaluating Trade Execution/ LOS h

- measure execution quality of a trade -evaluate
Pg-25
- measure overall performance of the trader/broker/algo.
1 − 𝐏 ∗ ) × 𝐒𝐡𝐚𝐫𝐞𝐬
𝐂𝐨𝐬𝐭 ($) = 𝐒𝐢𝐝𝐞 × (𝐏 1 = average execution
𝐏
𝐂𝐨𝐬𝐭 ($/𝐬𝐡) = 𝐒𝐢𝐝𝐞 × (𝐏1 − 𝐏∗)
price of order
1 − 𝐏∗
𝐏
𝐂𝐨𝐬𝐭 (𝐛𝐩𝐬) = 𝐒𝐢𝐝𝐞 × 9 : 𝟏𝟎, 𝟎𝟎𝟎 𝐏 ∗ = reference price
𝐏∗
Side = +1 Buy order
𝐏 ∗ can be: arrival price, VWAP, TWAP,
-1 Sell order
market-on-close
➝ market-adjusted cost: adjusts for general market movement
MAC = Arrival cost (bps) – 𝛃 · Index Cost (bps)
𝐈𝐧𝐝𝐞𝐱 𝐕𝐖𝐀𝐏 / 𝐈𝐧𝐝𝐞𝐱 𝐚𝐫𝐫𝐢𝐯𝐚𝐥 𝐩𝐫𝐢𝐜𝐞
𝐈𝐧𝐝𝐞𝐱 𝐜𝐨𝐬𝐭 (𝐛𝐩𝐬) = 𝐒𝐢𝐝𝐞 × @ 𝐈𝐧𝐝𝐞𝐱 𝐚𝐫𝐫𝐢𝐯𝐚𝐥 𝐩𝐫𝐢𝐜𝐞
B × 𝟏𝟎, 𝟎𝟎𝟎
OID100851170. (in-text question)

➝ Evaluating Trade Execution/ LOS h

-evaluate
· Added Value/ compare arrival cost with estimated pre-trade cost
Pg-26
Added Value (bps) = Arrival cost (bps) – estimated pre-trade cost (bps)
o − 𝐏∗
𝐏
1 = 50.35
e.g./ 𝐏 𝐀𝐫𝐫𝐢𝐯𝐚𝐥 𝐜𝐨𝐬𝐭 = 𝐒𝐢𝐝𝐞 × n p × 𝟏𝟎, 𝟎𝟎𝟎
𝐏∗
𝐏 = 50
∗
𝟓𝟎. 𝟑𝟓 − 𝟓𝟎
est. pre-trade cost = 60 bps = 𝟏 × R S × 𝟏𝟎, 𝟎𝟎𝟎
𝟓𝟎
Buy order = 𝟕𝟎 𝐛𝐩𝐬
∴ added value (bps) = 70 bps – 60 bps = 10 bps

34
 Last Revised: 08/19/2021

➝ Trade Governance/ LOS i

-evaluate
- all asset managers should have a trade policy
Pg-27
document that articulates the firms trading policies
(mandated by major market regulators, e.g. SEC)
➝ objective of a trade policy ➝ ensure execution and order-handling
procedures are in line with the duty of best execution owed to clients

Includes/
1/ meaning of best execution - involves identifying the most
appropriate trade- off between:
· execution price · not just best
· firm must · trading costs price at lowest
take all · speed of execution cost
sufficient steps · likelihood of execution and settlement
to ensure · order size
best execution · nature of trade

➝ Trade Governance/ LOS i

Includes/ -evaluate
2/ Factors determining the optimal execution approach Pg-28

· urgency of order · characteristics of the securities traded

· rationale for a trade · characteristics of the execution venue used
· investment strategy objectives

3/ List of eligible brokers and execution venues

OID100851170. - relevant factors: · quality of service · financial stability
· reputation · settlement capabilities
· speed of execution · cost competitiveness
· willing to do principal trades
4/ Process used to monitor execution arrangements
- all brokers and execution venues used should be subject
to ongoing monitoring for reputational risk, irregularities,
criminal actions and financial stability

35
 Last Revised: 08/19/2021

LOS i
➝ Trade Governance/
-evaluate
4/ Process used to monitor execution arrangements Pg-29
- use of a ‘Best Execution Monitoring Committee’
- firm-wide responsibility for trade execution monitoring
- trading records stored and accessible for several years

(in-test questions - 2)

OID100851170.

36
 Last Revised: 08/19/2021

Portfolio Performance Evaluation

a. explain the following components of portfolio evaluation and their interrelationships:

performance measurement, performance attribution, and performance appraisal;

b. describe attributes of an effective attribution process;

c. contrast return attribution and risk attribution; contrast macro and micro return
attribution;

d. describe returns-based, holdings-based, and transactions-based performance attribution,

including advantages and disadvantages of each;

e. interpret the sources of portfolio returns using a specified attribution approach;

f. interpret the output from fixed-income attribution analyses;

g. discuss considerations in selecting a risk attribution approach;

h. identify and interpret investment results attributable to the asset owner versus those
attributable to the investment manager;

i. discuss uses of liability-based benchmarks;

j. describe types of asset-based benchmarks;

k. discuss tests of benchmark quality;

l. describe problems that arise in benchmarking alternative investments;

m. describe the impact of benchmark misspecification on attribution and appraisal analysis;

OID100851170.
n. calculate and interpret the Sortino ratio, the appraisal ratio, upside/downside capture
ratios, maximum drawdown, and drawdown duration;

o. describe limitations of appraisal measures and related metrics;

p. evaluate the skill of an investment manager.

37
 Last Revised: 08/19/2021

Portfolio Performance Evaluation

⇒ Performance LOS a
a) measurement (typically relative to a benchmark) -explain
Pg-1
- absolute return ➝ what the portfolio achieved over
a specific period
- excess return ➝ portfolio return - benchmark return
- also involves measuring the risk incurred to achieve that return

b) attribution - how that performance was achieved or how

the risk was incurred
- explain absolute or relative return
- what portion was driven by active mgr. decisions
- decompose excess return into component sources
- decompose risk

c) evaluation - draw conclusions regarding the quality of performance

- distinguish manager luck from skill

- an effective process must LOS b

1) account for all the portfolio’s return or risk exposure -describe
2) reflect the investment decision-making process Pg-2

3) quantify the active decisions of the PM

4) provide a complete understanding of the excess
return/risk of the portfolio

· Return attribution – analyzes the impact of LOS c

-distinguish
active investment decisions on returns
OID100851170.
· Risk attribution - analyzes the risk consequences of those decisions
(absolute or benchmark relative terms)
· Micro attribution - understanding the drivers of a manager’s
returns and whether those drivers are consistent with
the stated investment process

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 Last Revised: 08/19/2021

LOS c
· Macro attribution - measures the effect of the
-distinguish
asset owner’s (sponsor’s) choice to deviate
Pg-3
from the SAA
- also measures the effect of the manager selection and
timing decisions

· Returns-based attribution LOS d

- uses only total portfolio return -describe
- most appropriate when underlying portfolio information
is not available at the requires frequency or detail
- easiest to implement
- least accurate
- vulnerable to data manipulation

· Holdings-based attribution LOS d

-describe
- used actual holdings (beginning of period)
Pg-4
- all transactions are assumed to occur at end of day
- accuracy improves when data has shorter time intervals
- most appropriate for investment strategies with little turnover
· transactions-based attribution
- uses both the holdings and the transactions during the
evaluation period
- most accurate, but most difficult and time consuming to implement
- choice of approach depends on the availability and quality
OID100851170. of the underlying data

39
 Last Revised: 08/19/2021

Page 5
➞ Approaches/ - specific approaches have been designed LOS e
to evaluate specific types of assets - interpret

Equity attribution/
1/ Brinson-Hood-Beebower (BHB) Brinson-Fachler (BF)
Pw
Allocation only Allocation
Allocation Interaction = (Pw - Bw) x rB this = (Pw - Bw)(rB - RB)

W Bw
Benchmark Selection Selection
Contribution = (rp - rB) x Bw
= (rp - rB) x Pw
rB rp
Interaction
R = (Pw - Bw)(rp - rB)

Page 5b
Equity attribution/ LOS e
- interpret
1/ Brinson-Hood-Beebower Brinson-Fachler

Rewards: overw. when rs > 0 Rewards: overw. when rs > RB

underw. when rs < 0 underw. when rs < RB

e.g./ wp = 8% wB = 4% rB = -3% RB = -9%

Allocation = (Wp - WB) x rB Allocation = (.08 - .04)(-.03 - (-.09))

OID100851170.
= (.08 - .04) x -.03 = .04 x .06
= -.0012 = .0024
(penalizes) (rewards)

BHB views allocation from an BF views allocation from a

absolute positive or negative relative perspective versus
perspective total benchmark return

40
 Last Revised: 08/19/2021

Page 5c
Equity attribution/ LOS e
1/ Brinson-Hood-Beebower Brinson-Fachler - interpret

RA = 1.9%

Allocation: (Pw - Bw) x rB = (Pw - Bw)(rB - RB)

Energy: (.5 - .5) x .10 = 0% (.5 - .5)(.10 - .082) = 0%
HC: (.3 - .2) x -.02 = -.2% (.3 - .2)(-.02 - .082) = -.0102
Fin: (.2 - .3) x .12 = -1.2% (.2 - .3)(.12 - .082) = -.0038
-1.4% -1.4%

Security: (rp - rB) x Bw Interaction: (rp - rB)(wp - wB)

Energy: (.18 - .10) x .5 = 4% (.18 - .10)(.5 - .5) = 0%
HC: (-.03 - (-.02)) x .2 = -.2% (-.03 - (-.02))(.3 - .2) = -.1%
Fin: (.1 - .12) x .3 = -.6% 3.2% (.1 - .12)(.2 - .3) = .2% .1%

LOS e
· Equity attribution/
-interpret
2/ Factor-based - fundamental factor models Pg-6
- decompose contributions to excess returns from factors
𝐑 𝐩 − 𝐑 𝐟 = 𝛂 + 𝐛𝟏 𝐑𝐌𝐑𝐅 + 𝐛𝟐 𝐒𝐌𝐁 + 𝐛𝟑 𝐇𝐌𝐋 + 𝐛𝟒 𝐖𝐌𝐋 + 𝛆𝐩 (Carhart
market size value momentum
4-factor
e.g./ (<0 = Lg. Cap) (>0 = value) model)
Benchmark
OID100851170.

RMRF = 1 = broad-based
market index
SMB = -1 = large-cap. index
HML = 0 ➝ no value/growth
bias
portfolio ➝ large-cap. value
(ex # 4)

41
 Last Revised: 08/19/2021

· Fixed Income Attribution LOS e

-interpret
1/ Exposure decomposition – top-down approach
Pg-7
Benchmark ➝ Duration vs. Portfolio
➝ Yield curve positioning - active decisions
➝ Sectors (i.e. gov’t., corporate) to deviate from
benchmark exposures
e.g./ active duration bets ➝ increase duration relative to benchmark
in anticipation of falling rates
yield curve positioning ➝ barbell for a flattening curve
sectors ➝ overweight credits in anticipation of spreads narrowing

· how well, relative to the benchmark, did these active

decisions work out, what contribution to active return
- used primarily for client reports, easy to understand

LOS e, f
-interpret
Pg-8

25% × 4.42
+ 25% × 7.47
+ 50% × 10.21
= 8.08
× 40% weight
OID100851170.
= 3.23
vs.
3.91 for the
benchmark

42
 Last Revised: 08/19/2021

LOS e, f
-interpret
Pg-9

𝟑.𝟒𝟖%
𝟒.𝟒𝟐
= . 𝟕𝟖

𝟒.𝟑𝟑%
𝟒.𝟒𝟎
= . 𝟗𝟖

S M L
78 69.5 42.9 G
98 82.9 58.2 C

LOS e, f
-interpret
Pg-10

𝐑 𝐩 −𝐑 𝐁 =
-5.03% - (-4.83%)
= -.20%

OID100851170.
+65 bps

-84 bps

-19 bps

43
 Last Revised: 08/19/2021
LOS e, f
-interpret
Pg-11

level total
𝐃𝐩 𝐯𝐬. 𝐃𝐁 slope underperformance
curvature

where along Bw in Gov’t./Credits

the curve the vs. Pw (-/+)
difference in duration comes from

· Fixed Income Attribution LOS e

2/ Yield curve decomposition - duration based -interpret
Pg-12
- can be either top-down or bottom-up
➝ estimates the returns based on duration
% total return = % Income return + % Price change

- applied to both the portfolio and the benchmark -ModDur × ∆𝐲𝐢𝐞𝐥𝐝

- difference = effect of active PM decisions
- requires more data points than exposure decomp.
OID100851170.

- typically used in reports for analysts & PMs

3/ Yield curve decomposition - full repricing - instead of using estimates

- prices out each security
- most complex attribution of the three

44
 Last Revised: 08/19/2021

LOS e, f
-interpret
Pg-13

positive ➝ yield overweight negative roll ➝ overw. long bonds

slope long shift ➝ DP > DB
curve bonds spread ➝ overweight
credits
specific ➝ bond selection
residual ➝ duration is only an
estimate
example #5

➝ Risk Attribution/ LOS g

-discuss
- absolute mandates ➝ identifies sources of volatility
Pg-14
- benchmark relative ➝ identifies the sources of tracking risk

Investment Decision- Relative Absolute

Making Process
Bottom up - position’s marginal - position’s marginal
contribution to tracking contribution to total
OID100851170.
risk risk
Top Down - attribute tracking risk to - factor’s marginal
relative allocation and contribution to total
selection decision risk and specific
risk
Factor-based - factor’s marginal
contribution to tracking
risk and active
specific risk (example #6)

45
 Last Revised: 08/19/2021

- Macro Attribution/ sponsor level LOS h

-distinguish
- decision #1 ➝ deviations from the SAA
Pg-15
· success = overweighting an asset class that outperforms
its benchmark (or combined weighted benchmark)
- decision #2 ➝ selection of investment managers
· success = selecting a manager that performs their benchmark

𝟐𝟎
. 𝟗𝟗 = @𝟕𝟖B 𝟐. 𝟑𝟗
𝟓𝟖
+ @𝟕𝟖B . 𝟓𝟏

.95 = .78 (.99)

+ .22 (.82)
𝟏 𝟐
. 𝟑𝟐 = (𝟏. 𝟓𝟐) +
𝟑 𝟑
(−. 𝟐𝟖)

LOS h
-distinguish
Pg-16
for Value:

Allocation: Selection + Interaction

o 𝐁)
∆𝐰𝐢 · (𝐑 𝐢 −𝐑 𝐁𝐰 #𝐑 𝐩 −𝐑 𝐁 & + ∆𝐰 #𝐑 𝐩 −𝐑 𝐁 &
(.78 - .75)(.0032 – (-.0003)) = .75 (.0099 - .0032) + (.78 - .75)(.0099 - .0032)
= .03 (.0035) = .005025 + .000201
= .000105 = .005226 or .5226%
OID100851170.

or .0105% Note 𝐁𝐰 + ∆𝐰 = 𝐏𝐰
= 𝐏𝐰 #𝐑 𝐩 − 𝐑 𝐁 & = . 𝟕𝟖 (. 𝟎𝟎𝟔𝟕) = . 𝟎𝟎𝟓𝟐𝟐𝟔

46
 Last Revised: 08/19/2021

LOS h
-distinguish
Pg-17

for Growth:

(neg)

Selection + Interaction
Allocation:
o 𝐁) 𝐁𝐰 #𝐑 𝐩 −𝐑 𝐁 & + ∆𝐰 #𝐑 𝐩 −𝐑 𝐁 &
∆𝐰𝐢 · (𝐑 𝐢 −𝐑
= .25 (.0082 – (-.0108) + (.22 - .25)(.0082
= (.22 - .25)(-.0108 – (-.0003))
– (-.0108))
= -.03 (-.0105)
= .00475 + (-.00057)
= .000315
= .00418 or .418%
or .0315%
Note 𝐁𝐰 + ∆𝐰 = 𝐏𝐰
= 𝐏𝐰 #𝐑 𝐩 − 𝐑 𝐁 & = . 𝟐𝟐 (. 𝟎𝟏𝟗) = . 𝟎𝟎𝟒𝟏𝟖

LOS h
- Micro Attribution/ portfolio manager level -distinguish
Pg-18

- use the Brinson

Model

Lg.-Cap
Allocation
.08 (-.0028 - (-.0003))
= -.0002 or .02%
OID100851170.
( 𝐁)
Allocation: ∆𝐰 ⋅ (𝐑 𝐢 −𝐑 SM-cap Selection + Interaction
= (.20 - .25) (.0152 – (-.0003)) .58 (.0051 – (-.0028))
= -.000775 or -.0775%
= .004582 or .4582%
Selection + Interaction: 𝐖𝐢 𝐑 𝐀 + ∆𝐰𝐑 𝐀
.25 (.0239 - .0152) + (-.05)(.0239 - .0152)
= 𝐖𝐏 ⋅ 𝐑 𝐀 = .20 (.0239-.0152) = .00174 or .17%

47
 Last Revised: 08/19/2021

LOS h
-distinguish
Pg-19

RB
Sm cap 1.52
Lg cap -.28

➝ Benchmarks/ - a collection of securities that LOS i

represents the pool of assets available to the pm -discuss
Pg-20
- should reflect the investment process and the constraints
that govern the construction of the portfolio
- market index ➝ represents the performance of a specific security
market, market segment, or asset class
- may be a benchmark
- Liability-based benchmarks – focus on the cash flows the assets must
OID100851170.
generate
- track a fund’s progress towards fully funded status or track
the performance of assets relative to the changes in liabilities
- Characteristics of the liabilities influence the composition of
the asset portfolio
Example #8

48
 Last Revised: 08/19/2021

LOS j
➝ Asset-Based Benchmarks/
-discuss
- properties of a valid benchmark Pg-21
· unambiguous – securities/weights clearly identified
· investable – possible to replicate and hold the benchmark to
earn its return
· measurable - on a reasonably frequent and timely basis
· appropriate - consistent with the PMs style or area of expertise
· reflective of current investment opinions - manager should be
familiar with constituent securities
· specified in advance - constructed prior to evaluation period
· accountable - manager should accept it

➝ Asset-Based Benchmarks/ LOS j

Types/ -discuss
Pg-22
· Absolute return benchmark - a minimum target return
- not investable, do not satisfy benchmark validity criteria
· Broad market indexes - well recognized, easy to understand, widely
available
- not appropriate if manager style deviates considerably from
the style reflected in the index
· Style Indexes - often well-known, easy to understand, widely available
(e.g. Value, growth)
· Factor-model-based benchmarks - are ambiguous, not specified in
OID100851170.
advance, may not be investable
(e.g. many ways to get value exposure)

49
 Last Revised: 08/19/2021

LOS j
➝ Asset-Based Benchmarks/
-discuss
Types/ Pg-23
· Returns-based 𝐑 𝐏 = 𝐛𝟎 + 𝐛𝟏 𝐒𝐈𝟏 + 𝐛𝟐 𝐒𝐈𝟐 + 𝐛𝟑 𝐒𝐈𝟑 𝐞𝐭𝐜.

style indexes, ∑ 𝐛𝐊 = 𝟏
e.g. 12% lg-cap value, 48% mid cap value, 40% lg cap growth
· Manager Universe (manager peer group)
- broad group of managers with similar investment disciplines
- expected to beat median manager
- fails all tests of benchmark validity
· Custom-security-based - built to reflect investment discipline of
a specific manager
- satisfies all benchmark validity criteria
- will reflect the investment process + all constraints

➝ Benchmark Quality/ (Bailey 1992) LOS k

-discuss
Pg-24
P = B + A P
A
M + S E B
∴ P = M + S + A S 𝛒𝐀𝐒 = 𝟎
M 𝛒𝐄𝐒 ≠ 𝟎

Example #10 - if B captures style, A should

be uncorrelated with S

➝ Benchmarking AI/
OID100851170.

- lack of investible market indexes LOS L

- frequent use of leverage -describe
challenges in
- limited liquidity selecting a
- lack of readily available market values benchmark
- use of IRR vs. twrr

50
 Last Revised: 08/19/2021

➝ Benchmarking AI/ LOS L

-describe
· Hedge funds – encompass a broad range of possible strategies
Pg-25
- may have an unlimited investment universe
∴ difficult to create a single standard
- broad market indexes are unsuitable as benchmarks
- 𝒓𝒇 + spread is sometimes used
- fund manager universe may be used as a benchmark
· unlikely to be representative of any single fund
· suffer from survivorship and backfill bias
· HF performance is self-report and not confirmed by the index
· Real Estate - numerous indexes available
Limitations: based on subsets, not fully representative of the asset class

➝ Benchmarking AI/ LOS L

· Real Estate Limitations: -describe
Pg-26
· performance likely to be highly correlated with largest
data contributors
· based on self-report
· weighting may place more emphasis on most expensive
cities and asset types (if weighted by fund or asset value)
· valuations typically appraisal-based (smoothing), are
infrequent and often lag the market
r
· benchmark returns may be levered
· do not reflect high transaction costs
OID100851170.
· Private Equity - mostly peer group benchmarks
Limitations/ - valuation methodologies may differ
· fund’s IRR depends on timing of gains/losses/CFs

51
 Last Revised: 08/19/2021

➝ Benchmarking AI/ LOS L

-describe
· Private Equity - PME – public market equivalents
Pg-27
- based on aggregated cash flow data
· Commodity Investments
- tend to use indexes based on performance of
futures-based investments (considered investible)
- can vary greatly in their composition and weighting
- actual funds use varying degrees of leverage (index
typically delivered)
· Managed Derivatives - benchmarks typically specific to a
single investment strategy
· Distressed Securities - illiquid and non-marketable, difficult
to construct an index

LOS m
➝ True active return = P – normal portfolio/benchmark -describe
Pg-28
true benchmark
➝ Misfit active return = P – investor benchmark

named in SAA
- misspecification can lead to mismeasurement of the value added
- the normal portfolio/benchmark most closely represents the
manager’s typical positions in his investment universe

➝ Appraisal/ LOS n
- was value-added a result of skill? -calculate
OID100851170.
- assess ability of PM to add value on a -interpret

risk-adjusted basis

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 Last Revised: 08/19/2021

➝ Appraisal/ 𝐑 𝐩 /𝐑 𝐟
LOS n
𝐒𝐑 = ➝ uses total risk -calculate
1/ Sharpe Ratio 𝛔𝐩
-interpret
➝ penalizes for upside risk
Pg-29
𝐑 𝐩 /𝐑 𝐟
2/ Treynor Ratio 𝐓𝐑 = ➝ uses systematic risk
𝛃
- for well diversified ➝ requires an appropriate benchmark
portfolios as a proxy for systematic risk

3/ Information Ratio 𝐑𝐩 '𝐑𝐁 𝐑𝐀

- active return
𝐈𝐑 = =
𝛔(𝐑 𝐏 +𝐑 𝐁 ) 𝛔𝐑 𝐀
per unit of
active risk

➝ Appraisal/ LOS n
4/ Appraisal Ratio 𝐀𝐑 =
𝛂 - alpha 𝐛𝟎 -calculate
𝛔𝛆 𝚺𝛆𝟐 -interpret
- SEE @ A
𝐧'𝟏 Pg-30
𝜶 - can be computed from any factor model
- Jensen’s alpha originally used
𝝈𝜺 - s.d. of portfolio’s residual (non-systematic) risk
- note: Variances are additive (and can be subtracted)

𝐑𝐩 '𝐑𝐓 ➝ RT = target return

5/ Sortino Ratio 𝐒𝐑 𝐃 =
𝟏
𝛔𝐃 ➝ semi-deviation
𝚺𝐦𝐢𝐧 (𝐫𝐭 −𝐫𝐓 , 𝟎)𝟐 𝟐
𝛔𝐃 = • ƒ ➝ or n-1 for a sample
𝐍

➝ Appraisal/ LOS n
-calculate
5/ Sortino Ratio – can assess performance when
-interpret
OID100851170.

return distributions are not symmetrical

Pg-31
∴ better for hedge funds & commodity trading funds
- when inflation is RT, SRD most relevant when a
primary goal is capital preservation
(example #11)

6/ Capture Ratios - measures the PM’s participation in up and

down markets
upside capture UC - when benchmark is positive
downside capture DC – when benchmark is negative

53
 Last Revised: 08/19/2021

LOS n
➝ Appraisal/
-calculate
𝐑 𝐩𝐠
6/ Capture Ratios 𝐔𝐂 = 𝐑 𝐰𝐡𝐞𝐧 𝐑 𝐁 ≥ 𝟎 -interpret
𝐁𝐠
Pg-32
𝐑 𝐩𝐠
𝐃𝐂 = 𝐰𝐡𝐞𝐧 𝐑 𝐁 < 𝟎
𝐑 𝐁𝐠
𝐔𝐂
upside/downside ration = 𝐃𝐂
– measures the asymmetry of
return
> 1 = positive asymmetry (convex return profile)
< 1 = negative asymmetry (concave return profile)

LOS n
➝ Appraisal/
-calculate
6/ Capture Ratios -interpret
Pg-33

OID100851170.

54
 Last Revised: 08/19/2021

➝ Appraisal/ LOS n
-calculate
7/ Drawdown 𝑽𝒑𝒕 '𝑽𝒑 ∗
𝐌𝐚𝐱𝐃𝐃 = 𝐦𝐢𝐧 G 𝒕
, 𝟎H -interpret
𝑽𝒑 ∗
𝒕
Pg-34
peak

Max DD = cumulative peak-to-

trough loss during a
continuous period

Drawdown Duration - total time

from first drawdown to recovery

- Recovery typically longer than

drawdown

➝ Appraisal/ LOS n
- positive asymmetry is a desirable trait (i.e. convex) -calculate
-interpret
- some strategies are convex on their own
Pg-35
- other strategies rely on manager skill to create
convexity
- capture ratios are useful for assessing consistency between
stated investment process and reported performance
e.g. Lg-cap, value, low 𝜷 fund
➝ UC < 100%
DC < 100%

OID100851170.

55
 Last Revised: 08/19/2021

Appraisal/ LOS n
-calculate
- manager response to large drawdowns
-interpret
- can provide evidence of the robustness and Pg-36
repeatability of the investment, portfolio construction,
and risk mgmt. process
- was any action taken (i.e. selling, hedging, buying more)
part of the investment process, a misalignment of interests,
or simply panic/overreaction
i.e. taking more risk to
recover

OID100851170.

56
 Last Revised: 08/19/2021

Investment Manager Selection

a. describe the components of a manager selection process, including due

diligence;

b. contrast Type I and Type II errors in manager hiring and continuation

decisions;

c. describe uses of returns-based and holdings-based style analysis in

investment manager selection;

d. describe uses of the upside capture ratio, downside capture ratio, maximum
drawdown, drawdown duration, and up/down capture in evaluating
managers;

e. evaluate a manager’s investment philosophy and investment decision-

making process;

f. evaluate the costs and benefits of pooled investment vehicles and separate
accounts;

g. compare types of investment manager contracts, including their major

provisions and advantages and disadvantages;

h. describe the three basic forms of performance-based fees;

i. analyze and interpret a sample performance-based fee schedule.

OID100851170.

57
 Last Revised: 08/19/2021

Investment Manager Selection

suitability LOS a
· Universe what is the feasible -describe
style
set of managers Pg-1
active v. passive
- new search/new strategy ➝ examine a broad universe
- adding a manager within a strategy ➝ look for a complement
to current holdings
- replacing a single manager within a strategy ➝ look for best in
that strategy universe
· Quantitative – manager’s performance track record
- attribution/appraisal
· Qualitative · Investment due diligence – philosophy, process,
· is the manager expected to continue people, portfolio
to generate this return distribution
· Operational due diligence - process and procedure,
investment vehicle, terms, monitoring

H0: manager skill = 0 LOS b

-contrast
Type I error ➝ hiring/retaining a manager who
Pg-2
subsequently underperforms
- rejecting the null when it is true
Type II error ➝ ‘not hiring’/firing a manager who
subsequently outperforms
- general predisposition to focus on Type I errors/
OID100851170. 1/ - Type I errors are errors of commission ➝ create explicit costs
(vs. Type II ➝ errors of omission ➝ create opportunity costs)
- psychologically, Type I errors are more painful
2/ Type I errors are relatively straight forward to measure and
are directly linked to decision maker’s compensation
- Type II errors are less likely to be measured

58
 Last Revised: 08/19/2021

- general predisposition to focus on Type I errors/ LOS b

3/ Type I errors are more transparent to investors -contrast
Pg-3
- what actually happened vs. what could have happened
- note: a consistent pattern of Type II errors suggest weakness
in the manager selection process
➝ cost of Type I error is holding a manager without skill
· cost driven by characteristics of the return distributions of
the managers

higher cost
unskilled of errors unskilled

o𝟏
𝒙

smaller cost
skilled
skilled of errors

o𝟐
𝒙
example #2

LOS c
- Quantitative Elements/ -describe
➝ Style analysis/ - understand the manager’s risk profile Pg-4
- mgr.’s self-report risk exposures are
compared to the results of a returns-based risk exposures relative
OID100851170.
to the benchmark
or holdings-based style analysis
- should be consistent over time
- deviations signal issues such as style drift
- style analysis will be most useful with strategies that hold
publicly-traded securities where pricing is frequent
1/ Returns-based style analysis ➝ top-down approach
- involves estimating the portfolio’s sensitivities to
security market indexes representing a range of distinct factors
𝐑 𝐩 = 𝐛𝟎 + 𝐛𝟏 𝐋𝐂𝐕 + 𝐛𝟐 𝐋𝐂𝐆 + 𝐛𝟑 𝐌𝐂𝐕 + 𝐛𝟒 𝐌𝐂𝐆 + 𝐛𝟓 𝐒𝐂𝐕 + 𝐛𝟔 𝐒𝐂𝐆

59
 Last Revised: 08/19/2021

- Quantitative Elements/ LOS c

-describe
➝ Style analysis/
Pg-5
1/ Returns-based style analysis ➝ does not require a large amount
of difficult or hard to acquire data
- comparable across managers and through time
- provides an objective check NOT subject to window dressing
-/
- portfolio being analyzed may not reflect the current or future
portfolio exposures
- illiquid securities tend to have stale prices (smoothed returns)
2/ Holdings-based style analysis ➝ bottom-up approach
- classifies the actual holdings in a portfolio at a
point in time (estimates current risk factors)
- comparable across managers and through time

- Quantitative Elements/ LOS c

-describe
➝ Style analysis/
Pg-6
2/ Holdings-based style analysis ➝

-/
- subject to window dressing
- more complex strategies increase the computational effort
- requires manager transparency
- may not reflect the portfolio going forward, particularly for
high turnover strategies
OID100851170.
LOS d
- Capture ratios, Drawdowns ➝ complete repeat
-describe
from previous reading

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 Last Revised: 08/19/2021

Qualitative Elements/ LOS e

-evaluate
· investment due diligence ➝ attempt to assess the
Pg-7
repeatability and consistency of the investment process
1/ Investment philosophy ➝ the managers underlying assumptions
about the factors that drive performance
i.e. market efficiency ➝ assumptions lead to passive or active
strategies
· passive ➝ seek risk premiums from factor exposures
· active ➝ security mispricing can be both identified and exploited
- inefficiencies can be
a) behavioral – created by the actions of other market
participants ➝ temporary
b) structural – created by internal or external rules
and regulations ➝ long lived

1/ Investment philosophy LOS e

-evaluate
- other active assumptions concern correlations,
Pg-8
intrinsic value and market price convergence, macroeconomic
influences, etc.

Questions/
a) Can the manager clearly and consistently articulate their investment
philosophy?
b) Are the assumptions credible and consistent?
e.g. I don’t believe technical analysis has any value.
OID100851170. ∴ a manager’s assumption of the usefulness of
technical patterns as a basis for investment
decisions is not a creditable assumption
c) How has the philosophy developed over time - ideally it is unchanged
through time ➝ changes should reflect changing market
conditions vs. reactions to performance

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 Last Revised: 08/19/2021

1/ Investment philosophy LOS e

-evaluate
Questions/
Pg-9
d) Are the return sources linked to credible and
consistent inefficiencies?
- is it of sufficient frequency
- does it provide a sufficient level of return to
justify active mgmt. fees
- is it repeatable
- is it sustainable ➝ what is the opportunity’s capacity
2/ Investment Personnel
- even the best process can be compromised by poor
execution
a) Does the investment team have sufficient expertise and experience
b) Do they have sufficient depth

2/ Investment Personnel LOS e

- what is the level of key person risk -evaluate
Pg-10
- what kinds of agreements and incentives exist
to retain and attract key employees
- what has been the turnover
3/ Investment Decision-Making Process
4 elements
1/ Signal creation (Idea Generation)
OID100851170.
- how are investment ideas generated?
- is the information ➝ unique (informational edge)
➝ timely (timing edge)
➝ Interpreted differently
2/ Signal capture (Idea Implementation)
- translating the idea into an investment position
- what is the process? – is it repeatable?

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LOS e
3/ Investment Decision-Making Process
-evaluate
3/ Portfolio Construction - how positions are implemented Pg-11
· how are allocations set and adjusted - should be consistent
with the investment philosophy and process
· are allocations consistent with conviction - over/under-weightings
· how has growth in AUM affected portfolio characteristics
· are stop-losses used to manage risk
· what types of securities are used
· how are hedges implemented
· how are long and short ideas expressed - paired or indep.
· what levels of liquidity are maintained
- any limitations
4/ Monitoring the portfolio

· Investment Vehicle/ LOS f

- 2 broad options for implementing investment -evaluate
Pg-12
strategies
1/ individual separately managed accounts
- adv. · ownership - investor owns the individual securities directly
- liquidity events for other investors do not
affect the account holder
· customization – constraints/preferences can be handled
· tax efficiency - no capital gains taxes as a result of
liquidity events in other accounts for other investors
OID100851170.
· transparency - real-time, position level detail
- disadv. · Cost ➝ SMAs do not scale well
➝ higher transaction costs since trades cannot be
aggregated

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· Investment Vehicle/ LOS f

-evaluate
1/ individual separately managed accounts
Pg-13
- disadv. · Tracking risk ➝ if SMA is customized
- performance will reflect investor constraints
- makes attribution messy
· Investor behavior ➝ attempts to manage the account
negate the benefit of hiring a manager
2/ Pooled or comingled vehicle
- money from multiple investors is held as a single
portfolio and managed without potential customization
for any investor

LOS g
➝ terms of the investment ➝ in the prospectus, private placement
-compare
memorandum and/or limited partnership Pg-14
agreement
- these documents are the contract between the investor and the
manager
a) Liquidity – different vehicles provide different degrees of liquidity
· most liquid ➝ closed-end funds, ETFs (listed securities)
· open-ended are slightly less liquid – daily liquidity at closing NAV
· limited partnerships ➝ limited/no liquidity
a) hedge funds · redemption frequency – limits how often an
OID100851170.
investor can withdraw capital
· notification period – how far in advance
notice of a redemption must be given

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a) Liquidity LOS g
-compare
a) hedge funds · lockup – period during which there are
Pg-15
no redemptions
➝ hard lock ➝ no redemptions
➝ soft lock ➝ penalty on redemption
· gates – limit the amount of funds that can
be redeemed at one redemption date
b) private equity/venture capital
- least liquidity
- investors are contractually obligated to contribute committed
capital and wait for distributions (10-12 yrs. period)
- LP disadv.
- reduced flexibility to adjust portfolio allocations
- reduced ability to meet unexpected liquidity needs

a) Liquidity LOS g
LP-adv. – funds can hold less liquid securities with -compare
reduced risk of having to sell at inopportune times Pg-16
- removes investor’s potential for overreaction during
times of market stress

b) Mgmt. Fees – cover operating costs

- fixed costs ➝ technology, lease, etc.
- variable ➝ human capital, marketing
OID100851170.
c) Assets under Management Fee (AUM)
- ad valorem fee
➝ related to ability to attract and retain capital and
increase asset value

d) Performance Based Fees - determined by portfolio returns

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 Last Revised: 08/19/2021

LOS h, i
d) Performance Based Fees
-describe
- structured in one of 3 ways -analyze
1/ a symmetrical structure in which the manager is fully Pg-17
exposed to both the downside and upside
Computed Fee = Base + Sharing of Performance

minimum

e.g. Standard fee = 50 bps, base = 25 bps, Max = 75 bps

2/ bonus structure with downside limit but no upside limit
Computed Fee = higher or ➀ Base
➁ Base + upside
e.g. Base = 25 bps, upside = 20% (Active Return – 25 bps)

d) Performance Based Fees LOS h, i

- structured in one of 3 ways -describe
3/ Bonus in which downside and upside are limited, but not -analyze
Pg-18
symmetrical
Computed Fee = higher or ➀ Base
➁ Base + upside to limit

e.g. Base = 25 bps, upside = lower of limit or 20% (Active Return – 25 bps)

exhibit #7
- performance fees paid annually
- may include high water marks (HF)
- PE, HF, and RE funds typically have no limits
OID100851170.

- low RA, low performance fee ➝ investor benefit

- high RA, higher performance fees ➝ manager benefit

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d) Performance Based Fees LOS h, i

➝ in the event of underperformance ➝ base fee still paid -describe
-analyze
(negative for investor)
Pg-19
➝ low manager revenue as a result of only a base fee increases
operational risk
(big reason why symmetrical fee structures are not popular
with managers)
- if managers have clients with varying fee structures, may favour
clients with performance-based fees
- when managers can control the timing of profit realization, may
have an incentive to hold on to assets until a profit is earned
(clients may benefit from selling at a loss and investing elsewhere)
- HF managers may have an incentive to return funds
if MVp < high water mark

OID100851170.

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Case Study in Portfolio Management: Institutional

a. discuss tools for managing portfolio liquidity risk;

b. discuss capture of the illiquidity premium as an investment objective;

c. analyze asset allocation and portfolio construction in relation to liquidity

needs and risk and return requirements and recommend actions to address
identified needs;

d. analyze actions in asset manager selection with respect to the Code of Ethics
and Standards of Professional Conduct;

e. analyze the costs and benefits of derivatives versus cash market techniques
for establishing or modifying asset class or risk exposures;

f. demonstrate the use of derivatives overlays in tactical asset allocation and

rebalancing.

OID100851170.

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QUINCO Case
Page 1
University Endowment
Balance
ensure long-term sustainability
support spending policies of the endowment
meet liquidity needs in establish optimal exposure to
a timely fashion illiquid assets

Liquidity management: policies/practices that ensure the portfolio

complies with the investment policy yet can meet cash
outflow needs in a timely and orderly manner
- avoid distressed sales of illiquid assets, especially in weak
market conditions
but// allow the portfolio to benefit from the expected liquidity
premium associated with the long-term private market
allocations

Page 2
Liquidity management tools/
1/ Liquidity profiling and time-to-cash tables
donations
income (int./div.)
first: identify cash inflows
return of capital/rebalancing
potential cash
-
-
-
-
-
-
-
-
-

flows cash outflows - spending requirement IH (1/3/5 yrs.)

OID100851170. - capital calls for private
funds
Outflows - Inflows = need for liquidity

liquidity classification schedule Liquidity budget

(a.k.a. time-to-cash table) - assign portfolio weights
- defines portfolio categories (or buckets) to each liquidity classification
based on the estimated time it would - becomes the liquidity
take in the normal course of business benchmark for the portfolio
to convert those assets to cash without construction process
having a sig. impact on market conditions and prices

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Page 3

reflects
acceptable
liq. req. that
must be met,
- time-to-cash may even in a
core principle - identify liquidity liquidity
also depend on the
categories relevant to the stress scenario
investment vehicle
e.g./ HF - notification periods types of cash outflows the
- liquidity gates investor will face

assessing liquidity is a bottom-up process

- not all securities within an asset class are equally
liquid, nor are all investment vehicles
exh. #2

Page 4
2/ Rebalancing/Commitments

systematic policies - calendar with pre-specified

- percent range bands
automatic adjustment mechanisms
- using public market allocations to rebalance private market risk
- targets desired risk profile but changes liquidity
e.g. Public equities ➞ 𝛃 = 𝟏 Private equity ➞ 𝛃 = 𝟏. 𝟔
OID100851170. PE weight ↑ 1%, lower public equity weight 1%
beta targeting - lower dollar-beta of public equities by dollar beta
of PE increase
typically done with derivatives - avoids rebalancing costs associated with
illiquid assets
Private market fund commitments: having a multi-year funding strategy
to reach and keep a target allocation in place helps manage
this draw on liquidity

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Page 5
Commitments: objective is to develop a pacing
Strategy to meet the desired allocation over time
without overshooting the allocation

$100M fund (𝟏 + 𝐫𝐏 )𝟑 𝐅𝐕𝐏 ∴ PE allocation in

15% PE 3 years equals
3 yrs. 15% of 𝐅𝐕𝐏
PE fund grows at 𝐫𝐏𝐄
requires cash flow modelling with assumptions for
speed of capital calls
pace of distributions
growth of asset size, etc.
3/ Stress testing - understand how the liquidity profile of the portfolio
and the liquidity needs of the institution may change
over time

Page 6
4/ Derivatives - gain exposures with lower cash commitments
(only margin)
- deploy remaining cash into assets with required
liquidity profiles, typically very liquid
- reduce the need to buy/sell semi-liquid/illiquid securities to
accomplish rebalancing

Illiquidity premium/ expected compensation for the additional risk of

OID100851170. tying up capital for a potentially uncertain period
- premium size positively related to the length of
the illiquidity horizon
- but how much?
e.g./ marketable price = X illiquid asset price = X - put premium
(hypothetical - requires estimation) (strike of X)
- generally difficult to isolate the illiquidity premium

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Page 7
1/ long IH
experience with private assets
dedicated senior PM + analyst
lower expected return going forward from traditional asset
classes
illiquidity premium
lower risk profile than peers
lower private asset allocation than peers
lower long-term risk of erosion in purchasing power
better portfolio efficiency (SR = .34 vs. .33)
higher portfolio real return (5.3% vs. 5%)
above sp. rate of 5%

2/ higher s.t. risk for lower long-term risk

still within IPS erosion of purchasing power
risk obj.

Page 8
1/ . 𝟔𝟔𝐒𝐭)𝟏 + . 𝟑𝟒𝐕𝟎 < 5% AUM

. 𝟔𝟔𝐒𝐭/𝟏 + . 𝟑𝟒𝐕𝟏 > 5% AUM + donations weak

𝐕𝟏
𝐕𝟎
𝐕𝟐 𝐕𝟒

. 𝟔𝟔𝐒𝐭)𝟏 + . 𝟑𝟒𝐕𝟐 > 5% AUM . 𝟔𝟔𝐒𝐭)𝟏 + . 𝟑𝟒𝐕𝟑 < 5% AUM

𝐕𝟑
+ donations weak
√
OID100851170.

2/ Liquidity profiling + Liquidity budgets

Rebalancing/Commitments
cash flow forecasting (develop a pacing strategy)
√
Stress test analysis
Derivatives ➞ rebalance semi-liquid

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Page 9
3/ Objectivity ➞ lowers portfolio liquidity
stressed
45% ➞ 39% highly liquid/liquid 41% ➞ 36%
22% ➞ 23% semi liquid 20% ➞ 21%
33% - 39% illiquid 39% ➞ 43%

Subjectively ➞ not that significant

6% ↓ in highly liquid/liquid (6% x 7B = 420M)
7% ↑ in semi + illiquid
➞ as long as stress scenario is within the liquidity
budget.

Page 10
- Asset Manager Selection/
I(B) Independence and Objectivity
- M/C must exercise reasonable care and judgment to
maintain independence and objectivity
work/opinions unaffected by any potential conflict of
interest or other circumstance adversely affecting their judgment
M/C should endeavor to avoid situations that could cause
or perceive to cause a loss if independence/objectivity
M/C must resist subtle and not-so-subtle pressures
OID100851170.

to act in conflict with the interests of clients/beneficiaries

I(C) Misrepresentation
M/C must not knowingly make any misrepresentation
I(D) Misconduct
M/C must not engage in any professional conduct
involving dishonesty, fraud, deceit

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Page 11
- Asset Manager Selection/
III(D) Performance Presentation
M/C must make reasonable efforts to ensure investment
performance information is fair, accurate, and complete
avoid misstating performance information
III(E) Preservation of Confidentiality
M/C must keep information about current/former/prospective
clients confidential
IV(A) Loyalty M/C must act for the benefit of their employer
and not deprive them of their skills and abilities or
divulge confidential information
must place the interests of the client/beneficiary above
the interests of the employer

Page 12
- Asset Manager Selection/
V(A) Diligence and Reasonable Basis M/C must:
- exercise diligence, independence, and thoroughness in taking investment
action
- have a reasonable and adequate basis, supported by appropriate
research and investigation for any investment action
VI(A) Disclosure of Conflicts M/C must make full and fair disclosure
of all matters that could reasonably be expected to impair
their independence and objectivity or interfere with respective
OID100851170.
duties to clients/employers
M/C must ensure that such disclosures are prominent, delivered in plain
language, and communicate the relevant information effectively
➞ Asset Manager Selection/
Board of Trustees
Hall conflict - should be disclosed
founder and MP at [VI(A), IV(A), III(E)]
GVC
ely Conf. of I Loyalty Conf. info.
most lik
➞ info. used that came from her position as a trustee

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Page 13
➞ Asset Manager Selection/
Bud Davis ➞ Indep./Objectivity ➞ mother-in-law = founder/MP or
GVC
+ HUGE conflict of interest [I(B), VI(A)]
Jason Allen ➞ performance results in presentation ≠ third-party sources
(possible misrepresentation) [I(C), III(D)]
Winter - concerns about accuracy of info. ➞ hires GVC anyways

- University employee Conf. of I. Ind./Obj. confid.

- pres./treasurer urging GVC conflict of interest [VI(A), I(B), III(E),
- Hall donates to the I(C), I(D), V(A)]
university MiSR. MISC. Dil./Reas.
aware of. Basis
- confidential info. used ➞ no response loyalty
Confid.
[IV(A), III(E)
Pres./Treas. - acting in best interest of the University
VI(A), I(B)]
➞ is it the best interest of the endowment?
Conf. of Int. Ind./Obj.

Page 14
Asset Allocation 80M cash rate
51 bps TRS: Receive Equity Return + Div. y.
(+150 at 4:1) Pay floating Receive floating
(60M x .02)/80M = 1.5% (3 mos.)
(lowest 𝐓𝐄) delevered
- counterparty risk

42 bps Futures 𝐅𝟎 = 𝐒𝟎 𝐞(𝐫'𝐲).𝟐𝟓 Receive 𝐫

OID100851170.
(+150 at 4:1) 𝐅𝟎 = 𝐒𝟎 𝐞'𝐲(.𝟐𝟓) (3 mos.)
(60M x .02)/80M = 1.5%
- dividend 𝐲 not precise ➞ forecast errors ∴ 𝐓𝐄
35 bps ETF ∆𝐒𝟎 + 𝐃𝐢𝐯. 𝐲. no cash rate
(+187.50 at 4:1) - 𝐓𝐄
(60M x .025)/80M
= 1.875%
All receive ∆price + Div. yield
∴ select most cost effective balanced with
4:1 leverage
maintaining liquidity (this is TAA)
use futures

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Page 15
Rebalancing/

Global equities
favourable
growth environment

Fixed-Income
↑ 𝐫 in anticipation
of higher inf. exp.
requires a withdrawal from one
external manager and a deposit to another

equities Bonds edge of the corridor

or SAA target?
expectation?
11.5%
9% 9%
6.5% Derivatives or
expectation
Cash?

OID100851170.

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Case Study in Risk Management: Private Wealth

a. identify and analyze a family’s risk exposures during the early career stage;

b. recommend and justify methods to manage a family’s risk exposures during

the early career stage;

c. identify and analyze a family’s risk exposures during the career development
stage;

d. recommend and justify methods to manage a family’s risk exposures during

the career development stage;

e. identify and analyze a family’s risk exposures during the peak accumulation
stage;

f. recommend and justify methods to manage a family’s risk exposures during

the peak accumulation stage;

g. identify and analyze a family’s risk exposures during the early retirement
stage;

h. recommend and justify a plan to manage risks to an individual’s retirement

lifestyle goals.

OID100851170.

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Case Study: Private Wealth

Page 1
Early Career:
Paul €45,600 net = 33,670
very bond-like, stable, steady increases
modest upside potential
low risk of unemployment
skill not very portable to other countries
Jessica €24,000 net = 20,490
very equity-like 54,160
significant upside
higher probability of unemployment
very portable skill
Living exp. 34,800 ➞ 2900/month
19,360 surplus
Savings 15,000
Debt Ø

Page 2
Early Career:

2900/mo.
- payroll taxes
provide both g = 10%
future benefits (𝐭 = 1-10)
+ put options g = 1%
(𝐭 = 11 ➞)
(value of put
OID100851170.
not listed) N = 62

probability of survival to age 𝐭 (estimate)

wages (net) over past year
𝐍
𝐏(𝐒𝐭 )𝐖𝐭'𝟏 (𝟏 + 𝐠 𝐭 ) growth in wages for year 𝐭
𝐏𝐕𝐇𝐂 = P
(𝟏 + 𝐫𝐟 + 𝐲)𝐭 (estimate)
𝐭;𝟏
𝐖𝐭/𝟏 (𝟏 + 𝐠 𝐭 ) = 𝐖𝐭
risk-free occupation
discount rate specific risk premium (estimate)

78
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Page 3
Early Career:
pr./int. = 1360
Objectives: short-term: purchase home 270k
vs. 1000 rent
long-term
(+4320/yr.)
- plan for comfortable retirement
- financial security
Risk Exposures: Current mitigation Gap

Earnings 800/person
Unemployment 4513 - 1600 = 2913/m.
risk: = 1600/month

1500/person
Disability Jessica - 87.8% of 𝐖𝐭 12.2% 𝐖𝐭
Paul - 53.46% of 𝐖𝐭 46.54 𝐖𝐭
(increases in 4 years)
funeral costs
Death Ø cash reserve
increased burden for
100% of shared costs

Page 4
Risk Exposures: Current mitigation Gap

Potential: House int. + pr. = 360/m. increment

maintenance = 225/m. Ø
585/mo. ➞ 7020/yr.
36% of surplus
Vehicle compulsory insurance damage to
property vehicle itself
OID100851170.

PL/PD
personal

Recommendations: (Gaps)
Unemployment ➞ increase cash reserve (6 mos. x 2900 = 17,400)
(self insurance)
Disability ➞ extra policies (lump sum or annual payments)
Jessica - replace 12.2% of income (increase over time)
Paul - replace 46.54% of income (reduce in 4 years)

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Page 5
Recommendations: (Gaps)
Disability

46.54% 𝐖𝐭

𝟏. 𝟎𝟑 N = 37
𝟑𝟕
𝐭
𝟐, 𝟒𝟗𝟎(𝟏. 𝟎𝟐) R S − 𝟏 = . 𝟗𝟖 𝐈0 = .98 CPT
𝐏𝐕 = Ž = 𝟕𝟔, 𝟗𝟓𝟕. 𝟒𝟔𝟑 𝟏. 𝟎𝟐 𝐘 PV
(𝟏. 𝟎𝟑)𝐭 PMT = 2490
𝐭]𝟏
FV = 0
Death ➞ Life Insurance (Paul’s life only)
funeral costs
30k
human value method needs analysis ↑ cash reserves
ongoing: PV(50% of
shared costs)

Page 6
Recommendations: (Gaps)
Vehicle ➞ leave as is ➞ raise cash reserve (self insure)
House ➞ delay ➞ saves 7,020 in incremental costs

save this
Plan/ surplus of 19,360
extra ins.: 2500
OID100851170. 17,860 ➞ bring cash reserve up to 17,400 (from 15k)
➞ investment plan beyond that

Did purchase home: 285,000

- 80,000 loan from Jessica’s parents
- 5,000 personal funds
- 200,000 mortgage - 25 yrs., 3.6% fixed, 5 yrs.
1,012/mo. (p./int.)
- Property Ins. of 200k

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Page 7
1. Increase prop. insurance to 285k + contents + liability
2. Increase life insurance coverage - cover new debt.
3. Rebuild cash reserve Example #1
Needs analysis
Cash needs Capital needs
Funeral costs 15k PV(expenses) 1,157,347
Reserve fund 15k (N = 62, 𝐈,𝐘 = .98, PMT = 25k, FV = 0)

30k PV(income)
(N = 37, 𝐈,𝐘 = 0, PMT = 20,490 FV = 0) 758,130
399,217
or/ 34,800 x .5 = 17,400 Total needs = 429,217
Joint exp. Less: total available
N = 62, 𝐈4𝐘 = .98, PMT = 8700 FV = 0 Cash 15,000
= 402,756 𝐏𝐕𝐫𝐞𝐭. 11,800
402,417

Page 8
Career Development/
1. Specify the objective
2. Identify risks ➞ flow from both objectives and economic
balance sheet
3. Evaluate risks and select appropriate methods to manage the
risks
current situation
mitigate the gaps
OID100851170.

- current mitigation
= gaps
4. Monitor outcomes and risk exposures and make appropriate
adjustment methods
Ex. #3

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Page 9

lack of
diversification

repairs
peril
liability

earnings
risk
- unemployment ➞ offers 13.5k/yr. each
- disability ➞ Jessica: 25.2k + 112k L.S./ Paul: 30.245k + 686k L.S.
- premature death ➞ kids now involved

Page 10
Disability/
Jessica ➞ current income (net) 53,650
current mitigation 25,200
28,450 shortfall/yr.
(N = 20, 𝐈?𝐘 = .98, PMT = 28,450, FV = 0) ➞ 514,431 PV of shortfall
less: current PV(extra mitigation) 112,000
OID100851170. 402,231 - raise dis. coverage
by 402k
Life/ Human life value method: Paul
Net income 46,510 ➞ g = 2% N = 20
less direct exp. 10,000 𝐈? = .98
𝐘
add: lost benefits 10,000 PMT = 46,510
46,510 ➞ r = 3% FV = 0
CPT PV = 1,203,831
less current mitigation 638,000
exh. #12
~ 566k

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Integrated Cases in Risk Management: Institutional

a. discuss financial risks associated with the portfolio strategy of an

institutional investor;

b. discuss environmental and social risks associated with the portfolio strategy
of an institutional investor;

c. analyze and evaluate the financial and non-financial risk exposures in the
portfolio strategy of an institutional investor;

d. discuss various methods to manage the risks that arise on long-term direct
investments of an institutional investor;

e. evaluate strengths and weaknesses of an enterprise risk management system

and recommend improvements.

OID100851170.

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Case Study: Risk Management - Institutional

Page 1
Financial risks associated with the portfolio strategy of
long-term institutional investors

- Dimensions of financial RM.

1/ Top-down and bottom-up
overall risk guidelines sub-portfolio/asset class
(volatility, active risk, VaR, interaction effects - e.g. vol. & liquidity
long-term objectives)
2/ Portfolio level vs. asset-class specific risk

different asset classes will require

different RM techniques (e.g. public vs. private,
liquid vs. illiquid, data transparency, data frequency)
difficult to aggregate these results at the
overall portfolio level

Page 2
- Dimensions of financial RM.
3/ Returns-based vs. holdings-based
risk estimation relies on risk estimation relies on the
historical return streams of return series of individual security
either an external manager or holdings
a portfolio more costly and time consuming
easy to implement to implement
may produce biased estimates if requires sub-portfolio
OID100851170.

the manager/portfolio strategy transparency

going forward is not the same as the past
4/ Absolute vs. relative risk

𝛔, VaR, CVaR concerned about the underperformance

max. drawdowns vs. policy benchmarks
- measures the potential 𝐓𝐄
for losers

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Page 3
- Dimensions of financial RM.
5/ long-term vs. short-term
probabilities of: 𝛔, VaR, CVaR
capital losses - assess potential for
not meeting cash flow needs near-term losses
not maintaining purchasing power
- typically assessed using MC simulation
6/ Quantitative vs. Qualitative

backward looking and forecasts, assessments (CMEs)

generally parametric
7/ Pre- vs. post- investment risk ➞ monitoring
➞ performance
operational and investment due
attribution/evaluation
diligence prior to making an investment
➞ hire/fire decisions
(i.e. the manager/firm itself)

Page 4
Risk considerations for long-term investors/
ultimate objective of RM is to ensure that the
organization survives and can meet its long-term objectives
e.g./
(exh. #1)

OID100851170.

too little investment risk - jeopardize long-term objectives

too much investment risk - jeopardize short-term payout requirements
e.g./ max. P(maintain PP) may be at odds of keeping drawdowns
below a specific %’age of assets

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Page 5
Risk considerations for long-term investors/

increasing allocations to private assets supports long-term

risk reduction but introduces liquidity risk
- exacerbated during financial crisis (interaction
between market stress and liquidity)
may increase needs from the portfolio
capital calls may be accelerated
capital distributions slow down
external liquidity may ↓
rebalancing will become more important/critical
(requires liquidity)
- main sources of liquidity for L.T. portfolios:
- cash, fixed income
- most inst. hold low allocations

Page 6
Risk considerations for long-term investors/

private assets generally illiquid - not available to meet liquidity

HF ➞ redemption gates
equities ➞ depressed, typically want to add
- withdrawals may affect relationships with
in-demand external managers

Risks associated with illiquid asset classes/ PE/PRE/Infra.

- typically subject to a drawdown structure
OID100851170.

need for - committed capital called at an unknown schedule

liquid assets - capital distributed at an unknown schedule
- use of cash flow modelling ➞ solve for both:
1/ the commitment strategy to reach a certain target
allocation
2/ the liquidity needs to meet capital calls

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Page 7
Risks associated with illiquid asset classes/ PE/PRE/Infra.
- typically subject to a drawdown structure
- overshooting will increase liquidity risk
- as AUM ↓ in stress periods, private assets do not
reprice downwards as fast
∴ illiquid assets as a %’age of AUM ↑
- undershooting ➞ risk of not meeting long-term goals
- stale pricing, appraisal-based, lagged response to movements
in public markets
- understates volatility
- can use public market proxies to measure risk of
private assets
e.g. small-cap. equities as a proxy for private equity
- can unsmooth the return series - removes serial correlation
- results in higher volatility and higher correlation
to public equity markets

Page 8
Risks associated with illiquid asset classes/ PE/PRE/Infra.
- cannot be rebalanced easily and cost efficiently

Direct vs. fund investments/

avoid fees but/ requires dedicated and experienced
more control over investments in-house team (often just acquire
OID100851170.
better able to manage liquidity a GP) quality of team affects
(no capital calls) ability to source deals
full discretion on when to may have higher concentration risk
exit tend to opt for larger investments
governance shortfalls
investment staff may not be able
to sit on the board of a private company
may be difficult to match market-based
compensation

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Page 9
Managing liquidity risk/
1/ Establish liquidity risk parameters (liquidity benchmark)
%’age of assets highly liquid
liquid
semi-liquid
illiquid
invested capital + uncalled commitments

lower % - upper % ➞ reduce commitments or even reduce investment

2/ Assess the liquidity of the current portfolio and how it evolves over
time
- create a liquidity classification schedule
%’age that can be liquidated within a day, week, month, quarter, year or
> year
3/ Develop a cash flow model and project expected cash flows
external spending
inflows outflows
internal liabilities
4/ Stress test liquidity needs and cash flow projections

Page 10
Managing liquidity risk/
5/ Put in place an emergency plan (in a crisis)
- what to liquidate and in what order
- how to rebalance
➞ Environmental/Social risks:
Universal owners, externalities, responsible investing

large institutional investors impact that individual or

OID100851170.

that effectively own a slice corporate activities have

of the whole economy on a third party
exposed to
costs of negative externalities

- costs externalized by a portfolio company can negatively

affect the profitability of another portfolio company
∴ externalities have portfolio impacts
(increased insurance premiums for companies, taxes, physical
costs of weather-related disasters) see exh. #7

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Page 11
Material Environmental Issues for an Inst. Investor/
Physical climate risks
heavy precipitation, droughts, hurricanes
more frequent, higher magnitude
wildfires - more numerous, forestry devastation
sea level rise - coastal flooding
Impact on real assets
residential/commercial real estate - prime coastal properties
- negative affect on rents/property values
impairments
infrastructure - roads/railways
- prolonged exposure to extreme heat shortens
useful life ➞ accelerated depreciation
rising cost of peril insurance (if even covered)
fire, storm, flooding

Page 12
Material Environmental Issues for an Inst. Investor/
climate transition risks (for traditional business)
restrictions on carbon emissions
carbon pricing (tax)
changes in consumer behavior
utilities (coal, nat. gas) vs. renewables
exh. #10
auto sector (ICE vs. EV)
OID100851170.

climate opportunities
companies focused on climate change, mitigation and
adaptation clean energy
sustainable agriculture energy efficiency
water use efficiency batteries and storage
smart grids
materials

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Page 13
Material social issues for institutional investors:
managing community relations and the social license to operate
some investments may have negative social impacts
(poor labour standards, forced relocation)
good corporate behavior is part of a sustainable corporate strategy
consideration of all stakeholders (needs and concerns)
labour issues in the supply chain
- driven by globalization, supply chains reach into emerging and
frontier markets
- labour rights issues - heavy reliance on temporary workers,
excessive or forced overtime, low wages, even forced
labour/child labour
- can cause significant damage to brands and reputations,
as well as costs and/or fines
recall/returns, lost sales, inventory writedowns

Page 14
Material social issues for institutional investors:
the ‘just’ transition
- transitioning to sustainable practices will displace some
workers and obsolete some industries, and raise some
costs that adversely affect lower income households
- a just transition aims to limit the negative social impacts
OID100851170. Case: Investment 1: Sunnyland Airport
Island nation (tropical location)
several hotels
desire to boost tourism ➞ airport capacity = 5 million visitors/yr.
new runway ➞ 1 km from sea
2% of AUM (investment)
300M USD debt
2 yr. construction period - fixed price contract

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Page 15
Case: Investment 1: Sunnyland Airport
25 yr. concession contract ➞ airport fees = 70% of revenue
regulated charges + CPI
Financial risks
interest rates - hedge flooding:
currency - proxy hedge 1 in 100 year
Revenue shortfalls sensitivity analysis? events
Cost overruns Exit gates? +
-
Non-Financial risks avg. temp
political 99%
sea level Sep. - June
environmental (flooding)
climate change 1 in
+ 10-20 yrs.?
(storm damage, tourist
-
season)
social - increased air traffic avg. 80%?
- increased tourist presence temp
Oct. - Apr.?

Page 16
Case: Investment 2: Atsui Beverage Company
investment to modernize plant
located in a tropical, land-locked geography
only local manufacturer of carbonated beverages
- all others imported ➞ high tariffs currently (100%)

OID100851170.
upcoming election ➞ could lower tariffs
financial *
factory located near a river - allows transport to shipping port
known for its biodiversity
environmental*
minority stake only ➞ 35% + 2 board seats of 7
.05% of AUM, 25M.
plans to eliminate 200/500 jobs
* social

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Page 17
Case: Investment 2: Atsui Beverage Company
Financial risks
currency import competition
Revenue shortfalls export markets less enthusiastic
recession
shortfalls on
lack of domestic demand
productivity gains
Sensitivity analysis? v

Non-financial risks
social implications of eliminating 200 jobs - huge!
environmental issues associated with the river
increased water traffic to ship exports to port
dock will need to be built

OID100851170.

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REVIEWS

OID100851170.

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PM for Inst. Investors

Review - 1
LOS a/
1/ Scale small - min. AI, external mgrs.
very large – diseconomies of scale – pushed into direct
investing of AI
2/ Long-term investment horizon – long IH + low liquidity needs

allow for AI
- banks/insurance ➞ perpetual horizon + short IH
3/ Regulatory framework – differ by jurisdiction
4/ Governance framework BoD + Investment Committee
external
- implemented through an Inv. office
internal
5/ Principal-agent issues – interests not aligned

LOS b/ 1/ Norway model ➞ 60%/40% equity/bonds, very few AI, largely passive
➞ limited value-added potential

Review - 2

LOS b/ 2/ Endowment Model ➞ high AI exp., active mgmt., outsourcing

- low liquidity needs, skill in outsourcing AI
3/ Canada model ➞ high AI, active mgmt., insourcing
4/ LDI ➞ focus on hedging liabilities and interest rate risk by
using duration matching FI + growth component
OID100851170.
Pension Funds/
Stakeholders ➞ employer, employees/retirees, shareholders
Liabilities ➞ PV of all future benefit payments
main objective ➞ sufficient assets to cover future
benefit payments
𝐅𝐕𝐚𝐬𝐬𝐞𝐭𝐬 shortfall = net pension Liab.
funded ratio = •𝐏𝐕
𝐛𝐞𝐧.𝐨𝐛𝐥.
surplus = net pension asset

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Review - 3
Pension Funds/
Investment horizon ➞ longer if:
plan assets small vs. sponsor assets 𝛔
low corr. (op. results, plan assets)
vol. of contributions acceptable
fewer retired lives, younger active lives
Liquidity needs low ➞ active/retired high, young workforce
- surplus ➞ funded status
- no early ret., no lumpsum, no switching
Legal/Regulatory – varies by country
Tax/Accounting – tax exempt

Risk Considerations/ Plan funded status ➞ surplus = higher RT

➞ deficit but willing to make
contributions = higher RT

Review - 4
Pension Funds/
Risk Considerations/ Sponsor financial strength ➞ higher = higher RT
- size of plan assets to sponsor assets
➞ low = higher RT
Sponsor and fund common risk characteristics
corr. (op. results, plan assets) = higher RT

OID100851170.
Plan design – early ret., plan switching, lump-sum payments = lower RT
Workforce characteristics – younger, few retired lives, higher turnover
= higher RT
above 100%
Investment Objectives/ funded status above some
Risk objective – stated in terms of min.
contributions min. vol. of
- typically forms the basis of a contributions
secondary inv. objective min. PV of
contributions

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Review - 5
Pension Funds/
Investment Objectives:
Return objective – long-term rate ≥ discount rate
- objectives may differ for active vs. retired lives
Investment mission – achieve returns that adequately fund its
pension obligation on an inflation-adjusted basis

Investment portfolio: Equities – growth role (return-seeking)

Fixed Income – defensive role (hedging)
Alternatives – inflation hedge + growth role

Sovereign Wealth Funds/

short IH
1/ Budget Stabilization Funds
very liquid, low equity, no AI
(fixed income, cash)
- capital preservation
- 10: returns > inflation w/ low prob. of loss

Review - 6
Sovereign Wealth Funds/
2/ Development Funds – med. to long IH, low liquidity needs
- real rate of return > rGDP or productivity growth
- main investment = infrastructure (direct)

3/ Savings Funds – long IH, risky & illiquid assets, low liquidity needs
- maintain PP of assets in perpetuity while achieving
returns sufficient to sustain spending necessary to support
gov’t. activities
OID100851170.
- growth assets (equity, AI)

4/ Reserve Funds – liabilities = CBs monetary stabilization bonds

- long IH, lower liquidity needs than budget stab.,
higher than savings
- rate of return > yield on stabilization bonds
- equity, FI, AI

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Review - 7
Sovereign Wealth Funds/
5/ Pension Reserve Funds – long IH, liability = future pension obligations
- earn a return sufficient to (accumulation/decumulation phase)
max. likelihood of meeting low liquidity high liquidity
future obligations needs needs
- large equity allocations, 10 - 15% AI

Endowments/Foundations/
Endowments/ Stakeholders ➞ students, alumni, school
Investment horizon ➞ perpetual (maintain long-term PP)
Liabilities ➞ spending rate – constant growth
spending
Market value rule
rules
Hybrid
- target real return ≥ spending rate
- gifts/donations ➞ lower liquidity needs, reduce gross spending rate
- %’age of operating budget ➞ lower = higher RT
- ability to issue debt ➞ allows for illiquid investments

Review - 8
Endowments/Foundations/
Endowments/ Liquidity needs ➞ low, long IH = high AI allocation
Invest. Obj.: real rate of return ≥ spending rate + inflation
with expected vol. 10-15% over 3 - 5 years
mission: maintain PP of assets into perpetuity and generate
returns sufficient to support university budget

OID100851170.
Sec. 10. ➞ outperform a long-term policy benchmark

Foundations/ Stakeholders – donors, grant recipients

Investment horizon – perpetual
Liabilities ➞ 5% of AUM + investment fees + any donations that
period
Liquidity ➞ low, but higher than endowments
Invest. Obj.: total real ret. of 5% + Inv. fees w/ expected vol. 10-15%
over 3 - 5 yr. period (inflation = CPI)

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Review - 9
Endowments/Foundations/
Asset allocation: ➞ large equity, AI, lower FI
- smaller = lower AI allocation

Banks/Insurance/
Banks: Stakeholders ➞ Shareholders, creditors, depositors, employees
Assets ➞ loans, financial securities (originate assets)
Liabilities ➞ deposits, bonds, wholesale funding
Investment horizon ➞ short-to-med. term
Liquidity ➞ short duration liabilities
- mandated liquidity ➞ LCR, NSFR
Investment objective ➞ balance risk and liquidity of non-portfolio
assets vs. liabilities
- securities act as an adjustment mechanism
- below average risk tolerance

Review - 10
Banks/Insurance/
Insurance Stakeholders ➞ Shareholders, policyholders, mgmt.
Liabilities ➞ Life – long-term liabilities, predictable (actuaral)
Investment horizon: 20 - 40 yrs.
➞ P&C – short duration liabilities, high uncertainty
Investment horizon: short
Liquidity needs: Life – low, but when rates rise, liquidity needs ↑
P&C – high (cash, short-term FI, gov’t. bonds)
OID100851170.

Investment portfolio segmented ➀ Reserve portfolio – highly liquid, low

risk
➁ Surplus portfolio – growth assets
Investment Objective: manage reserve portfolio for liquidity
- grow surplus over time

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Review - 11
Banks/Insurance/
liability yield
Investment Strategy/ 𝚫𝐢
𝐃𝐄 = ^𝐀•𝐄a𝐃𝐀 − ^𝐀•𝐄 − 𝟏a𝐃𝐋 R S
𝚫𝐲 asset yield
equity dur. asset dur. liab. dur.
leverage

- the higher the leverage, the more critical it is to have 𝐃𝐀 = 𝐃𝐋

- to lower 𝐃𝐀 - hold cash, CB reserves
- make floating rate loans
- securitize fixed rate loans
- to raise 𝐃𝐋 – issue LT debt
- derivatives
- to lower 𝐃𝐄 - issue shares ➞ lowers leverage
𝟐 𝟐
𝛔𝟐∆𝐄 = V𝐀X𝐄Y 𝛔𝟐∆𝐀 + V𝐋X𝐄Y 𝛔𝟐∆𝐋 − 𝟐V𝐀X𝐄YV𝐋X𝐄Y𝛒𝛔∆𝐀 𝛔∆𝐋
𝐄 𝐀 𝐋 𝐀 𝐋

↓↑ ↓↑ ↓↑ ↓↑ ↓↑ ↓↑

OID100851170.

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Trade Strategy & Execution

Review - 1
LOS a/ 1/ Profit-seeking - information-based
- short-term profit opp. ➞ high trade urgency
➞ 𝛂 decay is high
- long-term ➞ low urgency
2/ Risk management/hedging - generally low urgency
3/ Cash flow needs ➞ inflow ➞ cash equitization
➞ outflows ➞ client redemptions
→
➞ urgency may be high or low
4/ Corporate actions/Index Reconstitution/Margin Calls
- coupons/dividends need to be reinvested
- margin or collateral calls

LOS b/ Order characteristics

1/ side of order - trending vs. non-trending market
2/ size of order - large = market impact

Review - 2
LOS b/ Order characteristics
2/ size of order - best evaluated in terms of % ADV
➞ Security characteristics
1/ security type - affects liquidity, trading costs
2/ short-term alpha - 𝛂 decay ➞ results from adverse price movement
3/ price volatility ➞ increases trade urgency if fast
- affects execution risk
→
OID100851170.
4/ liquidity ➞ higher = lower execution risk
➞ Market conditions - lower market liquidity = longer trading horizon
- higher market volatility = higher trade urgency
➞ Individual risk aversion - higher risk aversion = higher trade urgency

trade too fast ➞ market impact

trade too slow ➞ market/execution risk

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Review - 3
LOS c/ 1/ Pre-trade benchmarks
a) decision price - price at the time PM made decision
b) previous close ➞ Quant. PMs
c) opening price - no overnight risk, Fundamental PMs
d) arrival price ➞ price at time order is entered into the market
➞ short-term alpha traders
→
2/ Intraday benchmarks - for funds that trade passively over the day,
seek liquidity, or rebalancing
a) volume weighted average price – VWAP: - participate with volume
patterns
b) time-weighted average price - TWAP: - when outlier trades make
VWAP unreliable

Review - 4
LOS c/ 3/ Post-trade benchmarks - closing price
- typically use by index & mutual funds

4/ Price target benchmarks - set by PM

LOS d/ - trade size, trade urgency, motivation, risk aversion

➞ all determine trade strategy

LOS e/ high touch - principal - large urgent,

→ small urgent, illiquid
high touch - agency - large non-urgent, illiquid
OID100851170.
algorithmic trading - standardized securities, liquid markets
A/ Execution algorithms
i) scheduled:
1/ POV - percent of volume (participation algo.)
- as volume increases, algo. trades more

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Review - 5
LOS e/
A/ Execution algorithms
i) scheduled:
b) VWAP/TWAP ➞ time slicing schedule (equal or volume
weighted)
appropriate for: non-trending markets
tolerance for execution risk, min. market impact
small order sizes (5% - 10% of ADV)
relatively liquid or balanced
→ trades
ii) liquidity-seeking (opportunistic)
appropriate for: large orders with high trade urgency, min. market
min. information leakage impact
less liquid, thinly traded
iii) Arrival price - trade more aggressively at beginning of order
- used when adverse price movement expected

Review - 6
LOS e/
A/ Execution algorithms
iii) Arrival price
appropriate for: risk averse PM
liquid security, < 15% ADV
iv) Dark strategies/liquidity aggregators - min. info. leakage
appropriate for: large order size, min. market impact, low urgency
illiquid securities
OID100851170.

v) Smart order routers - small market/limit orders, low market

- high urgency or no info. content impact
large, urgent ➞ high touch
LOS f/ 1/ Equities ➞ exchanges, dark pools
large, non-urgent ➞ trading algos.
small ➞ electronic trading
2/ Fixed Income - OTC
small + large urgent ➞ high touch principal
non-urgent ➞ agency

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Review - 7
LOS f/
3/ Exchange Traded Derivatives - electronic, algos.
- large, urgent ➞ liquidity-seeking algos.
4/ OTC Derivatives
- large, urgent ➞ principal
- non-urgent ➞ agency

5/ Forex – electronic

LOS g/ IS = Paper return - Actual return

= (𝐏𝐧 − 𝐏𝐝 )𝐒 − ]∑𝐒𝐣 (𝐏𝐧 ) − ∑𝐒𝐣 𝐩𝐣 _ - Trading Fees
ending p. decision p. execution costs price when
decision order placed order was
’(∑𝐒𝐣 )𝐏𝐨 − ^∑𝐒𝐣 a𝐏𝐝 “ + ’∑𝐒𝐣 𝐩𝐣 − (∑𝐒𝐣 )𝐏𝐨 “
placed
𝐏𝐝 𝐏𝐨
delay trading

Opportunity cost = ^𝐒 − ∑𝐒𝐣 a(𝐏𝐧 − 𝐏𝐨 ) - unexecuted shares

Review - 8
LOS g/
Improving execution performance
- reduce delay
- determine proper order size ➞ reduce lost opportunity
Evaluation/ average price
o − 𝐏∗
𝐏
𝐂𝐨𝐬𝐭(𝐛𝐩𝐬) = 𝐒𝐢𝐝𝐞 × n p × 𝟏𝟎, 𝟎𝟎𝟎
𝐏∗ Arrival
-1 = sell reference price VWAP
OID100851170. +1 = buy TWAP
closing
𝐈𝐧𝐝𝐞𝐱 𝐕𝐖𝐀𝐏 − 𝐈𝐧𝐝𝐞𝐱 𝐀𝐫𝐫𝐢𝐯𝐚𝐥 𝐩𝐫𝐢𝐜𝐞
𝐈𝐧𝐝𝐞𝐱 𝐜𝐨𝐬𝐭 = 𝐒𝐢𝐝𝐞 × R S × 𝟏𝟎, 𝟎𝟎𝟎
𝐈𝐧𝐝𝐞𝐱 𝐀𝐫𝐫𝐢𝐯𝐚𝐥 𝐩𝐫𝐢𝐜𝐞

Market Adjusted Cost = Arrival Cost - 𝛃 Index Cost

Added Value = Arrival Cost - estimated pre-trade cost

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Review - 9
LOS i/ - Trade Policy: includes
1/ meaning of best execution
2/ factors determining optimal order execution approach
3/ List of eligible brokers and execution venues
4/ Process used to monitor execution arrangements

OID100851170.

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