PORTFOLIO MANAGEMENT

TECHNIQUES

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 PORTFOLIO MANAGEMENT
TECHNIQUES

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PORTFOLIO MANAGEMENT TECHNIQUES

Content Overview
1 Portfolio Management: Overview
2 Ethics and Portfolio Management
3 The Institutional Investor
4 The Investment Management Firm
5 The Front, Middle, and Back Offices
6 Managing Equity Portfolios
7 Managing Fixed Income Portfolios: Trading Operations, Management Styles, and Box Trades
Managing Fixed Income Portfolios: Other Bond Portfolio Construction Techniques, High Yield
8
Bonds, and ETFs
9 The Permitted Uses of Derivatives by Mutual Funds
10 Creating New Portfolio Management Mandates
11 Alternative Investments
12 Client Portfolio Reporting and Performance Attribution
G Glossary

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 PORTFOLIO MANAGEMENT TECHNIQUES iii

Table of Contents

1 Portfolio Management: Overview

1•3 INTRODUCTION

1•3 WHAT IS A PORTFOLIO MANAGER?

1•4 REGISTRATION CATEGORIES UNDER NATIONAL INSTRUMENT (NI) 31-103

1•4 Dealer Categories
1•5 Advisor Categories
1•5 Individual Categories
1•7 INVESTMENT INDUSTRY REGULATIONS
1•7 CIRO-Managed Account Requirements
1•8 The Canadian Securities Administrators (CSA)
1 • 13 Financial Transactions and Reports Analysis Centre of Canada (FINTRAC)
1 • 14 BEST PRACTICES

1 • 15 MANAGED ACCOUNTS WITHIN A CIRO DEALER MEMBER

1 • 17 SUMMARY

2 Ethics and Portfolio Management

2•3 INTRODUCTION

2•3 ETHICS
2•3 What Is Meant by Ethics?
2•4 What Are Values?
2•5 Ethical Dilemmas
2•7 CODE OF ETHICS
2•7 Strengths and Weaknesses
2•8 Best Practices

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iv PORTFOLIO MANAGEMENT TECHNIQUES

2•9 TRUST AND FIDUCIARY DUTY

2•9 Trust
2 • 11 Fiduciary Duty
2 • 13 SUMMARY

2 • 14 APPENDIX A
2 • 14 CIRO’s IDPC Rule 1402, Standards of Conduct (For Information Purposes Only – Not
Examinable)
2 • 15 APPENDIX B
2 • 15 The CIM® Code of Ethics (For Information Purposes Only – Not Examinable)

3 The Institutional Investor

3•3 INTRODUCTION

3•3 FINANCIAL INTERMEDIATION

3•4 Institutional Investors
3•9 Other Industry Participants
3 • 10 Principal-Agent Relationships in Investment Management
3 • 12 GOVERNANCE
3 • 12 Regulatory Environment
3 • 13 Institutional Investment Fund Governance
3 • 16 SUMMARY

4 The Investment Management Firm

4•3 INTRODUCTION

4•3 OWNERSHIP AND COMPENSATION STRUCTURES

4•4 Privately Owned Structure
4•5 Publicly Owned Structure
4•6 Compensation Structures
4•8 REGULATIONS AND LICENSING
4•8 Individual Registrants Versus Corporate Registrants

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 TABLE OF CONTENTS v

4•8 ORGANIZATIONAL STRUCTURE

4•9 Front, Middle, and Back Offices
4 • 11 Ultimate Designated Person and Chief Compliance Officer
4 • 11 INVESTOR TYPES
4 • 12 Non-Exempt Investors
4 • 12 Exempt Investors
4 • 12 Investor-Firm Interaction
4 • 13 SERVICE CHANNELS
4 • 14 Pooled Funds
4 • 15 Segregated/Managed Accounts
4 • 15 Limited Partnerships
4 • 15 Sub-Advisory Capacity
4 • 16 INVESTMENT MANDATES
4 • 16 Domestic Single-Sector Mandates and Balanced Funds
4 • 16 Specialty- or Sector-Focused Mandates
4 • 17 Style-Focused Mandates
4 • 18 Passive Investment Management
4 • 18 Alternative Investments
4 • 19 Global Mandates
4 • 19 Offshore Investments
4 • 20 ROLES AND RESPONSIBILITIES OF INSTITUTIONAL INVESTMENT MANAGERS
4 • 20 Advisory Versus Sub-Advisory Relationship
4 • 21 Management Structure of Canadian Mutual Funds
4 • 24 Portfolio Manager’s Roles and Responsibilities as a General Partner
4 • 24 INVESTMENT MANAGEMENT FEES
4 • 26 Performance-Related Fees
4 • 27 INDUSTRY CHALLENGES
4 • 28 Investment Performance
4 • 28 Access to Suitable Distribution
4 • 29 Increased Compliance Requirements
4 • 30 Increasing Competition
4 • 31 Human Resources
4 • 31 Growth of Passive Investment Mandates

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vi PORTFOLIO MANAGEMENT TECHNIQUES

4 • 32 CORPORATE GOVERNANCE
4 • 32 Aspects of Good Corporate Governance
4 • 32 Potential Benefits of Good Corporate Governance
4 • 34 SUMMARY

5 The Front, Middle, and Back Offices

5•3 INTRODUCTION

5•3 AN OVERVIEW OF THE FRONT OFFICE

5•4 THE FOUR AREAS OF THE FRONT OFFICE

5•4 Portfolio Management
5•6 Trade Execution
5•7 Sales and Marketing
5•7 Client Service
5•8 INFORMATION FLOW AMONG FRONT OFFICE STAFF

5 • 10 FRONT OFFICE BEST PRACTICES

5 • 10 Performance Measurement
5 • 11 Dual Signatures
5 • 11 Employee Personal Trading
5 • 12 Investment Management Agreement
5 • 12 GETTING CLIENTS
5 • 12 Institutional and Mutual Fund Sponsors
5 • 15 Individual Investors
5 • 15 Timeline for Getting Clients
5 • 16 LOSING CLIENTS
5 • 16 Weak Investment Performance
5 • 17 Poor Client Service
5 • 17 Termination Process
5 • 17 OVERVIEW OF THE MIDDLE OFFICE

5 • 18 THE MIDDLE OFFICE

5 • 18 The Compliance Function
5 • 20 The Legal Function
5 • 21 The Auditing Function

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 TABLE OF CONTENTS vii

5 • 22 The Accounting Function

5 • 23 The Middle Office’s Key Operational Interfaces and Information Flow
5 • 24 Middle Office Best Practices
5 • 26 THE BACK OFFICE
5 • 26 The Back Office’s Key Operational Interfaces and Information Flow
5 • 27 Back Office Best Practices
5 • 28 SUMMARY

6 Managing Equity Portfolios

6•3 INTRODUCTION

6•3 BOTTOM-UP AND TOP-DOWN APPROACHES

6•3 The Bottom-Up Approach
6•6 The Top-Down Approach
6•6 PORTFOLIO MANAGEMENT STYLES
6•6 Passive Management Styles
6 • 14 Active Management Styles
6 • 17 Active Portfolio Construction
6 • 26 Comparing Passive and Active Portfolio Construction Techniques
6 • 28 THE USE OF DERIVATIVES IN EQUITY PORTFOLIO MANAGEMENT
6 • 28 Hedging a Portfolio with Equity Index Derivatives
6 • 30 Changing a Portfolio’s Asset Mix
6 • 31 TAX CONSIDERATIONS

6 • 32 THE USE OF EXCHANGE-TRADED FUNDS IN EQUITY PORTFOLIO MANAGEMENT

6 • 32 Key Features
6 • 33 Analysis of the Choices to ETFs
6 • 34 Portfolio Management Techniques Using Equity ETFs
6 • 37 Considerations when Investing in ETFs
6 • 38 Expanding Choices with ETFs
6 • 40 SUMMARY

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viii PORTFOLIO MANAGEMENT TECHNIQUES

7 Managing Fixed Income Portfolios: Trading Operations,

Management Styles, and Box Trades
7•3 INTRODUCTION

7•3 FIXED INCOME TRADING OPERATIONS

7•3 Fixed Income Department – Functional Organization
7•4 Bond Financing and Repo Transactions
7•5 Comparison of Sell-Side and Buy-Side Fixed Income Professionals
7•7 BOND MANAGEMENT STYLES
7•7 Interest Rate Sensitivity
7•8 Duration
7•9 Passive Portfolio Management
7 • 13 Active Portfolio Management
7 • 15 BOX TRADES
7 • 15 Bond Swaps
7 • 18 Dual Bond Swap (Box Trade)
7 • 22 SUMMARY

8 Managing Fixed Income Portfolios: Other Bond Portfolio

Construction Techniques, High Yield Bonds, and ETFs
8•3 INTRODUCTION

8•3 OTHER BOND PORTFOLIO CONSTRUCTION TECHNIQUES

8•3 Asset-Backed Securities
8•5 Mortgage-Backed Securities
8 • 11 Other Fixed Income Securities
8 • 12 Using Derivatives in Fixed Income Management
8 • 20 Advantages and Disadvantages of Securitization
8 • 21 HIGH-YIELD (JUNK) BONDS
8 • 21 High-Yield Bond Issuers
8 • 22 High-Yield Bond Investors
8 • 22 High-Yield Bond Market Indexes

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 TABLE OF CONTENTS ix

8 • 22 Credit Rating Methodology

8 • 24 Default Risk and Default Rates
8 • 25 Unique Coupon Structures
8 • 27 FIXED INCOME EXCHANGE-TRADED FUNDS (ETFS)
8 • 27 Investment Mandates for Fixed Income ETFs
8 • 28 Investment Management Techniques for Fixed Income ETFs
8 • 30 SUMMARY

9 The Permitted Uses of Derivatives by Mutual Funds

9•3 INTRODUCTION

9•3 THE TYPES OF MUTUAL FUNDS THAT USE DERIVATIVES

9•3 MUTUAL FUND REGULATIONS

9•4 Transactions for Hedging Purposes
9•4 Transactions for Non-Hedging Purposes
9•5 HOW MUTUAL FUNDS USE DERIVATIVES
9•5 Hedging Uses
9•6 Non-Hedging Uses
9•9 THE ADVANTAGES OF DERIVATIVES

9 • 10 THE POTENTIAL RISKS OF DERIVATIVES

9 • 12 SUMMARY

10 Creating New Portfolio Management Mandates

10 • 3 INTRODUCTION

10 • 3 NEW INVESTMENT PRODUCT DEVELOPMENT PROCESS

10 • 4 Step One: Identifying Potential Market Opportunities
10 • 5 Step Two: Determining the Required Portfolio Management Skills
10 • 6 Step Three: Assessing the Market
10 • 8 Step Four: Determining Legal and Regulatory Restrictions

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x PORTFOLIO MANAGEMENT TECHNIQUES

10 • 9 Step Five: Developing a Marketing and Distribution Strategy

10 • 10 Step Six: Preparing a Financial Forecast
10 • 13 Step Seven: Obtaining Approval from the Investment Management Firm’s Senior
Management Team
10 • 14 Step Eight: Developing and Launching the Product
10 • 16 INVESTMENT GUIDELINES AND RESTRICTIONS
10 • 17 Common Design Factors for Investment Guidelines and Restrictions
10 • 20 Unique Factors in Equity Mandate Design
10 • 22 Unique Factors in Fixed Income Mandate Design
10 • 23 Unique Factors in Balanced Fund Mandates
10 • 25 SUMMARY

11 Alternative Investments
11 • 3 INTRODUCTION

11 • 3 DEFINITION OF ALTERNATIVE INVESTMENTS

11 • 4 Hedge Funds
11 • 5 Commodities
11 • 5 Managed Futures Funds
11 • 5 Private Market Investments
11 • 13 Real Estate
11 • 15 REASONS TO INVEST IN ALTERNATIVE INVESTMENTS

11 • 16 ISSUES AND CHALLENGES WITH ALTERNATIVE INVESTMENTS

11 • 16 Asset Allocation Process
11 • 18 Security Pricing and Valuation
11 • 18 Short Sales
11 • 18 Accounting for Leverage
11 • 19 PERFORMANCE ATTRIBUTION
11 • 19 Lack of Suitable Performance Benchmarks
11 • 20 Lack of Mandate Definition and Standardization
11 • 20 Lack of Investment Strategy Transparency
11 • 20 THE UNIQUE RISKS OF ALTERNATIVE INVESTMENTS

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 TABLE OF CONTENTS xi

11 • 24 DUE DILIGENCE
11 • 25 Assessing an Alternative Investment Fund’s Risk Profile
11 • 26 CURRENT TRENDS AND DEVELOPMENTS IN ALTERNATIVE INVESTING
11 • 26 Increased Government Regulation
11 • 27 Institutionalization
11 • 27 Continued Innovation
11 • 27 Digital Assets
11 • 29 SUMMARY

12 Client Portfolio Reporting and Performance Attribution

12 • 3 INTRODUCTION

12 • 3 CLIENT PORTFOLIO REPORTING

12 • 3 Global Investment Performance Standards
12 • 3 Key Aspects of the GIPS Standards
12 • 5 PORTFOLIO MANAGEMENT REPORTS
12 • 6 Book Versus Market Prices
12 • 7 Comparing Portfolio Manager and Custodian Reports
12 • 7 PERFORMANCE ATTRIBUTION
12 • 8 An Example of Performance Attribution Analysis
12 • 11 Sector Attribution
12 • 13 Performance Attribution Styles
12 • 16 SUMMARY

G Glossary

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 Portfolio Management:
Overview 1

CONTENT AREAS

What Is a Portfolio Manager?

Registration Categories Under National Instrument (NI) 31-103

Investment Industry Regulations

Best Practices

Managed Accounts within a CIRO Dealer Member

LEARNING OBJECTIVES

1 | Describe what a portfolio manager is.

2 | Identify and explain the various dealer, advisor, and individual registration categories available in
Canada.

3 | Describe the regulatory environment in Canada.

4 | Identify CIRO-managed account rules with respect to the documentation required and the account
approval and oversight process.

5 | Outline the various investment practices the Canadian Securities Administrators (CSA) regulates.

6 | Explain the compliance requirements of the Financial Transactions and Reports Analysis Centre of
Canada (FINTRAC).

7 | Outline some of the investment management industry’s best practices.

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1•2 PORTFOLIO MANAGEMENT TECHNIQUES

KEY TERMS

Key terms are defined in the Glossary and appear in bold text in the chapter.

Canadian Securities Administrators (CSA) National Instruments

dealers Personal Information Protection and Electronic

Documents Act (PIPEDA)
fairness policy
portfolio manager
Financial Transactions and Reports Analysis
Centre of Canada (FINTRAC) provincial and territorial securities
commissions
high closing
self-regulatory organizations (SROs)
Know Your Client (KYC) rule
soft dollar arrangement
late trading

market timing

© CANADIAN SECURITIES INSTITUTE

 CHAPTER 1 PORTFOLIO MANAGEMENT: OVERVIEW 1•3

INTRODUCTION
In the 1930s, Benjamin Graham and David Dodd published their seminal work on investing,1 suggesting that
securities could be valued according to relatively simple yet immensely powerful concepts, based on the idea that
some securities were inherently more attractive than others. These insights moved investing out of the realm of
outright speculation and into that of a profession. In the 1950s, investment became the subject of doctoral-level
research as Harry Markowitz, a graduate student at the University of Chicago, first developed the idea that became
known as modern portfolio theory (MPT),2 which numerous scholars have since expanded upon.
Decades ago, most individuals worked for one employer, or a small number of employers, over their working
lifetime. They expected to retire at the age of 65 with a secure company pension, bolstered, in Canada at least, by
government pension arrangements, such as the Canada Pension Plan (CPP) and the Québec Pension Plan (QPP),
which provided for a comfortable lifestyle in their retirement years. Nowadays, when it comes to company pension
plans, the trend is toward a defined contribution approach, rather than a defined benefit approach, where the
responsibility for investing for retirement has shifted from employers and governments to individuals.
At the same time, life expectancy for most Canadians has increased. This means that individuals must not only
plan for their own retirement, but also ensure their investments will sustain their lifestyle for a longer period of
retirement than ever before.
As a result, portfolio management — whether for individual clients, in the case of investment advisors, or for
institutional investors, such as mutual funds or insurance companies — is a growing area in the financial services
industry.
Not just anyone can decide to be a portfolio manager; first, there are credentials to acquire and specific educational
and licensing requirements to meet. This chapter will describe the basics of the industry, including how to become a
portfolio manager and what the role involves, as well as some of the basic regulatory requirements of the portfolio
management business.

WHAT IS A PORTFOLIO MANAGER?

Apart from the legal and regulatory definition, which we will discuss later in this chapter, what is meant by the
term “portfolio manager”? Simply put, a portfolio manager is an individual, or a team of individuals, who advises
clients, which can be individuals or different types of institutional investors, on investments that are appropriate to
a client’s individual circumstances and investment objectives. A portfolio manager may make recommendations on
broad asset allocation decisions, such as the appropriate allocation to equities, bonds and cash, or they may make
specific recommendations on particular stocks or bonds, or do both.
From a regulatory perspective, a portfolio manager has the authority to make discretionary trades in securities
on behalf of clients. For anyone currently registered with the various securities commissions to act in a sales
capacity for securities or mutual funds, this authority is recognized as a special status. Securities regulators
require a specific set of qualifications in order for an individual to be registered as a portfolio manager. National
Instrument (NI) 31-1033 explains the education and experience required for individuals who wish to be registered
as a portfolio manager-advising representative (see the feature box “Overview of Required Educational Programs”
for a description of the course requirements for becoming a portfolio manager). In addition, an individual may be
registered as a portfolio manager-associate advising representative, which places them under the direct supervision
of a portfolio manager-advising representative.

1
Benjamin Graham and David Dodd, Security Analysis (New York: McGraw-Hill, 2004). First published by Whittlesey House, New York, in 1934.
2
Harry M. Markowitz, “Portfolio Selection,” The Journal of Finance 7, No. 1 (March 1952): 77–91.
3
National Instrument (NI) 31-103 can be found at https://www.bcsc.bc.ca/Securities_Law/Policies/Policy3/PDF/31-103__NI___June_12__2019/

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1•4 PORTFOLIO MANAGEMENT TECHNIQUES

An individual at an investment dealer who meets the educational and experience requirements of the Canadian
Investment Regulatory Organization (CIRO) Investment Dealer and Partially Consolidated (IDPC) Rule 2600 may be
registered as a portfolio manager or associate portfolio manager.

Exhibit 1.1 | Overview of Required Educational Programs

• Chartered Financial Analyst (CFA®) Program

The CFA Program is offered exclusively by the CFA Institute, the issuing body for the CFA designation. The CFA
Program requires the completion of three six-hour exams and the accumulation of 48 months of approved work
experience. Topics of study include accounting, economics, equity analysis, fixed income analysis, derivatives,
real estate, statistics and ethics.

• Chartered Investment Manager (CIM®) Designation

The CIM designation is achieved through a program offered exclusively by the Canadian Securities Institute.
There are two ways to obtain the CIM designation, with the most popular requiring the completion of three
courses: the Canadian Securities Course (CSC®), the Investment Management Techniques (IMT®) course and
the Portfolio Management Techniques (PMT®) course. A chief advantage of these courses is that the material
focuses on the marketplace, financial markets and regulatory environment in Canada.

REGISTRATION CATEGORIES UNDER NATIONAL INSTRUMENT (NI)

31-103
Firms in Ontario must be registered with the appropriate regulator, either the Ontario Securities Commission (OSC)
or an approved self-regulatory organization, namely CIRO. Firms can fall into several registration categories under
the two main categories of dealers and advisors.

DEALER CATEGORIES
A dealer is a person or company that is in the business of trading in securities in the capacity of a principal or agent.
Some of the relevant dealer categories include:

Investment dealer A dealer who engages in the business of trading in securities in the capacity of an
agent or principal, and is a dealer member of CIRO. An investment dealer also has the
authority to act as an underwriter.

Mutual fund dealer A dealer registered exclusively for the purpose of trading in shares or units of mutual
funds. Other than in Quebec, a mutual fund dealer must be a member of CIRO.

Scholarship plan dealer A dealer who is restricted to scholarship plans, educational plans or educational trust
investments.

Exempt market dealer A dealer who trades or advises in the exempt market, such as private placements.

Restricted dealer An open category that will allow flexibility in registration.

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 CHAPTER 1 PORTFOLIO MANAGEMENT: OVERVIEW 1•5

ADVISOR CATEGORIES
NI 31-103 enables the uniform registration of advisors in all provinces and territories. The registration categories are:

Portfolio manager A person or company that manages clients’ investment portfolios through the
discretionary authority granted by the clients.

Restricted portfolio A person or company that acts as an adviser regarding a security in accordance with the
manager terms, conditions, restrictions or requirements applied to its registration.

INDIVIDUAL CATEGORIES
The following are the registration groups for an individual who, under securities legislation, is required to be
registered to act on behalf of a registered firm:

Dealing representative An individual who may act as a dealer or an underwriter regarding a security that the
individual’s sponsoring firm is permitted to trade or underwrite.

Advising representative An individual who may act as an adviser regarding a security that the individual’s
sponsoring firm is permitted to advise on.

Associate advising An individual who may act as an adviser regarding a security that the individual’s
representative sponsoring firm is permitted to advise on if the advice has been pre-approved by an
individual that the sponsoring firm has designated.

Ultimate Designated An individual who must supervise the firm’s activities that are directed towards ensuring
Person compliance with securities legislation and each individual acting on the firm’s behalf. In
addition, they must promote the firm’s compliance, as well as the individuals acting on
its behalf, with securities legislation.

Chief compliance An individual who must, along with other requirements, establish and maintain policies
officer and procedures for assessing the firm’s compliance, as well as the individuals acting on
its behalf, with securities legislation. In addition, they must monitor and assess the firm’s
compliance, as well as the individuals acting on its behalf, with securities legislation.

Exhibit 1.2 | Educational and Experience Requirements for a Portfolio Manager

i. Portfolio Manager – Advising Representative:

a. The individual must have earned the CFA designation and have 12 months of relevant investment
management experience earned in the last 36 months prior to applying for registration; or
b. The individual must have earned the CIM designation and have 48 months of relevant investment
management experience, with 12 months of this relevant experience earned in the last 36 months prior to
applying for registration.

ii. Portfolio Manager – Associate Advising Representative:

a. The individual must have completed Level 1 of the CFA Program and have 24 months of relevant investment
management experience; or
b. The individual must have received the CIM designation and have 24 months of relevant investment
management experience.

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1•6 PORTFOLIO MANAGEMENT TECHNIQUES

Exhibit 1.2 | Educational and Experience Requirements for a Portfolio Manager

iii. Portfolio Manager – Chief Compliance Officer:

a. The individual must have earned the CFA designation or a professional designation, such as a lawyer,
Chartered Accountant, Certified General Accountant or Certified Management Accountant in a jurisdiction in
Canada; a notary in Quebec; or the equivalent in a foreign jurisdiction.
The individual must have also successfully completed the Partners, Directors and Senior Officers (PDO)
course or the Chief Compliance Officers (CCO) qualifying exam, and, if they have not earned the CFA
designation, the Canadian Securities Course (CSC). The individual must have 36 months of relevant
securities experience at an investment dealer, a registered advisor or an investment fund manager, or have
provided professional services in the securities industry for 36 months. The individual must have also worked
at a registered dealer, a registered adviser or an investment fund manager for 12 months; or
b. The individual must have successfully completed the CSC and either the PDO or the CCO and have worked
at an investment dealer or a registered advisor for five years (including 36 months in a compliance capacity),
or the individual must have worked for five years at a Canadian financial institution in a compliance capacity
relating to portfolio management and worked at a registered dealer or registered adviser for 12 months; or
c. The individual must have successfully completed the PDO or the CCO and have met the requirements of a
portfolio manager-advising representative.

iv. For CIRO registrants: Portfolio Manager or Associate Portfolio Manager

The individual must meet the requirements outlined in CIRO’s IDPC Rule 2600 – Proficiency Requirements and
Exemptions from Proficiencies.

DID YOU KNOW?

Managers, Portfolio Advisors and Sub-Advisors

In Canada, much confusion arises around the definitions of the terms manager, portfolio advisor and
sub-advisor.

In a regulatory sense, the manager is the sponsoring organization of a managed product such as a
mutual fund. A fund’s manager bears ultimate responsibility for its adherence to the various pertinent
regulations governing operations, including advertising, performance presentation, sales and
compliance.

The portfolio advisor is the entity engaged to provide actual portfolio management and advice services
to a fund’s manager. Of course, the management firm and the advisory firm may be one and the same,
or the portfolio advisor may be a division of the manager. Every fund must be managed in some sense,
and so the portfolio advisor must be disclosed in prospectus materials.

For several reasons, the advisor may hire the portfolio management and advice services of a third-party
firm, the sub-advisor. First, in-house portfolio management is expensive, requiring software systems for
record-keeping and portfolio accounting, infrastructure for a portfolio management team and salaries
for staff. A start-up operation or one with relatively low assets under management may find it more
economical to employ sub-advisors for portfolio management services. Second, an advisor may employ
a sub-advisor that has a different investment style from the portfolio manager, or one with a particular
skill in a sector-specific mandate that the advisor or manager cannot provide.

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 CHAPTER 1 PORTFOLIO MANAGEMENT: OVERVIEW 1•7

INVESTMENT INDUSTRY REGULATIONS

The investment industry is one of the most regulated sectors of Canada’s economy. However, it should be
remembered that no amount of regulation will prevent outright fraud and criminality. At the same time, those in
the industry, particularly portfolio managers, should view regulation as a positive for the business.
Above all in their profession, portfolio managers are charged with the stewardship of their clients’ money.
Regulation is designed to protect investors not from their own imprudence, but from impropriety and a lack of
professionalism on the part of those entrusted with their assets. A firm’s senior leadership that exhibits a strong
commitment to the highest level of ethics and professionalism helps breed a culture of compliance throughout the
organization.
Canada is the only major industrialized nation without a national securities regulator. Securities regulations in
Canada fall under the jurisdiction of the various provincial and territorial securities commissions, which are
charged with enforcing and helping to frame the various securities acts of the provinces. Thus, at the highest level,
there are 13 primary regulators in Canada: 10 provincial and three territorial. This is in contrast to the U.S., where
the U.S. Securities and Exchange Commission is the national securities regulator.
The registration and regulation of portfolio managers remain the chief responsibility of the provincial securities
commissions. Portfolio management firms with multiple operations — for instance, portfolio management,
securities dealing, mutual fund dealing and securities trading — may well be faced with different primary regulators
for each activity or line of business. Portfolio managers should be familiar with the primary regulators for each of
their intended operations.
In many cases, the various securities commissions have delegated the regulation of the investment industry to
self-regulatory organizations (SROs), which are charged with monitoring the activities of their member firms. For
instance, the regulation of investment dealers has been largely delegated to CIRO.
Canada’s regulatory environment is under increasing scrutiny and pressure for reform, with many market
participants believing that overlapping regulations result in the duplication of effort, the squandering of time and
resources, and an increased overall cost of investing, which must ultimately be borne by investors. In a number of
areas, efforts have been made to streamline and coordinate securities regulations across the country.

CIRO-MANAGED ACCOUNT REQUIREMENTS

A managed account is an account that is subject to a suitability obligation where investment decisions are made
and executed on a continuing basis by a portfolio manager or associate portfolio manager or by a third party
hired by the dealer member. This means that discretionary authority has been given on an ongoing basis, and is a
permanent arrangement, rather than a temporary one. CIRO must approve dealer members to handle managed
accounts and ensure they are compliant with its rules.
No dealer member or any person acting on its behalf is permitted to exercise discretionary authority over these
accounts unless the individual responsible for the account has been approved by CIRO as a portfolio manager
or associate portfolio manager. CIRO permits third-party sub-advisors to manage these accounts provided that
there is a written sub-advisor agreement with the dealer member in place, and the individual or dealer member is
registered to provide discretionary portfolio management services in the jurisdiction in which the client resides. The
jurisdiction must have conflict of interest provisions that are at least equivalent to CIRO Rules, or the sub-advisor
must agree that it will comply with CIRO Rules.
Managed accounts may be solicited.4 In order for a dealer member to approve a managed account, a client must
sign a managed account agreement, and the dealer member’s designated supervisor must accept it. The managed
account agreement must also clearly indicate the client’s investment objectives for the account and they must be

4
A common definition of solicit is “to seek or invite”.

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provided with a copy of the dealer member’s procedures to ensure the fair allocation of investment opportunities
among managed accounts. A responsible person (e.g. portfolio manager or associate portfolio manager) or a dealer
member must not trade for his or her own account in reliance upon information relating to trades made or to be
made in a managed account, or knowingly cause any managed account to purchase or sell a security or derivative of
a security of an issuer from or to the account of a portfolio manager, an associate portfolio manager or an associate
of a portfolio manager or an associate of an associate portfolio manager.
Without the client’s written consent, a responsible person or a dealer member must not knowingly allow a managed
account to:

• Invest in a security or derivative of a security of an issuer that is related or connected to a responsible person or
the dealer member
• Invest in a security or derivative of a security of an issuer if the individuals authorized to deal with managed
accounts is an officer or director of the issuer unless the position is disclosed to the client; or
• Invest in new issues or secondary offerings underwritten by the dealer member

The designated supervisor must review each managed account on a quarterly basis to ensure that a client’s
investment objectives are diligently pursued and that the managed account is being conducted in accordance with
CIRO rules. Reviews may be conducted on an aggregate basis, where decisions are made centrally and applied
across a number of managed accounts.
Both a client and dealer member may terminate a managed account agreement, as long as the request is submitted
in writing. A client may terminate an agreement at any time, but if a dealer member is terminating it, the client
must be given at least 30 days’ notice.
Managed accounts of partners, directors, officers, employees, or approved persons of a dealer member are exempt
from CIRO rules about client priority where the account is centrally managed with other client accounts and the
account participates equally with client accounts when investment decisions are implemented.

THE CANADIAN SECURITIES ADMINISTRATORS (CSA)

Although there is no national securities regulator in Canada, the Canadian Securities Administrators (CSA) is a
working group of regulators from each provincial and territorial regulator that is charged with forging uniformity in
regulation, where possible. The CSA has issued a number of national instruments, a series of regulations applicable
across the country that serve to harmonize rules and regulations in each jurisdiction.
For example, National Instrument (NI) 81-102 is the framework for the mutual fund industry in Canada. NI 81-102
regulates many aspects of the mutual fund business — from rules on acceptable investments for mutual funds,
performance presentation and advertising, to rules on the use of derivatives and the degree of controlling share
ownership. Every portfolio manager who manages mutual fund portfolios, or who advises clients on investing in
mutual funds, needs to be very familiar with the rules of NI 81-102.5
The following sections outline some of the activities that the CSA regulates or bans.

HIGH CLOSING
Essentially, high closing is entering a higher bid price for a security at closing to artificially increase the net asset
value (NAV) of the fund to which the security belongs. Securities exchanges operate on the basis of a bid-offer
spread. Mutual funds and other managed portfolios offer a daily pricing mechanism, whereby a fund’s market value
per share is established at the end of each business day. In order to do this, it is necessary to obtain a market price
for each security in the portfolio. This price is established at the end of an exchange’s trading day (4 p.m. Eastern
Standard Time in Toronto and New York).

5
The full text of NI 81-102 is available from a number of sources on the Internet, including this one from the British Columbia
Securities Commission: https://www.bcsc.bc.ca/Securities_Law/Policies/Policy8/PDF/81-102__NI___January_3__2019/

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Accounting rules mandate that a portfolio’s securities be valued at the bid price at the close of trading.

EXAMPLE
Suppose a security, which is held in a fund’s portfolio, has been quoted at a bid price of $10.00 and an offer of
$10.10 for the entire day, and has traded only at $10.00 during the day. The portfolio’s security would be valued
that evening at $10.00 per share. High closing involves the portfolio manager entering a bid price of $10.05
seconds before the close of trading, even though they have no intention of actually purchasing shares at that
price. In that case, the portfolio’s security would be valued at the bid price of $10.05, rather than $10.00, thus
artificially inflating the fund’s NAV.

WHY WOULD A MANAGER DO THIS?

In a highly competitive business, the difference between a first-quartile performance and a second-quartile
performance can be a matter of basis points. Since portfolio managers are typically evaluated and compensated
on the basis of relative performance, high closing artificially inflates the fund’s value, and thus potentially its
performance. Purchasers of the fund that evening would pay a higher price than warranted by the security’s
trading, while sellers would receive benefits they would not otherwise have enjoyed. In addition, because fund
managers are paid as a percentage of assets under management, by artificially boosting a fund’s reported NAV,
a manager would increase the fees that the fund would pay them or their firm, all to the detriment of unitholders.

Portfolio managers should be aware that, in addition to being unethical, high closing is illegal.

LATE TRADING
Managers of mutual funds and other managed products must provide pricing for their products so that investors
may purchase units or redeem them on a regular basis — in the case of mutual funds, usually on a daily basis. In
order to achieve this, firms must establish a cut-off time for the fund’s orders to be placed so that they can be
processed at that day’s NAV. Usually, but not always, that cut-off time is 4 p.m., to coincide with the close of
trading of a securities exchange.
The essence of trading in mutual fund units is that all traders are placing their orders “blind”; that is, they do not
know what price they will either purchase or sell at, only that they will trade at that day’s established price. Late
trading occurs when a mutual fund company allows a trader to enter an order, either to purchase or sell, after the
established cut-off time.

WHY WOULD A TRADER DO THIS?

A trader might want to do this because, with a reasonable idea of the securities held by a mutual fund, they
would have a reasonably good idea of what the day’s price might be for that mutual fund. The trader could then
place an order to buy knowing the fund would benefit from market action that day. Conversely, if the trader
knew of an event that would adversely affect a fund’s performance or price, they could enter an order to sell and
benefit at the expense of other investors, who would be placing their orders without foreknowledge of the fund’s
price.

Late trading is decidedly illegal. Portfolio managers must make themselves familiar with the published rules around
late trading at their firms, and also be aware of their firms’ processes for placing orders.

MARKET TIMING
Market timing is another practice that emerged from a late-trading scandal. However, in contrast to late trading,
market timing is not illegal. The marketing literature of most mutual fund companies praises the virtues of long-
term investing and actively discourages investors from frequently trading units of their funds. Indeed, mutual funds

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are intended as long-term investment vehicles, and frequent trading suggests the lack of either a solid long-term
financial plan or a clear understanding of the risks involved in financial markets.
Market timing generally involves large investors taking advantage of inefficiencies in the way mutual funds are
priced, notably international funds, where the portfolio’s securities must be priced daily, but the overseas markets
are closed hours ahead of North American ones. The growing correlation between global equity markets means that
a major event in the afternoon in North America will be reflected in market performance on the same day, but it will
not spill into Europe until the next day, simply due to differing time zones.

WHY WOULD A TRADER DO THIS?

Market timers have an incentive to sell their global funds today, knowing that negative developments in North
America will not appear in the price of their international funds until tomorrow. The reverse is also true; a market
timer could take advantage of salutary market news by buying the international funds today, knowing the
positive news will not have an impact on the fund until tomorrow.

In short, fund companies are required to actively discourage and deter market timing efforts. Prospectuses must
clearly state that the firm does not practice market timing. Short-term trading penalties must be strictly adhered
to if they are published, and fund companies must be prepared to refuse orders from clients who demonstrate a
pattern of market timing attempts.

CLIENT PRIVACY REQUIREMENTS

Portfolio managers are in a unique position because securities regulation requirements mean that portfolio
managers must gather all manner of highly sensitive and confidential financial information about their clients,
such as income, net worth, personal circumstances, bank accounts and the like. In addition, portfolio managers
must keep detailed records of transactions on behalf of their clients. Clearly, portfolio managers must be diligent in
protecting the security of that data from unauthorized access.
In Canada, the Personal Information Protection and Electronic Documents Act (PIPEDA) mandates the security
of all personal and private data. PIPEDA established 10 principles that businesses, including portfolio management
firms, must follow when collecting, using and disclosing private information about clients, as follows:
1. An organization must appoint a privacy officer who is accountable for maintaining the business’s compliance
with the principles.
2. A business must disclose the reason for collecting the information at the time it is collected.
3. The consent of the individual providing the information must be sought before it is collected, used or disclosed.
4. The data collected must be limited to that which is necessary, and shall be collected by lawful and fair means.
5. The information collected must be used only for the stated purpose, and retained only as long as is necessary.
6. The information must be accurate and up to date for the purposes in which it is to be used.
7. The information must be protected in a manner consistent with its sensitivity.
8. A business must make its policies on the collection, use and disclosure of data available to its customers.
9. Upon request, an individual must be informed of the existence of their personal information, its use and
disclosure, and have the opportunity to challenge its accuracy.
10. An individual must have the ability to challenge the business’s compliance with the requirements of PIPEDA.6

Portfolio managers must make clear to their clients the reasons for the collection of their information, and that they
will safeguard that information. An important point to remember is that many portfolio managers work for very

6
For more information about PIPEDA, please visit: https://laws-lois.justice.gc.ca/PDF/P-8.6.pdf

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large organizations, such as banks, where sharing information between various departments within the organization
used to be commonplace. Now the managers must treat that information as inviolate and ensure that it is not
shared or disclosed, except with the client’s express consent, unless it would be appropriate to do so, as in the
reporting of suspicious activity to the Financial Transactions and Reports Analysis Centre of Canada (FINTRAC), as
will be discussed later.

TRADING SECURITIES ON THE INTERNET

The Internet has changed the way we live and work. One of its chief benefits is that the globe seems a much smaller
place because a web page is accessible from anywhere in the world. In the investment industry, the Internet has
been used to distribute securities. Obviously, regulating Internet trades is much more difficult than regulating other
types of trading. National Policy (NP) 47-201 (Trading Securities Using the Internet and Other Electronic Means) is the
response of Canada’s regulators to dealing with the distribution of securities via the Internet.7
NP 47-201 states that an offering of securities that is accessible to Canadian investors is subject to Canadian
disclosure rules, including prospectus requirements, unless the distribution prominently and clearly states that
the offering is not available to Canadian investors. Otherwise, anyone distributing securities via the Internet is
considered subject to Canadian rules.

FAIRNESS POLICY
“Fairness” relates to the way an investment firm and its employees deal with clients in the matters of making and
providing investment analysis, recommendations or trade services. For example, most portfolio managers maintain
and manage accounts for a number of different clients. Some of those clients may have completely separate
accounts, but generally, there is a fair degree of overlap between the portfolios in similar mandates.
For instance, if a portfolio manager is buying a particular security, they would probably want to buy the same
security across all of those portfolios. The challenge regarding fairness is that frequently a portfolio manager is
unable to purchase or sell the entire position in a security for all of their clients in a single trade. Those trades may
take days to complete, particularly for less liquid securities.
Portfolio managers must have standards for allocating trades between their clients in a way that is fair, which is
usually outlined in a fairness policy. Allocation does not have to be equal, but it must be fair to all of the portfolio
manager’s clients. A fairness policy may cover trade allocations as follows:

• Trades can be allocated on the “first in, first out” rule; that is, client accounts receive shares on the basis of
having a trade ticket with an earlier time and date stamp than other clients with a similar trade request.
• Block trades of a single security should get the same execution price and commission rate.
• Partially executed block trades should be allocated on a pro-rata basis. For instance, an account with twice as
many shares as another account would get double the allocation.
• Issues in high demand (hot issues) and initial public offerings (IPOs) are assigned in one of three ways:
randomly, on a pro-rata basis or on a cycle schedule (meaning no account is assigned a multiple allocation until
the needs of all accounts have been satisfied at least once).

Portfolio managers will be well served by employing third-party software programs, many of which are available in
the marketplace, to handle the allocation of trades and commissions.

SOFT DOLLAR ARRANGEMENTS

A soft dollar arrangement is one in which an investment firm purchases services via commission dollars, rather
than via an invoice for the goods or services.

7
National Policy 47-201, Trading Securities Using the Internet and Other Electronic Means, can be found at:
https://www.bcsc.bc.ca/Securities_Law/Policies/Policy4/PDF/47-201__NP__August_13__2013/

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EXAMPLE
An investment firm may pay for investment research performed by a brokerage firm by agreeing to channel
an amount of trading business through the brokerage firm in an amount equal to the amount charged for
the service.

Another example is for services received that aid the investment firm in servicing its clients, such as the provision
of financial data terminals. In these cases, the brokerage firm would add a certain amount to each trade placed
through it by the firm, and apply it to the invoice amount of the terminal. The brokerage firm would actually pay the
invoice for the terminal, and then recoup its cost through the additional commission charge.
Many investors take a dim view of soft dollar arrangements, because they may appear unseemly and slightly
unsavoury. After all, other businesses have to invest their own money to make equipment or service purchases,
so why should investment firms be any different? The fact is that it has proven very difficult for brokerage firms to
separate out their research services from their trading activities, and charge for both.
Even so, the CFA Institute, the body to which all CFA charterholders (a large number of whom are portfolio
managers) belong, has published its standards for soft dollar arrangements that are binding on all CFA Institute
members.8 There are seven broad standards, as follows:
1. Brokerage is the client’s property. Members must seek client brokerage services on the basis of the best
execution at all times.
2. To allow clients to make the best decision, members must disclose to clients that soft dollar arrangements
may be entered into before employing soft dollars with that account.
3. Members must choose brokerage according to the brokerage firm’s ability to effect best trade execution, as
well as on the basis of its quality of research and overall service.
4. Members must evaluate whether the research purchased with soft dollars benefits clients in a specific and
measurable way.
5. Members must not direct brokerage from another account to pay for the client-directed brokerage.
6. Members must plainly disclose to clients its soft dollar arrangements and policies.
7. Members must keep accurate records of all soft dollar arrangements.

Soft dollar arrangements are an accepted part of the investment business and channelling of commissions.
The main point about using soft dollar arrangements is that they must be fully and plainly disclosed to a client
before they are put into effect, and if the client is not in agreement, the arrangements must not be entered into
for that account.

FINANCIAL TRANSACTIONS AND REPORTS ANALYSIS CENTRE OF

CANADA (FINTRAC)
The Proceeds of Crime (Money Laundering) and Terrorist Financing Act (PCMLTFA) requires financial institutions to
verify the identities of their clients and to report any activity tied to money laundering or terrorist financing.9 The
PCMLTFA established the Financial Transactions and Reports Analysis Centre of Canada (FINTRAC) to be the
agency responsible for ensuring compliance with the PCMLTFA and for dealing with reported and other information.
FINTRAC collects, analyzes, assesses and discloses information to assist in the detection, prevention, and deterrence

8
CFA Institute Soft Dollar Standards: Guidance for Ethical Practices Involving Client Brokerage (Charlottesville, Virginia: CFA Institute, 1998;
reprinted 2004, corrected 2011). Available online at: https://www.cfainstitute.org/-/media/documents/code/other-codes-standards/soft-
dollar-standards-corrected-2011.ashx
9
The complete text of the Proceeds of Crime (Money Laundering) and Terrorist Financing Act is available at:
https://laws-lois.justice.gc.ca/eng/acts/p-24.501/

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of money laundering and terrorist financing. It is authorized to provide key identifying information on suspicious
transactions to law enforcement agencies if there are reasonable grounds to suspect that the information would be
relevant to investigating or prosecuting a money laundering offence. This information can also be provided to the
Canada Revenue Agency (CRA), the Canadian Security Intelligence Service (CSIS) and Immigration Canada if there
is reason to suspect tax evasion or a threat to national security. Investment and financial services businesses are
required to submit regular reports to FINTRAC on the following four transaction categories:

Suspicious transactions The definition of a suspicious transaction is very broad and covers virtually any
transaction that a financial firm has reason to suspect may be created for the purpose of
money laundering or the financing of a terrorist organization.

Large cash transactions Deposits of amounts of $10,000 or more in cash in a single transaction or two or more
cash amounts of less than $10,000 that total $10,000 or more within 24 consecutive
hours of each other by or on behalf of the same individual or entity.

Electronic funds You send or receive a SWIFT MT 103 message for $10,000 or more outside Canada at the
transfer request of a client in a single transaction or in two or more transfers of less than $10,000
that total $10,000 or more within 24 consecutive hours of each other by or on behalf of
the same individual or entity.

Terrorist property Property in their possession or control that they know is owned or controlled by or on
behalf of a terrorist group must be reported to FINTRAC.

Financial institutions are required to keep records of all suspicious or reportable transactions. Failure to do so can
result in a prison sentence and/or a fine for non-compliance.

COMPLIANCE WITH FINTRAC

The account application and its updating, where warranted, is a proven way to stay in compliance with the
fundamental Know Your Client (KYC) rule. FINTRAC requires portfolio managers to not only maintain a signed
account application on behalf of each client with signing authority over the account, but to also verify the account
opener’s identity through a government-approved photo identification card, such as a driver’s licence, passport, or
similar form of identification.
The first step to meeting FINTRAC’s requirements is for portfolio managers to have in place a strong culture of
compliance in their firm, whether they act as their own compliance officers, in the case of smaller firms, or within
a larger organization. A culture of compliance instills the notion that compliance is not only the requirement of
regulatory bodies, but also good for clients, and thus ultimately good for business.

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The second step is for portfolio managers, as well as principals and officers of firms, to be familiar with the
requirements of the PCMLTFA and their reporting obligations to FINTRAC. A detailed and easy-to-read outline is
available online at https://www.fintrac-canafe.gc.ca/
Finally, if a transaction is at all suspicious, the right course of action is to report it and allow FINTRAC to do
their work. Firms are indemnified from liability in the case of reporting transactions that turn out to be entirely
legitimate, but can be subject to harsh penalties for failure to report suspicious transactions.

BEST PRACTICES
“Best practices” is a management term that refers to those processes and practices that most effectively deliver its
objectives. In an investment management firm, best practices translate into what is in the best interest of the firm’s
clients: practices that sustain a trust-based advisor-client relationship and meet a client’s investment objectives. A
firm’s standards of practice should address all of the best practices employed in dealing with clients, as well as those
dealing with regulators, the media and competitors. The standards should be an embodiment of the firm’s code of
ethics, both in spirit and to the letter.
A firm’s standard of practice should include guidelines on the following topics:

Best execution The requirement to seek the best execution for trades is also a standard under the
CFA Institute’s code of conduct. The definition of best execution is unclear at best. It
should be noted that best execution does not necessarily mean lowest cost, although
the attempt to keep commissions minimized should be a guiding principle. Portfolio
managers are entitled to consider trading ability, research capability and overall service
levels, as well as commission rates, when deciding upon best execution.

Maintaining proper One of the most common areas of deficiency that regulators identify when auditing
records firms is the failure to maintain proper records. Records serve as evidence of compliance;
are an enormous help in investigating occurrences, such as trading errors; and are a good
business practice. A firm’s standards should mandate which records are kept and outline
to clients why such records are kept.

Changing investment The process to identify, monitor and document investment objectives should be clear.
objectives This includes how changing investment objectives are implemented for clients and
whether they are still within a firm’s expertise or purview.

Trading errors A firm should have a clear and delineated trading protocol spelled out to minimize
errors. In the event of an error, a clearly identified process should be stated to deal with
the issue, including recourse; compensation to clients and investment dealers, if needed;
and the degree of participation of the firm’s legal and compliance departments.

Conflicts of interest Conflicts of interest, either real or perceived, should be disclosed to clients and
employers. This includes conflicts on an individual or firm level that might impair
independence and objectivity with respect to a client’s needs. If a conflict is overlooked,
its size or insignificance will not be an excuse.

Personal trading Best practices for personal trading should be closely tied to conflict of interest policies.
Procedures should be clearly in place to prevent investment staff from personally
benefitting at the cost of the client and the firm’s best interests. This topic is covered
further in Chapter 5.

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Confidentiality and Although this is now mandated by law under PIPEDA (as we discussed earlier), a
client privacy statement of a firm’s practices about client privacy is a worthwhile effort. Portfolio
managers should remember that they are privy to the confidential financial information
their clients provide to them. They should strive at all times to maintain the
confidentiality of that information and protect its security.

Trading of non-public Insider trading is unethical and illegal. A firm’s standards of practice should make sure
information that either staff or clients do not tolerate such activity.

Fair dealing and soft As detailed earlier, a firm has several strategies to deal with these matters, including
dollar arrangements the random allocation of securities purchases and also the disclosure of how soft
dollars are used.

Many of these best practices will be expanded on throughout this course. Ethics and best practices are of the utmost
importance in the investment management industry and should always be kept in mind.

MANAGED ACCOUNTS WITHIN A CIRO DEALER MEMBER

In recent years, with the support and encouragement of their firms, more and more investment advisors have
evolved their business model from the traditional transaction-based model to a fee-based one. Many investment
advisors have taken this evolution even further by seeking the approval of their firm and CIRO to offer managed
accounts to clients.
The primary reason for this trend is that, under a managed account structure, the advisor and firm are better able to
offer more personal, direct, tax-effective and cost-effective discretionary services to high-net-worth clients, many of
whom do not have the time or expertise to manage their own investable assets.
Portfolio managers and associate portfolio managers are held to the highest legal standards in relation to their
clients — a fiduciary standard, which is explained in Chapter 2. As such, CIRO and its dealer members set quite
stringent initial and ongoing requirements for investment advisors who are operating managed accounts. The
CIRO rules were mentioned earlier in this chapter. Generally, CIRO dealer members will set even more stringent
requirements around who they will accept as a portfolio manager or associate portfolio manager.

EXAMPLE
Some dealer members require an advisor to have been in their current role for a set number of years (for
example, five years), already have a large book of business (for example, in the $40-$50 million range) and have
a clean compliance record before they are eligible to be in the firm’s advisor-managed account program. These
requirements are above and beyond the CIRO proficiency requirements for portfolio managers and associate
portfolio managers.

Portfolio managers and associate portfolio managers generally follow a model portfolio that is aligned with a
client’s profile. Model portfolios generally range from an aggressive portfolio, which is designed for a younger client
with a higher risk profile, is focused on capital growth and has a long time horizon, to a conservative portfolio, which
focuses more on preservation and income generation for a client who may be in or nearing retirement.
Dealer members may manage a number of model portfolios that are based on a range of client objectives and risk
profile levels. It is a portfolio manager’s or associate portfolio manager’s key responsibility to align a client’s profile
to the most appropriate model portfolio. A key advantage of a managed account is that its trading system allows
an investment advisor to bulk all clients within their model for a particular trade, then make one trade without any
calls to clients. Not having to gain client approval on a trade-by-trade basis and then bulking the trades allows the
advisor to make more timely trades in client accounts.

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In some cases, research and security selection within these portfolios is done by internal research or fund managers.
Advisors who prefer to outsource these activities, together with the help of the bulk trading order system, have
much more time for prospecting activities and to focus their practice more on relationship management and
financial planning.
Conversely, rather than outsourcing model portfolio construction, as well as research and security selection, some
portfolio managers and associate portfolio managers manage portfolios on the basis of their own model portfolios,
while doing their own analysis and making their own security selections. However, a dealer member must review
and approve these model portfolios before they can be offered to a client.
Finally, some portfolio managers and associate portfolio managers offer a hybrid approach. They pick and choose
recommendations that are part of a model portfolio or recommended list offered by their dealer member while still
retaining the ability to make their own selections based on their own analysis.
It should be noted that most, if not all, investment advisors who offer managed accounts also have non-managed
accounts under their administration. Generally, a managed account is only offered to top-level clients who have
investable assets at or above a certain dollar amount. Smaller portfolios may not lend themselves to managed
accounts due to their cost structure and concerns that a feasible portfolio cannot be structured under a certain
dollar amount of investable assets.
As mentioned earlier, CIRO regulations require that a designated supervisor be responsible for the quarterly reviews
of managed accounts. Given the level of sophistication required to perform these reviews and the sheer number of
them a designated supervisor may be responsible for, this task could be outsourced to portfolio experts. However,
the accountability would remain with the supervisor. The benchmark metrics that could be used to evaluate the
performance of managed accounts include, among other factors, asset allocation, security quality and level of
diversification. Naturally, a portion of the review would involve ensuring that the portfolio manager or associate
portfolio manager has generally stayed within the portfolio’s stated mandate.

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SUMMARY
After completing this chapter, you should be able to:
1. Describe what a portfolio manager is.
• A portfolio manager is an individual, or a team of individuals, who advises clients, which can be individuals
or different types of institutional investors, on investments that are appropriate to a client’s individual
circumstances and investment objectives.

2. Identify and explain the various dealer, advisor, and individual registration categories available in Canada.
• Firms can fall into several registration categories under the two main categories of dealers and advisors.
Some of the relevant dealer categories include investment dealer, mutual fund dealer, scholarship plan
dealer, exempt market dealer and restricted dealer. The advisor categories are portfolio manager and
restricted portfolio manager.
• The registration categories for an individual who, under securities legislation, is required to be registered
to act on behalf of a registered firm are dealing representative, advising representative, associate advising
representative, Ultimate Designated Person and chief compliance officer.
• Portfolio managers face a detailed set of educational requirements in order to be registered with provincial
regulators, including CSI’s Chartered Investment Manager (CIM) designation and the Chartered Financial
Analyst (CFA) Program. Portfolio managers also need to meet specific experience requirements.

3. Describe the regulatory environment in Canada.

• Canada does not have a national securities regulator. Securities regulation in Canada falls under the
jurisdiction of the various provincial and territorial securities commissions.
• The various provincial and territorial regulators have come together in the form of the Canadian Securities
Administrators (CSA), which works to harmonize rules and regulations across the country, where possible.
• In many cases, the various securities commissions have delegated the regulation of the investment industry
to self-regulatory organizations (SROs).

4. Identify CIRO-managed account rules with respect to the documentation required and the account approval
and oversight process.
• In order for a dealer member to approve a managed account, a client must sign a managed account
agreement, and the dealer member’s designated supervisor for managed accounts must accept it. The
managed account agreement must also clearly indicate the client’s investment objectives for the account
and the client must be provided with a copy of the member’s procedures to ensure the fair allocation of
investment opportunities among managed accounts.

5. Outline the various investment practices the Canadian Securities Administrators (CSA) regulates.
• Activities that the CSA regulates include high closing, late trading, market timing, client privacy
requirements, trading securities on the Internet, fairness policy and soft dollar arrangements.

6. Explain the compliance requirements of the Financial Transactions and Reports Analysis Centre of Canada
(FINTRAC).
• Investment and financial services businesses are required to submit regular reports to FINTRAC on the
following four transaction categories:
« Suspicious transactions: The definition of a suspicious transaction is very broad and covers virtually
any transaction that a financial firm has reason to suspect may be created for the purpose of money
laundering or the financing of a terrorist organization.

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« Large cash transactions: Deposits of amounts of $10,000 or more in cash in a single transaction or two or
more cash amounts of less than $10,000 that total $10,000 or more within 24 consecutive hours of each
other by or on behalf of the same individual or entity.
« Electronic funds transfer: You send or receive a SWIFT MT 103 message for $10,000 or more outside of
Canada at the request of a client in a single transaction or in two or more transfers of less than $10,000
that total $10,000 or more within 24 consecutive hours of each other by or on behalf of the same
individual or entity.
« Terrorist property: Property in their possession or control that they know is owned or controlled by or on
behalf of a terrorist group must be reported to FINTRAC.
• FINTRAC requires portfolio managers to not only maintain a signed account application on behalf of each
client with signing authority over the account, but to also verify the account opener’s identity through
a government-approved photo identification card, such as a driver’s licence, passport or similar form of
identification.

7. Outline some of the investment management industry’s best practices.

• “Best practices” is a management term that refers to those processes and practices that most effectively
deliver its objectives.
• A firm’s standard of practice should include guidelines on the following topics: best execution, maintaining
proper records, changing investment objectives, trading errors, conflicts of interest, personal trading,
confidentiality and client privacy, trading of non-public information, and fair dealing and soft dollar
arrangements.

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Portfolio Management 2

CONTENT AREAS

Ethics

Code of Ethics

Trust and Fiduciary Duty

LEARNING OBJECTIVES

1 | Explain the importance of ethics in the investment management industry.

2 | Explain how end and means values form a value system.

3 | Explain how a value system influences a portfolio manager’s behaviour.

4 | Explain what an ethical dilemma is.

5 | Identify the primary pattern of a value conflict that results in an ethical dilemma.

6 | Identify the strengths and weaknesses of a code of ethics.

7 | Explain the best practices relating to a firm’s code of ethics.

8 | Explain trust and fiduciary duty.

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KEY TERMS

Key terms are defined in the Glossary and appear in bold text in the chapter.

beneficiary fiduciary

code of ethics fiduciary duty

end values means values

ethical dilemma trust

ethical principles values

ethics value system

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INTRODUCTION
Investment management is a business of trust. If one or more parties are acting unethically, there can be no trust.
From the perspective of someone outside of the securities industry, such as a client, the issues of ethics, trust, and
fiduciary duty might seem straightforward. An outsider might logically assume the following:

• An investment advisor or portfolio manager should ensure that the client’s interests come first.
• From their first meeting with a client, an advisor’s actions should indicate that they will always put the client’s
interests first.
• An advisor is aware that most retail clients rely on their knowledge and experience to provide guidance on
financial matters, unless otherwise agreed upon. This is especially true in the case of an advisor who exercises
discretionary authority.

Most firms of any size are staffed with a number of resources for discretionary portfolio managers to consult, with
department supervisors being a logical first step.
For the purposes of this chapter, we use the term discretionary portfolio manager to mean both a CIRO-approved
portfolio manager or associate portfolio manager and a portfolio manager–advising representative who falls
under the provincial securities commission’s jurisdiction.
Compliance departments are another excellent source of guidance. Compliance officers are trained in securities
regulation and have a network of contacts from which to draw.
However, an investment advisor or portfolio manager may need to make decisions quickly on matters affecting a
client that might not seem as straightforward as the aforementioned assumptions suggest. These types of decisions
are discussed in this chapter, which introduces the concepts of ethics, values, ethical dilemmas, code of ethics, trust,
and fiduciary duty.
Discretionary portfolio managers work very hard to attain their positions and academic credentials. An
accomplished career in portfolio management is one that strives to embody both intellectual and moral excellence.
In chapter 1, we explained the management term “best practices”. Ethics play an integral role in best practices.
The relationship between best practices, compliance and ethics should be fully understood in order to enhance an
investment firm’s and a discretionary portfolio manager’s objectives.

ETHICS

WHAT IS MEANT BY ETHICS?

Ethics serve as a foundation for the rules of the financial services industry and provide a structure that allows
participants to interpret and evaluate any circumstances. However, following industry regulations comprises only
the bare minimum of ethical behaviour. Ethics represent a whole approach to dealing with the industry’s various
stakeholders. In the long run, good ethics are good business.
Ethical principles help guide behaviour in situations where no regulations exist or apply. These principles may be
influenced by public opinion, consumer demand or advocacy groups, all of which may raise ethical behaviour to a
level higher than the minimum standards set out by the regulators.
Often, the media widely exposes and reports on unethical conduct, such as insider trading or the misuse of
client funds. This attention can damage the reputations of all parties involved. Therefore, efforts to avoid ethical
misconduct in the first place can help safeguard the interests of clients, registrants (both individuals and firms), the
industry and capital markets.

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In a general sense, ethics may be defined as a set of consistent values that guide individual behaviour, such as
accountability, fairness, honesty, loyalty, reliability and trustworthiness. However, in essence, the term has three
distinct meanings, as follows:

• The standards that govern the behaviour of a particular group, such as a profession.
• A set of moral principles or values. Morals are the norms of an individual or society established with
reference to standards of right and wrong. Moral standards address the right and wrong of telling the truth or
undertaking some action that may cause harm to others, for example. Moral standards are based on reason, and
authoritative bodies cannot establish or change them. Although, moral standards may underpin decisions made
by those authorities.
• The study of the general nature of morals and moral choices that individuals make. Occasionally, the term
ethics may even be used to refer to the study of morality.

In this chapter, ethics are portrayed as a continuous process of examining behaviour and making decisions in the
context of moral principles.

WHAT ARE VALUES?

Morality, integrity, trust, honesty and competency are values prized by all professionals, not just advisors, working
in the securities industry. The absence of any of these values may compromise the reputation and public perception
of advisors as individuals, and of the industry as a whole. This is because values apply to almost every decision a
person makes.
Values have the following common characteristics:

• They are beliefs, not facts.

• They are long-lasting, but not necessarily unchangeable.
• They guide individual and corporate behaviour, and goals.

Values that influence the goals a person would like to achieve can be separated into end values and means values.

• End values represent the ends toward which a person strives and influence how a person acts today to achieve
tomorrow’s goals. They include a sense of accomplishment, family security, self-respect, social recognition and
wisdom.
• Means values are the actions taken in the present to achieve a future goal. These include ambition, competence,
honesty, independence and responsibility.

A unified value system is one in which the ends and means mutually reinforce and support each other. Individuals
and corporations get into trouble when their means values do not support their end values.
A portfolio manager’s value system will accomplish the following:

• Influence their perception of situations and problems.

• Influence their decisions and solutions to problems.
• Set limits on their understanding of what constitutes ethical behaviour.
• Help them resist when they are being pressured to do something that they believe is wrong.

Value systems represent what an individual believes is important and what needs to be emphasized. In making
decisions, individuals are faced with many possible solutions. Clearly articulated values guide the determination of
priorities and goals in making those decisions. They tell the world what a person stands for.

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At the corporate level, values are usually articulated in a code of conduct and code of ethics. In their personal or
corporate actions, portfolio managers need to ensure that articulated values guide the selection of objectives and
that personal and/or corporate objectives do not dictate the selection of values.

ETHICAL DILEMMAS
Conflicts in values can fall into two general categories: right versus wrong, and right versus right. In the case of right
versus wrong, it is usually quite obvious what the proper decision is, because some element of the situation provides
clear guidance, such as:

• One choice is clearly illegal.

• One choice lacks a basis in truth.
• The negative consequences of one particular decision will far outweigh any possible positive results.
• The proposed action does not conform with the code of fundamental inner values that are widely shared and
understood, and that define what is considered to be right or wrong actions.

Right versus wrong issues tend to be black and white. A code of conduct, a code of ethics and compliance policies
are mainly concerned with right versus wrong issues. However, most situations involve a number of possibilities,
and each possibility has some right and some wrong elements. The difficulty is in determining the right decision.
An ethical dilemma exists when two or more of the possible choices pit different values against each other. For
example, one choice would lead to the fulfillment of an end value, such as social recognition, yet at the cost of a
means value, such as honesty, while another would fulfill the end goal of self-respect, yet at the cost of a means
value, such as ambition.
The most difficult ethical dilemmas to resolve are those of right versus right. Each of the possible solutions to the
problem has a degree of right and none of the possible solutions appear to be clearly wrong.
The following are the four primary patterns of value conflict that result in ethical dilemmas:

• Truth versus loyalty: The values of honesty or integrity clash with the values of commitment, personal
responsibility or keeping a promise.

EXAMPLE
You discover that several senior portfolio managers — including your boss and mentor, who gave you a chance
and hired you — are very seriously stretching the trading rules to their benefit. They have not actually broken
the law, but they are getting close. Do you keep quiet or report them, likely causing your mentor to be fired?

• Individual versus group: The values of an individual clash with the rights or values of a group. This type of
dilemma may appear in the form of “us versus them” or “self versus others”.

EXAMPLE
A new fee structure is proposed at your firm. It will greatly benefit the firm as a whole and those senior portfolio
managers who have many high-net-worth clients, but it will not benefit you because you are new and still have
just a few clients. In fact, it might even reduce your income. Do you vote for or against the new fee structure?

• Short term versus long term: Immediate needs or desires run counter to future goals or prospects.

EXAMPLE
A client has specified her desire for both long-term safety and growth in her account. You see the opportunity
to suddenly make a great deal of money for her, but it is risky. Do you make the trade in the client’s account?

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• Justice versus mercy: The values of fairness, equity and righteousness conflict with the values of compassion,
empathy and love.

EXAMPLE
A new employee, who has tremendous potential and is doing well in all other respects, is breaking an
important company policy. This is the second time he has done so, but the first time a senior employee told
him the policy is “actually more of a guideline” and that “everyone does it”. Do you fire the new employee or
give him another chance?

Although resolving each dilemma requires time and thought, it is important to avoid rationalizing behaviour
by trying to put one’s actions into the context of so-called accepted norms. Typical rationalizations include the
following:

• If I do not do it, somebody else will.

• It does not hurt anyone.
• That is the way it has always been done.
• If everybody else does it, then it must be okay.

Rationalizations are not values; rather, they are excuses for following a course that conflicts with values.

Case Study #1 | Where Is My Research?

The investment firm that you work for has an investment banking relationship with ABC Corp., which has recently
received controversial takeover offers from two suitor companies. As such, the investment research department is
not able to render an opinion on the status of the current takeover offers or any other opinion on ABC Corp.
Rachel Stein is a client who owns several thousand shares of ABC Corp. in her private investment management
account. She has telephoned you to ask what to do with her ABC Corp. holdings. Mrs. Stein is quite adamant that
your firm’s opinion be conveyed to her, as she wants to be able to make an informed decision as to which suitor’s
offer she should accept. She requests that the latest comments from your research department on ABC Corp. be
sent to her so she can consider her options.
1. Do you give her an opinion?
2. Do you explain to her the circumstances of the current situation between your firm and ABC Corp.?
3. Do you use third-party research to satisfy her request?

Case Study #2 | Conflicting Views

Ronald Greene is a 78-year-old client who holds a managed account with you. Mr. Greene is an experienced investor
who has a thorough understanding of capital markets. He has stated that his investment objectives are highly
conservative. You also manage accounts for his son and daughter, who are both in their mid-forties.
Lately, Mr. Greene’s son has suggested his father’s account should be rebalanced to reflect his and his sister’s
investment objectives since they will ultimately be receiving the assets upon their father’s death. Both he and his
sister feel that a more growth-oriented portfolio would be in their best interests, since their father does not rely on
the portfolio for his day-to-day living requirements.
1. What should be your response to Mr. Greene’s son?
2. Should you broach the subject with Mr. Greene?

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CODE OF ETHICS
A written code of ethics and conduct is an excellent way to reinforce a strong ethical sense. An appropriate code of
ethics is an integral part of ensuring that a discretionary portfolio manager’s fiduciary duty is performed and that all
clients and investors are treated fairly and appropriately. It also helps to ensure an investment management firm’s
proper functioning. An institutional investment management firm’s inability to conduct its affairs in accordance
with its own code of ethics can result in the loss of professional designations and regulatory licences for both the
staff and the firm.
A firm’s code of ethics should be reviewed regularly and updated when necessary. Clients should be made aware of
the existence of such a code. Presenting a client with a firm’s code of conduct is a written promise of how you will
treat them and their account.
Most institutional investment management firms have adopted a particular code of ethics. Occasionally, the code
that is adopted is unique to a firm. However, the majority of institutional investment management firms have
adopted the CFA Institute’s Code of Ethics.

STRENGTHS AND WEAKNESSES

A code of ethics has both strengths and weaknesses. The following are some of its strengths:

• It confirms that the company or industry is prepared to be explicit about ethics.

• It can be a valuable, formal and updateable expression of appropriate behaviour. A well-written code clearly
identifies appropriate behaviour and may enhance a registrant’s perception of ground rules. When evaluating
actions, this guidance should help a registrant judge what is right and wrong, as distinct from effective or
ineffective.
• It provides a social contract for the workplace, and a basis for working together in reciprocal dignity and fairness.
• It supports an individual’s and a firm’s responsibilities and accountabilities. Without a code, a wrongdoer can
claim (often with some justification) that there were never any rules, or that they were not sufficiently explicit.

However, a code of ethics is neither a prerequisite for, nor a guarantor of, ethical behaviour. The following are some
of its weaknesses:

• It may lull management and regulators into a false sense of security, believing that the mere existence of a code
is sufficient to ensure ethical conduct. A code can often end up gathering dust in drawers. To be effective, it
must be well supported and reinforced.
• It typically deals with resolving conflicts between right and wrong, but not with the more complex and difficult
conflicts between two rights.
• It may focus on what to do without explaining why. To be effective, a code should not simply mirror problems
that may have spurred its introduction in the first place. A code should also be based on broad ethical principles,
so that employees and registrants are appropriately guided in all situations, whether explicitly addressed in it or
not.
• It may only deal with an employee’s obligations to their employer, and not the employer’s obligations to an
employee, such as professional development, personal respect, a fair workplace and freedom from harassment.
• A poorly written code may contain policies that are inconsistent with an industry or firm’s investment
philosophies and incentive strategies.

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For a code of ethics to be effective, the following four elements are necessary:

Senior management must Why would employees abide by a code that senior management does not
support it follow? Senior executives should be seen as having or having had an active role
in the development of a firm’s code of ethics. Management should also foster
ethics in every message they convey, both in what they say and do.

Employees, at all levels, must By actively including its employees in the process, the firm garners support
participate in its development for the project. It can show that a code of ethics is not just about sending a
and reinforcement message from management, but is also an issue that requires input from all
levels.

Its training and reinforcement Training should take place when an employee joins a firm and should be
must be implemented repeated at regular intervals. The value of reinforcing a code of ethics is twofold.
First, it can give meaning to and extend specific applications of normative values
and rules. Second, it defines how much freedom, responsibility and trust is being
vested in staff and managers to apply these principles on a daily basis.

It should be reviewed Management and employees should reaffirm an existing code of ethics or
periodically and updated when amend it as necessary. This will retain the code’s relevancy in the current
necessary environment.

BEST PRACTICES
Compliance and adherence to an institutional investment manager’s code of ethics should begin as of an
employee’s first day on the job. The employment hiring process should include a review and discussion with the
employee of the firm’s adopted code of ethics. Upon hiring, the employee should promptly deliver the appropriate
signed verification that they have read and understood the firm’s code of ethics.

Good business practice Distributing the firm’s code of ethics to all affected employees at least on an annual basis
is good business practice. This practice should also include having all recipients reaffirm,
in writing, their commitment to adhere to the firm’s code of ethics.

An institutional investment management firm must also ensure that its operations and compliance personnel
integrate monitoring processes and procedures to ensure strict adherence of the firm’s employees to its code of
ethics.

EXAMPLE
A prime example relates to the personal investment activities of the institutional investment manager’s staff.

Written personal The firm must have written personal trading guidelines that apply to its affected staff. It
trading guidelines is also very important that effective administrative processes and procedures are created
and implemented that allow designated staff, usually the compliance department, to
implement the firm’s personal trading guidelines.

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Prior approval process It is fairly common for institutional investment management firms to build their personal
trading guidelines around an effective prior approval process. In essence, the process
requires that all affected employees obtain written confirmation of permission from
designated compliance or senior management personnel prior to placing trades in their
personal account.

Standard follow-up procedure requires that an employee have the brokerage firm with which they trade their
personal account send a copy of their security transaction confirmations and month-end account holding reports
directly to the institutional investment management firm’s compliance department. The compliance department
staff then conducts a reconciliation to ensure that all of the security transactions in the employee’s personal trading
account obtained the institutional investment management firm’s written approval prior to the trade’s execution.

TRUST AND FIDUCIARY DUTY

TRUST
Trust is the belief that those people on whom we depend, either by choice or circumstance, will meet the
expectations we have placed on them; however, trust does not just happen naturally. A client has to make a
conscious choice to trust their investment advisor. A portfolio manager has to make a conscious choice to trust
their employer, assistant, colleagues and clients. A client’s trust in a portfolio manager is based on the portfolio
manager’s reputation, which is acquired over time through consistent ethical behaviour. Three elements must be
present for trust-based relationships to develop between portfolio managers and their clients:

The portfolio manager has Given the emphasis on proficiency requirements in the Canadian investment
specialized knowledge that the industry, it is assumed that all portfolio managers have more knowledge about
client does not have investing and securities in general than the average client.

The portfolio manager belongs All properly licensed discretionary portfolio managers in Canada are subject to
to an industry that is well the rules, regulations and ongoing scrutiny of at least one regulatory body. In
regulated many instances, there is regulatory oversight by multiple regulators.

The portfolio manager places Discretionary portfolio managers must meet this last principle. Unfortunately,
the interests of the client this is the source of most ethical dilemmas that today’s portfolio managers face.
before their own

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Case Study #3 | Do I Know My Client?

Mr. Wilcox is a client in his late forties who has stated that his investment objectives are aimed at growth and
moderate risk exposure. Several months ago, Mr. Wilcox suffered a concussion in a skiing accident but appeared to
make a complete recovery.
Lately, Mr. Wilcox has been increasingly agitated about the performance of his account and has made suggestions
that a more aggressive stance be taken in the management of his account. During a recent telephone conversation,
Mr. Wilcox made illogical comments that were contrary to his usual analytical approach. He said he is willing to
assume much greater levels of risk than his stated investment objectives indicate. After witnessing several months
of deteriorating good judgment and heightened emotional instability by Mr. Wilcox, you become convinced he
may have suffered a mild traumatic brain injury that is proving to be detrimental to his ability to provide the proper
parameters for his investments.
1. Do you continue to accept Mr. Wilcox’s increasingly illogical demands?
2. Do you have the obligation to report your suspicions about Mr. Wilcox’s condition to anyone?
3. What steps would you take to ensure Mr. Wilcox’s well-being and protect your position as his portfolio
manager?

The trust relationship between a discretionary portfolio manager and their client is based on two principles:
competence and integrity. Both are essential in building a trust relationship with a client. Competence without
integrity leaves a client at the mercy of a self-serving professional. Integrity without competence puts a client in
the hands of a well-meaning but inept individual. A portfolio manager’s ability to communicate competence and
integrity is the key to establishing trust with any client.
In any meeting a discretionary portfolio manager has with a prospective or current client, they must do the
following:

• Listen intently to what the client is saying.

• Not be manipulative, exploitative or deceptive.
• Admit when they do not know something.
• Perform all tasks competently.

Trust is expressed by way of three constant elements in a relationship with a client, as follows:

Disclosure of The freer the flow of information between a portfolio manager and their client, the
information greater the possibility that a strong bond of trust will form.

Influence over A client must know that the information they are sharing with their portfolio manager is
decisions positively affecting the decision-making related to the client.

Exercising control A client feels some control over the relationship with their portfolio manager, and does
not feel manipulated or patronized.

When a client is determining the level of trust they place in a discretionary portfolio manager, some of the key traits
they look for are competence, awareness of their needs, compassion, fairness, openness and consistent behaviour.

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FIDUCIARY DUTY
The fiduciary role carries with it the highest standard of care. Often, a person who holds a position of trust has a
duty to the individual who has placed trust in them. This could be in connection with the care of assets or when they
are responsible for the personal affairs of others. This is called a fiduciary duty. The person in whom the trust has
been placed is called a fiduciary; the person to whom the fiduciary owes this duty is called the beneficiary.
A fiduciary relationship may exist where there is a special relationship of confidence and trust. A fiduciary duty may
be defined as the duty of a person in a position of trust to act solely in the beneficiary’s interest without gaining
any material benefit, except with the knowledge and consent of the beneficiary. This may occur when a person has
a reasonable expectation that another party (the fiduciary) will act in their (the beneficiary’s) best interests and on
their behalf. A fiduciary should not profit at the beneficiary’s expense. Fiduciary duties have been found to exist in
such relationships as a doctor and a patient, a lawyer and a client, and a director and the corporation they serve.
When disputes between dealer members and clients are resolved through civil litigation, the courts may hold
that a Registered Representative (RR) owes a fiduciary duty to a client if the RR provides investment advice and
recommendations to the client, and the client relies on such advice. Criteria that may be used to determine whether
a fiduciary duty is present in an RR-client relationship include the client’s high degree of reliance on the RR’s advice
and their vulnerability.
The existence of such a fiduciary duty imposes a higher standard of care upon the RR than would be the case if they
merely executed a client’s orders without providing any advice. Regardless of whether or not a fiduciary duty exists,
an RR has a duty under provincial and territorial securities laws to deal fairly, honestly and in good faith with their
clients.

FIDUCIARY DUTY AND DISCRETIONARY AUTHORITY

There is a distinct difference between the standard to which a discretionary portfolio manager and an RR are
held. While RRs may be held to a fiduciary standard depending on the advisor-client relationship (as mentioned
above), discretionary portfolio managers are without exception considered to be a fiduciary. The existence of a
fiduciary relationship imposes the highest standard of care on an investment advisor. The advisor must act carefully,
honestly and in good faith in their dealings with clients, and not take advantage in any way of the trust their clients
have placed in them. Furthermore, the discretionary portfolio manager must not only make the most suitable
recommendations for a client, but must also avoid or disclose conflicts of interest.

FIDUCIARY DUTY AND INSTITUTIONAL INVESTMENT FUNDS

Many of the actions involved in operating an institutional investment fund are fiduciary duties, and the individual
or entity performing them is a fiduciary. Using discretion in administering and managing a fund or controlling its
assets make that person a fiduciary to the extent of that discretion or control. Thus, fiduciary status is based on the
functions performed for a fund, not just on an individual’s title.
A fund must have at least one fiduciary (an individual or entity) named in its trust indenture, or through a process
described in trust documents as having control over the fund’s operation. The named fiduciary can be identified by
office or name. Normally, a fund’s board of trustees has the ultimate fiduciary responsibility, although for some
funds it may be an administrative committee or a company’s board of directors.
A fund’s fiduciaries will ordinarily include the trustee, investment advisors, all individuals exercising discretion in the
fund’s administration, all members of the fund’s administrative committee (if it has such a committee) and those
who select committee officials. Lawyers, accountants and actuaries are not generally fiduciaries when acting solely
in their professional capacities. The key to determining whether an individual or entity is a fiduciary is whether they
are exercising discretion or control over a fund.

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FIDUCIARY DUTY AND CORPORATE PENSION PLANS

In the case of a corporate pension plan, a number of decisions are not fiduciary actions, but rather business decisions
made by the employer who sponsors the pension plan. For example, the decisions to establish a pension plan,
determine the benefits package and include certain features, as well as amend the plan or terminate it, are all
business decisions, not fiduciary decisions. When making these decisions, an employer is acting on behalf of its
business, not the pension plan, and therefore is not a fiduciary. However, when an employer (or someone it hired)
takes steps to implement these decisions, the employer is acting on behalf of the pension plan and, in carrying out
these actions, is a fiduciary.

WHAT IS THE SIGNIFICANCE OF BEING A FUND’S FIDUCIARY?

Fiduciaries have important responsibilities and are subject to standards of conduct because they act on behalf of a
fund’s investors and beneficiaries. These responsibilities include:

• Acting solely in the interest of a fund’s participants and their beneficiaries, and with the exclusive purpose of
providing benefits to them.
• Carrying out their duties prudently.
• Following a fund’s documents or trust indenture.
• Diversifying a fund’s investments.
• Paying only reasonable fund expenses.

Case Study #4 | Unconventional Investment

Fran Tucker is employed in the Personal Wealth Management (PWM) division of a large bank. Recently, sales
management has been presenting a new investment opportunity for growth-oriented clients. The bank has
securitized mortgage loans and plans on marketing them to wealthy clients through a pooled fund.
During a sales conference call, Mr. Tucker and other members of the PWM division are told about the benefits and
risks associated with the new investment opportunity. As an incentive to market these investment vehicles, lucrative
performance bonuses have been offered to those advisors who place clients in the pooled fund.
Mr. Tucker has a limited knowledge of the fundamentals of the new investment opportunity, and his experience has
made him very cautious with respect to such unconventional products. Friends of his that are also in the securities
business have often spoken of the hazards of such investments. Considering all the facts, Mr. Tucker does not feel
comfortable with the product and is very hesitant to offer it to his clients.
1. Should Mr. Tucker ignore his concerns and offer the product to his clients who meet the investment objective
criteria?
2. Should Mr. Tucker voice his concerns to his superiors?
3. Should Mr. Tucker re-educate himself about the product to see if he may change his opinion and thereby
enhance his compensation?

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 CHAPTER 2 ETHICS AND PORTFOLIO MANAGEMENT 2 • 13

SUMMARY
After completing this chapter, you should be able to:
1. Explain the importance of ethics in the investment management industry.
• Ethics serve as a foundation for the rules of the financial services industry. Ethical principles help guide
behaviour in situations where no regulations exist or apply.

2. Explain how end and means values form a value system.

• A unified value system is one in which the ends and means mutually reinforce and support each other.
Individuals and corporations get into trouble when their means values do not support their end values.

3. Explain how a value system influences a portfolio manager’s behaviour.

• A portfolio manager’s value system can influence their perception and decisions, limit their knowledge of
ethical behaviour and help them when they are being pressured.

4. Explain what an ethical dilemma is.

• An ethical dilemma exists when two or more of the possible choices pit different values against each other.
5. Identify the primary pattern of a value conflict that results in an ethical dilemma.
• The four primary patterns are truth versus loyalty, individual versus group, short term versus long term, and
justice versus mercy.

6. Identify the strengths and weaknesses of a code of ethics.

• Strengths include the following: Can be a formal and updateable expression of appropriate behaviour,
provides a social contract for the workplace, and supports an individual’s and firm’s responsibilities and
accountabilities.
• Weaknesses include the following: May lull management and regulators into a false sense of security,
typically deals with resolving conflicts between right and wrong, may focus on what to do without explaining
why, may not deal with an employer’s obligations to staff and may be inconsistent with an industry or firm’s
philosophies and incentive strategies.

7. Explain the best practices relating to a firm’s code of ethics.

• Good business practice: Distributing the firm’s code of ethics to all affected employees at least on an
annual basis.
• Written personal trading guidelines: The firm must have written personal trading guidelines that apply to its
affected staff.
• Prior approval process: Requires that all affected employees obtain written confirmation of permission from
designated compliance or senior management personnel prior to placing trades in their personal account.

8. Explain trust and fiduciary duty.

• Trust is a belief that people we depend on will meet our expectations. Trust is expressed in a client
relationship through the disclosure of information between parties, a client seeing the positive effect of the
decisions from the disclosed information and a client feeling some control over the relationship.
• A fiduciary duty involves a person in a position of trust acting solely in the beneficiary’s interest.

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APPENDIX A

CIRO’S IDPC RULE 1402, STANDARDS OF CONDUCT (FOR INFORMATION

PURPOSES ONLY – NOT EXAMINABLE)
CIRO’s IDPC Rule 1402, Standards of Conduct, summarizes CIRO’s expectations of regulated persons as follows:
1. A Regulated Person:
i. in the transaction of business must observe high standards of ethics and conduct and must act openly and
fairly and in accordance with just and equitable principles of trade, and
ii. must not engage in any business conduct that is unbecoming or detrimental to the public interest.

2. Without limiting the generality of the foregoing, any business conduct that:
i. is negligent,
ii. fails to comply with a legal, regulatory, contractual or other obligation, including the rules, requirements,
and policies of a Regulated Person,
iii. displays an unreasonable departure from standards that are expected to be observed by a Regulated Person,
or
iv. is likely to diminish investor confidence in the integrity of securities, futures or derivatives markets, may be
conduct that contravenes one or more of the standards set forth in subsection 1402(1).

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 CHAPTER 2 ETHICS AND PORTFOLIO MANAGEMENT 2 • 15

APPENDIX B

THE CIM® CODE OF ETHICS (FOR INFORMATION PURPOSES ONLY – NOT

EXAMINABLE)
The CIM® Code of Ethics is presented below.

1.0 GENERAL RESPONSIBILITIES

CIM® designates will comply with legal and regulatory principles that govern the financial services industry. You will
be professional, compliant, and recognize your limitations, exercise due diligence and practice with sound judgment.
To be compliant with this code of ethics you must respect all of the requirements set out below.
As a CIM® you will:
1.1 Make yourself aware of the legal and regulatory requirements to operate in your jurisdiction. Maintain
knowledge of and comply with all applicable laws, rules, and regulations of any government, regulatory
organization, or professional association governing your professional activities. However, this Code of Ethics
may set out different standards of behaviour than does the law. Where there is a conflict between the Code
of Ethics and the law, you must abide by the law.
1.2 Act with dignity, integrity, professional competence and in an ethical manner when dealing with the public,
clients, prospects, employers, and colleagues. You must use reasonable care and exercise independent,
professional judgment.
1.3 Recognize your own limitations. When appropriate, seek additional opinions and services.
1.4 Abide by the annual license renewal and continuing education requirements as required to maintain the
CIM® designation.

2.0 RESPONSIBILITIES TO THE CLIENT

All CIM® designates will strive to maintain the highest level of personal integrity when dealing with clients. By
demonstrating respect, honesty, due diligence and practicing sound compliance, you will honour the trust of clients,
while providing an environment of confidentiality, free from discrimination.
As a CIM® you will:
2.1 Treat each client with respect, put the client’s interests ahead of your own, and not exploit a client for
personal advantage.
2.2 Not discriminate against any client on such grounds as age, gender, marital status, national or ethnic origin,
physical or mental disability, political affiliation, race, religion, sexual orientation, or socioeconomic status.
You only have the right to refuse to accept a client for legitimate business reasons.
2.3 Constantly exercise due diligence in making recommendations for financial products.
2.4 Use particular care in executing your duty of care when working with clients.
2.5 Preserve the confidentiality of information communicated by clients, prospects and employers.
2.6 Not make any oral or written statements that misrepresent the services that you or your employer are
capable of performing, your qualifications or the qualifications of your firm. Do not make or imply any
assurances regarding any financial product except to communicate accurate information regarding the
product.

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2 • 16 PORTFOLIO MANAGEMENT TECHNIQUES

3.0 RESPONSIBILITIES TO THE PROFESSION

CIM® designates will operate in accordance with financial services regulation governing the activity you are
conducting and licensed to provide, and in accordance with the law. CIM®s have a responsibility to conduct
themselves with honesty, trust, competence and abide by the terms of the CIM® Certification Mark License
Agreement.
As a CIM® you will:
3.1 Enter into associations only if you can maintain your professional integrity.
3.2 Only use the CIM® designation in a dignified and judicious manner and in compliance with the CIM®
Certification Mark License Agreement.
3.3 Not engage in any professional conduct involving dishonesty, fraud, deceit or misrepresentation, or commit
any act that reflects adversely on your honesty, trustworthiness, or professional competence.
3.4 Abide by the Ethical Misconduct Review Process, cooperate with an investigation request and comply with
decisions of the Designation Ethics Committee and/or Appeal Panel.

4.0 RESPONSIBILITIES TO THE EMPLOYER

In addition to the General Responsibilities, Client Responsibilities, and Responsibilities to your Profession within this
code; you also have responsibilities in dealing with your employer.
As a CIM® you will:
4.1 Place your employer’s interests ahead of your own and not exploit your position for personal advantage.
4.2 Disclose to your employer all matters that reasonably could be expected to interfere with your duty to your
employer.
4.3 Comply with any prohibitions on activities imposed by your employer if a conflict of interest exists.

© CANADIAN SECURITIES INSTITUTE

 The Institutional Investor 3

CONTENT AREAS

Financial Intermediation

Governance

LEARNING OBJECTIVES

1 | Explain the role of financial intermediation in the function and growth of capital markets.

2 | Describe the various groups of institutional investors, and explain each of their activities.

3 | Explain the role of other industry participants.

4 | Describe the principal-agent relationship in investment management.

5 | Describe the regulatory environment in domestic institutional investment management and the
roles of the Office of the Superintendent of Financial Institutions (OSFI) and the Ontario Securities
Commission (OSC).

6 | Describe the roles of the board of trustees, investment committee, investment consultant, and
investment manager in governing an investment fund.

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3•2 PORTFOLIO MANAGEMENT TECHNIQUES

KEY TERMS

Key terms are defined in the Glossary and appear in bold text in the chapter.

board of trustees investment committee

collective investment vehicles investment policy statement (IPS)

defined benefit (DB) Office of the Superintendent of Financial

Institutions (OSFI)
defined contribution (DC)
Ontario Securities Commission (OSC)
endowment funds
pension consultants
financial intermediaries
plan sponsor
financial intermediation
pooled investment vehicles
institutional investors

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 CHAPTER 3 THE INSTITUTIONAL INVESTOR 3•3

INTRODUCTION
For a growing economy, the primary source of capital is individual investors. However, it is too expensive and
generally impractical for individuals to directly lend to or invest with the primary users of capital, governments and
corporations. These users need a massive amount of funds in relation to an individual investor’s available capital.
Furthermore, because of economic growth and the effects of inflation, both the supply of and demand for capital
have grown substantially over time.
Financial intermediaries — including banks, life insurance companies, mutual funds, pension plans and others —
have responded to this growing opportunity by creating and distributing investment products and services that
meet individual investors’ various financial goals. The success of these intermediaries at distributing such products
and services has allowed them to amass large amounts of capital by essentially combining or pooling individual
investors’ capital. With these large pools of capital, intermediaries can lend or invest funds on more favourable
terms than those of individual investors. Indeed, most of these investment opportunities are not otherwise available
to individual investors, because of the small amount of funds typically available to them for investment. For
individual investors, well-designed financial products that give an attractive and competitive share of the benefits
have also fuelled the growth of institutional pools of capital.
The success of financial intermediaries, especially relative to industrial companies, is readily apparent by looking
at the size of the largest financial institutions in Canada — and the same is true for other Western countries. In a
given country, the largest financial institutions rank among the top 10 corporations, regardless of if it is in terms of
capitalization or even the number of employees. In Canada, the various firms and organizations that make up the
financial sector have been significant sources of employment and economic growth.
The purpose of this chapter is to outline the key aspects of each major type of financial intermediary that is
operating in Canada. It will discuss in detail the financial intermediary’s role as an institutional investor and the
nature of the relationships involved in the institutional investment management process, which differ substantially
from typical individual investor relationships. This chapter will also examine and describe fund governance in terms
of each institutional investment management participant’s typical roles and responsibilities.

FINANCIAL INTERMEDIATION
Essentially, financial intermediation involves the movement of funds between those who supply capital and those
who use it. The primary sources of capital are depositors, lenders, policyholders and investors. The users of capital
are typically governments and corporations, as well as individuals by way of consumer financing products, such as
home mortgages, automobile loans and credit cards. The various companies and organizations that connect and
move capital between these two groups are commonly referred to as financial intermediaries.
Up until the mid-1960s, the primary financial intermediaries were banks and life insurance companies. After the
mid-1960s, a number of factors encouraged the growth of other types of financial intermediaries, including mutual
funds, pension plans and endowments. Six of these major factors were as follows:
1. Demographic influences, particularly those related to the maturing of the baby-boom generation and its
evolving financial planning needs.
2. The proliferation and growth of pension plans, driven by demographic trends and the competitive pressure on
corporations to attract and retain employees by offering post-retirement benefits.
3. Empowerment, as individual investors became more capable and comfortable in making their own investment
decisions due to better overall service in the financial services industry, less expensive and improved
technology and communications, and the expansion of the financial markets news media.
4. Innovation, through the creation of new types of securities and financial products to meet the ever-growing
financing needs of governments, corporations and individuals.

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5. Declining security transaction costs and the growth of low- or no-fee distributors of financial products, which
encouraged more individuals to invest in popular products, such as mutual funds.
6. Capital market liberalization and deregulation, which resulted in more competitive and cost-effective financial
markets, in turn fostering the growth of competitive investment products that better suited the needs of those
that provide and use capital.

Over the past 50 years, these six factors, among others, caused an explosion in the size, number and variety of
financial intermediaries. While all major types of intermediaries experienced tremendous growth, there was a large
shift in market share from banks and life insurance companies to mutual funds, pension plans and endowments.
Interestingly, although the industry expected individual investors to be far more active after these developments,
it was in fact the intermediary financial institutions that were more active. A prime example is the development of
futures, options and other financial derivatives since the 1980s. Individual investors have not embraced these types
of financial products. The biggest users of financial derivatives are the financial intermediaries themselves.
The interest of financial intermediaries in derivatives is driven by two main factors, as follows:
1. All financial intermediaries fall under one or more regulatory regimes. As regulatory environments become
more concerned with the risks they assume, financial intermediaries have used derivatives in their risk
management strategies and processes.
2. Financial intermediaries use financial derivatives extensively in the creation and management of customized
financial products for both their individual and institutional investors. These types of investment products
typically include features that provide a guarantee of principal protection and often some degree of exposure
to selected capital markets or economic indexes.

INSTITUTIONAL INVESTORS
Many financial intermediaries can be referred to as institutional investors. Traditionally, institutional investors
have been grouped as follows:

• Pension plans
• Mutual funds
• Insurance companies
• Endowments
• Charitable foundations
• Family trusts/estates
• Corporate treasuries

Despite the popular use of these categories, the terms themselves are increasingly not capturing the most
significant differences among industry players. For example, many insurance companies have launched their own
investment funds and have become involved in the management and provision of pension products.
Certain types of pension plans have a life insurance component to them, and both banks and life insurance
companies are acquiring or launching investment management companies. Some life insurance companies are
buying or building banking affiliates so they can offer their insurance clients savings and loan products. If anything,
there is increasing integration — and, with it, competition — among these traditional institutional investors.

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 CHAPTER 3 THE INSTITUTIONAL INVESTOR 3•5

DID YOU KNOW?

Collective Investment Vehicles

The overall costs of attaining diversification tend to be large. This reality creates an incentive for
individual investors and institutions to place their money in collective investment vehicles. In North
America, collective investment vehicles are generally referred to as pooled investment vehicles. The
most popular pooled investment vehicles are as follows:

• Mutual funds
• Exchange-traded funds (ETFs)
• Hedge funds
• Venture capital funds
• Private investment partnerships

The primary objective of using pooled investment vehicles is to achieve an attractive risk-return profile
by pooling the assets of many investors, which lowers average costs through the following:

• Better diversification
• A more efficient collection and processing of information
• Spreading fixed operational costs over a larger asset base
• Using size as a tool in the market environment to obtain better security transaction terms, such as
smaller bid-ask spreads and commissions

Pooled investment vehicle investors are entitled to the investment portfolio’s net returns and,
accordingly, bear all associated investment and fund operational risks. The growth of pooled investment
vehicles has been so profound that mutual funds have become the primary investment vehicle for
individual investors.

PENSION FUNDS
Funded occupational or individual pension plans are the private sector counterparts of public social security
programs that are common in most Western countries. Occupational pension funds, which are typically sponsored
by large employers or trade unions, collect and invest contributions from the beneficiaries and sponsors for the
purpose of providing retirement entitlements to the beneficiaries.
The management of pension plan investments may be internal, meaning it is performed by the fund itself; external,
where it is delegated to independent external investment managers; or a combination of both. The use of external
(third-party) investment managers is the norm, particularly for small- to medium-sized pension plans that have
not attained an asset base that is sufficient in size to support the costs associated with creating and operating an
internal investment management staff.
Pension plans and other financial intermediaries tend to use third-party investment managers if they can offer
expertise in specialized areas such as hedge funds, private equity, and foreign or regionally focused markets.

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3•6 PORTFOLIO MANAGEMENT TECHNIQUES

DIVE DEEPER

What is the difference between a defined benefit and a defined contribution pension plan?
The two main types of pension funds — defined benefit (DB) and defined contribution (DC) —
differ significantly in the distribution of investment risk between the sponsor and the beneficiary. In
DB programs, pension plan entitlements are typically calculated on the basis of an employee’s salary
profile and tenure of employment. These entitlements formally represent the sponsor’s liabilities, as
the sponsor is responsible for making contractual pension payments, regardless of how the investment
performs. With DB programs, a beneficiary’s risk tends to be limited to the sponsor’s default.
In contrast, under DC programs, the beneficiary is typically provided with a menu of investment choices
(including mutual funds) among which to allocate regular contributions. Beneficiaries take on the entire
investment risk, while the investments cumulative performance determines the payouts. Due to these
differences, DB pension liabilities tend to most closely resemble those of life insurers, in that the sponsor
will guarantee them. Due to the long-term nature of DB liabilities, which are effectively like inflation-
indexed long-term bonds, there is a potential for significant volatility in fund surpluses and deficits. This
means pension funds must focus their attention on risk management, as DB liabilities are difficult to
match on the asset side. As temporary swings in surpluses are unavoidable, investment horizons have
to be relatively long. On the other hand, the management of DC programs resembles more closely that
of a mutual fund. Because there is a wider product mix to offer and because DC funds do not have fixed
liabilities, their investment horizons can be in the short-, medium- or long-term range, and tend to vary
more across firms and products.
Prior to the 1980s, the vast majority of North American private pension plans were DB in nature.
However, both the number of employers offering DC plans and the amount of assets in them have
grown steadily and now constitute a substantial portion of North American pension plan assets. Younger
employees, a more mobile workforce that switches employers more often than in the past, as well as
the expense of carrying a DB plan on an employer’s statement of financial position and statement of
comprehensive income, are some of the reasons why this shift from DB to DC plans has occurred.

INSURANCE COMPANIES
Life insurance companies, which represent the largest segment of the insurance industry, offer products such as
annuities and guaranteed investment contracts that are tailored to the needs of individual and collective pension
plans. The return on the insurer’s asset portfolio and insurance elements determines the payoff of a life insurance
product. Therefore, life insurance products are an indirect way to provide ultimate beneficiaries with asset
management services.
However, insurance companies tend to differ from other institutional investors in their liability structure. Life
insurers’ liabilities are primarily actuarial in character, with fixed, income-like payout structures. This explains the
large portion of fixed income products in insurance portfolios. However, equity allocations have increased during
the past several decades, as life insurers have created and offered new life insurance products with valuations and
payouts based on equity market returns.
Insurance company assets are often managed internally rather than by external asset managers. This organizational
preference has led insurers to purchase external asset management firms if a particular investment expertise is
lacking in-house. As a result, some insurance companies now offer portfolio management and administrative
services to pension funds. In addition, there has been a recent trend among insurers to invest in or acquire
specialized investment vehicles and purchase specific asset management service providers.

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 CHAPTER 3 THE INSTITUTIONAL INVESTOR 3•7

MUTUAL FUNDS
Mutual funds have also undergone phenomenal growth during the past four decades. Mutual funds have become
the investment vehicle of choice for many individuals who do not have the time, inclination or resources to properly
research individual stocks and bonds to include in their portfolio.
Due to the economies of scale — and therefore the profit potential — the mutual fund industry has also undergone
much consolidation. Many mutual fund companies have also had to diversify and expand their product offerings to
meet new investor trends and demands. This development has been very prevalent in the area of offering investors
exposure to international capital markets.
Mutual funds with global mandates have grown in popularity as investors become more convinced of the
importance of diversifying their mutual fund investments beyond their domestic market. Another prominent
product trend has been the offering of specialist mandates. Many of the specialist-type mandates are focused on
industry sectors. These products offer exposure not only to traditional market sectors such as precious metals, but
also to established but still quickly growing industry sectors such as information technology and wireless.
Another reason for growth in the mutual fund industry is that some mutual fund companies have diversified their
investor base beyond the traditional individual investor. In search of additional assets to manage, they have often
taken their existing investment mandates and products, and repackaged them to attract other types of investors.
One successful investor diversification strategy focused on the tremendous growth in the number of employers
offering DC pension plans.
The strategy’s primary objective was for a mutual fund company to have some of its current investment mandates
included on the list of approved mutual funds for a company’s DC plan. This represented a somewhat wholesale
approach to individual investors, since the mutual fund company was targeting the employer rather than the
employees. Mutual fund companies are also able to leverage the brand awareness they currently have in the retail
mutual fund market.
The second growth opportunity that a number of mutual fund companies have pursued is the wholesale or standard
institutional marketplace. Some mutual fund companies have been quite successful at positioning their funds as
suitable investments for a number of institutional investors, including trusts, endowments, and small to mid-sized
pension plans. A number of Canadian mutual fund companies have sourced as much as 20% to 25% of their total
assets under management from these traditional institutional investors. In some cases, mutual fund companies
have become formidable competitors to traditional institutional investment managers.

ENDOWMENT FUNDS/TRUSTS
Endowment funds are portfolios that are managed to produce income for a beneficiary organization. They usually
invest in long-term assets and attempt to earn a targeted rate of return, typically in the range of 5% per annum.
This income finances part of the annual operating costs of the beneficiary’s organization.
Endowment funds encompass a broad range of institutions. Among these are religious organizations; educational
institutions; cultural entities, such as museums and symphony orchestras; private social agencies; hospitals;
and corporate and private foundations. Another rapidly growing area of endowment investing is non-profit
organizations, such as trade organizations or public foundations, which often have significant endowment or reserve
assets.
Endowments range in size from a couple of hundred thousand dollars to several billion dollars, depending on the
fund’s age and its success in soliciting contributions. Some of the largest endowments in Canada support post-
secondary educational institutions.

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Although often compared in terms of investment objectives and constraints, endowment funds and retirement
funds have only two major similarities. Both are usually long term in nature and — with few exceptions — are
not taxable. But the differences are far more important than their similarities. The range of an endowment fund’s
objectives is extremely broad and they are often qualitative in nature. For endowment funds and trusts, the
determination of an investment policy can be viewed as a resolution of a creative tension existing between the
highly demanding need for immediate income, and the pervasive and enduring pressures for a growing stream of
future income to meet future needs.
Trusts are very similar to endowments, but they usually have a very “narrow” list of beneficiaries that is typically
limited to family members or other named individuals. It is difficult to obtain any reasonable estimate as to the
size of trust assets, since the majority of trusts are family-structured or private in nature and do not make public
solicitations for contributions.
Endowments and trusts deal with essentially the same issues that most institutional investors face when making
investment management-related decisions. In response to growing demand, many investment managers offer
investment funds that accommodate the investment needs of endowments and trusts. Numerous banks and trust
companies have subsidiaries that specialize in offering both administration services and investment management
services tailored to meet the needs of trusts and endowments.
As is the case with other types of institutional investors, an endowment fund’s current asset size and its projected
growth are major factors that influence a decision as to whether resources should be expended to establish internal
investment management expertise or whether a fund should continue to use third-party investment managers.
More than two decades ago, the Board of Trustees of the University of Toronto’s endowment fund decided to create
and develop a team of internal investment managers to manage its assets.

CORPORATE TREASURIES
The management responsibility of a corporation’s financial assets normally resides with its corporate treasury
department. The range of investment management services and activities performed in the treasury department
can vary widely. In the case of small to medium-sized companies operating in only one country or currency, their
investment management responsibilities are essentially focused on cash management activities that support the
company’s liquidity and cash flow needs.
However, at the other extreme, very large multinational companies often have very sophisticated investment
management requirements and, accordingly, have committed substantial resources to their treasury functions.
Some large (non-financial) companies have treasury operations that rival those of a medium-sized investment
dealer.
Although cash management activities still form the heart of treasury operations, large corporations are often
engaged in other specialized investment management activities, such as foreign exchange risk management,
corporate funding and the use of complex derivatives to gain or hedge risk exposures particular to their industry
or company. In the case of industrial or non-financial firms, their treasury and investment management staffs are
required to perform their duties in accordance with operating guidelines and principles that the company’s senior
management establishes and its board of directors approves.
These types of companies, as well as their respective treasury staff, do not require registration with securities
regulators, since none of their investment activities fall under the purview of a securities regulator. Although they
do not require securities registration, many non-financial corporations nonetheless endeavour to incorporate the
appropriate best practices that prevail in the investment management operations of companies, such as investment
dealers or fund companies, that do require securities registration.
For companies that offer a DB pension plan, the corporate treasury department is normally responsible for the
operation of the pension plan’s investment management.

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 CHAPTER 3 THE INSTITUTIONAL INVESTOR 3•9

OTHER INDUSTRY PARTICIPANTS

INVESTMENT CONSULTANTS
In recent years, the importance of investment consultants (also referred to in North America as pension
consultants), who primarily advise institutional asset holders on the choice of external investment managers, has
been on the rise. Traditionally, investment consultants have been of greatest value to smaller pension funds, since
large pension funds have been less inclined to hire external investment managers. Recently, however, as investment
management has increasingly been outsourced, pension fund trustees have lost some of their internal support and
have started to rely more and more on investment consultants.

FUND RATING AGENCIES

Fund rating agencies specialize in providing market participants with information for investment decision-making
by formally scoring the rated company’s “quality.” In terms of generating these scores, fund rating agencies tend to
distinguish themselves by using an approach that is either based on quantitative ranking or qualitative ratings. While
fund rankings try to help investors evaluate pooled investment vehicles based purely on measures of historical
performance, fund ratings seek to evaluate investment funds against their investment philosophy background,
policies and procedures, and fund managers’ track records. With their services targeted mostly at the retail market,
both types of fund raters distinguish themselves from the investment consultants, which concentrate on the
business’s wholesale side.

MARKET INDEX PROVIDERS

Market index providers create and maintain market indexes, which measure the price performance of a hypothetical
investment. Over time, the role of these index providers has become increasingly visible in the asset management
industry. Since market indexes have become the benchmarks to which the performance of asset managers is
compared, they have come to strongly influence the structure of asset managers’ incentives. Conceptually, financial
market indexes are easy to understand and interpret.
Table 3.1 summarizes the key aspects for various types of institutional investors. The table lists the major groups
of institutional investors and compares them on the basis of ownership, management of funds, performance
evaluation and risk profile. One of the most important points of comparison pertains to who actually assumes
investment risk with these different types of investment products. The bearer of residual (investment) risk is
provided in the extreme right-hand column of the table. It is important to note that it is only in the case of DB
pension plans and life insurance products that the beneficiary or the insured, respectively, does not bear the
investment risk. With all other types of institutional investments, either the investor or the beneficiary bears the
investment risk.

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Table 3.1 | Participants in the Institutional Investment Industry and Their Activities

Type of Activity/Responsibility

Who Has the

Responsibility
for Monitoring
Who Is the Beneficial Who Manages the and Performance Who Bears the
Type of Investor Owner of the Funds? Capital? Evaluation? Risk?

Pension Funds Pension plan Normally, an external Trustees, consultants Plan sponsor
(Defined Benefit) investment manager

Pension Funds DC beneficiary Normally, an external Trustees, consultants DC beneficiary

(Defined investment manager
Contribution)

Insurance Insurance company Often, an internal Insurance company, Insurance company

Companies investment manager consultants

Mutual Funds Household Typically, an internal Investors, rating Household

(Retail Business) investment manager agencies

Endowments/ Endowment/trust Internal or external Trustees, consultants Beneficiaries

Trusts investment manager

Corporate Corporation Internal investment Corporation Corporation

Treasuries manager

Private Investor Household Household Household, rating Household

agencies

PRINCIPAL-AGENT RELATIONSHIPS IN INVESTMENT MANAGEMENT

At the core of the investment management industry, there is a separation between ownership and the control
of financial wealth. This results in a number of principal-agent relationships within the investment management
industry. Delegated investment management involves a layering of the various agency relationships. Figure 3.1
provides a schematic comparison of the typical principal-agent relationships associated with both individual and
institutional investors.

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 CHAPTER 3 THE INSTITUTIONAL INVESTOR 3 • 11

Figure 3.1 | Comparison of Individual and Institutional Asset Management Relationships

Individual Institutional

Investor Beneficiary

Sponsor Trustees

Fund Rating Agency/ Consultant/

Index Provider Index Provider

Asset Management Company Asset Management Company

Individual Asset Manager Individual Asset Manager

Capital Markets Capital Markets

The figure starts at the bottom with the source of all investments — the capital markets. In the case of an
individual investor, the overall relationship is very direct, with the asset management company functioning as the
intermediary between the individual investor and the capital markets. Typically, the only other agents involved are
mutual fund rating companies and capital market index providers. The primary role of these two service providers
is to provide independent data and analysis that assist an investor in evaluating the investment management
company’s performance.
The right side of Figure 3.1 depicts the typical principal-agent relationships associated with institutional investors.
There are two notable differences in their relationships compared to those of individual investors. First, a consultant
specializing in hiring and assessing institutional investment managers replaces the fund rating agency. A firm
specializing in servicing endowment and pension plans usually provides this service. Examples of large pension
consulting firms are Aon Hewitt and Willis Towers Watson. Second, the institutional model also involves the
important addition of two separate but related intermediaries. In the case of a private pension plan, the employer
offering the plan is described as the plan sponsor, because it offers the pension plan benefit to its employees.
In addition, an independent committee, usually referred to as a board of trustees, is established to oversee the
pension plan’s operation. A board of trustees is used in numerous types of institutional investment management
relationships, including private pension plans, endowments and family trusts.
It is also important to note that mutual funds established as trusts are also required to have a board of trustees,
which provides oversight to ensure that the mutual fund is operated according to the trust indenture under which it
was established.
In addition, the activities of fund and credit rating agencies, as well as index providers, will directly or indirectly
influence the behaviour of one or more of the other agents. Therefore, they will have a bearing on the relationship
between the ultimate investor and the fund manager. For example, seemingly insubstantial changes to the way a

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benchmark index is measured can have a material impact on index levels and returns. Therefore, once a portfolio’s
benchmark is chosen, index providers influence asset allocation and portfolio returns by deciding on index
composition.
As the number and complexity of principal-agent relationships increase, the likelihood that there will be conflicts
of interest between investors and their agents also increases. In consequence, investment decisions can vary across
funds, partly due to differing numbers and combinations of agency relationships. For example, the investments
chosen by DC pension funds can differ substantially from those in DB plans. In the former, individual employees
investing on their own are making the choices, whereas in the latter, they are guided by corporate treasurers or
pension plan trustees acting for the pension fund’s beneficiaries as a group. In addition, individual customers’
investment decisions might further be influenced by the advice of investment firms’ sales networks, which may
have certain incentives to sell or recommend particular products.

GOVERNANCE

REGULATORY ENVIRONMENT
A number of Canadian securities industry and non-securities industry regulators are involved in the regulation
of domestic institutional investment managers. However, in broad terms, two regulators oversee the majority of
firms and individuals involved in the creation, management, sale and distribution of financial products and services
in Canada:
1. The Office of the Superintendent of Financial Institutions
2. Provincial and territorial securities regulators

The first, the Office of the Superintendent of Financial Institutions (OSFI), is an independent agency of the
Government of Canada that reports to the federal Minister of Finance. The OSFI supports the government’s
objective of “contributing to public confidence in the Canadian financial system,” and according to its official
website, its mandate is to:

• Supervise federally regulated financial institutions and pension plans to determine whether they are in sound
financial condition and meeting regulatory and supervisory requirements;
• Promptly advise financial institutions and pension plans if there are material deficiencies, and take corrective
measures expeditiously, or require management, boards or plan administrators to do so;
• Advance a regulatory framework designed to control and manage risk;
• Monitor and evaluate system-wide or sectoral developments that may negatively impact the financial condition
of federally regulated financial institutions.

Further, the OSFI has “due regard for the need to allow institutions to compete effectively and take reasonable
risks,” recognizing that “management, boards of directors and plan administrators are ultimately responsible for risk
decisions and that financial institutions can fail and pension plans can experience financial difficulties resulting in
loss of benefits.”1
Note that the OSFI is considered to be a non-securities regulator because the principal products offered or managed
by the companies it regulates do not fit the definition of a “security.”

1
Office of the Superintendent of Financial Institutions, “Mandate.” http://www.osfi-bsif.gc.ca/Eng/osfi-bsif/Pages/mnd.aspx

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 CHAPTER 3 THE INSTITUTIONAL INVESTOR 3 • 13

EXAMPLE
A Canadian bank’s capital and products, such as chequing accounts and term deposits, are not considered
securities. The products that life insurance companies sell and the pension plans that corporate employers offer
are also not considered securities.

The other primary regulators of financial services in Canada are the various provincial and territorial securities
regulators. They are responsible for establishing and enforcing regulations and operational procedures that
support the effective operation of Canada’s securities markets and the proper conduct of its various participants.
Whereas the OSFI operates under a federal government charter and therefore has a nationwide mandate, securities
regulators operate under mandates that their respective provinces and territories grant them.
An example of a Canadian securities regulator is the Ontario Securities Commission (OSC). The OSC’s mandate,
set by statute by the Ontario government, is “to provide protection to investors from unfair, improper or fraudulent
practices, to foster fair and efficient capital markets and confidence in capital markets and to contribute to the
stability of the financial system and the reduction of systemic risk.”2
The OSC is responsible for establishing and enforcing regulations and operational standards associated with the
creation, management, sale and distribution of securities that are either managed in Ontario or sold to Ontario
residents. Also, in a manner similar to the OSFI, the OSC and other provincial and territorial securities regulators are
responsible for the creation and enforcement of regulations pertaining to the operation of the investment managers
over whom they have regulatory supervision.

INSTITUTIONAL INVESTMENT FUND GOVERNANCE

The governance standards and practices for institutional investment funds are very well established and are based
on concepts and standards, such as the prudent man rule and the concept of fiduciary duty. All institutional funds
have their own clearly defined governance standards and procedures, but for the most part, they operate at very
similar standards. They avoid any deviation from investment industry conventions and best practices, and all
industry participants in institutional investment are keenly aware of the requirements for excellent fund governance.
An institutional investment fund’s governance typically involves the following organizational structure:

• Board of trustees
• Investment committee (and its staff)
• Investment consultant
• Investment manager

BOARD OF TRUSTEES
As mentioned earlier, a fund’s board of trustees is ultimately responsible for all aspects of the fund’s operation. Its
specific roles and responsibilities are clearly established in the fund’s trust indenture or pension plan documents.
With particular regard to the investment aspect of the fund’s operation, the board of trustees will approve the fund’s
investment policy statement (IPS). Typically, in large funds, the IPS is developed by the investment committee for
the fund’s investment program.
The fund’s board of trustees, in its sole discretion, can delegate its decision-making authority to the investment
committee regarding the investment program within the IPS’s established guidelines.

2
Ontario Securities Commission, “Notice of Statement of Priorities for Financial Year to end March 31, 2021”
https://www.osc.gov.on.ca/en/SecuritiesLaw_sn_20200625_11-789_sop-end-2021.htm

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The investment committee will report regularly to the board of trustees on the portfolio’s financial performance and
on significant decisions related to the portfolio’s management.

INVESTMENT COMMITTEE DUTIES

Generally, a fund’s board of trustees will create a subcommittee with the specific mandate of focusing on the
investment management aspects of the fund’s operations. The investment committee is normally populated by a
subset of individuals who serve on the board of trustees. In the case of a pension plan, the investment committee
often includes one or more senior executives from the pension plan’s sponsor.
In the management of the fund’s investments, an investment committee discharges its obligations by performing
a number of key duties. For one thing, they prepare a comprehensive IPS that provides the framework for the
management of all of the fund’s investments.
The purpose of an IPS is to document the investment management process by:
1. Identifying the key roles and responsibilities related to the ongoing management of a fund’s assets; and
2. Setting forth an investment structure for a fund’s assets, which includes all of its asset classes and acceptable
ranges that, in aggregate, are expected to produce a sufficient investment return over the long term while
prudently managing risk.

This strategy should provide guidance in all market environments, and should be based on a clear understanding of
worst-case outcomes.
The investment committee also does the following:

• Establishes formalized criteria to measure, monitor and evaluate a fund’s performance results on a regular basis;
• Encourages effective communication among all fiduciaries, including external parties engaged to execute
investment strategies;
• Recommends the hiring and termination of investment managers;
• Monitors an entire fund’s performance and all of the sub-funds that form part of its total assets; and
• Reviews periodic (usually quarterly) reports about the operations and results of the various investment
managers prior to submitting them to the fund’s board of trustees.

STAFF DUTIES
Larger institutional investors often have dedicated internal staff that assist in a fund’s administration and operation.
They are generally responsible for implementing the IPS as directed by the investment committee, which includes
executing any documents necessary to facilitate the IPS’s implementation, including but not limited to contracts
with consultants and investment managers for providing services.
In addition to implementing a fund, the staff also maintain it. They manage the cash flows both into and out of
the fund as a result of investor redemptions or beneficiary payments, review the fund’s investments to ensure that
policy guidelines continue to be met and monitor investment returns on both an absolute basis and relative to
appropriate benchmarks. The information for these reviews comes from outside advisors, the custodian and the
fund’s investment managers.
If the fund needs to be adjusted, the staff will rebalance it in order to maintain the proper diversification within
the ranges the investment committee has approved, and in accordance with its established rebalancing policy. If
problems should arise, the staff will raise timely concerns with the investment committee and take appropriate
action under the investment committee’s direction if investment objectives are not being met or if policies and
guidelines are not being followed.
Administratively, the staff are responsible for recommending a qualified custodian for the fund, as defined by the ability
to handle investments, transactions and strategies that the IPS authorizes. The staff prepare monthly and quarterly

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 CHAPTER 3 THE INSTITUTIONAL INVESTOR 3 • 15

summaries of investment activity and performance for the investment committee. They also monitor each investment
manager overall to ensure that they conform to the terms of their contracts and that their performance monitoring
systems are sufficient to provide the investment committee staff with timely, accurate and useful information.

INVESTMENT CONSULTANT DUTIES

When retained for service, investment consultants typically perform the following services:

• Assist in establishing a fund’s investment policies, objectives and guidelines.

• Recommend institutional investment managers in accordance with a fund’s IPS and periodically review them.
• Review a fund’s investments at least monthly to ensure that policy guidelines continue to be met.
• Monitor a fund’s investment returns on both an absolute and relative basis to appropriate benchmarks, and
provide reports to the investment committee on a quarterly basis.
• Inform the investment committee regarding any qualitative changes to a fund’s investment management or
strategies, which is generally referred to as investment manager “style drift.”

INVESTMENT MANAGER DUTIES

Among its numerous responsibilities, a fund’s board of trustees is responsible for appointing suitable investment
managers to manage its assets. As mentioned earlier, investment managers can be internal staff or external third-
party investment managers, or both, depending on the fund’s size and particular needs.
Investment managers usually have discretion to develop and execute their investment program within the
constraints set forth in a fund’s IPS. At a minimum, investment managers should comply with applicable laws and
regulations governing their operations, conduct their business and professional affairs in a manner consistent with
their corporate code of conduct and ethics, and know and comply with all of the guidelines and restrictions outlined
in a fund’s IPS. They are also encouraged to identify investment policies or guidelines that may have an adverse
impact on a fund’s performance, and to initiate discussion with the fund’s staff or investment committee toward the
possible modification and improvement of those policies.
Investment managers are also responsible for maintaining thorough and appropriate written risk control policies
and procedures. The oversight of and compliance with these policies must be ongoing and independent of the fund’s
investment activity. They have to reconcile accounting, transaction and asset summary data with the custodian’s
valuations on a monthly basis, and communicate and resolve any significant discrepancies with the custodian. Any
unresolved discrepancies must be promptly reported to the fund’s staff.
Maintaining frequent and open communication with a fund’s staff, as well as with the investment committee,
is imperative. Some of the significant matters pertaining to the IPS that investment managers should be
communicating about are as follows:

• Major changes in investment outlook, investment strategy, investment process, sub-advisors or portfolio
structure.
• Significant changes in ownership, organizational structure, financial condition or senior personnel.
• All pertinent issues deemed to be of significant interest or material importance.

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SUMMARY
After completing this chapter, you should be able to:
1. Explain the role of financial intermediation in the function and growth of capital markets.
• Financial intermediation involves the movement of funds between those who supply capital and those who
use it.

2. Describe the various groups of institutional investors and explain each of their activities.
• Pension funds: The two main types of pension funds are defined benefit (DB) and defined contribution (DC).
• Insurance companies: Offer products such as annuities and guaranteed investment contracts that are
tailored to the needs of individual and collective pension plans.
• Mutual funds: Have become the investment vehicle of choice for many individuals who do not have the
time, inclination or resources to properly research individual stocks and bonds to include in their portfolio.
• Endowments/Trusts: Endowment funds are portfolios that are managed to produce income for a beneficiary
organization. Trusts are very similar to endowments, but they usually have a very “narrow” list of
beneficiaries that is typically limited to family members or other named individuals.
• Corporate treasuries: Responsible for managing a corporation’s financial assets.
3. Explain the role of other industry participants.
• A number of institutional services exist to aid in the selection and assessment of financial intermediaries.
The three key service providers are investment/pension consultants, fund rating agencies and market index
providers.

4. Describe the principal-agent relationship in investment management.

• Typically, investment management involves a number of principal-agent relationships. The nature
and number of these relationships vary depending on whether the investor or client is an individual or
institutional investor.

5. Describe the regulatory environment in domestic institutional investment management and the roles of the
Office of the Superintendent of Financial Institutions (OSFI) and Ontario Securities Commission (OSC).
• In broad terms, two regulators oversee the majority of firms and individuals involved in the creation,
management, sale and distribution of financial products and services in Canada: The Office of the
Superintendent of Financial Institutions (OSFI) and provincial and territorial securities regulators.
• The OSFI is considered to be a non-securities regulator. The OSFI’s mandate is to supervise federally
regulated institutions and pension plans.
• The OSC is responsible for establishing and enforcing regulations and operational standards associated with
the creation, management, sale and distribution of securities that are either managed in Ontario or sold to
Ontario residents.

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 CHAPTER 3 THE INSTITUTIONAL INVESTOR 3 • 17

6. Describe the roles of the board of trustees, investment committee, investment consultant and investment
manager in governing an investment fund.
• The governance of an institutional investment fund typically involves the following organizational structure:
« The board of trustees, which is ultimately responsible for all aspects of a fund’s operation.
« The investment committee, which is focused on the investment management aspects of a fund’s
operations. Larger institutional investors often have dedicated internal staff that assist in a fund’s
administration.
« An investment consultant, who typically performs such services as assisting in establishing investment
policies, recommending institutional investment managers and monitoring a fund’s investment returns.
« An institutional investment manager, who usually has the discretion to develop and execute their
investment program within the constraints set forth in a fund’s investment policy statement (IPS).

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 The Investment
Management Firm 4

CONTENT AREAS

Ownership and Compensation Structures

Regulations and Licensing
Organizational Structure
Investor Types
Service Channels
Investment Mandates
Roles and Responsibilities of Institutional Investment Managers
Investment Management Fees
Industry Challenges
Corporate Governance

LEARNING OBJECTIVES

1 | Describe an investment management firm’s basic ownership structure, and explain the differences
between public and privately owned firms.
2 | Describe an institutional investment management firm’s basic organizational structure.
3 | Identify and explain the major types of investors.
4 | Discuss the major investment product structures that institutional investment management firms
manage.
5 | Explain how the types of investment mandates an institutional investment management firm offers
can affect its structure and operations.
6 | Illustrate the primary roles and responsibilities of the various parties involved in the management of
a Canadian mutual fund.
7 | Explain how an investment manager collects fees, and identify the various types of fees institutional
investment management firms charge.
8 | Describe the key challenges the institutional investment management industry faces and the actions
being taken to mitigate these challenges.
9 | Explain the critical role of governance in an institutional investment management firm’s operations.

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4•2 PORTFOLIO MANAGEMENT TECHNIQUES

KEY TERMS

Key terms are defined in the Glossary and appear in bold text in the chapter.

chief compliance officer (CCO) pooled fund

corporate governance segregated account

exempt investors separation of duties principle

general partner sub-advisors

limited partnerships (LPs) trustee

non-exempt investors ultimate designated person (UDP)

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 CHAPTER 4 THE INVESTMENT MANAGEMENT FIRM 4•3

INTRODUCTION
The term institutional investment manager generally refers to investment management firms involved in the
management of pooled investment vehicles. However, the term is also used to refer specifically to firms that
focus solely on managing investments for institutional investors. These particular firms target investment
mandates from institutional investors, such as defined benefit pension plans, endowments, large family trusts
and corporate treasuries.
The business and marketing strategy of most institutional investment management firms is focused on the
accumulation of wholesale investment assets. These firms seldom, if ever, pursue investment management
mandates for investment products, such as mutual funds, that are sold to retail — that is, individual investors
— and for that reason these firms are not familiar household names. Unlike most of the major mutual
fund companies that spend significant resources on advertising and building brand name recognition, most
institutional investment management firms have insignificant advertising budgets since they are not attempting
to build brand name recognition with individual investors.
Institutional investment managers have competition from life insurance companies and mutual fund companies
that pursue the same target investors. These companies have designed investment products specifically for
institutional investors and have created skilled marketing teams that focus on this particular type of investor.
Some of these companies have experienced some success in accumulating assets from institutional investors
and, accordingly, have helped raise the degree of competitiveness in this particular niche market. Institutional
investment management firms usually offer only a limited number of investment mandates.
Historically, institutional investment managers have had mandates that focus on either the Canadian bond or
equity markets. However, many institutional investment management firms have combined their expertise of the
Canadian bond and equity markets, and offer a Canadian balanced fund. For a number of Canadian institutional
investment management firms, a balanced fund is their largest mandate in terms of assets under management.
However, with institutional investors showing an ever-increasing interest in global investment mandates,
institutional investment management firms have to consider whether to commit resources that enable them to
include international securities in their investment funds. Some firms have decided to make this investment, while
others remain stringently focused on domestic financial markets.
The purpose of this chapter is to explore the different aspects of an investment management firm. We begin the
chapter with a discussion of a firm’s ownership and compensation structures, followed by its regulations and
licensing requirements. This chapter also introduces the topic of an investment management firm’s organizational
structure, which will be dealt with in more detail in chapter 5 of this course. Types of investors, product structures,
and investment mandates are covered next, followed by the roles and responsibilities of investment managers. The
chapter ends with a discussion about industry challenges and corporate governance, which all investment managers
need to be aware of.

OWNERSHIP AND COMPENSATION STRUCTURES

Given the types of activities they are usually involved in, all investment management firms in Canada are structured
legally as corporations to be considered for, and receive registration from, the appropriate securities regulator or
regulators. As discussed in a later section of this chapter, appropriate securities registration is required not only for
the firm, but also for certain individuals. However, in addition to being necessary, this corporate ownership structure
offers numerous advantages to a firm’s owners, as follows:

• First, a firm’s owners want the benefits and protection that corporate entities offer. They receive the same tax
and fiscal benefits available to all those who choose to structure their business activities as corporate entities.
Of course, investment management firm owners also receive the benefits of limited liability protection, as
offered by the corporate structure.

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• Second, firms are usually envisioned as long life business ventures, and the corporate vehicle best suits this
objective. Investment management firm founders and owners plan and hope that, over time, their business will
develop a long history of stability and competitive returns for clients, as well as strong growth, both in terms of
the number of clients and the amount of assets under management.
• Third, some owners want to create brand identity in the institutional investor marketplace to aid in their firm’s
growth. A corporate vehicle is often the best way to accomplish this goal. Strong brand identity may also
minimize the impact to the firm if one or more of its senior portfolio managers should depart. The loss of a key
employee is often a considerable risk in the institutional investment management industry, particularly for
smaller firms. Strong brand identity attracts skilled personnel.
• Fourth, corporate share ownership is an incentive that attracts and retains key productive staff. Over time,
significant personal wealth can accrue for a successful institutional investment management firm’s owners as
the firm benefits from considerable economies of scale and the accompanying profitability.

PRIVATELY OWNED STRUCTURE

The vast majority of Canadian investment management firms are privately owned. Private ownership generally
takes one of two major forms: either 100% employee-owned or employee majority–owned with a passive
external owner.
Small to medium-sized firms are usually private corporations, with active staff members holding all of their shares.
This structure is typical for all investment management firms during their start-up phase, and also for those
larger privately owned firms that have striven to operate in an independent fashion and prefer a partnership-type
business relationship. By their nature, institutional investment management firms are not typically capital
intensive and can be funded at start-up by one or more individuals who want to operate in a private corporation
on a partnership basis.
If successful, these privately owned firms can generate more than sufficient profits to fund their planned growth and
therefore do not generally require any external capital to expand their operations over time. Figure 4.1 below depicts
the typical ownership structure for both privately owned investment management firms at start-up and larger
privately owned investment management firms that essentially operate as partnerships.

Figure 4.1 | Privately Owned Institutional Investment Management Firm

Director/Officer A Director/Officer B Director/Officer N

Investment
Management Firm
(Corporation)

Most privately owned investment management firms continue to operate as partnerships, with all of the firm’s
shareholders involved in its daily active management.

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 CHAPTER 4 THE INVESTMENT MANAGEMENT FIRM 4•5

However, over time, some medium- to large-sized individually owned firms may slightly change their share
ownership structure to accommodate an investment by an institutional investor. When it occurs, this change in
the firm’s ownership is normally limited to one institutional investor whose original investment is always limited
to a minority voting position in the firm and often starts with a modest 10% to 15% of its voting equity. Figure 4.2
depicts this type of shareholder arrangement.

Figure 4.2 | Privately Owned Institutional Investment Management Firm with a Passive Institutional
Investor

Director/Officer A Director/Officer B Director/Officer N Institutional Investor

Investment
Management Firm
(Corporation)

These transactions are essentially win-win situations. A firm enters into this arrangement because it will benefit
from the sales and distribution capabilities that the institutional investor already has in place, which can be used to
accelerate the growth rate of the firm’s assets under management. An institutional investor enters into this type of
transaction because it might not have the specific investment skills that a smaller firm can provide.
Essentially, in this instance, the institutional investor has decided that it would take an unacceptably long period
of time to build an internal investment management team with skills comparable to those of the investment
management firm, while the firm has concluded it can grow its business at a much faster rate and with less time
and capital by using the institutional investor’s resources. Each party faces the risk that without this type of business
arrangement, it might not be able to maximize its potential.
After selling its minority stake, the institutional investment management firm’s investment strategy is then quickly
repackaged into financial products that meet the needs of a financial institution’s current investor mix. Also, under
typical contractual terms, the institutional investment management firm is restricted from offering its investment
services and products to those firms the institutional investor deems competitors.

PUBLICLY OWNED STRUCTURE

Strictly speaking, from a legal perspective, there are no publicly owned investment management firms. All publicly
owned financial institutions consolidate their investment management personnel and operations within one or
more companies established specifically for that purpose. These companies are usually organized as wholly owned
subsidiaries of holding companies that are publicly owned. Figure 4.3 depicts the typical corporate ownership
structure for publicly owned financial institutions, such as mutual fund companies, life insurance companies, banks
and investment dealers, and their investment management subsidiaries.

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4•6 PORTFOLIO MANAGEMENT TECHNIQUES

Figure 4.3 | Institutionally Owned Investment Management Firm

Parent or
Holding Company
(Public Traded)

Portfolio Manager
100% Owned by
Mutual Fund Dealer and/or
Parent Company
Exempt Market Dealer

It should be noted that there have been a limited number of investment management firms that have been able to
successfully float their company stock on public stock exchanges. These companies have not been the traditional
long-only investment managers, but rather institutional investment managers that offer hedge funds and other
alternative investment vehicles, such as private equity and real estate–based investments.

COMPENSATION STRUCTURES
Compensation structures for institutional investment managers are typically comprised of some combination of the
following four types of benefits:
1. Base salary
2. Annual cash bonus
3. Shares (real or notional) or share purchase options, or both
4. Profit sharing

Actual compensation structures for institutional investment managers vary from firm to firm, but the amount of
total compensation is in direct proportion to such factors as:

• An individual’s level of investment management responsibility

• A portfolio’s performance
• An individual’s success at growing the firm’s client base and accumulating additional assets to manage
• An individual’s tenure with the firm
• A firm’s ownership structure (private or a wholly owned subsidiary of a public company)
• A firm’s overall financial success

BASE SALARY
Virtually all Canadian institutional investment managers receive a base salary as part of their compensation.
Salaries are based primarily on an individual’s level of investment management responsibility, including the role
they perform, such as investment analyst, assistant portfolio manager, portfolio manager or chief investment
officer, with their tenure in the industry as the second-most heavily weighted factor.

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CASH BONUS
An annual cash bonus is also fairly common in the institutional investment management industry. Annual cash
bonuses are normally set for each investment manager at a target amount, which is usually expressed as a
percentage of the portfolio manager’s base salary.
Table 4.1 provides the typical range of target cash bonus amounts (as a percentage of the base salary) for increasing
levels of portfolio management responsibility. The actual cash bonus payout is determined on the basis of how
successful the employee was at attaining the specific goals used in establishing their cash bonus targets.

Table 4.1 | Typical Range of Cash Bonuses for Institutional Investment Managers

Role Bonus (Percentage of Base Salary)

Analyst 25% to 50%
Assistant Portfolio Manager 50% to 100%
Portfolio Manager 100% to 150%
Chief Investment Officer 100% to 200%

The performance of the various portfolios under a portfolio manager’s responsibility is by far the major determinant
of cash bonus payments. The primary measurement of a portfolio’s performance is usually not its absolute rate of
return, but rather its percentile or quartile ranking in a representative universe of competitors’ portfolios with the
same investment mandate.
Another factor often considered in determining a portfolio manager’s cash bonus payment is their success at
marketing and attracting new assets for their firm to manage. Many institutional investment management firms
make it a priority to have senior portfolio managers be an integral part of a firm’s client service and marketing
activities, especially since many small and medium-sized firms do not have dedicated marketing and client service
staff. The firm develops a formula in advance to relate the amount of cash bonus to the dollar value of new assets
an individual portfolio manager has been able to source for the firm to manage.

PROFIT SHARING
Profit sharing is the payout of a certain percentage of an institutional investment management firm’s profits to
selected portfolio management staff. When a number of individuals share ownership of a firm, the payout of its
profits is calculated in direct proportion to the amount of equity each individual holds.
Of course, this particular calculation cannot be applied if a firm is a wholly owned subsidiary of a publicly traded
(or another privately owned) firm, since none of the employees own any actual shares in the institutional
investment management firm. In this case, the most senior portfolio managers typically own phantom shares in
the institutional investment management subsidiary.
Phantom equity does not carry votes, unlike actual equity shares, nor does it have any terminal value that can be
realized in the sale of actual equity. However, a program is often created whereby each eligible portfolio manager
receives a certain prearranged percentage of the institutional investment management firm’s profits. In the
aggregate, these managers do not have a claim to all of the investment management subsidiary’s profits, because
the actual owner also receives a set percentage of its profits — often more than 50%.
Sometimes, equity options in a publicly traded parent company are granted to selected portfolio managers in lieu
of phantom equity in a wholly owned institutional investment management firm. This arrangement provides some
opportunity for long-term capital growth for portfolio managers, since phantom equity does not carry any market
value and therefore does not offer any form of long-term financial incentive to portfolio managers.

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REGULATIONS AND LICENSING

The provincial and territorial securities commissions are responsible for the Canadian institutional investment
management industry’s regulatory supervision. In order to offer institutional investment management services and
products in Canada, an institutional investment management firm’s senior staff and the firm itself must hold the
appropriate securities registration.
Securities registrations and licences are required in each province where the institutional investment manager’s
targeted investors reside.

EXAMPLE
If an institutional investment management firm only markets its services and products in the Province of Ontario,
then securities registrations are only required from the Ontario Securities Commission.

Generally, institutional investment management firms that are in their infancy or still relatively small will be
registered in only one or two provinces. Larger institutional investment management firms may have security
registrations and licences in almost every province.

INDIVIDUAL REGISTRANTS VERSUS CORPORATE REGISTRANTS

There are a couple of reasons why institutional investment management firms require licences at two
levels — one licence for the firm itself, and one for certain individuals it employs — in order to engage in this
type of business activity.
First, institutional investment management firms must structure their business affairs in a corporate entity.
Although, in reality, it is the specific investment-related skills and abilities of individual portfolio managers that
are being offered to investors, it is the investment management firm — the legal entity — that is actually offering
portfolio management services to investors. The firm charges investors fees for its services and, like all companies,
assumes the liabilities and pays the expenses associated with operating the firm. With specific regard to liabilities,
the investment management firm is the entity exposed to potential claims and litigation from its investors, which
is why it must obtain and maintain suitable insurance coverage as part of its registration requirements. Under this
type of insurance arrangement, any successful claims against the institutional investment management firm are
paid by the insurance company that provides coverage.
Second, the requisite investment management and business skills reside, of course, with the individual portfolio
managers, not the company. Accordingly, registration is required for the portfolio managers who have the
appropriate skills and qualifications.

ORGANIZATIONAL STRUCTURE
Good organizational structure design is important to all types of companies and certainly to institutional
investment management firms that manage wealth on behalf of their clients. A sound and suitable organizational
structure is the first step toward ensuring that a firm functions at or above industry standards, and allows a firm to
properly implement good business practices, controls and procedures. A firm’s organizational structure should be
reviewed over time and modified as required.

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Figure 4.4 depicts a typical organizational structure for an institutional investment management firm. Like
many companies, its structure tends to be organized along functional lines. Figure 4.4 depicts an investment
management firm in its most robust form. It provides a visual representation of the key duties and activities that
a firm must perform in order to conduct its affairs appropriately. This organizational chart would be typical of
medium-sized and large institutional investment management firms that are privately owned and not part of a
larger financial institution.

Figure 4.4 | Organizational Structure of a Typical Institutional Investment Management Firm

President

Trade
Investment Marketing Compliance Accounting
Settlement

Legal

Audit

There are a number of instances where an institutional investment management firm’s organizational chart could
vary significantly from the structure outlined in Figure 4.4. For example, a very small firm with only two or three
partners would not normally have a sales and marketing department. The partners would share the sales and
marketing responsibilities in addition to performing their respective portfolio management duties.
However, other instances where the institutional investment management firm’s organizational chart does not
include a sales and marketing department are ones in which the firm is a wholly owned subsidiary of a mutual fund
or life insurance company. In these two situations, it is fairly common for the sales and marketing resources that are
responsible for the distribution of the institutional investment management firm’s funds to be part of the parent
company’s sales and marketing department.

FRONT, MIDDLE, AND BACK OFFICES

In an institutional investment management firm, the subgroups of the departments depicted in Figure 4.4 are
usually consolidated. This consolidation occurs in three organizational groups expressed as the front, middle, and
back offices, as shown in Figure 4.5.

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Figure 4.5 | An Institutional Investment Management Firm’s Front, Middle, and Back Offices

President

Trade
Investment Marketing Compliance Accounting
Settlement

Legal
Legend:
Front Office
Middle Office
Audit Back Office

The front office usually includes all staff functions pertaining directly to the firm’s portfolio management activities.
Accordingly, all portfolio management, analyst and trading staff would be part of the front office. Sales and
marketing staff are often also included in the front office. The middle office provides functions that are critical to
the efficient operation of the entire firm. The types of duties middle office staff perform have to do with compliance,
accounting, audits and legalities. They are responsible for ensuring that the firm’s products and services are
designed and delivered in accordance with industry best practices and pertinent regulations. Finally, the back office
generally involves those functions related to the efficient settlement of all of the firm’s security transactions. The
responsibilities, objectives and best practices of the employees in each of these categories will be further explored in
Chapter 5.

Exhibit 4.1 | Separation of Duties Principle

The separation of duties principle is incorporated into an organizational structure to minimize the potential for
employee self-dealing via collusion with another individual in the firm. Ideally, this principle should be incorporated
into the design of all organizations, and institutional investment management firms are no exception.
For example, investment fund accounting and performance measurement should not be done by any of the
portfolio managers or their staff who are executing trades on a fund’s behalf, or by the back office staff who are
responsible for ensuring that trades settle properly. This is why fund accounting activities are part of the middle
office and are not performed by, nor reported to, front or back office staff.
Similarly, portfolio performance measurement should be performed by middle office staff, not front office staff.
Independence between portfolio management and middle office staff in calculating portfolio rates of return is an
example of where a separation of duties is critical.
Most institutional investors actually take this principle even one step further. They receive portfolio holdings and
return information from their institutional investment manager and compare it to the security holdings and rates
of return information provided by their third-party custodian. In this case, the institutional investor is not relying on
portfolio holdings or rates of return information from any one organization, but is comparing the information from
two independent third-party service providers — its institutional investment management firm and its custodian.
This step provides another way of verifying the accuracy of the records.

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ULTIMATE DESIGNATED PERSON AND CHIEF COMPLIANCE OFFICER

Figure 4.6 also provides a typical organizational chart for an institutional investment management firm, but this
time it displays the reporting responsibilities of each individual role.

Figure 4.6 | An Institutional Investment Management Firm’s Reporting Structure

President
(UDP)

Chief Investment Chief Compliance Head of Head of Head of

Officer (CIO) Officer (CCO) Marketing Legal/Audit Administration

UDP: Ultimate designated person

CCO: Chief compliance officer

Notes: 1. UDP and CCO must be registered in this specific company.

2. Only one UDP and CCO are allowed per exempt market dealer.
3. UDP and CCO designations can be held by the same person.

It is important to note that from a regulatory perspective, there are two specific positions of critical importance:
1. The ultimate designated person (UDP)
2. The chief compliance officer (CCO)

The ultimate designated person (UDP) is responsible to the self-regulatory organizations for the firm’s conduct
and the supervision of its employees. The chief compliance officer (CCO) is responsible for designing and
implementing a supervision system that will provide the firm’s board of directors with reasonable assurance that
compliance standards are being met.
Securities regulators specifically define the roles and responsibilities for UDPs and CCOs. Both of these positions are
named, meaning that all exempt market dealers (EMDs) must register a specific qualified individual for each of these
positions in order to apply for and maintain an EMD registration.
Although it is considered a best practice — and consistent with the separation of duties principle — that different
individuals should hold these two positions, it is possible that they be held concurrently by the same individual. This
would be acceptable in the case of very small institutional investment management firms, but would be frowned
upon for medium-sized and large firms.

INVESTOR TYPES
In designing a firm’s structure and staffing requirements, a portfolio manager needs to consider the types of clients
or investors the firm is planning to service. Catering to different types of investors requires different skills, both at
the initial marketing stage and later at the client support stage.
Institutional investment management firms must incorporate these different investor needs and ensure they
have the proper resources to effectively grow and accommodate different investor types. There are two types of
investors: non-exempt and exempt. Non-exempt investors, such as mutual fund investors, are individuals (retail).
Exempt investors may be either institutions or individuals.

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NON-EXEMPT INVESTORS
Small individual retail investors are commonly referred to as non-exempt investors. Non-exempt refers to the
fact that investment dealers must sell securities to these investors via a prospectus, which discloses a fund’s full
information, including its background and essential data about its securities.

EXAMPLE
A prospectus is prepared when XYZ Mutual Funds would like to add a new Canadian equity mutual fund to its
family of mutual funds.

According to securities regulations, these types of distributions to non-exempt investors can only be made by
appropriately licensed staff employed by registered investment dealers. As noted earlier, an investment dealer is
required to determine the suitability of an investment for each investor. The dealer must undertake a Know Your
Client analysis to help protect small individual retail investors by ensuring that recommended investments are
deemed appropriate for each individual investor.
Although all mutual funds sold in Canada must have an investment advisor registered as a portfolio manager, a
portfolio manager/EMD is not permitted to market or distribute a mutual fund. A mutual fund’s distribution is only
done by an investment advisor with an appropriate licence to sell mutual funds to retail investors.

EXEMPT INVESTORS
Securities regulators do permit the sale of securities without a prospectus, but only under certain conditions and to
investors who meet certain qualifications, known as exempt investors. This is commonly referred to as an exempt
distribution into the exempt market. The exempt market is comprised of both institutional and individual investors.
Securities regulators allow the following three common prospectus exemptions:

• Accredited investor exemption

• Minimum investment exemption
• Offering memorandum exemption

INVESTOR-FIRM INTERACTION
The interaction between investors and institutional investment management firms varies depending primarily on
the type of investor and on the amount of assets the firm is managing on a particular client’s behalf.
In the case of very small institutional investment management firms, most, if not all, of the firm’s portfolio
managers will be responsible for servicing its current investors. These firms attempt to match certain investors
with particular portfolio managers, so that the manager can build a rapport with an investor and strengthen their
relationship over time.
In medium- to large-sized institutional investment management firms, a dedicated marketing and client service
staff is often established and resourced in order to provide most or even all of the investor servicing support.
Assuming the client service staff have the appropriate skills and abilities, as well as good internal interaction and
communication with the portfolio management staff, then the majority of written and in-person communications
with investors can be performed by senior members of the client service staff.

MUTUAL FUND INVESTORS

When an institutional investment management firm acts as an advisor (or a sub-advisor) to a mutual fund, there
is only limited communication with the mutual fund’s investors. Typically, a mutual fund’s institutional investment
manager (or portfolio manager) will participate and present at roadshows sponsored by the fund’s manager when
they are launching new mutual funds. The manager uses these presentations to introduce to distributors the

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individual portfolio managers who will be managing the new funds. Normally, these roadshows are not open to the
general public and attendance is by invitation only and restricted to those individuals who are licensed to distribute
mutual funds.
It is standard for a mutual fund’s portfolio manager to prepare written quarterly reports for investors. These reports
contain information regarding a specific fund’s periodic rate of return and a short analysis of its performance
relative to its performance benchmark, as well as a brief summary of the investment manager’s outlook for capital
markets and the fund’s positioning relative to that outlook. Beyond this, there is very limited communication
between a mutual fund’s portfolio manager and its investors.
Typically, a mutual fund’s portfolio manager does not communicate directly with its investors — only through the
fund’s manager. All written communications with a mutual fund’s investors come from its manager, rather than
from its portfolio manager. The fund’s manager is licensed to distribute the mutual fund and is therefore the primary
contact with its investors.

INSTITUTIONAL INVESTORS
Institutional investors usually include specific client service requirements when they enter into an investment
management agreement with an institutional investment management firm. Typically, an agreement states that the
manager will prepare detailed portfolio performance reviews and distribute them to its institutional investors on a
quarterly basis. The portfolio manager is typically asked to attend and present an investment management report at
the institutional investor’s quarterly investment committee meetings, where they explain the investment strategy’s
performance during the previous quarter, their outlook for capital markets, the overall investment strategy and
the portfolio’s positioning for upcoming quarters. The client’s investment committee members also take this
opportunity to ask the portfolio manager questions.
If the relationship is relatively new, the investment manager might be expected to present every quarter for the
first year or so. After the first year, assuming the portfolio’s performance is acceptable and within expectations,
and there are no servicing issues, the portfolio manager would likely be requested to present to the investment
committee less frequently, perhaps on a semi-annual or even annual basis.
Most institutional investors require that an institutional investment manager provide them with a monthly
statement of portfolio holdings, security transactions and rates of return. Institutional investors use these monthly
reports to prepare intra-quarterly reports for their management personnel.

HIGH-NET-WORTH INVESTORS
High-net-worth clients usually meet with their investment managers in person on a semi-annual or annual basis.
The frequency of these meetings is primarily influenced by the size of a client’s portfolio with the institutional
investment manager. High-net-worth clients normally receive portfolio management reports and portfolio holdings
reports on a quarterly or semi-annual basis.

SERVICE CHANNELS
Institutional investment management firms offer their services through different channels that are tailored to the
needs of different investors. Business convention and the unique features associated with each type of channel
are the primary motives for deciding which particular channel to use. An investment strategy does not generally
influence the choice of product structure. Some investment managers will offer the identical investment program
and strategy through multiple channels. Figure 4.7 depicts the relationship between the institutional investment
manager, the client type and the standard investment channel used in each case.

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Figure 4.7 | Product Structures by Client Type

Institutional Investment Manager

(Portfolio Manager/EMD)

Institutional Investor Mutual Fund Individual

(non-mutual fund) Sponsor Investor

Exempt/Accredited Investment Sub-Advisory Exempt/Accredited

Institutional Investor Capacity Individual Investor
(Pooled Fund) (Open-Ended Trust with (Pooled Fund)
(Segregated Account) Prospectus) (Segregated Account)
(Limited Partnership) (Limited Partnership)

Whatever channel is used, it is an industry best practice to have a written investment management agreement
between the institutional investment management firm and the investor. An investment management agreement
documents all aspects of the services the institutional investment management firm will provide and its relationship
with the investor.
In Canada, institutional investment managers offer their services by way of four main channels, as follows:

• Pooled funds
• Segregated/managed accounts
• Limited partnerships
• Sub-advisory capacity

POOLED FUNDS
In terms of assets under management, pooled funds are the largest of the four main product structures that
Canadian institutional investment managers use. A pooled fund is an open-ended trust in which investors
contribute funds that an institutional investment manager then invests or manages. A pooled fund operates like
a mutual fund, but under securities law, it is not required to have a prospectus. Trust companies, investment
management firms, insurance companies and other organizations offer pooled funds. They are legally separate
entities from investment management firms.
Small to medium-sized institutional investors and also high-net-worth individuals who can satisfy the minimum
investment criteria often prefer pooled funds. Virtually all Canadian institutional investment managers that cater to
institutional investors offer pooled funds.
For administrative ease, institutional investment managers prefer to limit the number of pooled funds they offer
and manage. A typical Canadian institutional investment management firm might offer as few as three pooled
funds. One pool would typically offer the firm’s equity mandate, a second pool would offer its fixed income
mandate and the third pool would offer its balanced fund mandate. To make operations even simpler, the third
pooled fund (balanced mandate) often only holds a fixed percentage of its value in units of the other two pools —
the equity pooled fund and the fixed income pooled fund. Changing the balanced fund’s asset mix weighting can be
done very easily by simply selling units in the overweighted pool and buying an equivalent amount of units in the
underweighted pool.

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From an administrative perspective, pooled funds are simple to operate since all of its security holdings are held
in and all of its security transactions are settled in one fund or trust. The other key administrative responsibility is
unitholder record-keeping, which keeps a record of each institutional investor’s respective proportional interest in
the pooled fund trust.

SEGREGATED/MANAGED ACCOUNTS
A segregated account is essentially an investment account that is owned by an institutional investor and managed
by a third-party portfolio manager. This is in contrast to mutual funds, wherein an investor’s assets are commingled
with the assets of other investors. It is important to note that for individual investors, this product structure is called
a managed account.
Both institutional and high-net-worth investors use segregated accounts. They generally have lower administrative
fees than pooled funds.
Investors prefer segregated account structures over pooled fund structures for two primary reasons, as follows:

• First, for safety reasons, certain investors stipulate that their assets remain with the custodian of their choice.
When investing in pooled funds, an investor’s money is transferred from their current custodian or banking
institution to either the institutional investment manager itself or to the custodian of the pooled fund. In either
case, the investor’s money is leaving the control of the institution where their assets are presently maintained.

• Second, segregated accounts are the preferred investment vehicle for personalized investment portfolios
tailored to an investor’s specific needs.
A segregated account is often a feasible solution in a situation where an investor wants to use the institutional
investment manager, but is unable to accept the current investment guidelines and restrictions applying to the
manager’s pooled funds.

LIMITED PARTNERSHIPS
Institutional investment managers often use limited partnerships (LPs) as product offerings. They are also
commonly offered to individual investors. An LP is a common form of business organization, with one or more
general partners who manage the business and assume legal debts and obligations, and one or more limited
partners who are liable only to the extent of their investment. Though unit trusts and LPs employ the same
investment strategy, the latter offer features, such as tax-loss selling to reduce a specific client’s tax liabilities, that
both institutional and individual investors prefer over the features of a unit trust. In particular, some investors place
high value on the limited liability aspect afforded to them when they make investments as a limited partner. For
certain investors, an LP investment may also offer tax-related advantages over a unit trust investment.
LPs have been used for well over 100 years in the institutional and high-net-worth investor markets, but they
constitute a relatively small proportion of the product structures used. They are used more extensively in the hedge
fund and alternative investment marketplace.

SUB-ADVISORY CAPACITY
The vast majority of mutual funds are structured as open-ended unit trusts, with a very small number structured
as corporations. In the case of a Canadian mutual fund, through an investment management services agreement
with the mutual fund manager, the portfolio manager delivers specific investment management services to the
mutual fund. The portfolio manager is not responsible for, or involved in, other duties related to the mutual fund’s
operation, such as marketing or performance measurement.

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INVESTMENT MANDATES
It is important for a portfolio manager to understand what impact the type and range of investment mandates
offered can have on a firm’s structure and operations. The structural and operational aspects of an institutional
investment management firm can change, often substantially, when foreign market investment mandates or new
product structures, such as hedge funds, are added to its product offerings.
It is often quite easy for an institutional investment management firm to underestimate the additional operational
requirements and risks associated with investing outside of national borders. This section looks at the major
investment mandate considerations that Canadian institutional investment management firms face, and discusses
the unique structural and operational adjustments that are an integral part of these new investment mandates.

DOMESTIC SINGLE-SECTOR MANDATES AND BALANCED FUNDS

Domestic investment mandates, including money market, fixed income, equities and balanced funds, constitute the
basic investment product platform for the majority of Canadian institutional investment management firms. Most
medium-sized and large firms organize their portfolio managers in alignment with the primary market for which
they are responsible.
For a number of institutional investment management firms, balanced fund mandates are becoming increasingly
popular and presently constitute a significant portion of their total assets under management. The fixed income and
equity portions of a firm’s balanced fund products are managed by their respective departments. The decision as to
what proportion of a balanced fund’s assets is invested in fixed income versus equities is usually determined by a
firm’s asset mix committee, which meets on a scheduled basis throughout the year (normally quarterly) to review
and adjust the target weighting for the two primary asset classes. The asset mix committee is usually made up of
the following individuals:

• Chief investment officer (Chair)

• Head of fixed income
• Head of equities
• Chief economist

SPECIALTY- OR SECTOR-FOCUSED MANDATES

The second most popular type of investment mandate is usually referred to as the specialty- or sector-focused
mandate. However, when measured in terms of assets under management, this mandate is a distant second to the
single-sector mandate discussed above. Most institutional investment management firms do not offer these types
of specialty funds, so that they can remain focused on their single-sector and balanced mandates. In addition, many
firms believe the potential market opportunity is not big enough for them to commit additional resources to fund
specialty mandates.
When offered, the specialty and sector-focused mandates tend to be managed by a mutual fund company’s internal
investment management department. There are only a very small number of institutional investment management
firms that have built their entire business platform around only managing specialty or sector-focused mandates.
The largest share of assets in the specialty and sector arena belong to industry-focused funds. Over time, the
number of specialty funds has proliferated as certain industries or economic sectors have gained prominence in
the economy.

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EXAMPLE
During the past 15 years, there has been significant growth in the number of mutual funds that have single
sector–focused mandates based on industries such as biotechnology, the Internet, real estate (and real estate
investment trusts), agriculture and alternative energy sources, just to name a few.

These particular types of investment fund mandates are popular, primarily with individual investors. Medium- to
large-sized institutional investors tend not to invest in specialty or sector-focused investment funds.
Rightly or otherwise, sector-focused funds are often considered as flavour of the week-type mandates. Many
mutual fund managers have a collection of specialty-focused funds that had a brief moment of interest and
investor enthusiasm, only to eventually see investor cash inflows grind to a halt when the particular sector began
to underperform. In the mutual fund industry, these portfolios are often referred to as legacy products. However,
this part of the institutional investment management industry is unquestionably dynamic and will likely continue
to grow.
As most of these mandates are equity market–based, the primary operational change involves hiring portfolio
management staff to manage these particular mandates. Of course, this decision is based on the amount of assets
under management that an institutional investment management firm believes it can accumulate over time. All
other operational aspects are identical to single-sector mandates.

DID YOU KNOW?

Responsible Investment
Responsible investment (RI) refers to the incorporation of environmental, social and governance (ESG)
factors into the selection and management of investments. There is growing evidence that incorporating
ESG factors into investment decisions can reduce risk and improve long-term financial returns. ESG issues
are also some of the most important drivers of change in the world today. And these are not just societal
issues; they are critical economic issues with significant implications for businesses and investors. In recent
years, RI has come to encompass ethical investing, socially responsible investing, sustainable investing,
green investing, community investing, mission-based investing and more recently impact investing. They
are all components of RI and have played a part in its history and evolution.
While RI fund offerings originally began with mutual funds, their structure and type have expanded to
include, for example, exchange-traded funds (ETFs) and pooled products.

STYLE-FOCUSED MANDATES
Although all institutional investment managers have unique investment skills and capabilities, they tend to
categorize their investment strategy as falling into one of the following five popular styles:
1. Growth
2. Value
3. Growth at a reasonable price (GARP)
4. Momentum (or sector rotation)
5. Technically based

Institutional investment management firms use investment strategy styles to describe (and differentiate) their
approach to security selection and other investment decisions. Firms are very careful in terms of communicating
which investment strategy style they use. They will endeavour to approach all of their various investment
mandates by using the same style, with only very little modification, depending on the specific mandate.

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They want to be careful to send only one marketing message to current and potential investors. Firms also tend
to stick with one style over time, since the decision to change investment management styles is often met with
scepticism by investors.
None of these style mandates requires any specific changes to the firm’s structure or operations from the
single-sector or balanced mandates.

PASSIVE INVESTMENT MANAGEMENT

The annual growth rate of assets under management for passive investment products has surpassed that of actively
managed products. There appears to be no slowdown in this trend as more and more individual and institutional
investors either allocate fresh investable cash or sell actively managed products and invest the proceeds in passively
managed investment products.
Most North American mutual fund companies have launched internally managed passive investment products,
index funds and/or ETFs as a defensive business strategy to help prevent the continued redemption and loss of
valuable long-term investor assets to passively managed investment products offered by competitors.
Most analysts conclude that two factors are primarily responsible for this huge shift in investor attitude. The first
factor is investor experience with mutual funds over the past 30 years and the realization that only very few actively
managed funds can outperform the market over the medium to long term. The second factor are the numerous
inherent structural advantages that ETFs have compared to mutual funds.
From a business perspective, one major drawback with passive investment products is that they cannot be
patented and are very easily replicated. Passive fund managers are continuously refining their investment products,
since they rely heavily on both low management fees and fund costs, as well as low tracking errors, to attract new
investor funds.

ALTERNATIVE INVESTMENTS
Alternative investments generally refer to non-traditional funds, such as hedge funds, private equity, venture
capital, real estate, infrastructure funds, LPs and leveraged buyout (LBO) funds. While based on standard
investment management skills, these types of investment mandates usually require other investment management
skills and administrative processes that are not part of traditional long-only investment strategies, which invest
in publicly traded stocks, bonds and money market instruments. Alternative investments are discussed further in
Chapter 11.
Depending on the particular alternative investment strategy, the following additional investment management
skills and processes are required:

• Short sales of publicly traded securities

• Security borrowing and financing
• Leveraging and the use of derivatives
• Negotiating private placement investments
• Pricing and valuing non-marketable securities

To be effective, the entire institutional investment management firm must be properly resourced to be able to
manage alternative investment mandates. Appropriate staff and systems must be in place prior to managing these
types of mandates. Compared to a firm that invests long-only, quite a number of major operational changes would
need to be made.

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First, legal and accounting services must be available in order to assist portfolio managers in assessing and
negotiating private placements. No two private placements have the same offering memorandum and associated
documentation, and it is a portfolio manager’s responsibility to ensure that an investment’s terms and conditions
are clearly understood and valued correctly. Often, these agreements are sufficiently sophisticated that managers
use legal and accounting counsel to prepare and interpret them.
Second, executing and accounting for short sales of public securities is somewhat different from only buying
securities (long) and then selling them later for cash. Short sales of securities also require adherence to securities
laws and stock exchange rules that, of course, do not apply when purchasing the same securities.
Third, administration staff must be properly trained in all aspects of securities borrowing and financing. Margin
calculations are performed daily and margin calls are a common occurrence. Short sales involve many market
conventions and practices that are not part of long-only investing, and administrative staff must be very familiar
with them.
Fourth, the valuation of non-marketable or publicly traded securities must be performed in an extremely rigorous
and documented process. Portfolio management theory suggests that investments in illiquid and non-marketable
securities can add benefits to an overall portfolio. However, investing in these types of securities brings along
the risk associated with pricing or valuing these investments. A number of firms in the alternative investment
marketplace have encountered serious problems by not being able to properly value their investments in these
types of securities. An institutional investment management firm that manages these types of investments must
be extremely diligent in ensuring that robust models or procedures are in place to obtain realistic pricing for their
non-marketable securities.

GLOBAL MANDATES
It is a major step for a domestically focused Canadian institutional investment management firm to decide to invest
globally, and it potentially involves a significant number of changes to the firm’s structure and operations.
Normally, only larger institutional investment management firms undertake global investing. This is the case
because of the sizable investment in resources a firm needs to make to be able to properly invest outside of their
domestic capital markets. Due to time zone differences and the relatively few internationally experienced portfolio
management personnel in the domestic market, many domestic firms decide to establish a physical presence in the
geographic areas of the global markets in which they intend to invest.

EXAMPLE
A Canadian-based institutional investment management firm with its head office and investment management
team located in Canada would likely decide to establish a permanent portfolio management team in London or
Paris when investing in European markets, and a similar operation in Tokyo when investing in Far East markets.

When a firm decides to expand into global mandates, it essentially needs to be rebuilt in each and every market it
plans to invest in. Operations and reporting structures become larger and definitely more complicated. The firm
must ensure that all of the best practices and procedures it employs in its domestic markets are transposed into
its foreign operations. It is extremely important that all of these practices and procedures also incorporate the
regulations and institutional investment management practices in those foreign markets.

OFFSHORE INVESTMENTS
Some institutional investment management firms offer investment funds and products that are registered
(or unregistered) in jurisdictions outside of Canada. These products tend to be offered and managed by firms
involved in the areas of LPs and hedge funds.

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There are two primary areas of structure and operations that an institutional investment management firm must
modify when offering offshore-based investment funds.
First, additional legal and tax counsel support is required to prepare the fund or investment product’s offering
documents, as well as to register the investment fund or structure in the offshore jurisdiction. Some of the larger
legal and accounting firms with capabilities in both the domestic market and the contemplated offshore locations
are involved when creating and registering these types of investment funds. Alternatively, some institutional
investment management firms will hire appropriate counsel in the domestic market and then hire different counsel
in the foreign jurisdiction. In addition, offshore-based funds can involve substantial tax risk and any firm that offers
them must address this risk appropriately.
Second, from an operational point of view, a domestic firm must make appropriate arrangements to ensure that
proper custody, safekeeping, security settlement and fund unitholder services are arranged for the offshore fund.
Domestic institutional investment management firms that offer offshore investment products normally acquire
these services from a suitable firm located in the offshore jurisdiction. In those particular offshore jurisdictions
where foreign investment via offshore investment vehicles are popular, a number of banks and related financial
institutions resident in the offshore jurisdiction have created turnkey service packages that deliver all of the
appropriate administrative services normally required by offshore funds.
Canadian-based institutional investment management firms that offer these types of offshore funds must, of
course, also make changes to their Canadian operations to ensure that all of the services the third-party offshore
affiliate provides are performed appropriately.

ROLES AND RESPONSIBILITIES OF INSTITUTIONAL INVESTMENT

MANAGERS
The registrations for a portfolio manager-advising representative and a portfolio manager-associate advising
representative are granted to the individuals employed by an institutional investment management firm who
are responsible for managing investors’ funds and operating the firm. As noted earlier, individuals who apply for
a portfolio manager-advising representative or portfolio manager-associate advising representative licence must
meet certain education and investment experience qualifications. An individual with a portfolio manager-advising
representative or portfolio manager-associate advising representative licence is usually able to retain and transfer
this licence when changing employment from one institutional investment management firm to another.
Meanwhile, the institutional investment management firm is the corporate entity that employs the portfolio
manager-advising representatives and portfolio manager-associate advising representatives, and offers the skills
and capabilities of its staff to appropriate investors. The institutional investment management firm is the legal
entity that offers the investment products and related services.

ADVISORY VERSUS SUB-ADVISORY RELATIONSHIP

By regulation, all investment funds must be managed by one — and only one — investment manager, who is
required to be registered as a portfolio manager. This particular investment manager is ultimately responsible for
the management of the fund and all of its assets. All of the fund’s offering documents must include the name of the
investment advisor who is managing the fund.
However, sometimes the firm managing an investment fund will make use of additional investment advisors when
it believes their expertise would be appropriate and beneficial. These advisors contract with and report to the fund’s
named investment advisor, and are referred to as sub-advisors. The fund’s named investment advisor assumes
responsibility for all of the sub-advisors’ actions. In addition, any failure of a sub-advisor to operate at the same
standard as the fund’s investment advisor is viewed by the regulators as the failure of the fund’s investment advisor
to fulfill their roles and responsibilities to the fund.

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Accordingly, the fund’s investment advisor must undertake a detailed due diligence review of all potential sub-
advisors before entering into a sub-advisory investment management agreement. A sub-advisor, although usually
only responsible for a portion of the fund’s assets, must conduct their portfolio management and business affairs at
the same level of standard as the fund’s investment advisor.
Figure 4.8 depicts the standard relationship between an investor, an investment product or fund, an investment
advisor to the fund and any sub-advisors hired by the investment advisor.

Figure 4.8 | Advisory Versus Sub-Advisory Relationship

Mutual Fund (2) Pooled Fund (3)

Fund Fund

Fund Manager EMD

Advisor (Portfolio Manager) (1) Advisor (Portfolio Manager) (1)

Sub-advisor Sub-advisor Sub-advisor Sub-advisor Sub-advisor Sub-advisor

Notes: 1. Each fund has only one advisor, but can have any number of sub-advisors.
2. Mutual fund: The fund is usually a trust, but a corporation may also be used.
3. Pooled fund: The fund is usually an LP if the EMD is offering the fund. The fund is often a trust and is a segregated account.

MANAGEMENT STRUCTURE OF CANADIAN MUTUAL FUNDS

The creation, management and distribution of investment funds in Canada involve a number of different parties.
Each of these parties brings unique skills and processes that, when carefully selected and properly combined, can
contribute to a well-structured and functioning investment fund.
For instance, it is useful to consider the various relationships involved in managing and distributing a Canadian
mutual fund. A mutual fund structure is a good example, since it involves all of the services that could be required
by virtually any other type of investment fund vehicle offered in Canada. Figure 4.9 depicts the relationships
between the various parties involved in the management of a Canadian mutual fund.

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Figure 4.9 | Management Structure of Canadian Mutual Funds

Investor

Trustee Mutual Fund Trust Principal Distributor

Portfolio Advisor Fund Manager Custodian

Independent Review
Registrar Auditor
Committee

The primary roles and responsibilities of each separate entity depicted in Figure 4.9 are discussed below.

FUND MANAGER
The fund manager is a mutual fund’s creator and sponsor. Its primary role and responsibility is to provide, or
arrange to provide, for the day-to-day administration of all aspects of a mutual fund’s operations. As with all parties
included in a mutual fund’s management, the fund manager is a corporate entity.
The mutual fund manager is normally the holding company or is nearest to the highest-level company in
the corporate structure, which is certainly the case with mutual funds that are managed by major banks and
independent mutual fund companies in Canada. This has the additional benefit of helping to build the manager’s
brand name and its association with the success of the mutual fund venture.
The fund manager’s primary responsibilities are as follows:

• Preparing and filing the mutual fund prospectus and all related regulatory and legal documents.
• Ensuring that all of its service providers exercise due diligence in creating, managing and distributing the
mutual fund.
• Negotiating appropriate service contracts with all of the mutual fund’s service providers.
• Ensuring that all service providers conduct their activities and affairs according to regulatory, legal and mutual
fund industry best practices.

PRINCIPAL DISTRIBUTOR
The principal distributor is responsible for a mutual fund’s marketing and distribution. It is usually a wholly
owned subsidiary of the entity registered as the mutual fund’s manager. In the case of mutual funds, the principal
distributor must be registered as a mutual fund dealer.

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The principal distributor’s primary responsibilities are as follows:

• Preparing all marketing and distribution materials related to the distribution of mutual funds. As a key part
of this particular responsibility, it must ensure that all marketing and sales activities are conducted in strict
accordance with both regulatory requirements and mutual fund industry best practices. It must also ensure that
all third-party firms and their staff who are involved in distributing the mutual funds are properly registered to
sell and distribute mutual funds.
• Negotiating and securing appropriate sales and distribution contracts between the mutual fund manager and
the various third-party distributors it plans to use.

TRUSTEE
A mutual fund’s assets are normally held in a trust. The trustee holds the title to the property (the cash and
securities) of a mutual fund (trust) on behalf of its unitholders. The trustee operates under the terms described in
the mutual fund’s declaration of trust. In the case of a large Canadian bank that offers mutual funds, the trustee is
often a wholly owned subsidiary of the bank that specializes in offering trust services. Alternatively, in the case of an
independent mutual fund company, the trustee is usually a third party, such as a trust company, that specializes in
offering these services to mutual funds.
The trustee’s primary roles and responsibilities are as follows:

• It is the legal owner of the trust assets and must maintain clear and continuous title/ownership of the mutual
fund’s assets.
• It must operate under the terms of the mutual fund’s declaration of trust, and exercise that authority for the
sole interest of beneficiaries, who in this case are the mutual fund’s unitholders.

CUSTODIAN
The custodian of a mutual fund holds all of the fund’s cash and securities, and ensures that those particular assets
are kept separate from any other cash and securities that it might be holding. Generally speaking, the custodian
functions as the safe keeper for the mutual fund’s assets.
The custodian’s primary roles and responsibilities are as follows:

• To maintain complete and continuous physical control over all of the mutual fund’s assets (safekeeping role).
• To provide for the proper settlement of all of the fund’s security transactions (security settlement role).

REGISTRAR
The registrar of a mutual fund keeps a current register of the individual owners of each unit of the fund. They receive
information on a daily basis from the principal distributor, including the investor’s name and other particulars, along
with the number of the fund’s units that this particular investor has purchased or sold, as well as their holdings at
the close of each business day.

AUDITOR
The auditor of a mutual fund audits the fund’s annual financial statements and provides an opinion as to whether
they are fairly presented in accordance with accounting standards.

INDEPENDENT REVIEW COMMITTEE

All Canadian mutual funds require an independent review committee, which reviews conflict of interest matters
referred to it by the fund manager and provides a recommendation, or, where required, an approval to the manager
relating to such matters. The members of the independent review committee are appointed by the fund manager.
None of the committee’s members can be an employee, director or officer of the manager; or an associate or

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affiliate of the manager; or, to the knowledge of the manager, an associate or affiliate of a portfolio sub-advisor.
Independent review committees are created in accordance with NI 81-107; Independent Review Committee for
Investment Funds.
In the normal course of business, the independent review committee reports to the fund manager. The committee
works closely with the fund manager and receives routine reports and information from the manager that allow
them to perform their duties.
The independent review committee’s primary purpose is to ensure that conflict of interest situations that may
develop when managing the mutual fund are addressed in an appropriate manner.

PORTFOLIO ADVISOR
The portfolio advisor provides, or arranges to provide, investment advice and portfolio management services to a
mutual fund. They are an institutional investment manager with the required regulatory licences.
The portfolio advisor performs a number of duties as outlined in their investment management agreement with the
fund manager, including the following:

• Assisting the fund manager in developing appropriate investment objectives and guidelines for each mutual
fund mandate.
• Providing for the effective daily portfolio management of each mutual fund in accordance with the investment
guidelines and restrictions for each mutual fund mandate.
• Providing the fund manager with timely reports on investment strategy and periodic returns for each
mutual fund.
• Supporting the fund’s distribution and client service by attending and presenting at various meetings with the
fund’s distributors and registered staff.

PORTFOLIO MANAGER’S ROLES AND RESPONSIBILITIES AS

A GENERAL PARTNER
As discussed earlier, an LP is often used as a fund structure. In this particular arrangement, the institutional
investment manager serves as the general partner to the LP. In this structure, each individual investor is a separate
limited partner.
As a general partner, the institutional investment manager has a fiduciary duty to the limited partners and must
always act in their best interests. The general partner not only provides direct investment advisory services to
the LP’s portfolio, but must also provide, or arrange to provide, all other services required to support the proper
functioning of an LP, including third-party services, such as custody/safekeeping, auditing, legal assistance and
partnership accounting.

INVESTMENT MANAGEMENT FEES

Investors may pay a number of different fees and expenses associated with the management of their
investment assets.
The type of fees and expenses investors pay depends on the type of investment product. In the case of Canadian
mutual funds, the following is a list of the typical fees and expenses that unitholders pay on an annual basis:

• Fund manager fees (often include sales and distribution-related expenses, such as trailer fees)
• Fund administrator (registrar) fees
• Fund custody and safekeeping fees

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• Fund legal and audit expenses

• Commissions and fees related to security transactions
• Investment management fees

As discussed earlier, and as evidenced by the length of the list above, a number of different services are required in
order to properly create, offer and manage an investment product or fund. Interestingly, most mutual fund investors
assume that the majority of the total fees they pay are for the services of the institutional investment manager who
is managing the fund. This assumption is certainly not accurate in most situations.

EXAMPLE
For a typical Canadian large-capitalization equity mutual fund, unitholders might pay somewhere in the range of
2% to 2.5% per year in fees. In this case, the investment management fee paid directly to the fund’s sponsor and
a manager (or portfolio manager) would typically be in the range of 40 basis points to 75 basis points. As such,
the institutional investment manager’s fee is only about 20% to 30% of the total fees and expenses charged to
the mutual fund’s unitholders.

Most of the fees charged to a mutual fund’s unitholders are paid to other third-party service providers and to the
fund’s distributors as trailer fees or commissions.
Although the fees paid to a fund’s institutional investment manager appear low, they can lead to substantial
profitability for the manager as the amount of assets under management grows, because of the fixed cost aspect
of institutional investment management. The costs and expenses of operating the institutional investment
management firm generally grow only marginally with the growth of assets under management, especially if they
are consolidated into a limited number of funds or portfolios managed by the institutional investment manager.
Investment management fees vary by the type of mandate for the fund, with money market mandates being
the lowest, followed by fixed income or bond mandates, then by large equity mandates (with the second most
expensive fees) and, finally, by small-capitalization or sector-specific equity mandates, which have the highest
investment management fees of all.
Table 4.2 provides a range of typical investment management fees charged for four standard mandates that are
invested in the Canadian financial markets.

Table 4.2 | Typical Investment Management Fees

Mandate Typical Range of Investment Management Fees

(Domestic Markets) (bps/year)
Money market 20 to 30
Fixed income 35 to 50
Equity — large capitalization 40 to 75
Equity — small capitalization and specialty 65 to 100+

As mentioned earlier, global investment mandates are becoming more popular with investors and are experiencing
growth, primarily in equity markets, with a smaller allocation going to global fixed income markets. Global
balanced fund mandates are also becoming more popular. Global investment mandates typically have much higher
investment management fees compared to the comparable asset class in the domestic Canadian market. As an
example, a large-capitalization global equity fund would typically have investment management fees starting in the
range of 100 basis points per year and often extending as high as 175 to 225 basis points per year.

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As the institutional investment marketplace has become more competitive, it is common for institutional
investment managers to negotiate a tiered investment management fee (in basis points) that declines as the size
of a fund increases. This is an acknowledgment by institutional investment managers that, as a fund grows, they
should share with investors or fund managers some of the economies of scale that are associated with direct
investment management activities.
A fund manager charges a mutual fund’s unitholders for all of the fees and expenses associated with the fund’s
operations, and then, in turn, disburses the fees to the fund’s various service providers, including the institutional
investment manager. When an institutional investment management firm is offering its services via a pooled
fund or limited product structure, it acts in a similar capacity as the manager of a mutual fund. The institutional
investment manager charges the pooled fund’s unitholders or limited partners — or both — the various fees and
expenses associated with the operation of the pooled fund or LP, in addition to its investment management fee.

PERFORMANCE-RELATED FEES
Up until the late 1990s, virtually all investment management fees were charged on the basis of the value of
the assets under management at current market prices. An institutional investment manager would increase
its investment management fees by increasing the investment portfolio’s value. This objective was attained by
accommodating strong capital market returns, resulting in higher prices for the securities, and also by successful
marketing efforts that brought more investors and their assets into a fund.
These types of asset-based fees comprise the vast majority of investment management fee agreements for
mutual funds, and also for most pooled funds and LPs. Asset-based investment management fees are the norm for
long-only investment mandates, and where a fund’s performance is usually compared to an appropriate peer survey
or market index return.
However, in general, asset-based fees are not the only fees charged in hedge fund or alternative investment
strategies. In these cases, an investment manager’s performance is measured on an absolute basis, versus the
relative basis that is commonly used in those investment strategies that can only invest long-only and are unable
to employ short sales or leveraging.
Hedge funds normally charge two types of investment management fees, as follows:

Asset-based fees This fee is called an investment management fee in the hedge fund industry. Hedge
fund management fees are in the range of 1.5% to 2% of assets under management.
However, for a hedge fund investment manager, the real attraction is the performance
fee it charges.

Performance fees A fixed percentage of the increase in a portfolio’s value over a certain period of time.
Hedge fund performance fees are typically set at 20% of the increase in a fund’s
value. Hedge funds marketers are quick to point out to potential investors that the
performance fee they charge is appropriate and beneficial, since it more closely aligns
the interests of the institutional investment manager with those of the hedge fund
investor. Hedge fund investors appear comfortable with this type of compensation
arrangement.

During the past decade, there has been some blurring of the compensation for long-only investment mandates,
versus those mandates that apply to hedge funds and other alternative strategies. Canadian mutual fund regulations
permit conventional mutual funds to engage in a limited amount of short selling within conventional mutual fund
portfolios. The short sale restrictions for conventional mutual funds are much more limited than the standard hedge
fund’s ability to make short sales. Short sales are not allowed to be more than 20% of a conventional mutual fund’s
net asset value.

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Exhibit 4.2 | The Keys to Success: Business Management and Portfolio Management Skills

When looking at them from the outside, and from a customer’s perspective, many types of businesses appear very
simple or straightforward. The same opinion or conclusion undoubtedly applies to the institutional investment
management industry. Many beginners to the industry also share this naive understanding, only to have their
eyes opened very quickly after a couple of days on the job with a new institutional investment management firm.
Although extremely important — and difficult to achieve over time — earning competitive rates of return on
portfolios is only one aspect of the numerous skills and abilities required in order to create, manage and grow a
successful institutional investment management firm.
Indeed, a lack of good business management skills is often the reason for the mediocre growth of institutional
investment management firms, and perhaps even their eventual failure. It is important to have a clear understanding
of all of the administrative and general business issues and decisions that are part of starting and operating a new
institutional investment management firm. At some point in the future, the failure to plan and implement effective
administrative procedures can and surely will come back to haunt the firm and its owners.
Some of the negative effects of operating an institutional investment management firm at below standard
administrative procedures are as follows:
1. An institutional investment management firm could fail an audit examination by the firm’s securities
regulator(s). Audit review letters from securities regulators articulate operational and other deficiencies
identified during the regulator’s routine on-site review of an institutional investment management firm.
2. A number of large institutional investors often conduct their own operational due diligence examinations
of the institutional investment managers they contemplate hiring. If they find something lacking in a firm’s
operational procedures, they may not hire the firm.
3. Problems arising from poorly designed or executed administrative processes often distract an investment
management firm’s senior management and portfolio managers, causing them to focus on those problems
rather than on portfolio performance or asset growth.
4. A history of operational or administrative weaknesses can escalate the premiums for a firm’s required business
insurance because of its higher risk profile assessment.
5. Finally, should the failure of administrative procedures result in a financial loss for any of an institutional
investment management firm’s investors, the firm could face civil litigation from its investors to recover
the loss caused by its substandard administrative procedures and business practices. There are two costs
associated with this particular situation: the potential damage payment resulting from an investor’s successful
litigation, and the potential loss of future institutional investors who decide not to consider the firm’s services
based on its litigation history.

INDUSTRY CHALLENGES
Portfolio managers should understand all of the major challenges facing the institutional investment management
industry today. This understanding will help them properly develop and execute business strategies to optimize their
firm’s results over time.
Chapter 3 discussed a number of the primary factors that contributed to the profound growth of the financial
services industry in general, and the investment management services sector in particular, over the past several
decades. Many of these factors, such as demographics (the Baby Boom generation); buoyant economic growth,
particularly in the developed world; and continuing technological advances that support the growth of an
information-intensive industry like investment management, are all still in place and will likely continue to promote
growth in this industry.

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However, although the total size of the investment pie continues to grow, the institutional investment management
industry faces a number of industry-wide challenges. Some of these challenges are not new and are likely to
linger. Other challenges are new to the scene and appear poised to become even more important in the future.
The purpose of this section is to discuss what these challenges are and how they affect institutional investment
management firms, as well as how various firms deal with them.

INVESTMENT PERFORMANCE
When asked what their number one challenge is, virtually every institutional investment management firm would
quickly say investment performance. For institutional investment managers, the key success factor remains their
ability to earn competitive rates of return for their investors over time. Institutional investment managers are
hired with the implicit expectation that they will be able to grow their investors’ wealth faster than competing
investment managers.
Usually, institutional investment managers place heavy emphasis on explaining their historic returns and the
advantages or uniqueness of their investment strategy in all marketing literature and during all presentations to
potential investors. The reality is that investment success over medium- and long-term horizons accrues to only
a very limited number of managers. Unfortunately, although a number of investment strategies may perform
well over short time horizons, very few of these same strategies provide competitive rates of return over longer
time periods.
Interestingly, the actual rate of return, which is most important to a client, is generally not the most important
performance number to an institutional investment manager. Institutional investment managers are very concerned
about their performance in relation to the appropriate market indexes and their peers’ performance. As indicated
in Chapter 3, a number of services exist that provide information about fund managers’ performances, ranking
them on the basis of relative performance, in order to aid both individual and institutional investors in assessing
institutional investment managers.

ACCESS TO SUITABLE DISTRIBUTION

As with most business enterprises, a limited number of factors primarily influence the degree of success a firm will
ultimately realize. To be financially successful, an institutional investment management firm must not only have
a sound investment strategy that delivers competitive rates of return over time, but it must also have assets to
manage. The ability to generate competitive rates of return alone will be of benefit to an institutional investment
management firm only to the extent that it has a sufficient amount of assets under management from which to
earn investment management fees, thereby sustaining itself and generating the capital needed to grow.
Many institutional investment management firms have strength and resources in the area of direct portfolio
management capabilities, but they might not have built their distribution capabilities. From time to time,
institutional investment management firms must decide whether they want to commit resources to grow their
distribution capabilities internally or acquire these capabilities by entering into business relationships with firms
that do have the desired strengths and capabilities. Institutional investment management firms deal with this issue
in three basic ways.

INVESTING IN RESOURCES
First, some firms have decided to invest in the resources to build an internal distribution team that can optimize
growth in their assets under management. This is the direction that a number of larger privately owned institutional
investment management firms in Canada have taken. These firms are closely held by the active managers of the
firm, and they prefer to have an internal distribution capability rather than enter into distribution agreements with
third-party firms.

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EXPANDING THE DISTRIBUTION NETWORK

Second, some institutional investment management firms have actively sought to expand their distribution
networks by entering into agreements with suitable third-party firms. This arrangement benefits institutional
investment managers by reducing the capital and resources needed to build a distribution resource similar to the
capabilities of their third-party partners. Another advantage is that the distribution capability becomes instantly
available upon executing the agreements, whereas it would take an extended period of time for a firm to build an
internal resource of similar capabilities.
These agreements also work to the benefit of third-party firms with the distribution capabilities, since they gain
access to a particular investment management strategy or product that might not be otherwise available in the
marketplace. Assuming an institutional investment manager’s products suit a third-party distributor’s clientele, they
now have the opportunity to realize additional sales and distribution fees and commissions. The major drawback to
this type of business arrangement is that neither party has effective control over the missing resource, whether it is
investment management skills or distribution capabilities.

PURSUING BOTH OPTIONS

Third, some institutional investment management firms decide to effectively pursue both options — expand their
internal distribution capabilities and enter into third-party distribution agreements with appropriate firms. In this
case, care is taken to ensure that the distribution resources — the internal and third-party ones — do not compete
head-to-head for the same potential clients.

EXAMPLE
This can apply to internal distribution staff that focus solely on distributing a firm’s products to institutional
investors, while a third-party distribution firm focuses solely on distributing products to high-net-worth investors,
or in the case of mutual funds, even individual retail investors.

INCREASED COMPLIANCE REQUIREMENTS

Over the past two decades, all sectors of the financial services industry, including investment management, have
committed additional resources to increasing the size and sophistication of their respective compliance-related
capabilities. Some of these improvements are the result of management decisions to operate their companies at
best practices standards, while others are the result of changes in regulatory requirements and CIRO standards.
These changes generally emanated from stock market volatility or well-publicized failures and shortcomings of
some financial services companies.
Compliance has been strengthened throughout these companies in various forms, including the following:

• More rigorous Know Your Client (KYC) processes and increased sales/marketing oversight
• Implementation of new IT software solutions that provide real-time monitoring of adherence to investment
guidelines
• Restrictions for managed client portfolios and investment funds

In aggregate, these new and additional compliance-related activities and processes generally lead to some
combination of the following three main benefits:

• Fewer issues arising from routine regulatory and self-regulatory organization compliance and supervisory audits
• Operating efficiency improvements arising from smoother business operations and fewer negative surprises for
senior management
• Increased level of client satisfaction and decreased risk of client complaints and litigation

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These compliance improvements can be extremely costly to implement, both in terms of upfront software costs
and higher post-implementation staffing expenses.
These compliance improvements undoubtedly lay the foundation for a better and stronger Canadian investment
management industry. Unfortunately, they come at a time when competitive pressures from direct competitors, as
well as new products, such as ETFs, are putting downward pressure on industry revenues.

INCREASING COMPETITION
Many competitors are entering the institutional investment management business because of the appeal of its
inherent economies of scale and relatively low capital requirements. It is a prime example of an industry which
is, qualifications aside, relatively easy to enter. Many institutional investment management firms can generate
extremely high levels of profitability, particularly if their investment results have been attractive and they have
realized good growth in their assets under management.
As discussed earlier, another contributing factor to increased competition is the profound growth in the number of
institutional investment management firms that offer a full range of services supporting the industry. These third-
party services are not only competing for the same clients as established firms, but they are also contributing to the
decline in the necessary capital costs to start an institutional investment management firm, since they do not have
to invest resources at the start-up phase to perform these activities themselves.
Of course, low barriers to entry have also contributed to downward pressure on investment management fees,
because these start-up investment management firms generally have very small capital costs to recover. Like many
businesses, new entrants can attempt to gain market share and accumulate assets under management by offering
investors investment management fees that are below the competition. Some parts of the investor marketplace are
more sensitive to investment management fees than others, which provides growth opportunities, particularly for
those investment management firms that are willing to provide their services at a discount.
In response to this competitive pressure, many established firms have resisted, within limits, from reducing their
investment management fee schedules. These firms are relying on their demonstrated strengths in the areas of
long-term portfolio performance and client service as a tool or argument to maintain their existing investment
management fee structure.
This downward pressure on investment management fees is likely to continue into the foreseeable future. Some
firms will experience more downward pressure than others, depending on the type of clients they are pursuing and
the pricing actions of their major competitors.

GLOBAL COMPETITORS
As with many sectors of today’s economy, the trend toward globalization is also firmly in place in the institutional
investment management industry. The unrelenting drive to accumulate more and more assets within the
global institutional investment management industry has led many firms to expand both their portfolio
management operations and their distribution activities beyond their home country. Significant improvements
in communications and technology, as well as the ongoing liberalization of capital markets, have provided a
tremendous boost to the growth of global competition in the investment management industry. Another major
factor causing the growth of global competition emanates from investors themselves. Many investors, both
individual and institutional, want to increase their amount of portfolio diversification and therefore have started to
invest a larger portion of their portfolio outside of their domestic capital markets.
Global competition is a threat on two basic levels. First, a domestically focused institutional investment manager
will see the potential growth rate for assets under management diminished as an increasing proportion of its
investors’ assets are managed by foreign-based global competitors. Second, by their global investment mandate,
foreign global competitors are required to invest a portion of their investors’ assets in the Canadian financial
markets. These firms contribute to the premium placed on high-performing portfolio managers, since the global

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competitors occasionally decide to hire competent institutional investment managers to assist them in their
Canadian operations, making it harder for all firms to attract and retain key employees (as discussed in the following
section). Some foreign global institutional investment managers have hired Canadian domestically focused
institutional investment managers on a sub-advisory basis in order to manage the Canadian portion of their global
mandate. Many of these relationships are not long-tenured and it is not clear whether more foreign institutional
money managers will take this route or go the direct route of hiring staff from domestically focused Canadian
institutional investment management firms.

HUMAN RESOURCES
The institutional investment management industry is not a bricks-and-mortar-type of undertaking. As noted above,
fixed capital requirements are very low. Staff skills and ability drive this industry.
The two primary skills that are coveted by the industry are the ability to generate competitive rates of return on
portfolios and the ability to market and accumulate assets from investors for a firm to manage. These skills are
very transportable from one investment management firm to another, and an employee’s success in either or both
of these two areas is very easy to quantify and readily communicated throughout the institutional investment
management community. Through marketing literature, trade journals and even the business press, it is very easy to
determine the success of the various institutional investment management firms. It is also easy to determine which
individuals in a particular firm are primarily responsible for a firm’s growth and success. This makes the human
resources aspect of institutional investment management very dynamic and competitive in nature.
Furthermore, investment management firms, even those with strong brand name recognition, can attribute a
significant portion of their success to the abilities of a handful of individuals who have demonstrated particularly
good investment management or marketing skills. Some firms have deliberately adopted the “star manager”
approach when marketing their firm to investors. Although this can often boost the firm’s growth rate in assets
under management in the short term, it also creates a risk for the firm if these individuals decide to leave the firm.
Compensation schemes also vary throughout the institutional investment management industry and can be a
decisive factor in obtaining and retaining key employees. The ability to offer equity in a firm is primarily available
to independent and privately owned institutional investment management firms, making it possible for them to
attract high-performing portfolio managers away from larger firms, such as banks, life insurance companies and
pension plans, which are unable to offer equity ownership. Since the loss of a key portfolio manager can be just as
detrimental to large firms as to smaller ones, it is important to structure attractive and competitive compensation
programs to not only attract but also retain productive portfolio management staff.

GROWTH OF PASSIVE INVESTMENT MANDATES

Passive investing was a very small portion of the institutional investment management market up until the mid-
1990s. However, since then, an ever-increasing proportion of investors, both individual and institutional, have
decided that, after incorporating fees, active investment management does not result in returns superior to those
generated by a passive investment style.
This shift away from active investment management strategies toward passive investment management strategies
is a threat to the industry for two primary reasons. First, it potentially diverts assets from the institutional
investment management firms that manage solely on an active basis. This diversion potentially impacts the entire
institutional investment management industry, because very few institutional investment management firms offer
both passive and active investment management products. Second, the investment management fees associated
with passive investment mandates are usually substantially lower than those associated with active investment
management strategies.

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In addition, in the past few years, we have witnessed significant growth in passive products in the form of
exchange-traded index or index-like products — that is, ETFs. These types of funds are accumulating investor
assets that might otherwise be invested in a fund that uses an active investment strategy. These types of products
were created specifically to appeal to those investors who favour passive investment strategies and simply want
exposure to particular equity markets or sectors of the equity markets.
Passive investments continue to grow both in assets under management and as a proportion of total investor
assets. The challenge for institutional investment management firms is not only to earn rates of return that are
competitive with the best results of other active institutional managers, but also to be competitive with the rates
of return realized by passive investment strategies, since the average active portfolio underperforms its passive
portfolio benchmark.

CORPORATE GOVERNANCE

ASPECTS OF GOOD CORPORATE GOVERNANCE

Despite the fact that virtually all institutional investment management firms are privately owned, it is still critical
that they operate with good corporate governance practices. In fact, a number of high-profile institutional
investment management firms are renowned for aggressive tactics against the management of publicly traded
companies in which they hold shares — if they feel these companies are not operating with sound corporate
governance practices.
As applied to an institutional investment management firm, good corporate governance practice involves a number
of aspects, including the following:
1. The firm’s owners and management must instill an attitude that supports the execution of their fiduciary duty
and compliance with all appropriate regulations and laws pertaining to all aspects of their operations.
2. The firm must create policies and procedures that can be monitored on a real-time basis to ensure that all
aspects of their operations remain in compliance. In order to do so, the firm must invest in systems and
personnel to monitor its activities relative to its policies and procedures.
3. The firm must create and implement an appropriate organizational design in order to ensure that the corporate
reporting structure facilitates the independence of areas such as compliance, audit and legal versus its
investment management and marketing functions.
4. The firm must be diligent and stay abreast of all good corporate governance developments. These changes and
their applicability to the firm should be assessed and decided upon promptly.

POTENTIAL BENEFITS OF GOOD CORPORATE GOVERNANCE

For institutional investment management firms, there are many potential benefits of having good corporate
governance practices, as follows:
1. As part of their due diligence hiring process, institutional investors are more often asking specific questions
regarding a firm’s corporate governance practices. With the newsworthy failure of some firms, institutional
investors have become extremely focused on clearly understanding the corporate governance practices of
potential firms. They are looking for an appropriate organizational structure and policies and procedures that
ensure a firm’s proper functioning.
2. Good corporate governance should decrease the risk of a firm’s business failure by promoting its proper
functioning and avoiding potential situations that could adversely impact the firm. A strong compliance
structure and reporting mechanism can certainly reduce the risk of loss from both honest errors and actions
by employees with dishonourable intentions.

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3. Good corporate governance is quickly becoming a major point of consideration for senior staff and portfolio
managers when contemplating a change of employment to another firm. These individuals are keenly aware of
the serious issues that can occur in firms that operate in a manner that does not fully embrace good corporate
governance principles and industry best practices.
4. Good corporate governance should also enable a firm to operate in a more organized manner. If the
appropriate governance and operational policies and practices are in place, there is an increased chance that
all aspects of a firm will run effectively and efficiently. Of course, efficient operations should lead to higher
profitability for a firm.

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SUMMARY
After completing this chapter, you should be able to:
1. Describe an investment management firm’s basic ownership and explain the differences between public and
privately owned firms.
• All investment management firms in Canada are structured legally as corporations to be considered for, and
receive registration from, the appropriate securities regulator or regulators.
• Private ownership generally takes one of two major forms: either 100% employee-owned or employee
majority–owned with a passive external owner.
• In the publicly owned structure, the investment management firm is usually organized as a wholly owned
subsidiary of a holding company that is publicly owned.

2. Describe an institutional investment management firm’s basic organizational structure.

• Typically, institutional investment management firms organize their corporate departments in three
organizational groups: the front, middle, and back offices. In addition, as required by securities regulators,
there must be an ultimate designated person (UDP) and chief compliance officer (CCO).

3. Identify and explain the major types of investors.

• The major types of investors are non-exempt and exempt investors.
• Non-exempt investors are small individual retail investors.
• Exempt investors meet certain qualifications. The exempt market is composed of both institutional and
individual investors.

4. Discuss the major investment product structures that institutional investment management firms manage.
• Institutional investment managers in Canada offer their services by way of four main channels: pooled funds,
segregated/managed accounts, limited partnerships and sub-advisory capacity.

5. Explain how the types of investment mandates an institutional investment management firm offers can affect
its structure and operations.
• An institutional investment management firm’s structure and operations are also dependent upon the
types of investment mandates it manages. The key types of investment mandates are domestic single-
sector mandates (equity, fixed income and money market) and balanced funds, specialty- or sector-focused
mandates, style-focused mandates, passive investment management, alternative investments, global
mandates and offshore investments.
• Alternative investments, global mandates and offshore investments can change a firm’s structural and
operational aspects.

6. Illustrate the primary roles and responsibilities of the various parties involved in the management of a
Canadian mutual fund.
• Fund manager: Primary role and responsibility is to provide, or arrange to provide, for the day-to-day
administration of all aspects of a mutual fund’s operations.
• Principal distributor: Responsible for a mutual fund’s marketing and distribution.
• Trustee: Holds the title to the property (the cash and securities) of a mutual fund (trust) on behalf of its
unitholders.
• Custodian: Holds all of the mutual fund’s cash and securities and settles all of its security transactions.
• Registrar: Keeps a current register of the individual owners of each unit of the mutual fund.

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• Auditor: Audits a mutual fund’s annual financial statements and provides an opinion as to whether they are
fairly presented in accordance with accounting standards.
• Independent review committee: Reviews conflict of interest matters referred to it by the fund manager and
provides a recommendation, or, where required, an approval to the manager relating to such matters.
• Portfolio advisor: Provides, or arranges to provide, investment advice and portfolio management services to
a mutual fund.

7. Explain how an investment manager collects fees and identify the various types of fees institutional
investment management firms charge.
• Mutual fund unitholders pay investment managers an investment management fee as compensation.
• Hedge funds normally charge an investment management fee and also a performance fee, which is based on
the increase in a portfolio’s value over a certain period of time.

8. Describe the key challenges the institutional investment management industry faces and what actions are
being taken to mitigate these challenges.
• The institutional investment management industry faces a number of industry challenges. Some of the most
important challenges are investment performance, access to suitable distribution, increased compliance
requirements, increasing competition (including global competition), attracting and retaining valued and
productive staff, and the growth of passive investment strategies.

9. Explain the critical role of governance in an institutional investment management firm’s operations.
• Good corporate governance involves instilling an attitude that supports the execution of a firm’s fiduciary
duty and regulatory compliance.

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 The Front, Middle,
and Back Offices 5

CONTENT AREAS

An Overview of the Front Office

The Four Areas of the Front Office

Information Flow Among Front Office Staff

Front Office Best Practices

Getting Clients

Losing Clients

Overview of the Middle Office

The Middle Office

The Back Office

LEARNING OBJECTIVES

1 | Describe the typical organizational structure of a modern institutional investment management

firm’s front office.

2 | Explain the key roles and responsibilities of portfolio management staff and traders.

3 | Describe an institutional investment management firm’s typical sales and marketing strategy.

4 | Describe the role that client service plays in both retaining and growing a firm’s assets under
management.

5 | Explain the best practices for risk control and securities trading procedures.

6 | Identify the main reasons why institutional investment management contracts are terminated.

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7 | Describe the organizational structure of a modern investment management firm’s typical middle
office.

8 | Outline the main roles and responsibilities of an investment management firm’s compliance
function.

9 | Outline the main roles and responsibilities of an investment management firm’s legal function.

10 | Describe the primary roles and responsibilities of an investment management firm’s back office.

KEY TERMS

Key terms are defined in the Glossary and appear in bold text in the chapter.

asset mix committee peer investment manager performance

surveys
audit
portfolio accounting information
chief investment officer
portfolio management information
client service
portfolio managers
compliance
portfolio turnover
fund accounting
pre-trade compliance testing
head of equities
target asset mix
head of fixed income
traders
investment management agreement
trading philosophy
market depth

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INTRODUCTION
This chapter introduces you to the four main areas of an institutional investment management firm’s front office
and explains how information flows among its staff. Next, front office best practices are explained. We also discuss
how institutional investment management firms acquire clients and why they may lose them. Next, we introduce
the middle office’s four main areas and explain its key interfaces, information flow, and best practices. We also
explain the back office’s key interfaces and information flow. The chapter concludes with an explanation of the back
office’s key best practices.

AN OVERVIEW OF THE FRONT OFFICE

A modern institutional investment management firm’s front office has four main areas of responsibility, as follows:
1. Portfolio management
2. Trade execution
3. Sales and marketing
4. Client service

Figure 5.1 shows how these four areas of responsibility are often combined into two logical sub-groups.

Figure 5.1 | The Four Main Functions of the Front Office

Front Office

Portfolio Trade Sales and Client

Management Execution Marketing Service

Portfolio management and trade execution are very closely related, and in most small institutional investment
management firms, these activities are performed by the same individual — the portfolio manager. The sales and
marketing and client service areas are also often combined into one area of responsibility, because they require
similar skills — specifically, supporting investors’ needs pre-sale and post-sale. Again, in smaller firms, these two
areas of responsibility are generally performed by the portfolio manager.
The combination of functions that an institutional portfolio manager performs in smaller firms is similar to
the multiple hats entrepreneurs wear. All of these front office duties are critical to an institutional investment
management firm’s survival and growth. To be successful, a firm must not only deliver competitive returns with
strong portfolio management and trade execution, but it must also attract and retain investors through effective
sales and client service expertise.
As an institutional investment management firm increases in size, the four areas of responsibility of its front office
are often separated and fulfilled by as many as four separate sub-groups. The amount of staffing and resources for
these four functions varies from firm to firm according to the number and type of investors.

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THE FOUR AREAS OF THE FRONT OFFICE

PORTFOLIO MANAGEMENT
The primary objective of portfolio management is to earn a competitive rate of return on an investor’s assets. This
return must be earned with an amount of risk that is acceptable to the investor and that they have agreed upon in
advance with the institutional investment manager. Portfolio risk is controlled through the manager’s adherence to
the unique investment guidelines and restrictions applying to the investor’s portfolio.
Figure 5.2 provides the typical organizational structure for the front office’s portfolio management function at a
medium-sized or large institutional investment management firm.

Figure 5.2 | Front Office Organizational Structure

Chief Investment
Officer

Sales and Marketing Asset

Equities Fixed Income
Client Service Mix/Economist

Sales and
Domestic Domestic
Marketing

Client
Foreign Foreign
Service

CHIEF INVESTMENT OFFICER

The chief investment officer has overall responsibility for an institutional investment management firm’s portfolio
management activities. The position normally reports directly to the firm’s president; however, in a smaller firm, the
same individual may hold both positions. The chief investment officer has two primary duties:
1. Providing general management of the firm’s investment management function and the supervision of their
direct reports, such as the head of equities and the head of fixed income. This position does not normally
have any involvement in the daily management of the firm’s various portfolios.
2. Acting as the chairperson of the firm’s asset mix committee, which is usually made up of the chief investment
officer and the heads of the various asset classes the firm manages. The primary purpose of the asset mix
committee is to establish the target asset mix, which is the desired market value weighting for the major
asset classes included in the firm’s various balanced fund portfolios.

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EXAMPLE
For a balanced fund made of stocks and bonds, the typical weighting for a target asset mix is 60% equities and
40% fixed income.

The asset mix committee normally meets on a quarterly basis with the purpose of reaffirming or modifying
the current weighting of the target asset mix. Most firms only make minor changes to the asset mix. In
fact, over a one-year period, the weighting of the target asset mix does not normally change by more than
5%. Interestingly, this activity is generally the closest a chief investment officer gets to making actual
investment decisions.
Given that the asset mix decision is the primary factor in determining long-term investment performance, most
firms leave this particular investment decision to their most senior investment officers, which are the members of
the asset mix committee.

HEAD OF EQUITIES
The head of equities, who reports directly to the chief investment officer, has overall portfolio management
responsibility for all of the equities managed by a firm. In most firms, equity portfolio managers will report
directly to the head of equities. In large firms that manage global equities, there is often another layer of
responsibility added, with a parallel reporting structure, with all portfolio managers responsible for domestic
equity mandates — that is, large- and small-capitalization Canadian equities, and various sector or specialty
Canadian equity mandates — will report to a head of domestic equities. All portfolio managers responsible for
foreign equities will report to a head of foreign or global equities management.
Although they are not normally involved in daily investment decisions, the head of equities does have the following
key responsibilities:
1. Providing direct managerial supervision to the firm’s equity portfolio managers.
2. Being involved in decisions to change the sector mix or cash weighting in the firm’s various equity portfolios.
Of course, these investment decisions are made within a particular portfolio’s investment guidelines and
restrictions, and are more tactical than strategic.

HEAD OF FIXED INCOME

The head of fixed income, who also reports to the chief investment officer, has overall portfolio management
responsibility for all of a firm’s fixed income and money market securities. In small to medium-sized firms, the various
fixed income and money market portfolio managers report directly to the head of fixed income. However, in larger
firms and those that manage global fixed income mandates, there is often another layer of responsibility added.
As is the case with equities, all portfolio managers responsible for domestic fixed income and money market
mandates report to the head of domestic fixed income, while all portfolio managers responsible for managing
foreign fixed income securities report to the head of foreign or global fixed income.
Like the head of equities, the head of fixed income is not normally involved in daily investment decisions and has
the following duties and responsibilities:
1. Providing direct managerial supervision to the firm’s fixed income portfolio managers.
2. Being involved in tactical investment decisions for the firm’s fixed income portfolios.

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PORTFOLIO MANAGERS
Portfolio managers are responsible for making the day-to-day investment management decisions that affect
the portfolios for which they are responsible. This is true for portfolio managers involved in all asset classes:
equities, fixed income, real estate, mortgages and alternative investments. Portfolio managers make all of the
security selection and trading decisions for their portfolios. They make these decisions within an investment
management control structure that does not require them to obtain prior approval from their respective asset
class head.

TRADE EXECUTION
The primary objective of security trade execution is to obtain the best execution — meaning, the best prices at
which securities are bought or sold. There is no question that a successful portfolio manager’s primary skill is
the ability to decide when and which particular security to buy or sell. However, it is also very important for the
portfolio manager to understand how “easy” it will be to actually execute this security transaction at prevailing
market prices.
In very small firms, individual portfolio managers typically perform all of the securities trading activities for the
portfolios for which they are responsible. However, as a firm grows and its portfolio managers become more
involved in other activities, such as marketing and client service, or investment mandates become more specialized,
such as sector, industry or small-capitalization funds, the firm must decide whether to hire and provide the
resources for a trading staff.
Traders, those individuals who execute trades, are an integral part of a firm’s portfolio management operations
and team. They are usually located in the same location or trading room that houses the portfolio managers.
Accessibility is very important for the trading staff to function effectively, as they are generally in constant two-way
communication with the portfolio managers.
In large portfolio management firms, there are usually two separate trading staffs — one for equities and one for
fixed income. The head of the equity trading staff normally reports directly to the head of equities, and the head
of fixed income trading reports directly to the head of fixed income. However, it is customary for the trading staff
to also have dotted-line reporting relationships with the various portfolio managers for whom they trade. In other
words, although traders do not officially report to portfolio managers, they are responsible for keeping them up to
date on their trading activity.
A trader’s primary responsibility is to execute the firm’s security trading activities in an effective and efficient
manner. The primary challenge for security trading, whether it is done by a portfolio manager or trader, is to
buy or sell the requisite amount of securities at a price that is as close as possible to the currently quoted bid or
offer prices.
It is imperative for a trader to understand market depth (the number of shares available at the bid and offer price),
market sectors and the individual stocks in which the firm invests. In order for a trader to fulfill their role, they must
be in constant contact with the traders at the various investment dealer firms with which their firm trades and deals.
This constant contact gives the trader the opportunity to understand the volume of securities that can be traded on
any given day. It also enables them to develop a good estimate of the price concession that must be paid — either
by paying a price that is higher than the offer price or selling at a price that is lower than the prevailing bid price — in
order to have the firm’s trade executed.
Normally, an experienced trader understands market depth better than a portfolio manager, who has less daily
contact with investment dealer traders. The trader’s knowledge is very important to the portfolio manager, because
the information the trader provides about the price concession may lead the manager to reconsider their intentions.
Good traders also are skilled in determining which particular investment dealer might have the greatest interest in
transacting with them. Investment dealers often have both long and short positions in their own portfolios, as well
as confidential knowledge as to which of their other institutional investment management firm clients might also

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have a potential interest in being on the other side of the contemplated security trade. In theory, this knowledge
should result in the best execution or trading outcome, because the negotiated price would be better than the one
achieved by filling the entire trade at the prices quoted on the stock exchanges.

SALES AND MARKETING

Institutional investment management firms are similar to other businesses in that they must sell a product or
service in order to earn revenue and, ultimately, a profit. As such, these firms must dedicate time and resources to
sell and promote their capabilities to potential investors.
In a small firm, the portfolio managers who own and operate the firm usually perform the sales and marketing
activities. This arrangement can be effective up to the point where the firm reaches a certain size and a certain
number of investors, when one of two things may occur:

• First, the firm’s portfolio performance may start to suffer since much of the portfolio manager’s time is spent
on sales and marketing activities, cutting into the time they need to dedicate to direct portfolio management
duties. As a consequence, the firm may miss investment opportunities that their competition may capture.
• Second, the firm may conclude that it is not reaching its growth potential because it is unable to dedicate enough
time to the sales and marketing efforts required to optimize its exposure to potential investors. Portfolio managers
in small to medium-sized firms work to maintain the delicate balance between these two functions. However,
as the firm grows, it must determine whether allocating part of a portfolio manager’s time to asset-gathering
activities should be done at the expense of lower rates of return.

Over time and with growth, most institutional investment management firms decide to resource and staff a
dedicated internal sales and marketing team, whose primary function is to effectively communicate their marketing
message to potential investors in order to accumulate assets for the firm. The sales and marketing process is
outlined in detail in the “Getting Clients” section of this chapter.
Of course, the size of the sales and marketing function will primarily depend on the number of investors a firm has.
Most firms start with one or two trained marketers and remain at that level for a number of years. Other firms will
add to the sales and marketing staff according to the growth in their number of investors.
The head of sales and marketing normally reports to a firm’s president, but there is often a dotted-line reporting
relationship with its chief investment officer. This is the case because, in order to be effective, sales and marketing
staff need to maintain a close relationship with portfolio management staff.

CLIENT SERVICE
To be successful, an institutional investment management firm must deliver more than just competitive rates of
return. It must also provide investors with ongoing client service that includes timely and relevant information
about the portfolios under management. The primary objective of client service is to provide current investors with
the appropriate amount of verbal and written communication regarding the management of their assets.
In a small firm, client service duties are normally performed by the partners, who are also the portfolio managers.
As the firm grows, particularly in its number of investors, the need for a separate client service function also
increases. Building the client service function usually starts by hiring one individual with the requisite qualifications,
including strong interpersonal and communication skills, an ability to clearly understand and explain investment
strategies, and experience in servicing institutional investors, and adding others as the firm expands.
Because client service essentially involves the same skills as those needed in sales and marketing, both functions are
often performed by the same individuals, although some of the very large institutional investment management
firms have separate staff for the two functions. In any case, the head of client service normally reports to a firm’s
chief investment officer or president (see Figure 5.2).

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Institutional investment management firms need to be diligent and ensure the proper resources are available to
meet the client service requirements of their current investors. These firms consider client service important for
three primary reasons, as follows:
1. Client service demonstrates to current and potential investors a firm’s level of commitment to the
delivery of an entire institutional investment management service — one that goes beyond just portfolio
performance results.
2. If done effectively, client service can be a “defensive” mechanism that helps a firm retain investors in the event
that its portfolio performance starts to deteriorate. Good client service, particularly the provision of timely and
informative communications, helps build confidence with institutional investors. This confidence can be crucial
if a firm’s investment performance starts to slip and an investor must decide whether to give the investment
manager additional time to let its strategy develop further and perhaps improve results.
3. If done effectively, client service reduces the amount of time a portfolio manager is out of the office presenting
and meeting with current and potential investors. Ideally, it is of net benefit to the firm, as it allows the
portfolio manager to focus on direct portfolio management, thereby increasing the likelihood of better
investment results.

Client service is also often viewed as an integral part of a firm’s sales and marketing efforts, in that satisfied current
clients will often allocate additional funds to the institutional investment manager as their own assets grow.

INFORMATION FLOW AMONG FRONT OFFICE STAFF

All of the various front office staff interact with each other and with other employees at the firm, as well as with
external contacts. This section outlines the way information flows among these staff members.

PORTFOLIO MANAGEMENT
For portfolio managers, the primary information flow within a firm is with other front office staff members.
Portfolio managers will normally be in constant contact throughout the day with their counterparts within the
firm and with trading staff. Contact with other portfolio managers is very important, since they will often hear or
analyze market opportunities that might be of benefit to some of their peers. This “pooling” of investment ideas
and market intelligence is a hallmark of a smoothly functioning portfolio management team. Portfolio managers
are also in constant contact with security trading staff, which provide them with good trade execution support
and information regarding the markets, especially about particular securities, which can be of great value to a
portfolio manager.

TRADE EXECUTION
As mentioned above, at an internal level, traders primarily interface with portfolio managers. When establishing
a trading program, a portfolio manager normally consults with a trader first. The portfolio manager provides
the trader with a list of the equities they plan on buying and selling, and the number of shares for each planned
transaction. Generally, the portfolio manager reviews this information with the trader, who then provides advice
regarding the price at which each of the trades will likely be executed. For some contemplated trades, the trader
might make discreet inquiries to a select number of investment dealers to get a better sense of the market’s
liquidity for particular securities.
After this discussion takes place, the trader and portfolio manager agree on the trades to be executed, and the
trader starts the trading activities with the third parties. Some trades might take an extended period of time to
complete, such as those involving stocks that have a very small capitalization, that are not widely held or that are
not easy for an investment dealer to borrow and then sell (short) to the institutional investment manager.

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At institutional investment management firms, the trader’s primary external contacts are the equity sales and
trading staff at the different investment dealers with which the firm has a relationship. It is fairly common for
medium- to large-sized institutional investment managers to have ongoing relationships and daily trading activities
with as many as 20 to 30 domestic and U.S. investment dealers.

SALES AND MARKETING

Internally, a firm’s sales and marketing staff primarily interface with its portfolio management staff. Although
this communication may not take place on a daily basis, the success of a firm’s sales and marketing efforts greatly
depends on how well this relationship works. Sales and marketing staff need input from the portfolio management
staff in order to update and prepare marketing materials.
Generally, portfolio managers will accompany sales and marketing staff to presentations to potential clients.
However, in the case of a firm that tries to minimize the use of its portfolio managers in external presentations,
it is imperative that the sales and marketing staff create presentations that demonstrate a very clear understanding
of both the firm’s investment strategy and the portfolio manager’s current market views.

CLIENT SERVICE
A firm’s client service staff primarily interface with portfolio managers and the fund accounting staff. The specific
roles and responsibilities of the investment or fund accounting staff will be discussed later in this chapter.
It is critical that the client service staff work very closely with the portfolio management staff, as they are often
primarily responsible for communicating the portfolio strategy and its results to institutional investors. Most firms
strive to have senior client service staff with a level of proficiency that enables them to effectively deliver the same
message as a portfolio manager, thereby reducing the number of investor meetings the portfolio manager must
attend. Client service staff are often in daily contact with portfolio managers.
Client service staff also interface with a firm’s fund accounting staff. This relationship is important, since a
significant portion of the regular communication with investors is focused on the financial and accounting
information that the fund accounting staff prepares.
Of course, at an external level, the client service staff communicate with a firm’s current institutional investors.
The contact and review process with clients is very structured and is normally built around an institutional investor’s
internal governance timetable. A typical annual client review process is as follows:

Monthly • Portfolio accounting report (details regarding the content are provided below)
• Portfolio rate of return
• Brief written investment report from portfolio manager

Quarterly • Portfolio accounting report

• Portfolio rate of return report (including performance attribution)
• A more detailed written investment report from portfolio manager
• On-site presentation by client service staff or portfolio manager, or both. In many
instances, this presentation is required on a less frequent basis — semi-annually
or annually — depending on recent portfolio performance and the institutional
investor’s level of comfort and familiarity with the firm

The information provided to the institutional investor in the portfolio management report falls into two basic
categories:
1. Portfolio accounting information
2. Portfolio management information

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PORTFOLIO ACCOUNTING INFORMATION

Portfolio accounting information is provided on a monthly basis and typically includes the following (for more
detail, see Chapter 12):

• Detailed portfolio holdings

• A report on all security transactions
• An income report

It should be noted that institutional investors generally tend to use investment structures where their assets
remain in the custody and safekeeping of a third-party custodian, not with the investment manager. Accordingly,
the institutional investor will independently receive monthly reports from the custodian that contain similar
information about the portfolio and its activity. A best practice is for an investment manager to reconcile its
investment accounting information with the information reported by the investor’s custodian. Further, it is
also a best practice for the institutional investor to ensure this reconciliation has been completed and that any
discrepancies between the two reports have been addressed.

PORTFOLIO MANAGEMENT INFORMATION

In addition to the portfolio accounting information noted above, institutional investment managers include
portfolio management information in their quarterly reports to investors. Some institutional investment
managers also provide a monthly portfolio management report, but it tends to contain only selective information,
since a more in-depth report is expected and delivered to the investor with the quarterly report.
The portfolio management information portion of the quarterly report typically includes return data, holdings data,
attribution analysis and market commentary. It is important to note that, although the focus of the quarterly report
is on the most recent quarter, it is standard for the portfolio manager to include all portfolio return information and
associated statistics on a yearly, quarterly and monthly basis since inception of the relationship with the particular
institutional investor. This is appropriate and necessary, because institutional investment managers are typically
assessed not only on their most recent performance, but also on the value they have added since the start of their
relationship with a particular investor.
The portfolio management information listed above is also included in the presentation the portfolio manager
makes to the institutional investor’s investment committee.

FRONT OFFICE BEST PRACTICES

As discussed in Chapter 4, an institutional investment management firm’s good organizational design uses the
separation of duties principle. This design principle is especially important when considering the processes and
procedures related to fund performance measurement, and the adherence to investment guidelines and restrictions
for each portfolio the firm manages.

PERFORMANCE MEASUREMENT
For an institutional investment manager, it is imperative that it accurately calculates investment fund performance.
In order to accomplish this, all income, gains and losses, as well as end-of-period security holding valuations, must
be accurate. The accuracy of performance results is important not only to a firm’s current investors, but also to the
firm itself, since these performance numbers undoubtedly become integrated into its reporting to third parties, such
as the financial press, pension consultants and, of course, current and potential institutional investors.
A firm’s eventual success depends to a great degree on its portfolio performance history. As well, for most
institutional portfolio managers, their variable compensation is directly dependent on the performance of the
respective funds for which they are responsible. Accordingly, there is a potential conflict of interest if a portfolio
manager is solely responsible for calculating the rates of return for the portfolios they are managing.

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Good organizational design requires that the middle office staff is solely responsible for calculating the periodic
rates of return for a firm’s various portfolios. If the separation of duties principle is used in a firm’s organizational
design, the middle office staff is independent of the front office staff, including its chief investment officer. The
middle office staff report directly to a firm’s most senior executive. This organizational design and approach to
calculating fund returns represents a best practice within the institutional investment industry.

DUAL SIGNATURES
Most institutional investment management firms allow — and usually expect — their senior portfolio managers to
manage their respective portfolios with freedom, providing, of course, that they do so with strict adherence at all
times to the investment guidelines and restrictions established for each of the various portfolios the firm manages.
Accordingly, senior portfolio managers will initiate security transactions without pre-approval from their supervisor.
This is an accepted practice in the institutional investment management industry.
However, it is an industry best practice that all completed security transaction confirmations (“tickets”) be signed
by two approved individuals in the portfolio management group. The first signatory is the portfolio manager who
originated the security transaction, while the second is usually either the portfolio manager’s supervisor or another
portfolio manager who is a peer.
It is good operational practice to develop a security transaction “signing authority matrix” that clearly articulates
which individual in the front office is allowed to co-sign a particular portfolio manager’s security transaction
confirmations. This signing authority matrix should be approved by the firm’s most senior management committee
and must be kept current to reflect changes in portfolio management staff, as well as any changes in the individual
investment mandates the firm manages.
This practice reduces the potential for transactions to occur that might not be approved or appropriate for a
particular portfolio. It also helps to avoid situations where there are errors in the tickets, such as an incorrect
security or an incorrect pricing or amount.

EMPLOYEE PERSONAL TRADING

It is very important for firms to have a clearly written policy regarding the personal investing activities of pertinent
staff. Firms are left to decide which particular personnel are required to abide by this personal trading policy. Some
firms take a blanket approach, so that the policy covers all employees. Other firms consider which staff members
have access to their trading plans and strategies, and limit their policy to these particular employees.
Policies vary by firm, but as a best practice, most firms abide by the following process:

• The employee contacts the appointed personnel, which is usually the designated person in the firm’s compliance
department, and requests written pre-clearance to do a trade for their personal account. Best practice requires
that this pre-trade permission be obtained not only for the employee, but also for all family currently living with
them. The request for pre-trade clearance includes the name of the security, whether it is a buy or sell, and the
name of the account in which the planned security transactions will occur.
• The compliance department then reviews the firm’s restricted list or other proprietary information regarding
its planned security trading activities, and decides whether to permit the trade. Permission is granted in written
form and includes all of the information about the requested trade. Note that, when granted, this permission is
normally for a fixed period of time — usually just for the date on which the permission is granted. After receiving
permission, the employee will then execute the trade with their own broker.
• As part of this pre-trade personal trading clearance policy, the employee must also ask the brokerage
firm with which they hold a personal account to send copies of all trade confirmations and month-end
account statements directly to the firm’s compliance staff. The compliance staff will then compare the
employee’s actual trading activities with the record of pre-trade clearances issued to the employee during
the previous month.

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INVESTMENT MANAGEMENT AGREEMENT

In business, it is always good practice for the two parties to a commercial transaction or relationship to document
the terms and conditions governing their business relationship through a properly executed contract.
The contract that governs the relationship between an institutional investment manager (the “Advisor”) and its
institutional investor client (the “Client”) is commonly referred to as an investment management agreement.
Each institutional investment management firm has its own unique investment management agreement. Typically,
some degree of negotiation and eventual modification of the contract occurs between institutional investors and
their investment managers. However, on the whole, contract terms are fairly standard throughout the Canadian
institutional investment management industry.
The investment guidelines and restrictions found in an appendix to the investment management agreement are
integrated into the software the firm uses to test a planned trade’s compliance before the institutional investment
manager assumes responsibility for the new investor’s assets. The pre-trade compliance test ensures that all
contemplated security transactions are made within the investment guidelines and restrictions for a particular
portfolio or mandate.

GETTING CLIENTS
As discussed in Chapters 3 and 4, there are essentially three basic types of institutional clients:
1. Institutional investors (non-mutual fund clients)
2. Mutual fund sponsors
3. Individual investors (high-net-worth clients)

Outlined below are the sales and marketing processes and strategies for each of these types of clients. Those for the
institutional and mutual fund investors are somewhat similar, but the ones for individual investors are unique.

INSTITUTIONAL AND MUTUAL FUND SPONSORS

The institutional investor marketplace is extremely large in terms of assets under management and has shown
great growth over time. However, the number of institutional investors has shown very little growth over time.
This pattern is typical of an industry that offers excellent economies of scale and is therefore a prime candidate
for merger activity and other forms of business consolidation. For institutional investment managers, new asset
management opportunities arise in the following situations:

• The institutional investor is dissatisfied with their current institutional investment manager and is therefore
starting a search for a replacement investment manager.
• The institutional investor is expanding their investment fund product mix and has decided to add new
investment managers with skills in these new mandates.

Accordingly, the majority of institutional investment management firms adopt sales and marketing strategies that
are based on these two main factors that motivate institutional investors to hire new institutional investment
managers. There are three primary steps in this institutional sales and marketing process, which are outlined in more
detail in the following sections:
1. Creating sales and marketing literature
2. Determining a sales and marketing approach
3. Preparing a presentation to potential investors

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CREATING SALES AND MARKETING LITERATURE

Sales and marketing materials introduce the firm to potential new investors and tend to focus on four main topics:
1. The owners/portfolio managers, including a brief history of the firm; the current ownership structure; an
organizational chart (both the overall corporate organization and the portfolio management organization); the
total number of employees, as well as a breakdown of the employees involved in each major functional area
of the firm; and a description of any significant partnerships or business relationships with other institutional
investment management firms.
2. The firm’s investment mandates, including a brief summary of each investment strategy and the amount of
assets managed in each respective investment.
3. The firm’s investment strategy and investment decision-making process, which highlights the fundamental or
technical investment approach, the key factors that are incorporated in the strategy and why they can lead to
superior investment decisions and returns, and a list of external databases and third-party analytical tools or
research used.
4. The firm’s portfolio performance track record, which consists of the growth history of its assets under
management by investment mandate and by year; summary details regarding the firm’s current investor mix,
including the number of institutional, mutual fund and individual investors, as well as the total assets managed
for each type of investor; the firm’s portfolio performance history, including rate of return data by mandate
and by year, quarter and month since inception; rate of return statistics, including volatility, correlation, beta
and relevant ratios; and the current portfolio value at risk.

DETERMINING A SALES AND MARKETING APPROACH

There are two basic sales and marketing approaches for institutional investors:
1. Direct contact
2. The use of pension consultants

The first approach entails a designated employee from the institutional investment management firm contacting
target institutional investors directly. At a smaller firm, the employee representing the firm will either be a
partner/portfolio manager, while at a larger firm they will be a senior sales and marketing person. The person who
is contacted at the institutional investor will normally be a very senior executive or the most senior executive
responsible for investment management.
This first sales and marketing contact tends to be a phone call alone or a letter that introduces the institutional
investment management firm and states that a follow-up call will be made to determine if an opportunity exists.
If this first contact by phone or letter elicits interest from the investor, the firm will send a package of materials
containing the information on the four topics outlined above to the investor’s contact.
The institutional investment manager’s representative places a follow-up call to the contact to see if they have
reviewed the materials and would like to meet to receive a presentation by the firm. At this stage, the following
scenarios can occur:

• If the contact agrees, arrangements are made for a meeting.

• If the contact does not agree to a presentation, then one of two routes is taken, where the choice depends on
the institutional investor’s potential future needs:
• If it seems the firm cannot meet the investor’s investment management needs, then no further contact
is made.
• If it seems that there might be a future opportunity, the institutional investment manager’s representative
keeps in touch with the potential investor by sending quarterly updates about the firm, including its growth
and fund performance statistics, to keep the door open.

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The second sales and marketing strategy for institutional investors is the use of pension consultants. Often, the
direct sales and marketing approach is supplemented by establishing contact and rapport with one or more pension
consultants. (The role of pension consultants was discussed in detail in Chapter 3.) Pension consultants often play
an integral role in the hiring of new institutional investment managers, particularly by small to medium-sized
pension plans and endowments. Their services are also used by large pension plans that do not have the internal
resources to conduct new investment manager searches.
In order to provide the highest level of service to current and potential clients, pension consultants invest heavily
in building detailed quantitative and qualitative databases of major participants in the institutional investment
management industry. To accomplish this, they do three main things:
1. Complete and maintain up-to-date and detailed due diligence files on institutional investment
management firms.
2. Interview new institutional investment managers and maintain a rapport with established managers.
3. Receive detailed portfolio management information from the institutional investment management firms
included in their investment manager database. This data includes month-end portfolio holdings, periodic
rates of return, the assets in each type of investment mandate and the number of investors or clients.

The primary objective of this particular sales and marketing approach is to have a number of pension consultants
agree to conduct a due diligence review of the firm. Afterwards, the firm becomes part of the consultants’
proprietary database of institutional investment managers. The long-term goal of this approach is to have the firm
included in pension consultants’ short lists of institutional investment managers for their pension plan and other
institutional investor clients, when these clients hire consultants to help them search for and hire a new manager.

PRESENTING TO POTENTIAL CLIENTS

The next major step in the sales and marketing process is to be included in the short list of institutional investment
managers that an institutional investor will interview. Usually, this list only includes four to six firms and was
developed after the investor carefully considered its needs, as well as all of the firms’ capabilities. The firms included
in the short list are asked to make a presentation to the institutional investor’s appropriate committee, which is
usually known as the investment committee.
These presentations are normally about a half hour in duration and are made in person to all of the institutional
investor’s investment committee members, as well as one or more representatives from the pension consulting firm
(if they are involved in the investment manager search). Most pension plan investment committees will try to have
a single day’s worth of meetings in which all of the short-listed candidates do their presentations.
The institutional investment management firm will usually be represented by two or three individuals, including
the head of sales and marketing and one or two senior portfolio managers. The presentation will include all of the
information from the sales and marketing literature plus any supplemental information the investment committee
requested.
After the candidates have completed their presentations, the members of the investment committee will meet
in private with the pension consultant to review the presentations. Often, the selection of a new investment
manager can be decided quite quickly, while in other situations, it might be necessary to have a second round of
presentations or meetings with two or three of the investment managers that participated in the first round of
presentations.
Generally, the governance practices of most institutional investors do not permit the sub-committees responsible
for investment management affairs to unilaterally appoint or hire a new investment manager. After the investment
committee completes the due diligence and interview process, it will deliberate to agree upon one (or sometimes
two) institutional investment managers to be recommended to their board of trustees for final approval. Because

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the hiring of new investment managers is a relatively infrequent process, many institutional investors arrange for
the investment committee to have its requisite meetings to hear presentations and its follow-up meetings just
before the regularly scheduled (usually quarterly) board of trustee meetings. This scheduling potentially shortens
the period between a candidate’s presentations and the announcement of the new investment manager.

INDIVIDUAL INVESTORS
A number of institutional investment management firms offer some of their investment mandates to individual
investors. Under regulatory requirements, these individuals must qualify as “exempt” investors. In addition, most
firms set a minimum initial investment threshold of $1 million, $2 million or even higher. Institutional investment
management firms that cater to these investors usually hire a team of individuals who market to and service only
this type of investor. These individual clients are generally offered the choice of either a managed account structure,
which is less expensive to the client, or units of one or more of the manager’s pooled fund products.
Individual investors receive reports that are very similar to those received by a firm’s institutional investors. The
number of annual client service meetings with an individual investor is generally related to the amount of money
they have invested with the firm. Usually, the firm offers the investor meetings with a representative on a quarterly
or semi-annual basis.
Some firms have a deliberate development strategy to grow their individual investor business. A firm with this
strategy may believe that individual investors can be a more stable book of business over time than institutional
investors. This is based on the assumption that institutional investors represent a bigger business risk should a firm’s
portfolio performance deteriorate. In general, these firms believe that institutions will more quickly terminate an
underperforming investment manager than individual investors will, and that an institution’s decision to terminate
usually involves materially larger amounts of assets leaving the firm.

TIMELINE FOR GETTING CLIENTS

The length of time it takes for an institutional investment management firm to be awarded its first mandate from
an institutional investor can vary substantially and depends on a number of factors, including:

• The length of time the firm has been in business

• The consistency and competitiveness of the firm’s portfolio performance over that period of time
• The firm’s sales and marketing capabilities

It is rare for a new institutional investment management firm with less than a three-year track record to secure an
institutional investor as its first client, unless its senior portfolio managers are able to effectively “transport” their
respective personal investment performance track records from their prior places of employment. For three main
reasons, three years is generally considered the minimum amount of time a firm must be in operation in order to
receive consideration. Potential institutional investors and pension consultants generally regard three years as the
minimum time needed to:

• Evaluate the robustness of the firm’s investment management strategy;

• Determine whether the firm’s partners can operate all aspects of the firm properly and effectively; and
• Test the cohesiveness of the partnership.

Of course, once the institutional investment management firm has obtained “critical mass” and has some
institutional investor clients, the typical time period between winning new investment mandates will shorten
substantially, assuming the firm’s investment performance remains competitive and its sales and marketing staff
are effective.

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Medium- to large-sized institutional investment management firms can be involved in a number of new investment
manager searches at any point in time, and it is common for large firms to win new institutional investor mandates
on a monthly basis.
It should be kept in mind that institutional investment management firms not only strive to increase the number
and breadth of their institutional investors, but to also increase their assets under management from each of their
existing investors.
Once a firm has been successfully awarded the investment mandate from an institutional investor, the only
remaining step is the contracting process. From a business perspective, it is very important that the firm has suitable
and comprehensive agreements pertaining to all aspects of its business relationships with its clients. An investment
management agreement, outlined in the previous section entitled “Front Office Best Practices”, is essential.

LOSING CLIENTS
All portfolio managers should be aware of the main causes of an investor’s disappointment and it can lead to the
termination of an investment management contract. Contract terminations tend to be a result of one or both of the
following factors:

• Weak investment performance (relative to peers)

• Low-quality client service

WEAK INVESTMENT PERFORMANCE

When hiring an institutional investment management firm, institutional investors tend to prefer firms that have
operated for a minimum length of time, preferably longer than three years. The longer the firm has been in business,
the more comfortable and confident the institutional investor is with the decision to hire the firm. Similarly, the
decision to terminate a firm is also based on results over a period of time.
Institutional investors analyze the investment performance of their investment managers with great diligence. An
institutional investor’s investment committee formally reviews performance results for each institutional investment
management firm on at least a quarterly basis within the context of the performance of its peers. Peer investment
manager performance surveys are produced by a number of larger pension consulting firms and contain sufficient
information to evaluate the effectiveness and competitiveness of an individual firm’s investment process.
Within the industry, it is common practice for an institutional investor to put an institutional investment
management firm on notice when its investment committee has become concerned that the firm is not meeting
the investor’s portfolio performance standards. Median performance is accepted by most institutional investors and
does not usually result in any notices or in the firm’s termination. However, performance that slips deep into the
third quartile or the top of the fourth quartile in a performance survey for two to four consecutive quarters will often
result in a discussion with the firm, which in turn might place it on notice.
The decision to dismiss a firm will partly depend on how effective it is at explaining its results in relation to the
investment strategy it employs. Most institutional investors and pension consultants understand that investment
results are affected by the choice of investment strategy, as well as by its execution, and will incorporate this
knowledge in their deliberations about the firm.
Some institutional investors will also consider the absolute amount of a firm’s underperformance relative to
the median performance results for the appropriate peer performance survey or investment manager universe.
In some environments, the difference in the rate of return between the median performance and the bottom
of the third quartile might be as small as 50 basis points of an annual rate of return, while in other market

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environments, this particular performance spread might be as large as 3% to 5% on an annual return basis. The
size of this absolute spread often affects the institutional investor’s decision to give a warning or termination
notice to a firm.
The situation discussed above deals with the more common situation where a firm has, at best, mediocre results
and is somewhat uncompetitive in comparison to its peers over time. However, unfortunately, there are also
situations where a firm experiences extremely poor performance over a short period of time. In these instances, the
termination timeline could be shortened substantially.
Normally, the firm will be requested to meet promptly with the institutional investor in order to explain in detail the
precise sources of its extreme underperformance. It is very important that the performance be carefully analyzed in
terms of the agreed-upon investment guidelines and restrictions for the particular portfolio. Termination is usually
immediate if it is concluded that the firm failed to operate precisely in accordance with the investment guidelines
and restrictions at all times.

POOR CLIENT SERVICE

Client service is a very important aspect of the institutional investment management relationship. Institutional
investors tend to be very precise with regard to the support and information they need and expect from their
various institutional investment management firms.
Most institutional investors will not tolerate client service that is below standard quantity and quality, and good
institutional investment management firms constantly seek feedback as to an investor’s level of satisfaction
with their service. Certainly, poor investment results will be tolerated for a shorter period of time if they are
accompanied by poor client service.

TERMINATION PROCESS
As noted above, the first step in the termination process is normally the institutional investor’s communication to
the institutional investment management firm that it has been placed on notice. Notice periods are not necessarily
defined, but it is typically understood that the firm may have between at a minimum two quarters and at a
maximum one year to deliver improved performance results.
Failure to meet these expectations will result in the notice of termination of the investment management
agreement. This notice is almost always immediate and will be delivered via telephone directly from the
institutional investor, as well as by written confirmation delivered via same-day courier.
Normally, the notice of termination also includes the clear and precise instruction that the institutional investment
management firm must immediately terminate all trading activities for the investor’s portfolio.

OVERVIEW OF THE MIDDLE OFFICE

A modern institutional investment management firm’s middle office has four main areas of responsibility:
1. Compliance
2. Legal
3. Auditing
4. Accounting

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These functions are shown in Figure 5.3 below.

Figure 5.3 | The Four Main Functions of the Middle Office

Middle Office

Compliance Legal Auditing Accounting

A very large investment management firm has a middle office structure similar to the one shown in Figure 5.3.
Each of the four main functions has its own specialized staff and reports to its functional head: the chief compliance
officer, the chief legal officer, the chief auditor, and the controller respectively. The functional heads typically
report directly to the firm’s president, who is also the ultimate designated person (UDP). The only exception to
this reporting structure is when a firm also has a chief operating officer. In that situation, all of the middle office
functional heads, with the exception of the chief compliance officer, report directly to the chief operating officer.
The chief compliance officer still reports directly to the president/UDP and often has a dotted-line reporting
relationship to the chief operating officer. In small-to medium-sized firms, some of these functions are consolidated
or even outsourced, with the only exception being the compliance function, which by regulation must be staffed by
an employee of the firm.
The final organizational component of an investment management firm is the back office, where trades are settled.
This section discusses the operations of a modern-day investment management firm’s middle and back offices,
including their main roles and responsibilities, best practices, and the flow of information between staff.

THE MIDDLE OFFICE

THE COMPLIANCE FUNCTION

The compliance function ensures that a firm is run in such a way that it is abiding by the rules and regulations set
by securities regulators, as well as the terms prescribed in its investment management agreements with investors
and the best practices it has established. The compliance function’s primary objective is to ensure that all of a
firm’s products, operations, and sales and marketing practices are in compliance with all security regulations and
applicable laws.
In Chapter 4, it was noted that the various provincial securities regulators require that only one individual at
an investment management firm or exempt market dealer should act as the designated compliance officer.
Accordingly, a firm must be structured in such a way that all compliance staff report to and all related activities
be reported to the designated compliance officer.
The roles and responsibilities of a firm’s compliance function focus on three primary areas:
1. Licensing and regulatory reporting
2. Sales and marketing, and client service
3. Portfolio management

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LICENSING AND REGULATORY REPORTING

The first area of focus for the compliance function is licensing and regulatory reporting, which ensures that both a
firm and its employees have the licences and registrations required to offer their investment products and services.
Regulatory licences are renewed annually, so it is the compliance department’s responsibility to ensure that all of the
appropriate renewal applications are properly completed and submitted to the respective securities regulators on time.
Compliance staff must also ensure that all securities regulators are informed of an individual registrant’s departure
no more than 15 days after they have left the firm. Likewise, they must secure registrations — portfolio manager
(PM) — for all of the firm’s new employees, or for those employees who have been promoted to the levels of
portfolio management responsibility that require registration.
Normally, compliance staff are the primary point of contact with securities regulators, so they are also responsible
for ensuring that the firm and its senior management have the most current regulatory information. They do so by
ensuring that senior management has received, read, and understood all relevant notices from regulators, and that
these notices are then communicated immediately to the relevant staff.
Provincial securities regulators also require registrant firms to file various interim reports each month. These reports
can cover topics ranging from calculations of the firm’s net free capital to confirmation of compliance to domestic and
international laws designed to prevent terrorists from using the global financial system to further their activities.1, 2, 3

SALES AND MARKETING, AND CLIENT SERVICE

The second area of focus for the compliance function is sales and marketing, and client service, which ensures
that all of a firm’s written and verbal communications, as well as its dealings with current and potential investors,
conform to appropriate regulations.
The compliance department must receive written confirmation that any third-party distributors used by the firm
have the appropriate securities registrations to sell its products and services to particular investors. The department
must ensure that the information included in the firm’s sales and marketing materials is presented in a manner that
is consistent with regulations and industry standards. This is also the case for scripted materials for use during sales
and marketing presentations to potential investors. Some examples of the type of information compliance staff
must review are as follows:

• Whether the firm is making any inferences or promises regarding the future rates of return for its portfolios
• Whether the portfolio rate of return calculations are in strict adherence to accepted practices. Any deviations
from these practices must be described and included in the materials. Two important questions compliance
staff will ask include:
• Are the rates of return calculated and presented in a manner consistent with Global Investment Performance
Standards (GIPS)? (Established by the CFA Institute, GIPS is the highest standard globally for establishing the
basis and methodology pertaining to the calculation and presentation of portfolio performance results.)
• Are the rate of return figures presented on a gross basis — that is, on a pre-fee basis — or are they net of all
fees related to the fund’s management?

In addition, the compliance department must review and approve all new forms of investment management
contracts and distribution agreements to be executed with third-party distributors. They must also ensure that, prior
to executing investment management agreements, written acknowledgments have been received from potential
investors confirming that they satisfy the regulatory requirements to qualify as exempt or accredited investors.

1
Criminal Code (R.S., 1985, c. C-46). Department of Justice, Government of Canada. Available online at:
http://laws-lois.justice.gc.ca/eng/acts/C-46/.
2
Regulations Implementing the United Nations Resolutions of the Suppression of Terrorism (RIUNRST).
3
United Nations Al-Qaida and Taliban Regulations (UNAQTR), Section 5.1.

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In terms of client service, compliance staff must also ensure that all reports and communications with current
investors are presented in a manner that is consistent with regulations and industry standards.

PORTFOLIO MANAGEMENT
The third area of focus for the compliance function is portfolio management. It is critical that each of the firm’s
investment portfolios is managed in a manner that complies with applicable guidelines and restrictions. The
compliance staff must ensure that each of the firm’s investment mandates has its own unique set of written
investment guidelines and restrictions, and that they form part of the investment management agreement executed
for each portfolio. The investment guidelines and restrictions for each portfolio are a combination of the following:
1. The investment restrictions stated in the applicable securities regulations.
2. The investment guidelines and restrictions negotiated with each investor.

EXAMPLE
An example of an investment restriction emanating from securities regulators would be the maximum permitted
investment in any one security issuer of 10% of a conventional mutual fund’s net asset value (NAV), as set forth
in National Instrument 81-102.

These restrictions must be combined with the investment guidelines that a specific investor has agreed to and that
form part of the firm’s investment advisory agreement with all of its investors.
In order to ensure these investment restrictions and guidelines are followed on a continuous basis, it is an industry
best practice to incorporate these guidelines and restrictions into software that will perform pre-trade compliance
testing of contemplated securities transactions. Pre-trade compliance testing ensures that securities trades are
compliant with all regulations pertaining to both the conduct of capital markets and a particular fund, as well as
the investment guidelines and restrictions that are agreed upon with investors prior to the execution of a trade.
Non-compliant trades, which are captured by pre-trade compliance testing, can be costly for an investor — and
accordingly, an investment management firm — since they can have severe regulatory, taxation and legal penalties.

THE LEGAL FUNCTION

The primary objective of an investment management firm’s legal function is to help ensure the firm has structured
its business affairs properly from a legal perspective — that is, the firm cannot get into a situation where it could
be held financially liable to another party. Investment management is a multidisciplinary activity and, accordingly,
a firm must use the services of a number of specialized third-party service providers. It is important that a firm has
competent legal counsel to ensure that all of these services are properly contracted for.
Investment management firms have numerous requirements for competent legal support. First, as with any
business, they require legal support for the following activities:

• Business registration and incorporation

• Business owner/partnership agreements
• Employment agreements
• Distribution agreements
• Investment management agreements
• Fund structure creation:
• Limited partnerships
• Trusts
• Managed account agreements

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• Review of service contracts from third-party service providers:

• Landlord
• Financial market data vendors
• Portfolio management software, such as a straight-through processing (STP) system
• Financial and portfolio accounting software
Generally, an investment management firm’s decision to staff an internal legal function depends on its type and size:

Is the firm a In most instances where a firm is a wholly owned subsidiary of a larger company, such as
subsidiary of a larger a bank, mutual fund company or life insurance company, it will normally have a service
corporation? agreement in place for the parent company to provide suitable legal support.

Is the firm If the firm is independent, the decision to fund an internal legal resource will be based on
independent? its size. Of course, the larger the firm is, the more likely it is to have permanent legal staff
on payroll. The major factor is the cost comparison of having to pay a third-party legal
firm versus having a permanent full-time lawyer and support staff on payroll.

Legal resources are most needed during a firm’s start-up phase, when it is creating and launching new funds or
products, and when it is entering new markets with new distribution partners. Otherwise, investment management
firms generally do not require many legal personnel in its day-to-day operations.
One final area the legal function should be involved with is investor dissatisfaction. A firm should have processes
in place to ensure that all instances of investor dissatisfaction or complaint come to the attention of its legal
department. Legal staff must be advised on a timely basis of all developments with dissatisfied investors.
In medium-sized firms, it is quite common for legal and compliance staff to form one organizational unit. This
arrangement generally makes good sense, since a number of the skills required to deliver legal and compliance
services overlap.

THE AUDITING FUNCTION

The primary objective of the auditing function is to audit a firm’s operations — that is, to verify that all of the
firm’s functions are conducting their affairs and activities in conformance with the operational procedures it has
established. In other words, that the rules established by the firm’s compliance and legal functions are being
followed. This is accomplished primarily through routine audit examinations.
Investment management firms generally require a number of different audit-related services throughout the year.
Depending on a firm’s specific requirements and circumstances, some of these services may be performed by
internal auditors — if the firm has an internal audit function — and some by external auditors.

EXTERNAL AUDITING
Some of a firm’s audit requirements must be performed by an external or third-party auditor. The two most
prominent instances are as follows:
1. Securities regulators require an investment management firm to provide audited financial statements as part
of its annual renewal application for its portfolio manager and exempt market dealer licences. Third-party
auditors must prepare these financial statements.
2. When acting in the capacity of a fund manager, an investment management firm should, according to industry
best practices, arrange for an annual audit of its investment funds. This particular audit requirement is included
in a fund’s prospectus and offering memorandum, as well as in limited partnership agreements, where applicable.
This audit is an integral part of a firm’s role as a fund manager and benefits investors or limited partners, or both.

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INTERNAL AUDITING
As with any business, it is always good practice to conduct periodic audits of all aspects of an investment
management firm’s operations. The degree to which a firm needs internal auditors varies depending on its size and
complexity. Generally, small- to medium-sized firms do not have an internal audit function and use an external
auditor when required. Generally, a larger firm, or one that is a wholly owned subsidiary of a larger corporation,
either has a permanent internal audit staff or uses the internal audit resources of its parent company. The latter
is almost always the case for the investment management subsidiaries of mutual fund companies, banks and life
insurance companies.

THE ACCOUNTING FUNCTION

The primary objective of an investment management firm’s accounting function is to provide effective and efficient
accounting services. Firms have financial accounting needs related to their own internal operations and to the
funds they manage. Depending on the size of a firm and the number and complexity of the funds it manages, it will
provide accounting services through permanent internal accounting or third-party accounting service providers, or a
combination of the two.
The primary roles and responsibilities of a firm’s accounting function are as follows:

• Financial accounting services: These relate to the investment management firm’s direct ownership and
operations. In this case, the accounting function provides information about the firm’s financial affairs and
condition for the benefit of its owners, creditors and regulators.
• Fund accounting: In most investment management firms, the majority of the accounting function’s efforts
and resources are directed towards fund accounting, which is the proper accounting of a fund’s asset values.
The firm, for both portfolio manager and exempt market dealer registrations, is responsible for maintaining
the financial records for each of the funds it manages. Fund accounting must incorporate and report on the
following information for each fund:
• Fund contributions and withdrawals
• Security holdings and market value
• Security transactions
• Income earned (dividends and interest received)
• Fund expense accruals, including charges from third-party service providers for which the fund is responsible,
such as audit fees, legal fees, custodial fees and investment management fees

• Unitholder record-keeping: This calculates and records the proportionate share or portion of a pooled fund that
is owned by each individual investor at any point in time. This percentage ownership is usually expressed in
terms of the number of a fund’s shares or units that each individual investor owns. This is somewhat in contrast
to fund accounting, where the purpose is to account for the entire fund and its total value without considering
who actually owns the fund. As such, fund accounting measures a total fund’s value, whereas unitholder record-
keeping determines the portion of a fund each investor owns.
Numerous third-party firms have expertise and specialize in providing unitholder record-keeping, which is
understandably a very important aspect of investment fund management. Some investment management firms
will perform unitholder accounting with internal accounting staff, while others will hire a third-party service
provider to fulfill these services on their behalf.

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 CHAPTER 5 THE FRONT, MIDDLE, AND BACK OFFICES 5 • 23

THE MIDDLE OFFICE’S KEY OPERATIONAL INTERFACES AND

INFORMATION FLOW
THE COMPLIANCE FUNCTION
The compliance department’s primary operational interfaces are within the front office’s portfolio management,
sales and marketing, and client service functions. This interaction is necessary, since the majority of an investment
management firm’s compliance requirements focus on matters that relate to the management of clients’ funds, as
well as to the information that is communicated to both current and potential investors.
However, the real function of a firm’s compliance department is to act as the go-between with securities regulators
in each province. The compliance department is a conduit through which information from a firm travels to the
regulators, and vice versa.

THE LEGAL FUNCTION

The legal function provides support to virtually all aspects of an investment management firm. Interaction tends to
be highest when a firm is making operational changes, such as launching new products, moving into new markets
and regulatory jurisdictions, and entering into new distribution arrangements.

THE AUDITING FUNCTION

Although the auditing function’s information needs tend to be extensive, it is not normally involved in the day-to-
day flow of information throughout a firm. However, when needed, the auditing function interacts with all aspects
of a firm over the course of an audit cycle. An audit cycle is the period of time during which the audit staff examines
every aspect of a firm. This period of time would typically be one year for areas such as portfolio management,
sales and marketing, and accounting. For other areas of the firm, where the overall business and related risks are
considered to be low, the audit cycle could be as long as two years.

THE ACCOUNTING FUNCTION

With regard to a firm’s own operations, the accounting function has standard interfaces that exist in most firms,
such as accounts payable, accounts receivable and payroll.
However, with regard to fund accounting, there are a number of major interfaces to and from which information
flows, both internally and externally, but these vary somewhat based on the type of fund information that is
being accounted for. In all cases, the accounting staff obtain data from at least two different sources to aid in
confirmation.

Fund contributions Sales and marketing or client service staff provide fund accounting and unitholder
and withdrawals record-keeping staff with information regarding fund contributions from new and existing
investors, as well as investors who are making withdrawals. This information is usually
provided in both the dollar amount and in the number of the fund’s shares or units
that are being purchased or sold. It is then reconciled with information from the fund’s
custodian regarding the amount of money that was received from or paid out to investors.

Security holdings and Security holdings information is obtained internally from a firm’s back office. This
market values, and information includes the security’s name and its description, the number of units bought
security transactions or sold, and the price paid or received, both on a per share or unit basis, and as the entire
security transaction’s value. This data is then reconciled with similar information provided
by the fund’s custodian. This comparison confirms the fund’s security holdings.

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Market values for a fund’s individual security holdings are also obtained from two
independent sources. Security pricing data are provided by the fund’s custodian. Daily
closing pricing information is obtained directly from various exchanges or third-party
security pricing data suppliers. A firm’s fund accounting staff compares the security
pricing data and investigates when there is a difference between pricing data that is
greater than a pre-determined allowable amount. Sometimes, a third independent
security pricing source is consulted and an average of all three prices is used in the final
calculation of a security’s market value.

Income earned Fund valuation includes all forms of income earned by a fund. The two major sources of
(dividends and income earned are dividends received on common stock and preferred stock holdings,
interest received) and interest received on money market securities and fixed income investments. The
fund accounting staff receives data from a fund’s custodian regarding the amount of all
dividends and interest paid to a fund. This information is compared to the amount of
interest income accrued and dividend income expected by the fund accounting staff.
Interest income is automatically accrued by a firm’s accounting software, while dividends
are calculated based on data feeds from third-party service providers who monitor and
report on particulars regarding declared dividends, such as the amount and payment date.

Fund expense accrual This aspect of fund accounting involves the accrual of various expenses related to a fund’s
overall management. As noted earlier, it includes third-party expenses, such as fund audit
fees, custodial fees, legal fees and investment management fees. All of these expenses are
paid by the fund to third-party service providers.

MIDDLE OFFICE BEST PRACTICES

THE COMPLIANCE FUNCTION
Key best practices related to the compliance function are as follows:

Leadership The head of the compliance function must be the individual designated with the
securities regulators as the firm’s chief compliance officer. In turn, the chief compliance
officer should report directly to the person designated with the securities regulators as
the firm’s ultimate designated person (the firm’s president).

Communications with All compliance-related matters and communications with regulators should be
regulators channelled through the compliance function to maintain clear and consistent
communication between the firm and its regulators.

Prior approval of new When a firm is launching new products or services, the compliance department’s prior
investment products approval is required. This ensures the new product or service complies with regulations, as
well as with registrations the firm holds.

Prior approval when The compliance function should be part of the review and due diligence process when a
contracting new firm enters into a new distribution contract.
distributors

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Straight-through The compliance department should be included in the process of analyzing a new STP
processing (STP) system to ensure that their needs, particularly with regard to monitoring portfolio
system management, are managed effectively.

Personal trading A firm must have a clear and concise policy and process regarding the administration of
pre-approval personal trading.

THE LEGAL FUNCTION

Key best practices related to the legal function are as follows:

Reporting relationship The head of the legal function should report directly to a firm’s president.

New product creation When a firm is contemplating the decision to offer new products or services, legal counsel
should be involved early in the process. This helps ensure that the product structure is
appropriate from a legal and regulatory standpoint.

New contract Processes should be in place across an entire firm to ensure that prior approval is
approval process obtained from legal staff for all new contracts.

THE AUDITING FUNCTION

Key best practices related to the auditing function are as follows:

Reporting relationship The head of the audit function normally reports directly to a firm’s president. However,
it is considered good practice for the head of the audit function to also have a parallel
reporting relationship to a firm’s management committee or board of directors, or
both — at least on a quarterly basis. This report should include information about the
results of the most recently performed audits and the status of the remediation of
deficiencies identified in previous audits.

Audit privileges with A firm should have a policy in place that attempts to negotiate audit privileges with
third-party contactors third-party contractors — that is, the ability to audit its contractors. It is unheard of for
a contractor to consent to full audit privileges. However, many service providers to the
investment management industry do have independent annual audits conducted on
those particular aspects of their operations that are considered to be of most importance
to their clients.

THE ACCOUNTING FUNCTION

Key best practices related to the accounting function are as follows:

Reporting relationship As with other middle office functions, the accounting function should report to a firm’s
president. From an organizational standpoint, the fund accounting function must be
separate and independent from both a firm’s front and back offices.

Straight-through In the case of the fund accounting function, an STP system is critical to ensuring
processing (STP) efficient fund accounting operations. As discussed earlier, the fund accounting function
system interfaces with numerous internal and external sources of fund information data. As
such, having all of this data online in one database can lead to efficient fund accounting
with minimal errors.

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THE BACK OFFICE

The primary objective of a firm’s back office is to settle security transactions in an efficient and effective manner.
This activity is otherwise known as the trade settlement function. Security trades are not complete until they
are settled.
The trade settlement function ensures that all of a firm’s security transactions, both purchases and sales, are settled
in the correct amounts and accounts or portfolios/funds, and at the agreed upon time. The number of security
transactions a firm generates depends on a number of factors, including:

• The number of separate mandates or funds managed

• The type of mandate, such as equity, fixed income or money market
• The geographic aspects, such as domestic or global
• The firm’s trading philosophy

Although the four primary factors listed above affect a particular investment management firm’s annual security
trading volume, its trading philosophy is likely the most important determining factor. Trading philosophy refers
to the role that active security trading plays in executing a particular fund’s investment management strategy.
All active portfolio management strategies, as compared to passive investment strategies, such as index funds,
involve some degree of security trading in their execution. However, the amount of trading is unique to each
individual portfolio manager. Even with identical investment mandates, two portfolio managers could have
very different attitudes regarding the amount of value they can add to a fund by trading securities on a more
frequent basis.
The degree or amount of active management, specifically trading activity, is usually measured and reported in terms
of portfolio turnover, which is calculated using the following equation:
Annual market value of security trades (5.1)
Portfolio turnover =
Market value of the portfolio

This ratio can be as low as 0.25 for a fairly inactive investment strategy, to as high as 2 to 4 for a very actively
managed fund. Most funds have annual portfolio turnover ratios in the range of 0.75 to 1.25.

THE BACK OFFICE’S KEY OPERATIONAL INTERFACES AND

INFORMATION FLOW
The back office has five main operational interfaces three internal, including portfolio managers, trading staff and
the fund accounting function, and two external.

Internal interfaces The firm’s trade settlement area receives electronic trade tickets or confirmations, which
provide information about confirmed trades with investment dealers, from its trading
staff. These tickets, which are normally received electronically if the firm uses an STP
system, inform the trade settlement staff that a security trade is pending settlement. The
internal trade confirmation provides all of the details about the particular security trade,
including the number of shares, price per share, commission, investment dealer’s name
and ID number, fund to settle the trade in, and so on. After the trade has been settled
successfully, which is generally the same day for money market trades, or two clearing
days for bond and equity trades, the trade settlement area will inform the fund accounting
staff. This information is also conveyed electronically through a firm’s STP system.

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External interfaces The back office also receives an electronic trade ticket from the investment dealer
with which the firm has executed the trade. The details on this ticket are automatically
matched to the details provided on the ticket the firm’s trading staff received. Any
variance in the ticket information will be immediately discussed and resolved with
the internal trader who generated it. The trade settlement staff will also receive a
confirmation from the fund’s custodian once the trade has settled at the custodian’s
facilities. This step marks the end of the trade settlement process.

BACK OFFICE BEST PRACTICES

Key best practices of a firm’s back office are as follows:

Reporting structure Trade settlement staff should report to a firm’s president and be independent of both its
front office and fund accounting functions.

Straight-through It is very important for a firm to use an STP system. Automation can ensure that security
processing (STP) trades are settled correctly and on time.
system

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5 • 28 PORTFOLIO MANAGEMENT TECHNIQUES

SUMMARY
After completing this chapter, you should be able to:
1. Describe the typical organizational structure of a modern institutional investment management firm’s
front office.
• In the modern institutional investment management firm, the front office has the following four main areas
of responsibility: portfolio management, trade execution, sales and marketing, and client service.

2. Explain the key roles and responsibilities of portfolio management staff and traders.
• Chief investment officer: Has overall responsibility for a firm’s portfolio management activities.
• Head of equities: Has overall portfolio management responsibility for all of the equities a firm manages.
• Head of fixed income: Has overall responsibility for the portfolio management of all of a firm’s fixed income
and money market securities.
• Portfolio managers: Are responsible for making the day-to-day investment management decisions that
affect the portfolios for which they are responsible.
• Traders: Primary responsibility is to execute the firm’s security trading activities in an effective and
efficient manner.

3. Describe an institutional investment management firm’s typical sales and marketing strategy.
• Primary responsibility is to effectively communicate the firm’s marketing message to potential investors in
order to accumulate assets for the firm.
• There are three primary steps in this institutional sales and marketing process:
1. Creating sales and marketing literature
2. Determining a sales and marketing approach
3. Preparing a presentation to potential investors

4. Describe the role that client service plays in both retaining and growing a firm’s assets under management.
• The primary objective of client service is to provide current investors with the appropriate amount of verbal
and written communication regarding the management of their assets.
• Institutional investment management firms consider client service important for three primary reasons:
« Client service demonstrates to current and potential future investors a firm’s level of commitment to the
delivery of an entire institutional investment management service.
« Client service can be a “defensive” mechanism that helps a firm retain investors in the event that its
portfolio performance starts to deteriorate.
« Client service reduces the amount of time a portfolio manager is out of the office presenting and meeting
with current and potential investors.

5. Explain the best practices for risk control and securities trading procedures.
• Best practices include dual signatures, employee personal trading policies and pre-trade compliance tests.
6. Identify the main reasons why institutional investment management contracts are terminated.
• Contract terminations tend to be a result of one or both of the following factors:
« Weak investment performance (relative to peers)
« Low-quality client service

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7. Describe the organizational structure of a modern investment management firm’s typical middle office.
• A modern institutional investment management firm’s typical middle office has four main functions:
compliance, legal, audit, and accounting.

8. Outline the main roles and responsibilities of an investment management firm’s compliance function.
• The roles and responsibilities of a firm’s compliance function focus on three primary areas:
« Licensing and regulatory reporting: Ensures that both a firm and its employees have the required licences
and registrations to offer their investment products and services. Provincial securities regulators also
require registrant firms to file various interim reports on a monthly basis.
« Sales and marketing, and client service: Ensures that all of a firm’s written and verbal communications,
as well as its dealings with current and potential investors, conforms to appropriate regulations.
« Portfolio management: Ensures that each of a firm’s investment mandates has its own unique set of
written investment guidelines and restrictions, and that they form part of the investment management
agreement executed for each portfolio.

9. Outline the main roles and responsibilities of an investment management firm’s legal function.
• The primary objective of an investment management firm’s legal function is to help ensure the firm has
structured its business affairs properly from a legal perspective — that is, the firm cannot get into a situation
where it could be held financially liable to another party.

10. Describe the primary roles and responsibilities of an investment management firm’s back office.
• The primary objective of a firm’s back office is to settle security transactions in an efficient and
effective manner.

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 Managing Equity Portfolios 6

CONTENT AREAS

Bottom-Up and Top-Down Approaches

Portfolio Management Styles

The Use of Derivatives in Equity Portfolio Management

Tax Considerations

The Use of Exchange-Traded Funds in Equity Portfolio Management

LEARNING OBJECTIVES

1 | Describe the bottom-up and top-down approaches to equity portfolio management.

2 | Differentiate between the value-oriented and growth-oriented approaches to investing.

3 | Describe the passive style of equity portfolio management, and discuss the three techniques
normally used to construct an index fund.

4 | Explain how to use the risk budgeting process to build a portfolio.

5 | Describe the active style of equity portfolio management, including enhanced active equity
investing, long–short investing and portable alpha strategies.

6 | Explain how derivatives can be used to reduce an equity portfolio’s systematic risk.

7 | Aside from hedging, demonstrate the ways in which derivatives can be used in equity portfolio
management.

8 | Discuss the taxation considerations of various equity portfolio management styles.

9 | Describe exchange-traded funds (ETFs) and discuss the ways in which they can be used in equity
portfolio management.

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6•2 PORTFOLIO MANAGEMENT TECHNIQUES

KEY TERMS

Key terms are defined in the Glossary and appear in bold text in the chapter.

active portfolio management index tracking

alpha management styles

beta passive portfolio management

bottom-up approach portable alpha

closet indexing prime brokerage structures

enhanced active equity investing replicating an index

enhanced indexing risk budgeting

fundamental indexing sector rotation

growth-oriented approach top-down approach

hedged portfolio tracking error

index funds value-oriented approach

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 CHAPTER 6 MANAGING EQUITY PORTFOLIOS 6•3

INTRODUCTION
It is well known that asset diversification within an investment portfolio reduces risk for a given level of expected
return if the portfolio’s assets have less than perfectly correlated expected returns. In a well-diversified portfolio,
the volatility of one security can offset the volatility of another.
Portfolio construction has been based on this concept ever since 1952, when Harry M. Markowitz released his
ground-breaking work entitled “Portfolio Section” in the Journal of Finance.1 In theory, the risk-reducing benefits
of diversification can be derived from as few as two randomly selected assets. In addition, fundamental statistical
concepts, such as portfolio expected return and portfolio risk, apply equally to small and large portfolios. With
large portfolios, although the concepts do not change as more and more assets are considered, the number
of computations grows quickly. In the real world, portfolios rarely have only two or three assets. Generally,
portfolio managers combine many assets in order to eliminate diversifiable risk as they build a preferred structure
of risk and expected return within a portfolio. They may design a portfolio to emphasize assets from a particular
sector or industry, or to meet a certain maximum or minimum capitalization size, or to achieve an international
mix of securities.
As hedge funds become more mainstream, the line between portfolio construction techniques employed by
conventional mutual funds and those employed by hedge funds has been blurred. To increase returns, institutional
investors are increasingly turning to the strategies hedge fund managers employ.
This chapter deals exclusively with the design and management of equity portfolios, both conventional and
non-conventional ones. For the most part, the content of this chapter has its foundation in modern portfolio theory
(MPT), which, in turn, is built on the assumptions of capital market efficiency. In practical terms, MPT proposes that
a portfolio manager construct a portfolio through diversification while they are establishing a clear, quantitative
picture of the expectations for its performance. Once the portfolio is in place, the manager must regularly maintain
and rebalance the portfolio in order to remain true to the original design objectives, assuming that the objectives
remain relevant.

BOTTOM-UP AND TOP-DOWN APPROACHES

The systematic method that a portfolio manager uses to select individual securities and build a portfolio may
be categorized as either a top-down or bottom-up approach. The type of approach used depends on a portfolio
manager’s assumptions about market efficiency, as well as their analytical strengths compared with other peers in
the financial marketplace. A portfolio manager’s approach naturally leads them to develop a management “style”.

THE BOTTOM-UP APPROACH

The bottom-up approach to investing can take the form of either a value-oriented or growth-oriented approach.
For both of these approaches, the portfolio manager begins by seeking out individual securities to include in a
portfolio.

VALUE-ORIENTED, BOTTOM-UP APPROACH

A portfolio manager who uses the value-oriented approach looks for undervalued securities with little focus on
overall economic and market conditions. The manager attempts to find stocks with a low price-earnings ratio that
are trading at a discount to book value. A value-oriented manager is usually prepared to wait many years in order to
recognize a stock’s full value.

1
Harry M. Markowitz, “Portfolio Selection,” The Journal of Finance 7, No. 1 (March 1952): 77–91.

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6•4 PORTFOLIO MANAGEMENT TECHNIQUES

Warren Buffett, the famous U.S. investor of Berkshire Hathaway, is an example — albeit an extraordinary one — of
a value-oriented, bottom-up manager. Buffett’s approach to portfolio management is based on security selection.
He is known to put little faith in portfolio management in the modern sense; rather, after thorough investigation,
he buys a selective few investments and then holds them for a long time, seemingly indefinitely. Buffett does not
believe the markets are efficient, and his phenomenal investment performance over the past 45 years is an anomaly
among portfolio managers, no matter what their approach.
During his post-graduate studies at Colombia University, Buffett was profoundly influenced by two of his
professors — Benjamin Graham and David Dodd — who both wrote landmark works in the field of value-oriented
investing.2, 3 In his early years of investing, Buffett followed Graham’s approach by seeking out highly undervalued
securities. Graham’s favourite technique was to find stocks that traded at one-third less than their net working
capital. However, this strategy became more difficult to implement once the market became efficient to the
strategy. Over time, Buffett’s strategies have evolved, but they remain based on the bottom-up approach to
portfolio building.4
The value-oriented, bottom-up approach to building a portfolio leads to a somewhat passive management style of
portfolio management, in the sense that once the securities have been selected, the manager remains invested in
them for a long period of time. Time is needed for the investment’s full potential to be realized and for the market
to also recognize this potential. Value-oriented, bottom-up investing presumes that the market is not completely
efficient at pricing securities. The manager must have superior skills to identify securities that are undervalued or
have unrealized potential.

EXAMPLE
Two Bottom-up Investment Strategies
Strategy #1: Benjamin Graham’s Asset Value Strategy

In his book Security Analysis, Benjamin Graham defines investment as follows: “An investment operation is one
which, upon thorough analysis, promises safety of principal and a satisfactory return. Operations not meeting
these requirements are speculative.”
Graham considered thorough analysis to be the careful study of available facts with the attempt to draw
conclusions based on established principles and sound logic. He considered “satisfactory” return to be a
subjective measure, and he strongly recommended diversifying investments to reduce risk. The net current
asset value approach is the name Graham applied to the strategy he reportedly first developed and tested in
the 1930s.*
A company’s current assets include cash, inventories, accounts receivable and other assets that are expected to
generate cash within one year or one operating cycle. Graham’s approach starts by adding up the current assets
and subtracting total liabilities. The difference is the company’s net current asset value. In order to determine the
net current asset value per share, one must divide the net current asset value by the number of shares outstanding.
Graham’s strategy calls for selecting stocks that sell for 66.67% or less of their net current asset value. For
example, according to Graham’s approach, if a stock’s net current asset value is $10 per share, an investor should
not pay more than $6.67 for it.
Here is an example of Graham’s method for selecting stocks:
1. Assume a stock’s current price is $12 and the number of shares outstanding is 4 million.
2. The company’s total current assets and total liabilities are $160 million and $80 million, respectively.

2
Benjamin Graham, The Intelligent Investor: The Classic Text on Value Investing (Toronto: Harper Business, 2005). First published in 1949.
3
Benjamin Graham and David Dodd, Security Analysis (New York: McGraw-Hill, 2004). First published by Whittlesey House, New York, in 1934.
4
Roger Lowenstein, Buffett: The Making of an American Capitalist (New York: Doubleday, 1995).

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EXAMPLE
Two Bottom-up Investment Strategies – (cont'd)
3. Subtract the total liabilities from the current assets ($160 million − $80 million) to get a net current asset
value of $80 million.
4. Divide $80 million by the number of shares outstanding (4 million), which gives a net current asset value of
$20 per share.
5. Graham’s strategy says the stock price cannot exceed 66.67% of the net current asset value — in this case,
$13.33 per share ($20 × 0.6667). At $12.00, the stock’s current price meets this criteria.

Strategy #2: Warren Buffett

As clients become more familiar with investment strategies, it is a portfolio manager’s responsibility to not only
understand the theories that their clients may be reading about, but also the strengths and weaknesses of these
theories as they pertain to their clients’ expectations and investment profiles. As mentioned earlier, Warren
Buffett is one of the most influential investors of our time, and a fundamental understanding of his investment
strategy is essential, whether one subscribes to the analytical approach or not.
Buffett’s strategy is straightforward, as follows:
1. Turn off the stock market.
2. Do not worry about the economy.
3. Buy a business, not a stock.
4. Manage a portfolio of businesses.

His 10 basic analytical tenets are the following:

1. Over the long haul, equities outperform other investments.
2. The soundness and potential of an individual underlying security is the true measure of value.
3. The ability to analyze a business’s fundamental soundness lessens the need to broadly diversify one’s
holdings, which tends to lower returns relative to a concentrated portfolio of well-performing stocks.
4. Investors are not always rational and may not process information correctly.
5. Risk is not based on price but on economic value. In other words, the spread between value and price is the
most important determinant of whether a security meets the selection criteria.
6. Focus on 10 to 12 securities of the highest value from high-potential companies, and stay with them for
the long term, unless there are overwhelming reasons for change. These would include a major change in a
company’s senior management that weakens its ability to compete successfully in the longer term.
7. The most important measuring stick is a company’s intrinsic value and its weighted average cost of capital
(WACC). The market may not recognize it right away in terms of price, which presents an opportunity for
the portfolio manager to acquire more shares at a bargain price until the market catches up.
8. Minimize the impact of transaction costs.
9. Measure returns on an after-tax basis.
10. Use the power of compounding returns to maximum advantage.
* Graham and Dodd, Security Analysis: 54.

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GROWTH-ORIENTED, BOTTOM-UP APPROACH

As a bottom-up approach, the growth-oriented approach focuses on individual stocks. However, where the
value-oriented approach looks for undervalued securities, the growth-oriented approach focuses on earnings.
Specifically, a growth-oriented portfolio manager chooses stocks with superior earnings growth rates relative to
the market in general. Another key difference between the value-oriented and growth-oriented approaches is
that a growth-oriented manager has higher turnover in their portfolio.

THE TOP-DOWN APPROACH

The top-down approach begins with a macro- and microeconomic analysis of trends and market forecasts
in the global, North American and Canadian economies. A portfolio manager selects the sectors they expect
will outperform other sectors within the expected economic outlook. To maximize liquidity, the manager buys
large-capitalization stocks within each sector.
The top-down approach is based on the premise that the performance of economic sectors ebbs and flows in
response to changes in the economic cycle, and that the portfolio manager has the skills to pick the sectors that are
most likely to experience superior growth. Such a manager is likely to display an active management style and could
be characterized as a sector rotator or market timer.

PORTFOLIO MANAGEMENT STYLES

Equity portfolio managers pursue a variety of investment strategies that are known as management styles. Today,
managers tend to be specialists within a particular management style. A manager hopes to take advantage of
superior skills in practicing their management style. The client, whether a plan sponsor or a fund investor, should
be prepared to pay the management fees in return for those specialized skills. Major fund sponsors may employ a
number of portfolio managers with different management styles in order to diversify a fund. Generally, portfolio
management styles fall into two categories: active and passive. Fund managers may also be differentiated according
to the market capitalization of the stocks they tend to buy and by their growth or value orientation. The section that
follows describes passive and active management styles and portfolio construction techniques. These styles will be
compared at the end of the section.

PASSIVE MANAGEMENT STYLES

Passive portfolio management is consistent with the view that securities markets are efficient — that is, securities
prices always reflect all relevant information concerning expected return and risk. By practicing the passive
management style, a portfolio manager admits their inability to consistently identify stocks as underpriced or
overpriced. Instead, they concentrate on portfolio construction that meets particular needs, and on maintaining
their preferred structure through periodic rebalancing.
Often, the strategic objective of passive portfolio management is to track the performance of a relevant target
benchmark, which is typically an index, such as the S&P/TSX Composite Index or the S&P 500 Index. These
are referred to as index funds. While index funds are passive, passive portfolio management is not necessarily
restricted to them. A portfolio can have virtually any expected risk-return profile. If they wish, a portfolio manager
may augment a portfolio with different characteristics for yield, sector, capitalization and so on, and then passively
maintain that structure.

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CONSTRUCTING AN INDEX FUND

Replication, tracking and index matching are terms related to passive portfolio management. The rationale behind
constructing an index fund is that a well-diversified index represents an average portfolio, and a portfolio manager
can do no better than the average over the long run. In terms of portfolio theory, an index fund only accepts
systematic risk. There are three approaches to constructing an index fund:
1. Replicating an index
2. Tracking an index
3. Fundamental indexing

REPLICATING
When replicating an index, a manager selects an appropriate index to replicate in a fund, then holds each stock
within the fund’s portfolio in exact proportion to its weighting within the index.

EXAMPLE
If the target index is the S&P/TSX Composite Index and the Bank of Montreal represents 0.75% of this index, the
replicating index fund must hold 0.75% of its assets in Bank of Montreal stock.

A portfolio containing all of the stocks in the S&P/TSX Composite Index is unwieldy. The majority of companies
within the S&P/TSX Composite Index have less than a 0.50% weight in the index. For practical purposes, a portfolio
replicating the S&P/TSX Composite Index is likely to be over-diversified, which occurs when the next stock added to
it contributes little or no reduction to the portfolio’s unsystematic risk.

TRACKING
An alternative to replicating is index tracking. With this approach, a portfolio manager constructs a subset of the
benchmark that faithfully mimics an index. In other words, the resulting portfolio is highly correlated with an index
without necessarily holding all of its stocks. Sampling and mathematical models are two different methods that
managers use in index tracking.
For example, with the sampling model, a portfolio manager might construct an index consisting of most of the
larger-capitalization stocks in the underlying index, plus only a sample of its smaller-capitalization stocks. The idea
is to capture the majority of the correlation using the large-capitalization stocks. This structure gives the fund a
portfolio that mimics the underlying index without being as large as the index. A mathematical model may involve
the use of historical data in order to construct a fund that does not hold all of the underlying index’s securities but
nevertheless faithfully mimics it.
The efficiency of index tracking must be weighed against the inaccuracy of tracking versus the index itself. The loss
of accuracy is referred to as tracking error, which is the standard deviation of the return difference between the
portfolio and the index. If an index fund is constructed properly, the tracking error tends to be small. For this reason,
full replication tends to be unnecessarily costly. Of the three methods of constructing an index, the industry’s
preferred method is tracking.

FUNDAMENTAL INDEXING
Market capitalization is the primary method for weighting a security in a conventional indexed portfolio. This
approach has the advantages of diversification, low turnover, broad market participation and modest expenses.
However, capitalization-weighted indexes suffer a structural flaw that imposes a drag on returns.
In a semi-efficient market, most stocks will be priced above or below their intrinsic value. Those priced above
their intrinsic value will have a capitalization higher than merited and an erroneously high index weighting. These
stocks will make up the majority of an indexed portfolio and will suffer a performance drag as prices migrate
towards their true value. Those priced below their intrinsic value will have a lower than merited capitalization
and an erroneously low index weighting. These stocks will give the index a performance boost, but one that is too

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6•8 PORTFOLIO MANAGEMENT TECHNIQUES

small to offset the losses from overpriced stocks, because the former constitute less of the portfolio. In this way,
capitalization-weighted indexes systematically overweight overpriced securities and underweight underpriced
ones. For example, consider the top 10 stocks in a capitalization-weighted portfolio. Some stocks are in the top
10 because they are very large companies whose true value is accurately reflected. However, others will get there as
a result of being overvalued. For passive index investors, more of their portfolio will be invested in overvalued stocks
and less in undervalued ones, which is the opposite of what common sense suggests.
Fundamental indexing was developed to solve the problem of structural return drag.5 According to the
methodology, each stock’s index weighting is determined by four fundamental measures — not by its expected
future size, as reflected in market capitalization — thus diluting weighting errors and erasing the link between
portfolio weight and over- or undervaluation. The fundamental metrics were chosen to reflect a company’s
business activity as accurately as possible, as follows:

• Trailing five-year cash flow (cash flow)

• Trailing five-year sales (sales)
• Trailing five-year gross dividends (dividends)
• Book value (book)

The top 1,000 stocks are selected in each metric and ranked proportionately in that category. The index is created
by equally weighting the four categories.

EXAMPLE
Imperial Oil (IMO) would receive a 3% weight in the sales index if its sales represented 3% of the combined
trailing five-year total sales of the top 1,000 sales companies.
If IMO represents 3% of the economy by sales and cash flow, 2% by book value and 4% by dividends, we average
the four measures to determine that it represents about 3% of the economy. IMO is given a weight of 3% in the
fundamental index, regardless of share price, valuation multiples or market capitalization.

Multiple metrics were used to smooth out some of the drawbacks of using a single measure:

Dividend-based metric A dividend-weighted index has the correlation of size to excess returns, and has the
largest tracking error relative to capitalization-weighted indexes, which leads to the
least consistent value-added of the metrics. On average, it is the only measure that has
underperformed in bull markets. However, the most glaring drawback of dividend-based
indexes is that they exclude more than half of the market’s publicly traded companies,
including most growth stocks and essentially all emerging growth companies. For this
very reason, a special provision is made for zero yield companies — those companies
that have paid no dividends in the past five years — so that they are weighted equally
according to the other three metrics.

Sales metric This metric is not well defined in some of the service industries, such as financial services
and trading companies.

Cash flow metric This metric may lead to over- or underexposure to highly cyclical companies.

Book value metric This metric may lead to over- or underexposure to companies with aggressive or
conservative accounting practices.

5
Robert Arnott, Jason Hsu, and Philip Moore, “Fundamental Indexation,” Financial Analysts Journal 61, No. 2 (March/April 2005): 83–99.

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 CHAPTER 6 MANAGING EQUITY PORTFOLIOS 6•9

Clearly, for any fundamental index, using a single metric can lead to a skewed sample of companies. A blend of
multiple measures, along with the use of multi-year smoothing, can mitigate exposure to any of these problems
and sharply reduce turnover.

EXAMPLE
Comparing Fundamental Versus Capitalization Weighting
Robert Arnott compared the return performance of the S&P 500 Index, the most widely used market
capitalization index in the U.S., to the performance of a fundamental index constructed from the largest 1,000
U.S. companies in each metric.* Over a 44-year evaluation period from 1962 to 2005, the fundamental index
produced excess returns of 2.1%, with slightly less volatility than the S&P 500 Index. Under different market
environments, on average the fundamental index outperforms marginally in bull markets, while producing
significant excess returns in bear markets.
The fundamentally weighted index’s turnover is extremely low relative to an actively managed portfolio, and only
slightly above that of an average capitalization-weighted index. The historical turnover is just over 10% versus
approximately 6% for an annually rebalanced portfolio of the 1,000 largest-capitalization stocks. Furthermore,
the fundamental index’s turnover tends to be in larger-capitalization issues, with smaller transaction costs, that
have seen changes in their fundamentals. Meanwhile, capitalization-weighted portfolios tend to experience most
of their turnover in smaller companies — meaning, higher transaction costs — that fall off, or step up onto, the
capitalization-weighted list, which is typically near the bottom of it.
More importantly, during periods of rapid price increases, the fundamental index did not become grossly
concentrated within one sector, as did conventional capitalization-weighted indexes; for example, during the
technology bubble of 1999. The S&P 500 Index’s technology sector weighting ballooned from 8% in 1995 to
well over 20% in 1999. In the fundamental index, the technology sector’s weighting rose no higher than 10%
in 1999 from 5% in 1995.** Under fundamental indexing methodology, companies do not receive additional
allocations within the index, unless they grow their cash flows, dividends, sales and book value faster than the
rest of the economy.

* Robert Arnott and John West, “Fundamental Indexes: Current and Future Applications,” Institutional Investor’s Fifth Annual
Exchange-Traded Funds Review (Fall 2006): 111–21.
** Jason Hsu and Carmen Campollo, “New Frontiers in Index Investing,” Journal of Indexes (January/February 2006): 32–58.

CLOSET INDEXING
Closet indexing refers to the tendency of active managers to build a portfolio that is close enough to a
performance benchmark, so that the portfolio neither underperforms nor outperforms the benchmark by much.
The purpose of this strategy is to help underachieving active portfolio managers avoid getting fired. It is a strategy
based on the management concept of “satisficing” — that is, a manager is happy to perform reasonably well and
their personal welfare is the motivating force. Closet indexing implicitly ignores the formal investment objectives
established for a portfolio.
The active portfolio manager is expected to add value to a portfolio, and clients pay a higher active management
fee in return for this value-added. Closet indexing is a practice that shortchanges the interests of a fund beneficiary
or holder in deference of a fund manager’s interests. The clients or beneficiaries of such a fund find themselves
paying active management fees for index performance, which is clearly unacceptable.
If a fund sponsor is faced with the choice of an index fund with low management fees and an actively managed fund
that has shown the same basic performance as the index fund because it has been closet-indexed, the sponsor will
opt for the former fund because of its lower management fees.

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ENHANCED INDEXING
Risk budgeting6 is a process that limits the deviations of a portfolio’s return from a benchmark. It is the most
common technique used to create an enhanced index portfolio. Enhanced indexing results in portfolios that are
designed to provide index-like performance with some excess return net of costs. Active risk is introduced by slightly
overweighting and underweighting securities. This level of active risk is closely monitored.
An acceptable tracking error is predetermined and alpha, which is the return from unsystematic risk, is maximized
within those limits. A typical enhanced index portfolio’s active risk is not allowed to exceed 2% per annum.
On a spectrum of systematic risk exposure, risk budgeting lies between passive indexing and active investment
management.
There are four steps in the risk budgeting process. The first step is to pick a benchmark portfolio, which should be
created cheaply and maintained passively. The benchmark’s expected risks and returns should match the investor’s
needs and preferences. If no better opportunity arises, the investor should view a passive investment in the
benchmark as a viable alternative.
The second step is to set the maximum acceptable portfolio tracking error. A tracking error indicates how closely the
portfolio is following the benchmark. A portfolio’s tracking error reveals the reliability of the portfolio’s alpha. If the
tracking error is high and the alpha is positive and low, the alpha is likely not to be repeated. As such, it is probably
a random fluctuation, not the result of superior investing, and there is a good chance the next period will carry a
negative return, which will wipe out any gains.
The ratio of alpha to tracking error can be monitored using the information ratio, as follows
Alpha (6.1)
Information ratio =
Tracking error

Given an expected alpha and a maximum tracking error, the information ratio can be used to ensure a portfolio is
producing enough excess return to justify the deviations from its benchmark.
The third step is to try and identify active management return opportunities. This means making — or trying to
make — superior tactical asset allocation decisions, as well as identifying superior securities from the benchmark or
superior investment managers.
The final step is to use the identified return opportunities to build a portfolio without exceeding the tracking error
limit. A portfolio could have a multitude of asset classes or a multitude of securities combinations that could fall
within the risk budget. However, only one will maximize the alpha and still remain within the tracking error limit.

Exhibit 6.1 | The Four Steps of the Risk Budgeting Process

1. Determine the portfolio’s appropriate benchmark.

2. Determine the portfolio’s maximum acceptable tracking error. This sets a maximum for how large of an
unexpected return “surprise” the portfolio could experience.
3. Identify the tactical asset allocation or specific return opportunities among securities.
4. Build a portfolio that deviates from the benchmark using the return opportunities identified in step three
(described above). The portfolio should maximize expected excess returns without exceeding the tracking
error limit determined in step two (also described above).

6
James Gilkeson and Stuart Michelson, “Risk Budgeting: Investment Cruise Control for Your Clients,” FPA Journal, November 2005.

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 CHAPTER 6 MANAGING EQUITY PORTFOLIOS 6 • 11

AN ILLUSTRATION: RISK BUDGETING AND ASSET ALLOCATION

Assume there is a portfolio composed of 55% stocks, 30% bonds and 15% cash, with a maximum risk budget of
1.00% per quarter. The expected return, risk (standard deviation of returns) and correlations for each asset class per
quarter are given in Table 6.1 below.

Table 6.1 | Expected Returns, Risk Percentages and Correlations a Sample Portfolio

Expected Correlation Correlation Correlation

Weight Return Risk (%) with Stocks with Bonds with Cash
Stocks 0.55 1.35% 4.50 +1.0 +0.6 0.0
Bonds 0.30 0.95% 0.90 +0.6 +1.0 0.0
Cash 0.15 0.75% 0.00 0.0 0.0 +1.0

If dw is defined as the change from the benchmark weight in each asset class, then the sum of all the asset class
deviations must be zero, since any increase in an asset class weight is at the cost of another asset class weight. For
the portfolio, this is determined from the following equation:
dw(cash) + dw(stocks) + dw(bonds) = 0 (6.2)

To illustrate, if the stock weight increases by 20%, the allocations to bonds and cash must together drop by 20%.
Therefore, the portfolio’s expected alpha can be expressed as follows:
E [ alpha] = E êé Rportfolio úù - E [ Rbenchmark ] = dw(cash) Rcash + dw(stocks)E [ Rstocks ] + dw(bonds)E [ Rbonds ] (6.3)
ë û
In a mean-variance framework, the expected tracking error can be expressed as follows:7
TE = SDportfolio-benchmark (6.4)
é dw 2 2 ù
ê (bonds) var(bonds) + dw (stocks) var(stocks) + ú
= square root ê ú
ê2dw dw SD SD corr ú
êë (stocks) (bonds) (bonds) (stocks) (stock, bond) úû

There is not a single solution to the tracking error equation that gives a maximum alpha while limiting the tracking
error to the budgeted amount. It depends on how the relationships play out between the expected returns, risks and
correlations. Furthermore, the formula grows more difficult as more asset classes (and correlations) are added. Still,
an investor can adjust the various benchmark allocations to find a good one.
This is done in Tables 6.2 and 6.3. In both tables, the columns correspond to changes in the cash allocation and the
rows to changes in the bond allocation. Each change in the cash and bond allocation implies a change in the stock
allocation. For instance, if the bond allocation decreases by 20% and the cash allocation increases by 10%, the
stock allocation must increase by 10% because the changes must add up to zero, as follows: (+10 − 20 + 10) = 0.
Shorting of stocks is not permitted.

7
Please note that “var” represents the variance. The variance is equal to the standard deviation squared, or conversely, the standard deviation
is equal to the square root of the variance. Also note that “corr” represents the correlation.

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Table 6.2 | A Portfolio’s Expected Alpha

Change in Cash Weight

−10.00% 0.00% 10.00% 20.00% 30.00% 40.00% 50.00%
−30.00% 0.06% 0.00% −0.06% −0.12% −0.18%
−20.00% 0.08% 0.02% −0.04% −0.10% −0.16%
−10.00% 0.10% 0.04% −0.02% −0.08% −0.14%
Change in Bond Weight

0.00% 0.06% 0.00% −0.06% −0.12%

10.00% 0.02% −0.04% −0.10%
20.00% −0.02% −0.08%
30.00% −0.06%
40.00%
50.00%
60.00%
70.00%

For example, in Table 6.2, let’s calculate 0.08% for the instance of a 20% decrease in the bond weight and a 0%
change in the cash weight (meaning that the stock weight increases by 20%). The expected returns are taken from
Table 6.1. The 0.08% was calculated as follows:
(Cash weight change × Expected cash return) + (Stocks weight change × Stocks expected return) + (Bonds weight
change × Expected bonds return)
= (0 × 0.75%) + (0.20 × 1.35%) + (−0.20 × 0.95%)
= 0% + 0.27% + (−0.19%)
= 0.08%

Table 6.3 | A Portfolio’s Expected Tracking Error

Change in Cash Weight

−10.00% 0.00% 10.00% 20.00% 30.00% 40.00% 50.00%
−30.00% 1.65% 1.21% 0.77% 0.36% 0.27% 0.65% 1.08%
−20.00% 1.25% 0.80% 0.37% 0.18% 0.58% 1.02% 1.47%
−10.00% 0.85% 0.40% 0.09% 0.51% 0.96% 1.41% 1.86%
Change in Bond Weight

0.00% 0.45% 0.00% 0.45% 0.90% 1.35% 1.80% 2.25%

10.00% 0.09% 0.40% 0.85% 1.30% 1.75% 2.20%
20.00% 0.37% 0.80% 1.25% 1.70% 2.15%
30.00% 0.77% 1.21% 1.65% 2.10%
40.00% 1.17% 1.61% 2.05%
50.00% 1.57% 2.01%
60.00% 1.97%
70.00%

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For example, in Table 6.3, let’s calculate 1.21% for the instance of a 30% decrease in the bond weight and a 0%
change in the cash weight (meaning that the stock weight increases by 30%). One adjustment must be made: the
standard deviation shown in Table 6.1 under risk must be squared to get the variance needed in the formula. For
example, the standard deviation (in decimals) for bonds is 0.009, and the square of this number is 0.000081.

2 2
(-0.3) ´ (0.000081) + (0.3) ´ (0.002025) + 2(0.3)(-0.3)(0.009)(0.045)(0.6)

= (0.0000073) + 0.0001823 + (-0.0000437)

= 0.0001459

= 0.0120789

Next, 0.0120789 multiplied by 100 equals 1.21% (rounded to two decimal places)
Table 6.2 shows a portfolio’s expected alpha for various combinations of cash and bond allocation changes.
Table 6.3 shows a portfolio’s expected tracking error for the same allocation changes. The changes shown in both
tables are restricted to plus or minus 10% increments. In both tables, the combinations that resulted in a negative
stock allocation were excluded.
The best choice is to decrease the cash allocation by 10%, decrease the bond allocation by 10% and increase the
stock allocation by 20% to 75%. These adjustments will produce an expected alpha of 0.10% per quarter.

RISK BUDGETING AND SECURITY SELECTION

Using risk budgeting to help in security selection is far more difficult than using it for asset allocation. Security
selection means one of the following two things:
1. Picking specific securities within each asset class; or
2. Choosing active fund managers who will create portfolios that are different from the asset class they represent
in an investor’s portfolio.

The major difficulty that arises is the volume of calculations. In a mean-variance framework, each asset has an
expected return, risk and correlation with every other asset. This is not a problem when an investor is looking at 10
or fewer assets. However, it becomes a major problem when an investor is choosing specific bonds or stocks to
buy from the thousands available, or deciding which mutual funds to invest in from the hundreds offered for each
asset class.
A second difficulty that arises is that there is no evidence that managers can produce positive alpha on a consistent
basis over time, or that there is any systematic relationship between alpha and tracking error. If mutual fund
managers are not producing higher excess returns when they deviate from their benchmarks, it would be a moot
point to attribute expected alpha and tracking error estimates to them.
The benefit of specifying a tracking error limit is that it indicates to the investor when a proposed allocation
deviates too far from the benchmark. Risk budgeting helps prevent big negative return surprises and is designed to
protect an investor from their own greed. Risk budgeting also requires an investor to visualize active investment
decisions in terms of the risks assumed, not the returns expected. Often, it is difficult to focus on risk once a large
alpha opportunity is perceived. Risk budgeting becomes even more important as the number of potentially risky
assets in a portfolio increases. The number of potential asset combinations increases as does the uncertainty of
return outcomes. Subsequently, a portfolio manager’s need to enforce risk discipline increases.
The drawback of using risk budgeting is that an investor could have much higher return opportunities at slightly
higher risk levels. The risk level is restricted, regardless of the opportunities in the market. Investors could settle
for managers or portfolios within the tracking error limit, even though there are managers or portfolios that might
deliver considerably more returns at marginally higher risk.

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ACTIVE MANAGEMENT STYLES

MPT, which is based on the theory of capital asset pricing, supports the use of passive portfolio management.
According to MPT, all financial assets, either as individual securities or portfolios, offer expected returns that fall
on the security market line (SML). Such returns are proportionate to a particular asset’s systematic risk.
To some extent, the following forms of active portfolio management conflict with the principles of MPT.
Nevertheless, while passive portfolio management is common, it is not the norm. In practice, the majority of
funds are actively managed to some degree by sector rotation, timing or momentum strategies, or by the search
for undervalued stocks.
In contrast to a passive portfolio manager, an active portfolio manager takes positions on equity values that
challenge the idea of market efficiency and the continuous equilibrium pricing of financial securities. An active
portfolio manager acts as if they can identify underpriced securities, known as the selection dimension, and can
also anticipate general market movements, known as the timing dimension.

SECTOR ROTATION
Sector rotation is an attempt to pick the best sectors. A portfolio manager identifies specific sectors that will offer
expected superior performance, then invests the majority of a portfolio’s funds in these sectors. As an example,
these sectors might include resources, financial services, high-tech, pharmaceuticals, electronics or utilities. A
portfolio manager’s task is not only to identify which sector is likely to outperform, but also when it will do so. There
is an element of short-term trading in sector rotation and timing is crucial. Sector rotation tends to be aggressive,
which is the opposite of the buy-and-hold approach.
Sector rotators believe in diversification, which is the basis of modern portfolio management, but they do not
accept all of the principles of MPT. They generally hold a number of stocks in a chosen sector (or sectors) in order
to capture the risk-reducing benefits of diversification. However, they also believe they can identify the highest
expected return-to-risk ratios in a given group of sectors. The presence of any ability to identify higher return-to-risk
opportunities contradicts capital market efficiency, which assumes no such ability exists.
If a sector rotation portfolio outperforms other portfolios in its systematic risk category, there is no consistent
basis for ascribing the portfolio’s superior performance to sector rotation per se. In fact, since a sector rotation
strategy is intended to produce a result that differs from indexes, indexes are probably inappropriate benchmarks
for measuring the performance of actively managed portfolios.

TIMING
Active portfolio management is substantially focused on timing; in other words, portfolio adjustments made
in anticipation of changes in the market’s direction. Effective timing implies that a manager can anticipate the
market’s general ups and downs. In particular, timing is premised on forecasts of protracted increases or decreases
in the market index. The objective is to take advantage of the market’s upswings and to minimize losses during
its downturns.
Timing strategies call for changes in a portfolio’s asset allocation in anticipation of general changes in the market’s
direction. The asset allocation mix can be represented as w% of the risk-free asset and (1 − w)% of a well-diversified
set of risky assets; for example, the market index. If a portfolio manager anticipates that the market index will rise,
effective timing calls for adjusting the asset allocation towards more of the index and less of the risk-free asset.
In other words, the manager needs to decrease w. However, if the manager expects the market to fall, they will
increase w.
Timing strategies can be interpreted in terms of an ex-ante Sharpe ratio, which is the expected risk premium
divided by a portfolio’s standard deviation. If the market index is expected to rise, then the ex-ante Sharpe ratio of a
well-diversified portfolio is likewise expected to rise. In this case, since the portfolio manager anticipates a higher risk
premium per unit of risk, the manager uses a timing strategy by allocating a higher proportion of the portfolio to risky
assets (or the market index) and a correspondingly smaller proportion to the risk-free asset, thus decreasing w.

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In terms of timing, the key question for the portfolio manager is whether the market will move up or down. Can the
manager answer this through scientific approach or does success depend on intuition or chance? Does the answer
lie in the technical analysis of trends or in an understanding of fundamental economic influences? Although in
practice there are many approaches to market timing, none has emerged as the basis for a stable, successful and
replicable strategy.
In the short run, if an individual portfolio manager can devise and effectively apply a timing strategy, their
portfolio will inevitably outperform the market. However, if the manager’s strategy and methods become widely
known, which is likely, since success attracts attention and imitation, the strategy’s replication will soon dilute
its advantage.
Stock prices represent the capitalized value of expected future earnings. As a result, market movement is driven by
changes in expectations of future earnings across the broadest spectrum of industries, along with the ever-shifting
estimates of interest rates and the cost of equity capital. Forecasting, estimating and guessing represent more or
less scientific attempts to peer into the uncertain future of industry-sector performance.
Most timing strategies involve the analysis of leading economic and financial indicators. Economic indexes of
planned capital expenditures, inventory accumulations, housing starts or consumer spending, or financial indicators,
such as the monetary conditions index or the term structure of interest rates, often provide the basic information
that portfolio managers use to predict market movements. However, in the end, when a portfolio manager acts
strategically in anticipation of a movement in the market, they act with the confidence that their view of its
direction or change in direction is superior to or at least in advance of the view of most other investors.
In summary, effective timing strategies assume superior forecasting ability. If a portfolio manager can predict
that the market will rise — and, equally important, when it will rise — the anticipated returns from the rise in the
market can be magnified by either shifting the portfolio’s weight to equities rather than bonds, or by increasing
the portfolio’s beta. Likewise, the manager can defend the portfolio against anticipated adverse movements in the
market by adjusting it in the opposite direction — that is, towards more bonds or a lower portfolio beta, or both.

VALUE, GROWTH AND CAPITALIZATION

When they are devising a strategy for investing in domestic equity markets, major plan sponsors seek specialized
portfolio managers whom they believe can add value within a particular area of expertise. These sponsors look
for managers who use methodologies that are broadly categorized as growth or value. They also distinguish
managers by the capitalizations in which they specialize. For example, a typical plan like OMERS might include
a growth stock manager who specializes in large-capitalization growth stocks and a value stock manager who
specializes in large-capitalization value stocks. The group of managers — internal or external — might also
include a small-capitalization stock manager or a further breakdown into small-capitalization growth and value
stock specialists.
Traditionally, mutual fund organizations describe a fund’s investment objectives in broad terms, such as growth or
income/growth, which might be construed as value. At the same time, portfolio managers typically portray their
investment strategies broadly as growth and value. These classifications are reinforced through their common use
among consultants, plan sponsors and performance evaluators.

INVESTING FOR GROWTH

Growth stocks are characterized as stocks that are expected to grow at superior rates, whereas non-growth stocks
are characterized as stocks that grow at a rate that matches the growth in the overall economy.
Growth expectations are unobservable, so proxies are required to assess the sort of growth that an investor expects
for a stock or group of stocks. One widely used measure for assessing growth expectations is the sustainable growth
rate, which is equal to the return on equity multiplied by the retention rate. The retention rate is the percentage of
the company’s net income that is not paid out in the form of dividends. For example, if a company pays out 20%
of its net income as dividends, then it retains 80% of its net income, so we would state that the company has a
retention rate of 80%.

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VALUE/INCOME INVESTING
Investing for value is a style that can be characterized as non-growth. A portfolio manager’s focus is on the quality
of individual stocks, which are chosen for their stability of earnings, high dividend yield and leadership within their
industry or importance in the economy. A value fund’s objectives are income and capital preservation, and the fund
is characterized by low volatility. Those who manage value portfolios have conservative expectations for capital
appreciation to supplement income flows from dividends or interest. High-yielding blue-chip stocks will usually
make up a value/income equity portfolio.
Mutual funds that are designed for value are often characterized as balanced funds. Such funds commonly include
bonds and blue-chip equities. Mixing bonds and stocks can help reduce the price volatility of a fund’s units because
of the low correlation of returns between the two asset classes. There will be fewer opportunities for capital
appreciation and the fund will produce income in the form of both interest and dividends.

CAPITALIZATION SIZE
Financial research has uncovered an interesting relation between equity returns and firm size. The smallest
capitalization firms (small caps) generate consistently higher returns on a conventional risk-adjusted basis.
This so-called size effect has been retested a number of times in a number of ways, and it seems to hold up
remarkably well.8, 9
The size effect is an anomaly to the capital asset pricing model (CAPM) and MPT. When the size effect was first
reported, many experts tried to reconcile the findings with the theory that it challenges. Because it is an important
issue for many portfolio managers, it is useful to briefly review some of the arguments that have emerged over the
years, including the following:

• One explanation for the small firm effect points to weaknesses in the statistical methods used to measure
systematic risk. The argument is that small firm betas are biased downward, making such betas appear
smaller than they truly are. Two reasons for the downward bias have been suggested. First, compared to larger
firms, small firms tend to be thinly traded, which introduces gaps in the data series. These gaps produce beta
estimates that understate the true value.
• Second, dealing with data as opposed to technique, many small firms have become smaller, or downsized, as a
result of strategic business decisions. These smaller firms are fundamentally different and typically riskier than
they previously were. However, since beta is measured from historical data, the old “larger firm” characteristics
remain embedded in the data. This so-called “errors-in-variables” problem would likewise lead to a downward
bias in the estimation of beta.
• Another reason why the CAPM may underestimate expected returns for small firms is linked to liquidity.
Investors demand a higher expected return for less liquid stocks, because trading them involves higher
transaction costs. There is substantial evidence that small stocks have higher bid-ask spreads. Furthermore,
less liquid stocks are more vulnerable to price impacts that result from large transactions. These considerations
suggest that the higher returns on smaller stocks are in part compensation for illiquidity.

In the meantime, while financial researchers wrangle about the reasons, the so-called size effect has spawned a
number of small-capitalization funds. Indeed, whether the excess returns are real or phantom, or whether they
compensate for higher transactions costs and illiquidity or not, smaller firms offer an unambiguous advantage
through diversification as the small-capitalization companies category’s returns are less than perfectly correlated
with the rest of the market.

8
Avner Arbel and Paul Strebel, “The Neglected and Small Firm Effects,” Financial Review 17 (1982): 201–18.
9
Marc R. Reinganum, “Abnormal Returns in Small Firm Portfolios,” Financial Analysts Journal 37 (1981): 52–56, 71.

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 CHAPTER 6 MANAGING EQUITY PORTFOLIOS 6 • 17

ACTIVE PORTFOLIO CONSTRUCTION

ENHANCED ACTIVE EQUITY INVESTING
Long-only portfolios — in which short selling is not allowed — are restricted in their ability to underweight securities
by more than the securities’ benchmark weights. The most a portfolio manager can do is not own the security.
Because the contribution of most securities in many benchmarks is relatively small, there is almost no opportunity
to significantly underweight unattractive securities in long-only portfolios. However, enhanced active equity
investing10 relaxes the long-only constraint, while maintaining full portfolio exposure to market return and risk.
In enhanced active equity investing, an active portfolio manager overweights the securities they expect will
outperform the benchmark, and underweights those they expect will underperform the benchmark. Any security
can be overweighted to achieve a significant positive active weight, but most securities cannot be underweighted
enough to achieve a significant negative active weight.
Allowing a portfolio manager to short stocks gives them more room to underweight overvalued securities and
enhances their ability to produce more attractive active equity returns. Short selling also reduces a portfolio’s equity
market exposure to systematic risk. Market exposure can be restored by matching the amount of stocks that are
sold short with additional purchases of stocks that are held long.
There are three main reasons why an enhanced active equity manager may want to short securities, as follows:
1. To take advantage of a singular opportunity: Shorting due to a unique alpha opportunity is straightforward. An
enhanced active manager shorts stocks based on the belief that a stock’s price will fall either in absolute terms
or relative to the market. These types of shorts are based on stock-specific events, catalysts or a company’s
fundamental characteristics.
2. To exploit relative returns between two stocks: Pairs trading involves simultaneously buying one security and
shorting another in the same industry with similar business or fundamental characteristics. For example,
consider two companies in the insurance industry: Manulife (MFC) and Sun Life (SLF). An enhanced
active equity manager buys MFC stock and shorts SLF stock based on their expectations that MFC’s stock
performance will positively diverge from that of SLF’s. Or the manager may short MFC’s stock and buy SLF’s
stock given the belief that the performance of these two stocks will converge to a historical norm.
3. To hedge out industry exposure in order to isolate an alpha return: In order to hedge out industry exposure to
isolate a stock-specific alpha signal, a portfolio manager may buy MFC’s stock and short SLF’s stock to isolate
exposure to a segment of business maintained by MFC but not SLF. Managers engaging in these types of shorts
are often interested in the company but not in the industry in which it operates.

Therefore, enhanced active equity portfolios are a variation of actively managed long-only portfolios. They are
constructed by selling short selected stocks and reinvesting the short sale proceeds into additional long positions.
For example, a manager with $100 of capital could sell short $30 of securities and use the $30 proceeds to purchase
$130 of long positions, which results in a 130–30 portfolio. The portfolio has a net equity exposure of $100 and its
capital remains fully exposed to the market, while the beta remains close to 1.00. Similarly, the manager can create
portfolios with other long–short combinations — 120–20, 150–50 and so on. Enhanced returns come from both
leverage and short selling.
Figure 6.1 (below) illustrates the mechanics of an enhanced active equity portfolio. For a 130–30 portfolio, the manager
deposits $100 in an account with a prime broker. The prime broker provides the back office services — securities
lending, financing, custody and clearing, and so on — to enable the short selling to take place. Next, the prime broker
arranges for the manager to borrow directly from the stock lender the $30 worth of securities that the manager sells
short. The $30 in proceeds from the short sales, with the initial $100, is used to purchase $130 of securities. The $30 in
long positions is used to collateralize the borrowed stocks, which are held in a stock loan account.

10
Bruce Jacobs and Kenneth Levy, “Enhanced Active Equity Strategies,” The Journal of Portfolio Management (Spring 2006): 45-55.

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Figure 6.1 | An Enhanced Active Equity Portfolio

1 2 3 4
Client deposits Manager $30 securities $30 proceeds
$100 with her borrows $30 are sold short from short sale
investment securities from go back to the
manager a stock lender manager

7 6 5
Stock lender $30 long stock $130 used by
given to stock manager to
lender as purchase stock
collateral for long
borrowed stock

In an enhanced active equity portfolio, short positions are likely to be smaller-capitalization stocks. These are
the securities that cannot be meaningfully underweighted until they are sold short. An enhanced active equity
portfolio’s short positions will generally have a smaller average capitalization than the benchmark. In order to
offset the small-capitalization bias, the portfolio’s long positions will also have a similar small-capitalization bias.
By establishing offsetting long and short positions, the entire portfolio will approximate the underlying benchmark’s
average capitalization. The enhanced active equity portfolio can benefit from greater diversification across the
opportunities provided by the individual stocks in the benchmark. Greater diversification across underweight and
overweight opportunities should result in greater performance consistency relative to the benchmark.
The advantage of being able to sell stocks short may be greater than the skill of buying undervalued ones. For
example, earnings disappointments may have a stronger impact on prices than positive earnings surprises. Portfolio
managers who are skilled at forecasting earnings disappointments can better use their abilities if they can increase
security underweights with short positions. Furthermore, there may be an information advantage to shorting
stocks, especially small-capitalization ones.
Most analysts are bullish in their recommendations, underrepresenting poorly performing companies. Also,
small-capitalization stocks are under-researched versus their large-capitalization counterparts. The underweight
constraint of long-only portfolios, the limited amount of short selling that takes place and the tendency for brokers
to favour buy recommendations over sell recommendations all suggest that overvaluation may be more common
and of greater magnitude than undervaluation.
Institutional investors may be more comfortable with 130–30 strategies than with alternative investment
strategies that use derivatives or exotic investments. Enhanced active equity construction allows them to use
familiar equity allocations.

LONG–SHORT INVESTING
Market-neutral long–short investing, which is also known as market-neutral investing or long/short in the following
section,11 is a portfolio construction technique designed to take greater advantage of information within equity
markets. The difference between market-neutral management and more traditional active management is that
market-neutral management eliminates the market’s effect and is more aggressive in its stock shorting, amplifying
the approach by using leverage.

11
Barra RogersCasey, “Market Neutral Investing”, 2000.

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There are two strategies to use in market-neutral investing: absolute return and alpha portability. Long–short is an
absolute return strategy with return and risk expectations in excess of those for Treasury Bills (T-bills). Within a
portfolio, many managers use market-neutral investing as part of a strategic allocation to alternative investments.
A benefit of long–short equity investing is the portability of its alpha. Using futures, the long–short alpha can be
applied to any asset class. (Alpha portability is discussed later in this chapter.)
In the construction of a long-short portfolio, a portfolio manager uses the starting capital to purchase securities,
which is the long portion. The second part of the strategy involves short selling securities.
In a long-short equity strategy, there are two primary sources of return. The first is the return from the long–short
positions, which has the following two components:
1. The long portfolio, where the portfolio manager is a buyer of stocks.
2. The short portfolio, where the long–short equity manager borrows stocks from another manager through
securities lending channels, then sells the stocks to generate the short portfolio.

The value added comes from the long portfolio’s return being greater than the short portfolio’s return.
In a long-short strategy, the goal of active management is to generate a positive spread between the long and short
portfolios. The second source of return comes from the strategy’s T-bill component. When the manager sells the
stocks short, they receive proceeds from the sale. These proceeds are reinvested in T-bills and become the second
source of return, as well as the strategy’s benchmark.
Table 6.4 illustrates that properly constructed long–short strategies can provide alpha in any market environment.
In the up-market scenario, the S&P 500 Index returned 25%. In this case, the long portfolio’s 18% positive return
trailed the S&P 500 Index, which is quite typical of active managers in an extremely strong market. The short
portfolio rose 12%, a negative return for a short manager. The net result is a +6% spread between the long and
short portfolios. When combined with T-bill returns, the strategy provides a 10% total return.

Table 6.4 | Long–Short Strategies and Their Effect on Alpha

Up Market Down Market Flat Market Perverse Spread

S&P 500 Index 25% −25% 0% +20%
Long-Short Strategy
Long Portion +18% −16% +7% +15%
Short Portion −12(+12)% +21(−21)% −2(+2)% −21(+21)%
Long/Short Spread +6% +5% +5% −6%
T-Bill Return +4% +4% +4% +4%
Total Return +10% +9% +9% −2%

Likewise, in the 25% down market, the long portfolio lost 16% and the short portfolio fell 21%, a positive 5% net
return for the manager. Again, the overall result is a 9% total return. In a flat market, the long position gained 7%
and the short position gained 2% for a 5% spread. Finally, when the spread between the long and short portions is
negative, which is referred to as a perverse spread, the returns of long–short strategies will trail T-Bills. As illustrated
in Table 6.4, one of the most attractive features of long–short strategies is that it does not matter what the S&P
500 Index does, as long as a positive spread exists between the long and short portfolios. The return is purely active,
reflecting the manager’s stock-picking skills.

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THE BENEFITS OF LONG–SHORT INVESTING

Market-neutral investing provides several benefits. First, the returns the strategy generates are independent
of the market’s direction. Long–short returns are broadly uncorrelated not only to stocks and bonds, but also
to equity-style returns and to the active returns of equity managers. Another benefit is that long–short equity
strategies use information more efficiently, which results in higher risk-adjusted returns. In addition, the alpha
that long–short equities generate is portable to other asset classes, which can be beneficial to rebalancing and
asset allocation.
Furthermore, long–short investing is said to make more efficient use of information. Portfolio managers develop
elaborate processes that rank the attractiveness of stocks from highest to lowest using various inputs. However,
long-only portfolio managers only use the top portion of the ranking output and discard the information about the
worst-ranked stocks. The short side of a long–short portfolio takes advantage of this discarded information.
Much of the investment community is focused on which stocks to buy, instead of which stocks to sell short. An
argument can be made that there are greater information inefficiencies on the short side of a portfolio. Long-only
managers are inherently constrained to the size of any given security’s underweight position, as its largest
underweight versus the benchmark is constrained at 0. A long-only manager must maintain stock holdings with
market average returns merely to maintain benchmark exposure.
In contrast, a long–short manager is not constrained by a stock’s benchmark weight and can have a greater
underweight in that security. Not only does long–short investing use more information, but some of the less
efficient information is used and provides greater opportunity. Therefore, long–short portfolios not only have the
value added or alpha of a typical long portfolio, but also the value added of the short side. This “double alpha”
provides better risk-adjusted returns than long-only strategies.
Another positive attribute of long–short equity strategies is the flexibility provided in asset allocation and
implementation. The alpha that is generated by a long–short equity strategy can be left as a cash-plus-alpha
strategy, or the alpha may be “ported” to any other asset class using futures. The alpha’s “portability” enables
managers to increase or decrease their stock, bond or cash allocations — or a combination thereof — or to rebalance
their fund structure as required through the use of an alpha-generating investment vehicle. This can be done more
cost-effectively, because these instruments allow the manager to transact without actually buying or selling
individual securities. Just as with long–short equities, the use of portable alpha strategies may in fact lower the
costs of an asset allocation or rebalancing policy without giving up alpha potential. The details of implementing a
portable alpha strategy are discussed later in this chapter.

ISSUES WITH LONG–SHORT INVESTING

In addition to the benefits of long-short investing, there are also some drawbacks.
Long–short equity strategies are more expensive to maintain than long-only ones. Not only are the management
fees higher, as most market-neutral strategies charge 1% plus some share of the profits, but also the turnover
is higher and the portfolios are costlier to implement. In addition, trading is more expensive in market-neutral
strategies, as there is usually at least twice as much of it, and short selling is clearly more complicated. In order to
address the implementation costs, long–short managers use principal or packaged trades instead of agency trades.
In principal trades, the manager packages all of the trades together and sends to brokers the characteristics of the
entire basket of stocks on which to base their bids. Generally, the lowest price wins.
When using a long–short strategy with futures, there is potentially an additional expense. Investing in futures
requires firms to manage rollover risk. Liquidity can be an issue in less popular indexes, which can make futures
more expensive to trade.
Another drawback is that the capacity of long–short equity strategies is limited. Investment managers face liquidity
constraints on a portfolio’s short side. More often than not, stocks that are sold short in a market-neutral portfolio
will fall into the small-capitalization end of the size spectrum. Therefore, market impact becomes a significant cost.
Also, stocks may have to be repurchased if the lender needs their shares back. These risks are generally higher in
Canada than in the U.S., because the Canadian market’s capitalization is far smaller.

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In addition, if the short seller is selling dividend-paying stocks, they must pay dividend reimbursements,
which depend on a stock’s cash dividends and only occur for stocks that are short on their ex-dividend dates.
Reimbursements are necessary because there are two owners of a shorted stock: the original owner who loaned
the stock to the short seller and the third party who purchased the stock from the short seller. Because the
third-party receives the dividend from the issuer, the short seller must reimburse the original owner for the
“lost” dividend.
The cost per share of the dividend reimbursement does not vary with the number of shares that are shorted, as the
dividend per share is fixed and does not change with the number of shares sold short. In contrast, the per share cost
of the stock loan fee could rise if the demand to borrow shares goes up. As a long–short portfolio increases in size, it
is possible it could face higher fees for shorting stocks, and at some point, these higher fees could have a significant
negative impact on performance.
The more pressing issue is the long-short strategy’s use of derivatives and leverage, but this can actually be avoided.
Unless the alpha is going to be “ported” to a different asset class, derivatives do not need to be used. In their
standard form, long–short equity strategies do not use derivatives. Leverage is typically a standard component of
the strategy. However, managers who are concerned with leverage, or those with guideline limitations on leverage,
have avoided this issue by implementing only 50% of their allocation to long–short strategies, thus reducing the
leverage from 2:1 to 1:1.

PORTABLE ALPHA STRATEGY

Conventional, long-only active investment managers try to build returns from two sources: exposure to systematic
or market risk (beta) and exposure to unsystematic or active risk (alpha). Managers do not take separate risk
exposures on these decisions; rather, when constructing a long-only portfolio, they assume a bundle of systematic
and active risks with each security selection. Thus, a typical active manager’s portfolio could have a beta of less or
more than 1.0 merely as a consequence of alpha exposure. A true active strategy does not depend on the market’s
direction. For example, a pure stock picker’s portfolio would have a beta of 1.0 relative to a market index, and the
value added would only come from security selection.
Portable alpha12 is the process of using derivatives or short selling to separate the alpha and beta return decisions,
and apply the alpha to portfolios made up of other asset classes. In effect, portable alpha enables a manager to
budget risk and increase alpha without drastically changing a portfolio’s asset allocation mix.
A portable alpha strategy consists of three components, as follows:

The beta portfolio As mentioned earlier, beta is the systematic risk or the extent to which an investment
moves with the market. Beta represents the passive returns of long or short exposures
to the market or a mix of these exposures in a portfolio. The benchmark or index
representing the beta should be easily replicable.

The alpha portfolio (or Alpha is the measure of a manager’s skill in adding value by taking active risk, which is
alpha engine) any non-benchmark–like security exposure, such as a stock’s underweight in relation to
its index weight. An alpha portfolio should be three things: (1) unrelated to its underlying
market, (2) independent of its market direction and (3) absolute in nature (to generate
positive returns).

The cash portfolio This component comes from an investor’s initial investment, from the proceeds of
securities sold short after hedging or investing, or from the cash collateral required for
margin on derivative exposures.

12
Edward Kung and Larry Pohlman, “Portable Alpha – Philosophy, Process & Performance”, 2004.

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A portable alpha strategy is where an alpha portfolio is made beta neutral and added to a beta portfolio. Therefore,
the alpha is transported or “ported” to the beta portfolio. Remember that the alpha and beta portfolios each
represent different asset classes (see Figure 6.2 below).

Figure 6.2 | Portable Alpha

Remove
Systematic Systematic Risk
Risk Asset 1
+ +
Unsystematic
Risk Asset 1 Asset 2 Asset 1 Asset 2

Systematic Unsystematic Systematic

Risk Risk Risk

1. Combining a long-only fund that produces consistent alpha with short positions in futures contracts or
exchange-traded funds (ETFs) that represent the underlying beta in an alpha portfolio; or
2. Creating a portfolio that has simultaneous long and short positions in exactly offsetting dollar amounts to
create beta neutrality.

EXAMPLE
Implementing a Portable Alpha Strategy
Assume a manager holds a large-capitalization equity portfolio indexed to the S&P 500 Index. Also assume
there is a separate active small-capitalization portfolio that has added alpha relative to the Russell 2000 Small-
Cap Index. Large-capitalization stocks are expected to outperform small-capitalization stocks over the next
12 months. If the manager wants to increase his small-capitalization exposure, he has to give up the incremental
large-capitalization returns. If the manager wants to avoid small-capitalization exposure, he will have to give up
the alpha from the small-capitalization portfolio.
To get the small-capitalization manager’s stock selection skills and to maintain exposure to large-capitalization
stocks:
1. The large-capitalization manager sells 20% of his portfolio to fund the purchase of S&P 500 Index futures
and the small-capitalization portfolio. The S&P 500 Index futures are purchased in a notional amount that
is sufficient to maintain the portfolio’s original large-capitalization exposure.
2. Futures contracts on the Russell 2000 Small-Cap Index are sold in an amount that is approximately equal
to the value of the small-capitalization portfolio in order to neutralize the small-capitalization beta in the
portfolio. What remains is the difference between the small-capitalization portfolio’s return and the small-
capitalization index’s return — the alpha.

The combined futures positions — one long and one short — allow the portfolio to transport alpha from the
small-capitalization portfolio to the large-capitalization asset class (see Figure 6.3).

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EXAMPLE
(cont'd)
Figure 6.3 | Implementing a Portable Alpha Strategy

Unchanged Small Cap Alpha

80% 20% 80% 20% Small Russell

Large Large Large S&P Cap 2000
Cap
+ Cap
= Cap
+ Index
+ Portfolio
- Index
Equity Equity Equity Futures Futures

Funding

Since the Canadian derivative markets are much smaller and limited, a Canadian portfolio manager might instead
use total return swaps. The manager can contract with a swaps dealer to exchange small-capitalization equity
returns for large-capitalization equity returns. The swap contract might specify that the manager pay quarterly
over the contract term an amount that is equal to the S&P/TSX SmallCap Index’s return multiplied by the small-
capitalization portfolio’s value. In return, the swap dealer pays the manager the S&P/TSX Composite Index’s
return multiplied by the small-capitalization portfolio’s value.

WHAT TO USE AS ALPHA

Most investment strategies can be converted into portable alpha strategies, provided there is alpha to begin with.
Efficient asset classes do not generate enough alpha to be worthwhile. Better alpha can be found in less efficient
markets, such as small-capitalization equities.
An investor should be able to modify the underlying beta. They also need a hedging vehicle to eliminate market
exposure. There should be an index future, swap contract or ETF available with enough liquidity. Some investment
strategies, such as real estate and private equity, do not lend themselves to portable alpha strategies because they
have no hedging vehicle. Table 6.5 provides a list of strategies that work well for portable alpha strategies.

Table 6.5 | Strategies That Can Be Turned into Portable Alpha Strategies

Aggressive growth Managed futures

Convertible arbitrage Market-neutral arbitrage
Currency Market-neutral equity
Dedicated short bias Market timing
Distressed short bias Opportunistic
Emerging markets Multi-strategy
Event-driven Variable
Fixed income arbitrage Short selling
Fund of funds Special situations
Income Value
Long–short equity Volatility arbitrage

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THE BENEFITS OF PORTABLE ALPHA

Portable alpha has a number of benefits. By liberating the security selection return from the benchmarks to
which the securities belong, portable alpha allows investors to maximize both manager selection and asset class
allocation. The decision to maximize alpha no longer needs to be bundled with an investor’s asset allocation
decision, as they can separately pursue the best opportunities in asset allocation and security selection.
Portable alpha may also liberate portfolio managers if they have neglected their own areas of skill in order to pursue
the returns their clients favour. Portable alpha frees managers to focus on the universes within which they feel they
have the greatest skills and the highest potential to add value. This independence should ultimately translate into
enhanced performance for their clients.
By divorcing security selection decision from the asset allocation decision, portable alpha gives investors increased
flexibility in structuring an overall fund. Reaching for greater alpha returns does not need to translate into higher
beta risk. This added flexibility should translate into enhanced performance. In a similar fashion, the manner in
which a portfolio manager constructs an individual portfolio can afford them increased flexibility to pursue excess
returns from security selection.
When it is added to a portfolio, portable alpha can reduce the portfolio’s volatility and increase its efficiency.
Strategies that employ portable alpha strip the systematic risk from the securities in the alpha engine. What
remains is uncorrelated to other asset classes. Also, due to the long and short nature of some of the investments,
portable alpha strategies have broader investment opportunities and should have better risk/return profiles than
conventional long-only strategies.
Finally, portable alpha offers investors improved control over risk budgeting. An investment policy and capital
market forecast allows for a limited amount of risk over an investment horizon. By separating the alpha and beta
decisions, any decisions impacting alpha do not adversely affect the level of beta risk. As such, an investor has better
control over the amount of residual and systematic risk.

ISSUES THAT ARISE WHEN IMPLEMENTING AN ALPHA ENGINE

Arguably, an alpha engine, which is a source of unsystematic returns, is the most important piece of a portable
alpha solution. When selecting an alpha engine, the objective is to find a consistent and positive source of excess
return (alpha) that has a low correlation with the beta to which it is being transported.
When selecting an alpha engine, an investor may err in one of the three following ways:
1. By selecting an inconsistent, unsustainable alpha engine;
2. By using an alpha engine that is inappropriate to meet their desired objectives; or
3. By incorrectly estimating the magnitude and volatility of betas embedded in an alpha engine.

First, to be recognized as skillful, a manager must deliver positive, consistent and sustainable alpha. Frequently, an
investor chooses a manager based on an expected high alpha without considering the reliability of the manager’s
track record. To assess this, an investor must examine the manager’s tracking error, which is the standard deviation of
the difference in the manager’s returns versus those of the benchmark. High tracking errors reduce the attractiveness
of high historical alphas, because they reduce the likelihood that high alphas will be achieved consistently in the
future. An investor who chooses a manager with a high tracking error relative to the expected alpha risks being
surprised with subpar returns. Managers who appear to be generating alpha may be providing beta that is disguised
as alpha. This can occur with managers who are simply leveraging fairly priced assets, or with those who use highly
situational strategies that pay a fair premium for infrequent events. These excess returns are not alpha.
Second, even when investors manage to find a true, consistent, positive and sustainable source of alpha, they
may face risks because they did not fully consider their objectives when choosing the source of alpha. The alpha
engine must provide enough returns to meaningfully impact an investor’s portfolio, while also avoiding imprudent
exposure to risks.

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Alpha is scarce in highly efficient markets, and to deliver significant amounts of it, managers must implement a
more concentrated strategy. However, investors must also be willing to accept the significant associated risks. They
must find a balance between strategies that do not allow significant shifts among asset classes and those that are
highly aggressive.
Finally, ideal alpha engines have consistently low embedded betas; but, as with any portfolio, the betas can be
expected to change over time. Investors who do not consider embedded betas when selecting an alpha engine risk
overpaying for that portion of their return. For example, the average market-neutral hedge fund has significant
embedded beta exposure. Paying hedge fund fees for this type of beta exposure diminishes the benefits of using
portable alpha.

DERIVATIVES STRATEGY
Alpha transport may face interference in the form of unavailability or illiquidity of derivatives instruments. In
particular, futures contracts are not traded on all asset class benchmarks that may be of interest to investors, and
even when they are available, the contracts may not have enough liquidity to support institutional-size needs.
When investors face insurmountable interference in transporting via futures, they can turn to the over-the-counter
(OTC) swaps market. Swaps can be customized to meet most investors’ needs.
Although the price of futures contracts will converge to the price of the underlying index at expiration, futures-
based strategies may not always provide the underlying index’s exact performance for many reasons.
First, although futures contracts are fairly priced to reflect the current value of an underlying spot index and are
adjusted for the forward interest rate and the dividend value of an underlying index, actual futures prices can diverge
from fair price. Less liquid contracts tend to experience greater tracking error. This type of basis risk can add to or
subtract from the performance of derivatives relative to an underlying index.
The performance of futures may also differ from an underlying index’s performance because of inefficiencies from
margin costs and the need to roll over near-term futures contracts. Because the purchase or short sale of futures
contracts involves a deposit of an initial margin — generally about 5% of the value of the underlying stocks — plus
daily marks-to-market, a small portion of the investment funds will have to be retained in cash. This will earn
interest at a short-term rate, but will represent performance drag when the rate earned is below the interest rate
that is implicit in the futures contracts.
Swaps, which are another type of derivative, reduce some of the risks of missing a target index. They generally
require no initial margin or deposit, and the term of the swap contract can be specified to match an investor’s
time horizon. In addition, swap counterparties are obligated to exchange payments according to contract terms;
therefore, payments are not subject to fluctuations in the underlying benchmark’s value, as is the case with
futures contracts.
However, swaps do entail price risk. A swaps dealer will generally charge a spread. For example, a party wanting to
exchange the Russell 2000 Index’s return for the S&P 500 Index’s return may be required to pay that of the Russell
2000 Index plus a few basis points.
In general, the price of a swap will depend on the ease with which the swap dealer can hedge it. If a swap dealer
knows they can lay off a swap immediately with a counterparty demanding the other side, the dealer will charge
less since they do not have to incur the risks associated with hedging its exposure.
Swaps also entail some credit risk, as unlike futures contracts, they are not backed by exchange clearinghouses.
The absence of an initial margin deposit and daily marking-to-market further increases credit risk. Although credit
risk will generally be minimal for an investor or manager swapping with a large, well-capitalized investment bank,
the credit quality of counterparties must be closely monitored to minimize exposure to potential default. Default
may prove costly, and as swaps are essentially illiquid, it may be difficult or impossible to find a replacement for a
defaulting counterparty.

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COMPARING PASSIVE AND ACTIVE PORTFOLIO CONSTRUCTION

TECHNIQUES
Table 6.6 compares enhanced active equity strategies with long-only and long–short strategies in terms of their
active weights and returns. A portfolio’s capital is allocated to seven securities, each with different degrees of
attractive or unattractive returns. The first column gives each security’s expected active return, and the second
column gives each security’s benchmark index weight. The expected contribution to active return is the product of
active weight multiplied by the expected active return. For any portfolio, the sum of the active weights should equal
zero, as capital is freed up from underweight securities to fund the overweight positions.

Table 6.6 | Comparing Active and Passive Equity Portfolio Construction Techniques

Market-Neutral
Enhanced Index Equity Enhanced Active Equity Long–Short Equity
Index Equity Portfolio Portfolio Active Weight Portfolio Portfolio (120–20) Portfolio
Security Benchmark
Security Return (%)

Index Weight (%)

Expected Active

Expected Contribution

Expected Contribution

Expected Contribution

Expected Contribution

Expected Contribution
to Active Return (bps)

to Active Return (bps)

to Active Return (bps)

to Active Return (bps)

to Active Return (bps)

Portfolio Weight (%)

Portfolio Weight (%)

Portfolio Weight (%)

Portfolio Weight (%)

Portfolio Weight (%)

Active Weight (%)

Active Weight (%)

Active Weight (%)

Active Weight (%)

Active Weight (%)

3 8 8 0 0 26 18 54 50 42 126 55 47 141 60 60 180

2 15 15 0 0 33 18 36 40 25 50 50 35 70 25 25 50

1 23 23 0 0 32 9 9 10 −13 −13 15 −8 −8 15 15 15

0 27 27 0 0 9 −18 0 0 −27 0 0 −27 0 0 0 0

−1 13 13 0 0 0 −13 13 0 −13 13 0 −13 13 −15 −15 15

−2 12 12 0 0 0 −12 24 0 −12 24 −15 −27 54 −25 −25 50

−3 2 2 0 0 0 −2 6 0 −2 6 −5 −7 21 −60 −60 180

Total Active Returns 0 142 206 291 490

The index equity portfolio does not underweight or overweight any security. The portfolio exactly matches the
benchmark’s returns.
The enhanced index equity portfolio can take small active positions by no more than plus or minus 18%. The first
two securities shown have the highest expected active security return of 3% and 2% respectively. Therefore, the
maximum active overweight to the portfolio of 18% is applied. The first security’s benchmark index weight is 8%, and
when we add the maximum active weight of 18%, the security’s portfolio weight becomes 26%. The second security’s
benchmark index weight is 15%, and when we add the maximum active weight of 18%, the security’s portfolio weight
becomes 33%. Note that the sum of the positive active weights in the enhanced index equity portfolio (18% + 18%
+ 9% = 45%) equals the sum of the negative active weights ((−18%) + (−13%) + (−12%) + (−2%) = −45%).
The enhanced index equity portfolio is overweight the most attractive stocks by 18%, but the portfolio manager’s
ability to underweight the most unattractive stock is constrained by its benchmark weight. The portfolio manager
could underweight this stock by only 2% (because it has a security benchmark index weight of 2%), even though it
has the same degree of expected active returns as the most attractive stock (i.e., 3% for the most attractive stock and
−3% for the most unattractive stock). Expected contribution to active returns over the index strategy is only 142 basis
points. To calculate the 142 basis points for the portfolio, we must calculate the expected contribution to active
return for each stock and then sum these. For example, for the first security shown, the expected active return is 3%,
and the active weight is 18%. This security’s expected contribution to active return is 54bps (calculated as 3% × 18%).

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The active weight equity portfolio manager is allowed to have a higher active security weight. Thus, the active
weight portfolio pushes its active weight to 67% of its capital. The portfolio is overweight the two most attractive
stocks by 42% and 25% respectively. But the underweights of the two most unattractive stocks are again
constrained by their benchmark weights of 2% and 12% respectively. The total expected active contribution to
active return is 206 basis points.
The constraint against short selling hampers all long-only portfolios in their ability to overweight stocks. None of
the long-only portfolios can take large underweight positions in the two most unattractive stocks, as holding a
zero weight in these stocks frees only a relatively small amount of funds to purchase the attractive stocks. Much of
the capital to fund the overweight positions comes from underweighting the only slightly unattractive or neutrally
ranked stock.
The enhanced active equity portfolio sold short securities equal to 20% of capital (calculated as the (−5%) +
(−15%) portfolio weights of the two most unattractive stocks) and purchased long positions equal to 120% of
capital (calculated as the 55% + 50% + 15% portfolio weights of the long positions held), so its capital is leveraged
1.4 times. Furthermore, the 20% sold short and 20% invested long are all in active positions.
The enhanced active equity portfolio can take larger underweight and larger overweight positions than the enhanced
index or active weight portfolios because it can sell short. Therefore, the enhanced active equity portfolio’s long
positions can contribute more to its return. The portfolio can also underweight the two most unattractive stocks
by more than their benchmark weights, which increases their expected contributions to active returns to 291 basis
points. Now, the most unattractive and attractive stocks can add meaningful expected active return.
The more short selling that is allowed, the more fully the managers can exploit information on expected security
returns. This is reflected with the market-neutral long–short equity portfolio. A market-neutral portfolio invests
100% of capital long and sells 100% short for a two-times leverage factor.13 The long and short positions offset
market exposure so that the portfolio has no market benchmark risk or return. All the return is from alpha. At
490 basis points, the portfolio’s expected contribution to active return is the highest of all of the strategies.
As Table 6.6 shows, the market-neutral long-short equity portfolio can take short positions of −100% (calculated
as (−60%) + (−25%) + (−15%)) that are equal in percentage terms to the long positions of 100% (calculated as
60% + 25% + 15%), and capture the equivalent amount of expected return. This portfolio has no exposure to the
underlying benchmark and does not capture market return or risk.

THE ENHANCED PRIME BROKERAGE STRUCTURE

The creation of enhanced active equity portfolios depends on prime brokerage structures that allow managers
to establish a stock loan account with a broker. The manager is not the prime broker’s customer, as would be the
case with a regular margin account, but instead is a counterparty in the stock loan transaction. This is an important
distinction. Managers can use the stock loan account to directly borrow the shares they want to sell, and the shares
they purchase serve as collateral for the ones they have borrowed.
In a margin account, the broker is an intermediary between the stock lender and the manager. The manager places
the proceeds from the short sale of the securities with the lender. In the stock loan account, the broker arranges the
collateral for the securities’ lenders, providing cash, cash equivalents, securities or letters of credit. This means that
the proceeds from the short sales are available to the manager to purchase securities long.
Furthermore, in a margin account, where the manager is a customer, the broker arranges to borrow the shares the
manager wants to sell short. These borrowed shares are marked-to-market daily. If the borrowed shares rise in price,
the manager must provide the lenders with additional cash collateral to make good on market losses. If the short
positions fall in price, the lenders return the cash to the manager. The manager with a margin account must retain a
cash reserve to meet such demands. This reserve does not generate investment returns, although it does earn interest.

13
The method used to calculate leverage is to add the fund’s short value to the long value and divide by the capital invested, i.e. (100 long +100
short)/100 capital = 2.

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In a stock loan account, the borrowed shares are collateralized by the long securities the manager holds, not by the
short sale proceeds, which eliminates the need for a cash reserve. Therefore, all of the proceeds of short sales and
any other available cash can be redirected towards long purchases.
In exchange for arranging shares to borrow and handling the collateral, the prime broker charges an annual fee that
is equal to about 0.50% of the market value of the shorted shares. Fees may be higher for shares that are harder to
borrow or for smaller accounts. For a 120–20 portfolio, the fee as a percentage of capital is about 0.10%. The broker
also generally obtains access to the shares the manager holds long, up to the dollar amount the manager has sold
short, without paying a lending fee. The broker can lend these shares to other managers to sell short. In turn, the
manager can borrow the shares the broker can pledge from other managers, as well as the shares the broker holds in
its own accounts and the ones it can borrow from other lenders.
Finally, as the manager is a counterparty in a stock loan account, rather than the broker’s customer in a margin
account, the fact the manager is borrowing shares to sell short is not subject to CIRO regulations. Instead, the
manager’s leverage is limited by the broker’s own internal lending policies. In theory, an enhanced active equity
manager could run a 200–100 portfolio holding long positions equal to 200% of its capital and selling short
positions equal to 100% of its capital, or maintain an even more highly leveraged structure.

THE USE OF DERIVATIVES IN EQUITY PORTFOLIO MANAGEMENT

One of the many conclusions of MPT is that diversification can reduce a portfolio’s unsystematic risk to zero,
but that systematic risk cannot be diversified away. With the advent of equity index derivatives, this conclusion
might be modified to read as follows: diversification can reduce a portfolio’s unsystematic risk to zero while
still maintaining an optimal portfolio return, and systematic risk cannot be diversified away without sacrificing
a portfolio’s level of return. This section will deal with the two applications of derivatives in equity portfolio
management: risk reduction — that is, hedging — and changing an asset mix.

HEDGING A PORTFOLIO WITH EQUITY INDEX DERIVATIVES

A hedged portfolio is a portfolio with no exposure to a specific risk. Since a portfolio with no risk should earn a
risk-free rate, why should portfolio managers hedge with derivatives? Why do they not invest in zero-risk T-Bills
to start with? The answer is that managers may wish to eliminate risk for only short periods of time. If a portfolio
manager anticipates an increased level of volatility and a potential for a market downturn, switching a portfolio’s
holdings from risky to risk-free assets (and eventually back again) can be time-consuming and very costly.
Derivatives offer portfolio managers a quick and cost-efficient alternative to a large portfolio overhaul.

HEDGING WITH EQUITY INDEX FUTURES

Portfolio managers can use equity index futures for both short and long hedging. Reducing a portfolio’s systematic
risk involves the implementation of a short hedge, which is implemented by selling equity index futures. If a
manager’s opinion on the market is correct, the actual portfolio position will show a loss, while the short futures
position will show an offsetting profit. The futures position will afford protection against overall market declines for
as long as the manager feels this risk is significant and they keep the position open. The disadvantage is that a short
hedge will be a performance drag if the market rises.
Portfolio managers typically establish long hedges when they want to add positions to a portfolio but do not yet
have the cash available. A long hedge is implemented by buying equity index futures, which gives managers market
exposure on an interim basis. When the cash becomes available, managers can replace the futures position with the
actual stocks that they want to add. Long hedges are frequently employed by equity index mutual funds to avoid
cash drag. Managers who receive a large inflow of cash on a particular day can invest it more quickly and easily by
purchasing index futures than by purchasing individual securities. For convenience and a lack of cash drag, managers
accept the risk of also being exposed to market declines.

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The first step in implementing a hedge, whether long or short, is to determine the total dollar value to be hedged.
The second step is to take the appropriate position — short for short hedges and long for long hedges — in
the futures market using a quantity of index futures that best replicates the portfolio (for short hedges) or the
anticipated addition to the portfolio (for long hedges).
Determining the quantity of index futures contracts that are needed in a hedge requires knowledge of a portfolio’s
beta. If the beta is not taken into consideration, the hedger may find that the portfolio is under-hedged in cases
where the actual beta is greater than 1, or over-hedged in cases where the actual beta is less than 1.
While the use of the beta to determine the number of contracts to use in a hedge cannot guarantee the elimination
of the risk of being under- or over-hedged, since beta only measures a historical relationship, it can give a portfolio
manager some level of assurance that potential losses will be minimized. The number of contracts a manager would
use to hedge a particular portfolio is calculated as follows:
PV (6.5)
H = bP ´
FCV

Where:
H = The number of contracts to use, also known as the hedge ratio
bP = The portfolio’s beta
PV = The dollar value of the portfolio to be hedged
FCV = The dollar value of one futures contract

EXAMPLE
Hedging with Equity Index Futures
Suppose the manager of a $25 million portfolio of Canadian stocks has a bullish long-term outlook for the
Canadian market. However, the manager has concerns about the market outlook over the next three to six
months. Rather than going through the process of selling the portfolio now and then buying it back later, the
manager decides to retain the portfolio and use S&P/TSX 60 Index futures as a hedge. March S&P/TSX 60 Index
futures are trading at 400, and the multiplier for each contract is $200 multiplied by the futures price. Given the
portfolio has a beta of 1.2, the manager implements a short hedge by selling 375 futures contracts:

$25,000,000
1.2 ´ = 375 futures contracts
(400 ´ $200)
Three months later, the S&P/TSX 60 Index has declined by 10%. The manager now feels that the market has
bottomed and she wants to lift the hedge. If the futures declined by 11% to 356 and the portfolio’s stocks
behaved according to their historical betas, the portfolio’s overall profit or loss is calculated as follows:
Underlying portfolio: $25 million × 1.2 × (−10%) = $3 million loss
Futures position: (400 − 356) × 375 contracts × $200 = $3.3 million profit

In this case, the futures position offset all of the portfolio’s loss and more. This is because the futures price
declined more than the cash price.
If instead of falling, the S&P/TSX 60 Index had risen, the portfolio’s gains would have been offset to a large
extent by losses on the short futures position. In effect, the price that the manager paid for downside protection
was to forgo — for as long as the hedge was in place — most, if not all, of the portfolio’s unexpected gains.

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There is no rule that requires a manager to hedge their entire portfolio. They can choose to hedge only a portion
of it. If so, the manager would calculate the hedge ratio using only the beta of the particular part of the portfolio
to be hedged. The same consideration should be made before implementing a partial long hedge. The manager
should estimate the average beta of the stocks that will be purchased and use this number when calculating the
hedge ratio.

CHANGING A PORTFOLIO’S ASSET MIX

The hedging illustration outlined in the previous section transformed the manager’s risky equity portfolio into a risk-
free portfolio that should earn a risk-free rate. The price of stock index futures is normally higher than a spot index.
A portion of this difference represents the interest that sellers forgo by selling futures, rather than selling the index
in the spot market and earning interest on the cash proceeds. The other portion, which actually lowers the price of
futures, represents the dividends from an index’s stocks that buyers forgo by buying futures instead of actual stocks.
However, what if the manager wants to transform their portfolio into 10-year Government of Canada bonds? Or
what if the manager wants to transform their portfolio into a portfolio of U.S. stocks? In this section, the following
two different methods for achieving these goals are discussed:
1. Stock index futures
2. Equity swaps

PORTFOLIO ADJUSTMENTS USING STOCK INDEX FUTURES

Stock index futures allow portfolio managers to change a portfolio’s asset mix in a relatively easy and inexpensive
way. For example, if a manager of Canadian equities wants to lower their portfolio’s Canadian equity exposure
and add (or increase) exposure to the U.S. equity market — or any other foreign market with available equity
index futures — the manager simply has to sell a Canadian stock index futures contract and buy a U.S. stock index
futures contract.
To illustrate, suppose the manager in the previous example wants to temporarily shift their portfolio to an all-U.S.
equity portfolio. In addition to selling the Canadian index futures, the manager has to buy U.S. index futures. The
manager’s portfolio of Canadian stocks will be hedged by the short futures position and the resulting exposure will
be to the U.S. index underlying the U.S. futures contracts. Again, in addition to determining the desired beta of the
portfolio’s U.S. exposure, careful attention to the Canadian portfolio’s beta is required.
The manager could also gain exposure to any market with futures contracts, whether it is bonds, gold, corn or crude
oil. The bottom line is that portfolio managers do not need to sell their actual portfolio and buy the actual assets
where an exposure is desired. It can all be accomplished through futures contracts.

PORTFOLIO ADJUSTMENTS USING EQUITY SWAPS

In the late 1980s, Bankers Trust, a then-leader in financial innovation, started offering various risk management
products based on equity cash flows. The most popular product to emerge from its innovation was the equity
swap. In an equity swap, one counterparty receives cash flows that are based on an equity index, while the other
counterparty receives cash flows that are usually based on interest rates.
There are different variations to an equity swap. One variation is the creation of a synthetic equity position, which
allows a portfolio manager to earn equity returns without actually taking an equity position. Another variation is an
equity swap that allows a portfolio manager to transform equity returns into returns on other assets. An example of
each is outlined below.

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EXAMPLE
Equity Swaps
Synthetic Equity Position

A portfolio manager with a $100 million fixed income portfolio has 20% of it, thus $20 million, invested
in three-month T-Bills. The portfolio manager would like to earn the S&P/TSX 60 Index’s return on the
$20 million portion of his portfolio, and would like to create a synthetic equity position by entering into
an equity swap. The portfolio manager agrees to pay a swap dealer the three-month T-Bill yield every three
months based on a notional amount of $20 million, and will receive the S&P/TSX 60 Index’s return over
each three-month period. Only a net payment representing the difference between these two payments is
made between the two counterparties. As a result, the portfolio manager is able to convert $20 million of his
portfolio that is earning the T-Bill rate to an equity investment that is earning the same rate of return as the
S&P/TSX 60 Index.
A portfolio manager with a $25 million Canadian equity portfolio wants to shift her portfolio entirely into
10-year Government of Canada bonds. Besides using Government of Canada bond futures, the manager enters
into an equity swap with a swap dealer. The equity swap is arranged so that the portfolio would make periodic
payments to the swap dealer based on the S&P/TSX 60 Index’s return. In turn, the swap dealer makes payments
to the portfolio based on the 10-year Government of Canada bond yield, which is currently 5.95%.
The portfolio’s beta is 1.2, so the manager enters into a swap with a principal amount of $30 million. If the portfolio’s
stocks behave as their beta suggests, its $25 million return will be equivalent to the return on a $30 million
investment in the S&P/TSX 60 index. The swap is structured so that payments will be made every six months.
After the first six months, the S&P/TSX 60 Index’s return was 6.5%. According to the above swap details, the
following payments will be made:
$1,950,000 from the portfolio to the swap dealer (6.5% of $30 million)
$892,500 from the swap dealer to the portfolio (2.975% of $30 million)

If the swap calls for net payments to be made between the two counterparties, the portfolio would pay the swap
dealer $1,057,500 [$1,950,000 − $892,500].

TAX CONSIDERATIONS
In practice, the tax treatment of the income a portfolio produces will determine the most appropriate type of
portfolio and portfolio management style for an investor or plan beneficiary based on their marginal tax rate,
investment horizon and investment income needs.
Non-taxable foundations created by tax-exempt institutions, such as religious organizations, or registered plans,
such as pension funds and RRSP-eligible mutual funds, allow realized income streams to compound within a plan
without being taxable in the hands of its beneficiary or contributor. Active management styles will realize capital
gains as individual security positions are liquidated and reinvested. When these realized gains are tax-exempt or
allowed to compound behind the tax shield, active management styles can add significant value to a portfolio.
Conversely, active management styles that realize taxable capital gains or taxable dividends or interest income may
not add value after taxes and transaction costs are considered.
In a taxable environment, investors will favour passively managed growth funds. Actively managed funds and those that
produce taxable income streams in the form of dividends and interest are a disadvantage in a taxable environment.

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The effects of taxation must play a role in an investor’s choice of investments. Investment advisors must be aware
of these factors and advise clients accordingly. A portfolio manager needs to address these issues at a fund’s
inception when establishing its investment policy. A clear understanding of the fund’s clients will guide the manager
in choosing the most appropriate securities and management style.

THE USE OF EXCHANGE-TRADED FUNDS IN EQUITY PORTFOLIO

MANAGEMENT
ETFs are one of the fastest growing types of investment products. While they are often thought of as a retail
product, ETFs were first introduced for use within institutional markets. Institutional portfolio managers continue
to be significant users of ETFs.
These portfolio managers are using ETFs for many different reasons, as outlined in this section. As the ETF industry
continues to grow, it is expected that the use of ETFs by portfolio managers will increase. There are four industry
trends that are driving the next level of growth in ETFs, as follows:

• Growth in fee-based business

• Growth in advisors as portfolio managers
• Demand for transparency
• Broad choices and ongoing innovation in ETFs

The broadest use of ETFs by portfolio managers is for a smaller portion of an overall portfolio. ETFs are seen as tools
with which portfolio managers can build more efficient portfolios.

KEY FEATURES
From a portfolio manager’s perspective, ETFs have a number of key features.

TRANSPARENCY
For passive ETFs, all of their holdings are disclosed on a daily basis for investors and portfolio managers to see. This
disclosure provides the ETF’s composition and helps assess its attributes when adding it to a portfolio. Knowing an
ETF’s holdings helps a portfolio manager use them as building blocks to attain desired exposures, while mitigating
potential duplication with other holdings within the portfolio. For example, a manager that wants international
exposure can easily review an ETF’s holdings to see the specific stocks and their respective sectors, which will
identify potential overlaps with a current portfolio and help identify potential diversification benefits.
In addition to an ETF’s holdings being transparent, the rules that govern these holdings are also transparent. ETF
companies and index providers post this information on their respective websites. Based on this information, a
portfolio manager knows what to expect from the management of an ETF’s holdings in advance. For example,
the rebalancing rules and limits on specific securities or sectors are all outlined. Knowing the model for which the
holdings are determined provides the portfolio manager with a level of confidence.
Lastly, some ETF providers also post the tracking errors to their respective indexes. This also provides transparency,
as portfolio managers can see how the index has performed and how well the ETF has tracked it.

TARGETED EXPOSURE WITH DIVERSIFICATION

With the advancement of equity ETFs into sectors and regions, portfolio managers can now use them to implement
their investment themes where they once only used stocks. Given this refinement, ETFs can be thought of as tools
to create or supplement a portfolio to obtain an exposure, which can make top-down asset mix decisions easier to
implement. While ETFs provide targeted exposure, they still also offer diversification that mitigates single security risk.

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TAX EFFICIENCY
In regard to overall tax efficiency, ETFs provide two benefits, as follows:

• They tend to have low portfolio turnover, resulting in fewer realized capital gains than other investment
products.
• The open market trading of ETF units has no direct effect on the underlying portfolio and no tax consequences
on other unitholders. This is unlike mutual funds, where trading of a fund’s units might trigger capital gains if
enough investors redeem their shares all at once and force the manager to sell off securities to raise cash. ETFs
are similar to owning individual securities in that the trading activities of short-term holders will not have a
tax impact on long-term investors. ETF redemptions are typically placed by institutional holders and ETFs have
a process to allocate capital gains from those redemptions directly to the redeeming counterparty, instead of
affecting all unitholders.

LOWER COSTS
An ETF’s management costs are significantly lower than those of mutual funds. In some cases, the use of ETFs
can result in cost savings versus individual stocks. The following are two examples of potential cost savings from
using ETFs:

Transaction costs A portfolio manager has the choice to buy a few select individual securities or a pre-defined
basket of securities within an ETF. With the pre-defined basket, the manager will only have
one cost to buy or sell multiple securities at once. In addition, some ETFs have automatic
rebalancing, often with no cost to the portfolio.

Reduced bid-offer For an ETF, the spread between the bid and offer can be even tighter than the weighted
spreads average bid-offer spread of its underlying constituents. While cost savings will be
more dramatic on less liquid assets, such as small-capitalization equities, the benefits
of supplementing an ETF for a portion of large-capitalization exposure can also
be beneficial.

LIQUIDITY
Like stocks, ETFs can be bought or sold throughout the trading day. It is important to outline that, unlike stocks, the
volume of trading is not a measurement of an ETF’s liquidity. An ETF’s true liquidity is an outcome of the liquidity
of its underlying securities. The fact that the liquidity of the underlying securities passes through to the ETF will be
explained in greater detail later in this chapter.
Liquidity is also a factor for how quickly a portfolio manager can implement their investment thesis. With ETFs,
a change in direction can be implemented with a limited number of transactions. This improves the speed in
which a directional move can be made and reduces the multiple individual stock transactions that are required to
implement a change.

ANALYSIS OF THE CHOICES TO ETFs

The development of ETFs has provided portfolio managers and their investors with another way to gain exposures
or provide cash equitization. The following is a review of three product choices with their advantages and
disadvantages.

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Table 6.7 | Review of Three Product Choices with their Advantages and Disadvantages

ETFs Futures Swaps/Forwards

Advantages

• Liquidity • Low cost • Fees can be negotiable

• Exchange traded • Real-time pricing • Exposure is fully customizable
• Easily accessible • Easily accessible • No tracking error
• Accessible without derivatives • Leverage • Leverage
licensing
• Growing choice in products,
which permits targeted
exposures

Disadvantages

• Tracking error can be higher • Tracking error from contango/ • Counterparty risk
than the other two choices backwardation and rolling of
contracts
• Lack of liquidity to exit the
• Fees can be higher than the trade prior to expiration
other two choices • Inability to allocate to smaller
• Lack of price discovery, as they
accounts are not traded on an exchange
• Liquidity issues on some
• Inability to allocate to smaller
contracts and limited choice in accounts
desired exposure

The increasing number of ETFs and the vastly different types of exposures they offer provide portfolio managers
with new options that can more precisely equitize a portfolio’s cash portion to effectively maintain their desired
exposures.

PORTFOLIO MANAGEMENT TECHNIQUES USING EQUITY ETFs

Over the years, the styles and types of portfolio management have changed. Initially, portfolio management was
provided in two different types of discretionary management, as follows:

• Through a pooled fund that the portfolio manager would be hired to run under a specific mandate. The
manager would develop and manage a model of holdings. All investors within the pool would receive the same
investment management.
• Through a separate account that an advisor would have discretion over. Each account would be different with
no centralized approach.

With the advent of technology, a centralized model can now manage securities within separate accounts. Through
this approach, managers can create several centralized mandates, such as income, growth and balanced. Each
mandate is comprised of a model portfolio of securities. Then, based on a client’s needs, an account is set up to
track the holdings of a respective model. This allows any changes to the centralized model to be reflected in a
client’s accounts. The process involves a bulk purchase or sale at the centralized level, then an allocation to the
client’s account. The holdings within the client’s account are tracked to confirm that they reflect the centralized
model. When a client’s account does not reflect the centralized model, the differences are flagged and an
explanation must be provided.

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These changes to how investment management is provided combined with the arrival of ETFs, has created new
ways for portfolio managers to manage pools while supporting the growth of separately managed accounts. As
ETFs trade similar to stocks, they can be used in this bulk and allocation approach, and are effectively a new tool for
portfolio managers to consider.
Beyond being another investment tool, ETFs offer some key advantages within the investment management
process that are outlined in the next section.

LIQUIDITY MANAGEMENT
Portfolio managers often have a portion of their portfolios accessible to withdrawals or available from ongoing
contributions, which can create several issues for them, including the following:

• Not all of a portfolio’s securities may be liquid

• Uneven withdrawals or purchases across a portfolio can change its asset allocation
• It can force the purchase or sale of a single security at a sub-optimal time

Holding a portion of a portfolio in cash can cause a cash drag on its mandate.
For all types of portfolio managers, ETFs offer liquid investments that can provide a way to be fully invested in a
portfolio’s mandate. Thus, using ETFs can increase a portfolio’s liquidity without changing its asset mix. ETFs can
also be used as a small percentage of each asset class to provide greater liquidity. Then, when needed, transactions
can be conducted in the ETFs without impacting a portfolio’s core holdings. This will provide a minimal amount of
transactions to invest or withdraw funds and it would be done evenly across the portfolio.

TRANSITION MANAGEMENT
Transition management was one of the first areas in which portfolio managers used ETFs. In managing a portfolio’s
mandate, a specific security can be sold when a replacement has yet to be selected. To keep a portfolio invested in
the market and to reduce cash drag, a manager can use an ETF to maintain this exposure. In effect, the ETF becomes
a temporary holding spot and can be replaced once a new security is identified. This provides a specific targeted
exposure with which to maintain a portfolio’s mandate, while providing a manager with the time to identify the
next outperforming security.
For institutional managers who use sub-advisors, ETFs can be used as a parking spot when transitioning from one
sub-advisor to another. During the selection process for an active manager as a sub-advisor, a passive investment in
an ETF can maintain the market exposure that is aligned with a portfolio’s benchmark.

CORE AND SATELLITE

Portfolio managers that focus on separately managed accounts often specialize in a specific market and manage
a core portfolio. They also recognize the need to supplement these core holdings to better diversify or make a
tactical call on the market. To meet this request, some portfolio managers use sub-advisors or mutual funds, but
liquidity and transparency are an issue with this approach. With the growing choices in ETFs, combined with their
transparency and liquidity, portfolio managers can consider them as an alternative low-cost diversification tool.
The broad choices and transparency of ETFs allow for the specific selection of a basket of securities that can work
as building blocks that work in concert with a manager’s holdings or asset allocation.
Institutional managers can use passive investments in ETFs as a low-cost way of accessing broad markets, then
focus on specialty areas to provide alpha to an overall portfolio.

SIMPLIFIED EXPOSURE TO PREVIOUSLY HARDER TO ACCESS ASSET CLASSES OR

STRATEGIES
As ETFs have expanded into offering hard to access asset classes, new levels of portfolio optimization can be
obtained. This is applicable to portfolio managers who manage pooled funds or separately managed accounts.

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6 • 36 PORTFOLIO MANAGEMENT TECHNIQUES

For example, gold was not easily purchased, stored or sold until the development of physical gold ETFs. Prior to
these ETFs, portfolio managers often used the equity position in a gold-producing company to indirectly provide
gold exposure. With gold ETFs, managers can now directly access this asset class at a low cost. In addition, there are
ETFs that offer other types of exposures, such as specific countries or emerging markets bonds, or strategies such as
covered calls. These ETFs are tools that have expanded the investment horizon, allowing portfolio managers to build
different types of portfolios that previously could not be created.

REBALANCING
Asset allocation is often considered the most important decision, and rebalancing is frequently a requirement for
a portfolio’s mandate. Rebalancing helps avoid drift and keeps portfolio risk within pre-defined limits. Having a
small allocation to domestic, international equity and fixed income ETFs provides an efficient way to rebalance
across asset classes when needed. The respective allocation to ETFs provides a simple and liquid way to rebalance
a portfolio’s asset allocation without impacting its core holdings. Using ETFs will also help lower the number of
transactions needed to rebalance a portfolio.

TACTICAL ASSET ALLOCATION

With the vast choice of available ETFs, portfolio managers can quickly gain diversified exposure to a targeted asset
class while instantly exiting a previous holding. Managers can use ETFs as a primary tool to implement tactical asset
allocation shifts or use them in combination with individual securities.
There are many approaches to conducting tactical asset allocation. In each case, these top-down investment
management approaches have been enhanced by the growing choice of ETFs. The following are just some of the
approaches to tactical asset allocation that ETFs can provide:

• Shifting between equities, cash, fixed income and commodities using broad market ETFs.
• Equity sector rotation using sector ETFs, such as utilities, industrials, energy and financials.
• Changing between value and growth equities with value and growth ETFs, or even with low- and
high-volatility ETFs.
• Global positioning for equities and fixed income with ETFs that focus on emerging or developed markets, as well
as country-specific ETFs.

In each of these examples, ETFs have enabled portfolio managers to more efficiently implement a top-down
investment style.

MODEL CONSISTENCY
For portfolio managers who use a centralized model to administer separately managed accounts, ETFs can be used
to provide consistency in applying the investment model to all clients, regardless of an account’s size. This simplifies
the model’s administration while minimizing the dispersion in performance returns between them. The following are
some approaches where ETFs are used to provide consistency:

For small accounts ETFs can be used to mimic the asset mix of a larger account. Using a small number
of ETFs provides diversification while targeting desired sectors. As this can be done
with significantly fewer holdings, small accounts can participate in the same type of
investment management as large accounts.

For accounts that are ETFs can be short-term holding spots with similar market exposure until an account’s assets
accumulating assets are a reasonable enough size that they can be deployed efficiently into individual stocks.

Employing a strategy ETFs allow all account sizes to access the strategy. When applied to large and small
such as a covered call accounts, it simplifies the model’s overall management.

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 CHAPTER 6 MANAGING EQUITY PORTFOLIOS 6 • 37

TAX-LOSS SELLING
Separately managed accounts have the flexibility to execute the tax-loss selling of specific securities within a
portfolio on an individual account basis. Tax-loss selling is a strategy that harvests capital losses within a portfolio to
offset capital gains so as to reduce an investor’s overall tax bill. In harvesting the loss, it is assumed that the specific
position remains desirable and will be required once the loss is crystallized. To crystallize the loss, the position must
be exited for a minimum of 31 days, when the security or very similar investments cannot be repurchased within
that period.
ETFs are a way of maintaining a mandate’s desired exposure while executing the tax-loss selling strategy. In this
approach, a specific security with a capital loss position is exited for 31 days. Instead of holding cash over these 31
days and potentially missing positive market movements, an ETF can be used to maintain the necessary market
exposure. Moreover, as ETFs cover all asset classes and most sectors, the replacement ETF can be refined to further
limit the opportunity cost of executing this strategy.

HEDGING
Often, portfolio managers want to hedge anticipated market movements. The broad choice of ETFs allows them to
consider them as a tool to hedge a portfolio.
Pooled fund managers can neutralize a good portion of a portfolio by entering a short trade in an ETF. This is an
alternative to selling securities within a portfolio, thereby avoiding capital gains and transaction costs. Alternatively,
pooled fund managers may want to take out the market movements relative to a specific security by shorting a
sector ETF and going long the specific security.
A challenge for separately managed accounts is that they tend not to permit short positions. A single inverse ETF
can be used to provide similar exposure. Hedging currency movements is also an issue for separately managed
accounts, as it is challenging to allocate the derivative to the account level. Some ETFs offer currency hedged
exposure to international markets, which provides an effective tool to enter a basket of international holdings that
are also hedged for currency movements. This all-in-one solution can be allocated to the respective accounts.

CONSIDERATIONS WHEN INVESTING IN ETFs

This section is based on discussions with portfolio managers who are using ETFs. In developing this section, we
wanted to know their key considerations when selecting an ETF. This section provides an understanding of these
key considerations.

AN ETF’S LIQUIDITY
One of the most misunderstood aspects of an ETF is liquidity and volume traded.
The volume traded of an ETF does not demonstrate liquidity, as it does for a stock. With ETFs, the buyer and seller
use an exchange, which is similar to purchasing stocks or closed-end funds in the open market. One key difference
between ETFs and stocks or closed-end funds is that they are open-ended, meaning that supply and demand do not
drive price.
The expanded role of the market maker for an ETF is a key part of this feature. The market maker supports the
liquidity of stocks and ETFs. However, with ETFs, the market maker can also provide a secondary level of liquidity by
exchanging a basket of holdings with the ETF companies for ETF units — and vice versa. This allows for the creation
and removal of ETF units within the market. This process is the key way in which an ETF will reflect the NAV of the
underlying basket of securities and trade throughout the day.
As an ETF is simply a basket of securities, if the underlying is liquid then so is the ETF. Since the basket of securities
is exchangeable for the ETF’s units, any differences are an arbitrage opportunity for market makers and are simply
traded away. In this way, the bid-offer spread of the underlying will transfer through to the ETF. As the bid-offer
spread transfers through, looking at the spread is a way to look at an ETF’s liquidity. Generally, ETFs with larger

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bid-offer spreads represent less liquid baskets. It is important when looking at the bid-offer spread to look at level II
quotes. With level II quotes, you see beyond the retail level of trading of a few thousand shares, seeing the spread to
move a block of 10,000 shares or more will show the ETF’s true liquidity. Wider spreads should be expected for ETFs
with small-capitalization stocks and international holdings, as they represent less liquid baskets. While the spread
will show an ETF’s liquidity, it is also another cost to investing in an ETF, and needs to be managed like all other
costs. In some cases, managers can look at the difference between the current market price and the NAV as another
way to look at an ETF’s liquidity.
ETFs that trade in the U.S. are required to post a real-time view of the NAV known as the indicative net asset value
(iNAV). In Canada, some ETF companies will provide the iNAV as a special service to portfolio managers as an
indication of where they should place their bid or offer to get their trade filled.

AN ETF’S TRACKING ERROR

An ETF’s tracking error measures its performance relative to its index. When there is full replication of the index,
the tracking error should simply be the fees. In cases where the manager is sampling the holdings to represent
the index, the tracking error could be larger. Beyond sampling, there are reasons why an ETF could have a tracking
error, including trading costs, hedging costs and cash drag. If a manager is looking to attain a specific exposure, it is
important for them to review an ETF’s tracking error to see the dispersion in performance. ETFs with lower tracking
errors will better represent the desired exposure. Some ETF companies post tracking errors on their websites.

FUND COMPANY, MANAGEMENT AND SERVICING

Like all fund companies, there is a level of due diligence required when investing in a product. This is still a
consideration when investing in ETFs on a long–term basis. Does management have the skills and expertise to
manage the existing offering or to create new products? Past tracking errors are a reflection of a manager’s skills.
When launching a new product, have they taken the necessary steps to factor in the liquidity of the underlying and
past demand for the product? Are they taking the time to analyze the market before launching a new product? Have
they regularly closed ETFs? Do they engage in securities lending and how much of the book is lent out? How is the
servicing on their products? What is their level of transparency? How often is their website updated? These are just
some of the things to consider when looking at the management and servicing of ETFs.

EXPANDING CHOICES WITH ETFs

Since the creation of an ETF based on the Toronto Stock Exchange in 1990, the industry has expanded in many ways.
While initially, ETFs tracked broad markets like the S&P 500 Index, they have advanced in several aspects to be used
as tools to attain new types of exposures and provide ways to build a portfolio that were simply not available only a
few years ago. Some examples of this innovation are discussed below.

SEGMENTATION OF THE BROAD MARKET INTO SECTORS

With the growing number of ETFs that segment the market, they can now be used to target exposures. For
example, investors who do not want to invest in the broader market or want to increase their holdings in a specific
sector can select ETFs that focus on just one sector of the market. In some cases, segmentation is further refined
to a specific industry.

DIFFERENT APPROACHES TO WEIGHT THE HOLDINGS

ETFs initially followed an approach that weighted the holdings based on their market capitalization, but the industry
has expanded and now provides many different weighting approaches to better represent the exposures that
advisors and investors are looking for. For example, equal or factor weighting approaches will each offer different
attributes. With equal weighting, diversification is set equally for all holdings, while factor weighting identifies a
specific factor, such as dividend yield or beta, to set the weighting.

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 CHAPTER 6 MANAGING EQUITY PORTFOLIOS 6 • 39

COUNTRY-BASED ETFs
Many advisors find it difficult to access specific countries to provide their clients with greater diversification or to
implement a tactical investment into a specific region. ETF providers have worked to fill this gap by offering region-
and country-based offerings on a low-cost basis.

STRATEGY-BASED ETFs
Many advisors and clients are looking for a specific strategy to be executed through an ETF. An early example would
be dividend-focused ETFs, and recent examples include covered call and low-volatility ETFs. With these types of
ETFs, the focus is on gaining exposure to a specific theme.

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SUMMARY
After completing this chapter, you should be able to:
1. Describe the bottom-up and top-down approaches to equity portfolio management.
• Bottom-up approach: The portfolio manager begins by seeking out individual securities to include in a
portfolio. It can take the form of either a value- or growth-oriented approach.
• Top-down approach: Begins with a macro- or microeconomic analysis of trends and market forecasts in the
global, North American and Canadian economies. A portfolio manager selects the sectors they expect will
outperform other sectors within the expected economic outlook.

2. Differentiate between the value-oriented and growth-oriented approaches to investing.

• Value-oriented: Looks for undervalued securities, with little focus on overall economic and market
conditions.
• Growth-oriented: Focuses on individual securities with superior earnings growth rates relative to the market
in general.

3. Describe the passive style of equity portfolio management and discuss the three techniques normally used to
construct an index fund.
• Passive portfolio management is consistent with the view that securities markets are efficient — that is,
securities prices always reflect all relevant information concerning expected return and risk.
• The three approaches to constructing an index fund are replicating an index, tracking an index and
fundamental indexing:
« Replicating an index: Select an appropriate index to replicate, then hold each stock within the fund’s
portfolio in exact proportion to its weighting within the index.
« Tracking an index: A portfolio manager constructs a subset of the benchmark that faithfully mimics an
index. Sampling and mathematical models are two different methods that managers use in index tracking.
« Fundamental indexing: Each stock’s index weighting is determined by four fundamental measures: trailing
five-year cash flow, trailing five-year sales, trailing five-year gross dividends and book value.

4. Explain how to use the risk budgeting process to build a portfolio.

• Risk budgeting is a common technique used to create an enhanced index portfolio.
• There are four steps in the risk budgeting process:
« Determining the appropriate benchmark for a portfolio.
« Determining the maximum acceptable tracking error for a portfolio.
« Identifying the tactical asset allocation or specific return opportunities among securities.
« Building a portfolio that deviates from the benchmark using the return opportunities identified without
exceeding the tracking error limit.

5. Describe the active style of equity portfolio management, including enhanced active equity investing,
long–short investing and portable alpha strategies.
• An active portfolio manager acts as if they can identify underpriced securities, known as the selection
dimension, and can also anticipate general market movements, known as the timing dimension.
• Enhanced active equity investing: An active manager overweights the securities they expect will outperform
the benchmark, and underweights those they expect will underperform the benchmark.

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 CHAPTER 6 MANAGING EQUITY PORTFOLIOS 6 • 41

• Market-neutral long–short investing: This is a portfolio construction technique designed to take greater
advantage of information within equity markets. The difference between market-neutral management and
more traditional active management is that market-neutral management eliminates the market’s effect and
is more aggressive in its stock shorting, amplifying the approach by using leverage.
• Portable alpha: This is the process of using derivatives or short selling to separate the alpha and beta return
decisions, and apply the alpha to portfolios of other asset classes.

6. Explain how derivatives can be used to reduce an equity portfolio’s systematic risk.
• Reducing a portfolio’s systematic risk involves the implementation of a short hedge, which is implemented
by selling equity index futures.

7. Aside from hedging, demonstrate the ways in which derivatives can be used in equity portfolio management.
• Derivatives can be used to change a portfolio’s asset mix. Methods to accomplish this include portfolio
adjustments using stock index futures or equity swaps.

8. Discuss the taxation considerations of various equity portfolio management styles.

• When realized gains are tax-exempt or allowed to compound behind the tax shield, active management
styles can add significant value to a portfolio.
• In a taxable environment, investors will favour passively managed growth funds.
9. Describe exchange-traded funds (ETFs) and discuss the ways in which they can be used in equity portfolio
management.
• From a portfolio manager’s perspective, ETFs have several key features, including transparency, targeted
exposure with diversification, tax efficiency, lower costs, and liquidity.
• ETFs are used by portfolio managers for many different reasons, such as liquidity management, transition
management, to supplement core holdings, simplifying exposure to previously harder-to-access asset
classes or strategies, rebalancing, tactical asset allocation, model consistency, tax-loss selling, and hedging.

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 Managing Fixed Income
Portfolios: Trading Operations,
Management Styles, 7
and Box Trades
CONTENT AREAS

Fixed Income Trading Operations

Bond Management Styles

Box Trades

LEARNING OBJECTIVES

1 | Describe a repurchase agreement (repo) transaction.

2 | Compare buy-side and sell-side fixed income professionals.

3 | Compare passive and active bond management styles, particularly how their approach to interest
rate risk differs.

4 | Discuss and describe the properties of duration in portfolio management.

5 | Describe the main strategies associated with a passive bond management style, including buy and
hold, using barbell and laddered portfolios and creating a bond index fund.

6 | Describe the process of target date immunization and contingent immunization.

7 | Describe the primary active portfolio management strategies, including interest rate anticipation and
box trades.

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7•2 PORTFOLIO MANAGEMENT TECHNIQUES

KEY TERMS

Key terms are defined in the Glossary and appear in bold text in the chapter.

active bond management contingent immunization rate anticipation swap

barbell portfolio horizon analysis repo transaction

bond swap immunization target date immunization

box trade interest rate risk tracking error minimization

buy-and-hold strategy laddered portfolio

cellular (stratified) passive bond management

sampling

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INTRODUCTION
As is the case with equities, bond portfolio management strategies can be passive or active. However, fixed income
portfolio management goes far beyond these two management styles.
The value of a bond portfolio, which comprises a variety of bonds of different maturities and from numerous issuers,
depends critically on the yield curve. A bond portfolio’s management involves selecting different bond issues and
maturities — a process that entails replacing maturing bonds and purchasing additional ones with new funds. Managing
the portfolio may also require the sale of bonds if funds are required or as a strategic response to perceived changes
in the yield curve. A more active management style involves making changes to a portfolio in response to economic
forecasts and their predicted effects on the yield curve and spreads between government and lower-grade bonds.
This chapter begins with a look at an institutional investment management firm’s fixed income trading operations.
Then there is a discussion of passive bond portfolio management strategies, including traditional portfolio design
and indexed portfolios, as well as immunizing a portfolio against interest rate changes and anticipated cash flow
requirements. The chapter concludes with a discussion about active portfolio management techniques that are used
in anticipation of interest rate changes and for profiting from the differences in yield spreads.

FIXED INCOME TRADING OPERATIONS

Most medium- to large-sized institutional investment management firms divide fixed income portfolio management
duties into two primary occupational roles: portfolio manager and trader. This division of duties does not normally exist
for small institutional investment management firms, where the fixed income portfolio manager performs both roles.

FIXED INCOME DEPARTMENT – FUNCTIONAL ORGANIZATION

The diagram below shows the typical functional organization of a fixed income portfolio management department
at a medium- to large-sized institutional investment management firm.

Diagram 7.1 | Typical Functional Organization of a Fixed Income Department

Chief Investment
Officer

Head Head
Fixed Income Equities

Portfolio Manager Portfolio Manager Portfolio Manager

Domestic Fixed Income Foreign Fixed Income High Yield Fixed Income

Trader Assistant Portfolio Manager Assistant Portfolio Manager

Domestic Fixed Income Domestic Fixed Income Domestic Fixed Income

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7•4 PORTFOLIO MANAGEMENT TECHNIQUES

The reporting line of authority is highlighted for the domestic fixed income portion of a firm’s assets under
management (AUM). Similar lines of authority normally exist for other major fixed income sectors, such as foreign
fixed income and high-yield fixed income.
Within a firm, the portfolio manager who is responsible for all domestic fixed income portfolio management
normally reports to the global head of fixed income portfolio management, who in turn reports to the chief
investment officer. The assistant portfolio managers and trader(s) who are responsible for domestic fixed income
portfolios report directly to the portfolio manager who is responsible for domestic fixed income. Under this typical
organizational structure, the portfolio manager is also ultimately responsible for the activities and effectiveness of
the fixed income portfolio trader(s) they supervise.

RELATIONSHIP BETWEEN A PORTFOLIO MANAGER AND TRADER

A fixed income portfolio manager and trader must work very closely together as a team in order to maximize the
overall effectiveness of their combined portfolio management duties and responsibilities. It is generally accepted — and
indeed often the case — that portfolio managers and traders have different skills and capabilities. However, the
effective combination of these skills and capabilities is key to maximizing the results for the portfolios they manage.
In order for the portfolio manager-trader relationship to be most effective, each individual must recognize the skills
and strengths of the other and strive to make decisions based on them.
Open and clear communication between the two individuals is also necessary for an effective working relationship.
Communication failures can potentially have drastic results for the portfolios under management and the
individuals themselves.
A fixed income portfolio manager’s primary focus is economic analysis, monetary policy and the creation of an
overall fixed income portfolio strategy, while a trader is focused on transaction execution. Strong capabilities in both
of these areas are required to excel in the highly competitive area of institutional portfolio management.

BOND FINANCING AND REPO TRANSACTIONS

Some institutional fixed income investment managers can invest their clients’ funds on a long-only basis and
therefore cannot incorporate other portfolio management techniques, such as leverage and short selling. This
limitation would normally apply to the following types of institutional investment managers:

• Pension plans and endowments

• Life insurance and property/casualty companies
• Institutional investment managers offering pooled funds to high-net-worth and institutional investors

However, certain types of institutional investment managers and traders can, and generally do, incorporate either or
both leverage and short-selling techniques in their portfolio and trading activities. The primary types are as follows:

• Traders/market makers at broker/dealers

• Proprietary traders at broker/dealers
• Hedge fund managers

Traders and market makers at broker/dealers normally leverage (finance) their fixed income portfolios by using
repo transactions. A standard repo transaction is essentially a sale/repurchase agreement wherein a broker/dealer
does the following:

• Sells a fixed income security to a third party, usually an institutional investor, on a specific day at an agreed
upon price; and
• Simultaneously agrees to buy back (repurchase) the same security from the institutional investor at a set price
on a future date, which is usually one day later; although, some repo transactions can be for as long as a week.

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The difference between the repurchase price and the sale price for the fixed income security is essentially the
borrowing (or financing) cost for the broker/dealer. The dealer then uses these borrowed funds to purchase other
fixed income securities for trading purposes, and accordingly leverages the size of its fixed income portfolio. Of
course, this financing cost is normally deducted from a portfolio manager’s trading performance, and therefore
represents an additional financial hurdle that they must consider when deciding to enter into trades that require
financing.

COMPARISON OF SELL-SIDE AND BUY-SIDE FIXED INCOME

PROFESSIONALS
Due to the over-the-counter (OTC) nature of fixed income markets, institutional fixed income portfolio managers
(buy side) and fixed income traders at broker/dealers (sell side) are normally on the opposite side of a transaction.
Although they are both trading the same security and trying to profit from the transaction, there are a number
of essential differences between the nature, goals and both internal and regulatory limitations placed on each of
these fixed income market participants, respectively. Table 7.1 highlights the primary differences between these
two professionals:

Table 7.1 | Sell-Side Versus Buy-Side Fixed Income Professionals

Comparison Fixed Income Trader Institutional Fixed Income

Aspect at a Broker/Dealer Portfolio Manager

Primary occupational Absolute performance: Earn the Relative performance: Rank as high as
goal/performance highest amount of capital gains and possible in appropriate peer performance
factor return on capital from fixed income analysis. High relative portfolio performance
trading operations. ranking is viewed as critical and essential in
order for the firm to grow its AUM, thereby
increasing its revenue through higher
investment management fees.
(Note: An absolute performance goal
is shared by fixed income hedge fund
managers.)

Secondary Increase the market share of trading Contribute to the growth of the firm’s AUM
occupational goal/ activity with institutional investor by supporting sales/marketing efforts and
performance factor target market. client service activities.

Tertiary occupational Assist with the growth and Contribute to a firm’s growth through the
goal/performance profitability of the firm’s fixed income support of new product design and launches.
factor underwriting operations by providing
counsel regarding market conditions
and new issue pricing.

Source of assets Broker/dealer capital. Investor funds (both individual and

institutional).

Regulatory capital Yes, broker/dealer must operate None.

charges and within the regulatory restrictions
limitations that govern the firm’s capital
management.

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7•6 PORTFOLIO MANAGEMENT TECHNIQUES

Table 7.1 | Sell-Side Versus Buy-Side Fixed Income Professionals

Comparison Fixed Income Trader Institutional Fixed Income

Aspect at a Broker/Dealer Portfolio Manager
Use of leverage Yes, with amount varying almost Not permitted, except for most fixed income
constantly, but within regulatory hedge funds.
limits. Required in order to
underwrite fixed income securities
and make two-way markets.

Use of short sales Yes, in fact it is required by those Not permitted, except for mutual funds and
broker/dealers who are required to most fixed income hedge funds.
make constant two-way markets for
government fixed income securities.

Immediate Head of domestic fixed income Head of fixed income.

supervisor trading.

Direct staff reports Usually none. In some cases, perhaps Assistant portfolio manager(s), fixed income
a fixed income trading assistant. trader(s) and some administrative staff.

Range of securities Normally responsible for trading/ Usually responsible for a very broad
managed/traded market making for a very narrow range of fixed income issuers — federal/
range of securities. Example: Only provincial governments, corporate issuers
Government of Canada bonds and securitized products — since most fixed
maturing within a one- to five-year income fund mandates relate to broad fixed
period. income market indexes. The range will be
narrowed accordingly for specialized fixed
income funds, such as government-only
funds or high-yield funds.

Individual First level: Salary First level: Salary

compensation
Second level: Annual bonus, primarily Second level: Annual bonus, primarily cash,
cash, based on a pre-defined portion mainly based on the quartile ranking of
of a portfolio’s pre-tax trading gains portfolios in peer performance surveys for
for the prior year, which is also known the prior year.
as direct drive. In addition, a portion
Third level: Stock options and/or restricted
of the annual cash bonus can be
shares.
based on the pre-tax trading gains of
the broader fixed income trading unit (Note: Variable compensation potential
or department. is typically higher for portfolio managers
at hedge funds, but it is based on a pre-
Third level: Stock options, restricted
determined percentage of a fund’s absolute
shares and/or share of the firm’s
performance for the prior year.)
overall profitability.

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BOND MANAGEMENT STYLES

Conventionally, bonds are viewed as very conservative instruments that are relatively simple to manage. This is
correct if one limits a bond’s management to a buy-and-hold strategy involving government or other investment-
grade bonds. However, this conservative strategy raises the question of whether to go long or short in maturity.
With a normal (rising) yield curve (see Figure 7.1), long maturities will have higher yields and be more attractive.
Although buy-and-hold guarantees the principal, if interest rates were to rise, it would actually be more profitable
to reinvest in the short term. Similarly, if interest rates were to fall, it would be better to invest long and sell
before maturity, thereby gaining on the bond’s value. With this aim of exceeding the fair rate of return by judicious
maturity selection, the seeds of active management are planted.

Figure 7.1 | The Yield Curve

Legend:
Inverted Yield
Yield to Maturity (%)

15%
Normal Yield Curve

10%

5%

0%
0 1 2 3 4 5 10 20
Years to Maturity

As with equity portfolio management, bond portfolio management techniques are formally segregated into
passive and active styles. These terms refer to a portfolio manager’s investment motivations, rather than the
degree of action required. Passive bond management minimizes the effects of interest rate risk on a bond
portfolio. With this style, no attempt is made to predict the direction or magnitude of interest rates. On the
other hand, active bond management attempts to profit from interest rate risk by predicting the direction or
magnitude of rate changes.
Once a portfolio manager decides to engage in active management, the conservative view of bonds no longer
applies. In fact, active management is far more sophisticated and can expose a portfolio manager to even higher
risks than those of passively managed stock portfolios. Anticipating changes in interest rates and the size of
spreads between high- and low-grade corporate bonds can lead to a variety of strategies that are designed to
profit from these changes. To understand how changes in interest rates can lead to changes in bond prices and
portfolio values, it is necessary to first examine the concept of duration and the risks associated with interest
rate changes.

INTEREST RATE SENSITIVITY

Interest rate risk, which is the variation in bond values due to changes in market yields, affects investors in two
ways. First, there is the well-known price risk, which is the variation in market value, and second, the reinvestment
rate risk, which is the chance that future proceeds will be reinvested at a lower future interest rate.

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The first step in choosing between passive and active management is to examine the sensitivity of bond values
to interest rate changes. Besides the inverse relationship that exists between a bond’s value and market rates
(interest rates), the factors that affect the price response to interest rate changes are the coupon paid and the
bond’s maturity.

EXAMPLE
Price Sensitivity
Consider three different maturities — one, 15 and 30 years — for two different bonds with a face value of $1,000:
one is a semi-annual pay 8% coupon bond and the other is a zero-coupon bond with semi-annual compounding.
Table 7.2 shows the prices for each bond for annual yields of 6% and 7%, as well as the change in value that
occurs as the yields rise from 6% to 7%, expressed as a percentage of the value at 6%.

Table 7.2 | Price Sensitivity of 8% and Zero-Coupon Bonds ($1,000 Face Value)

Market Rate One Year 15 Years* 30 Years

8% Coupon Bond
6% 1,019.13 1,196.00 1276.76
7% 1,009.50 1,091.96 1124.72
Price Change −9.63 −104.04 −152.04
As % of Value −0.94% −8.70% −11.91%
Zero-Coupon Bond
6% 942.60 411.99 169.73
7% 933.51 356.28 126.93
Price Change −9.09 −55.71 −42.80
As % of Value −0.96% −13.52% −25.22%

Two patterns of price sensitivity are evident from the information in Table 7.2:
1. All else being equal, the longer the bond’s maturity, the higher its sensitivity to changes in interest rates.
2. All else being equal, the lower the bond’s coupon rate, the higher its sensitivity to changes in interest rates.
* For the 15-year, 8% semi-annual coupon bond with a yield of 6%, the price of $1,196.00 was calculated using a financial calculator as:
N = 30, I/Y = 3, PMT = 40, FV = 1,000, compute PV to arrive at −1,196.00 (rounded to two decimal places).
For the 15-year, 0% coupon bond with semi-annual compounding and a yield of 6%, the price of $411.99 was calculated using a financial
calculator as: N = 30, I/Y = 3, PMT = 0, FV = 1,000, compute PV to arrive at −411.99 (rounded to two decimal places).

One way to understand price sensitivity is to recognize that a coupon bond, with payments at each semi-annual
period, is a more complex instrument than a zero-coupon bond. The earlier payment of interest helps to partly
shield it from the long-run effects of interest rate changes.

DURATION
Duration is an extremely useful concept with three applications. First, its primary use is to describe the effective
maturity of a bond and bond portfolio. The actual maturity of a bond portfolio would be that of its longest bond,
which is clearly an almost irrelevant statistic considering what proportion of funds is invested in that bond. Second,
duration measures the sensitivity of a bond’s price to changes in interest rates, which is important to a bond

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portfolio manager. Finally, depending upon what protection is needed, duration provides the key to immunizing
a portfolio.
In summary, duration does the following for a bond or bond portfolio:

• Captures its effective average maturity

• Measures its interest rate sensitivity
• Aids in immunizing it against interest rate sensitivity

PROPERTIES OF DURATION
For a bond portfolio, the sensitivity to interest rates is the portfolio’s modified duration, which is equivalent to the
dollar-weighted sum of the individual bonds’ modified durations.
A bond portfolio’s modified duration has five general properties, as follows:
1. A portfolio’s modified duration is the dollar-weighted sum of individual bond modified durations.
2. The proportional change in a bond’s price following a yield change is the product of modified duration and the
change in a bond’s yield to maturity.
3. For the same maturity, the higher a bond’s coupon rate, the lower its modified duration.
4. For the same maturity, the higher a bond’s yield to maturity, the lower its modified duration.
5. For the same coupon, the longer a bond’s term to maturity, the greater its modified duration.

PASSIVE PORTFOLIO MANAGEMENT

BUY-AND-HOLD STRATEGY
As the name suggests, a buy-and-hold strategy means purchasing bonds with available funds and holding each
bond to its maturity, thereby avoiding the interest rate risk on an early sale. This approach should be designed so
that a portfolio’s cash flow needs are met by the sale of bonds that are maturing. There will always be an adequate
supply of bonds with a one-year maturity, which can be sold at close to par, if necessary. With normal planning of
impending requirements, maturing bonds can be reinvested in T-bills for short periods. This strategy’s effect is to
ensure that, while the portfolio’s value may rise and fall inversely with interest rates, the value of bonds that are
sold or maturing will always be close to par. The fluctuations in the portfolio’s value are then inconsequential in
terms of delivering the required funds on schedule.
However, it is important to note that holding a bond to maturity does not necessarily guarantee the goal of
receiving a yield to maturity that is equal to the bond’s original coupon rate or its yield to maturity at the time of
purchase. The reinvestment of coupon payments will likely not be at the bond’s coupon rate or yield to maturity
at the time of purchase due to the volatility of market yields over the life of the bond. If interest rates rise over the
period, the realized yield will be higher than the bond’s coupon rate or yield to maturity at the time of purchase, and
vice versa.
There are two portfolio structures that achieve the goal of receiving a yield to maturity that is equal to a bond’s
original coupon rate or yield to maturity at the time of purchase: the barbell and the laddered portfolios. In a
barbell portfolio, bonds are initially purchased at both ends of the term structure — that is, the portfolio consists
of 30-year and one-year bonds. Each year, new one-year bonds are purchased to maintain the short end as the old
ones mature. At the same time, as the maturity of the long bonds decreases to 29 years, they are sold and replaced
by new 30-year bonds. With a rising yield curve, the required 29-year yield is slightly lower than the 30-year yield,
so the bonds can be sold at a slight premium. However, the difference in rates is minimal. The portfolio is once more
a 1–30 barbell. The weighting of the two ends depends on the portfolio manager’s willingness to accept risk for
return, as more long bonds will expose the portfolio to more interest rate risk.

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In a laddered portfolio, bonds are initially purchased with each maturity up to 30 years in equal proportions. After
the first year, each n-year bond is now an (n–1)–year bond — that is, the original one-year bonds mature and are
replaced by the original two-year bonds, which now have one year remaining to maturity. At the long end, there
are no 30-year bonds, because they are now 29-year bonds. The portfolio is rebalanced by using the proceeds of
the maturing bonds to reinvest in 30-year bonds. Changes in the yield curve are likely to cause the weights in each
maturity to vary slightly in market value. Adjustments can be made but are not necessary. Over time, each maturity
will return its original face value when redeemed.
Of the two portfolio structures, the barbell portfolio offers more flexibility in weighting and is more accommodating
for cash. The laddered portfolio can only release one-thirtieth of its value each year. A greater fund requirement
would call for the sale of a longer bond, which would then detract from the 30-year bond’s replacement. Generally,
these passive strategies are aimed at portfolios with no cash demands or net positive inflows, and where cash flow
is not a consideration. The issue of meeting specific cash flow needs will be explained later in this chapter.

BOND INDEX FUNDS

The general idea behind a bond index fund is similar to that of stocks. The intent is to create a portfolio that mirrors
a bond index’s performance and that requires no active security selection. The indexes most often replicated in
Canada are the FTSE Global Debt Capital Markets. While a fund can easily duplicate a stock index’s holdings, it is far
more difficult to duplicate a bond index. There are generally many more index members in a bond index than there
are in a stock index. Furthermore, many bonds are so thinly traded that their weights cannot be adjusted very easily.
This adjustment issue is complicated by a bond’s limited investment life, a problem that does not arise for equities.
Bonds with maturities that fall below one year are dropped from most indexes, while new issues must be added.
These adjustments must be matched by any index fund. At the same time, the coupon income from a bond index is
much higher than the dividend income from a stock index. All of the coupon interest must be reinvested.
With all of these complexities, it is virtually impossible to exactly duplicate an index’s composition. Instead, as an
effective substitute, two methods can be employed to replicate a bond index. The first is cellular, or stratified,
sampling. The characteristics that affect a bond’s value are its maturity, coupon and credit risk. A bond universe can
be described by these three attributes.

EXAMPLE
If a bond index is classified by 29 different year-to-maturity categories (2 to 30), 24 different coupon levels
(0.5% to 12%) and eight different credit rating agency categories (D to AAA), this gives it 5,568 cells
(29 × 24 × 8).

The percentage of the bond universe that exists within each cell is applied to the fund’s total capital, and
representatives of each cell are bought in proportion.

EXAMPLE
For a $500 million portfolio, if the 10-year 6.5% A+ cell is 0.05% of the bond universe, the fund would place
$0.25 million in some 6% to 6.5% A+ bonds with maturities of between nine and 10 years.

A bond index fund is achieved by creating a cellular portfolio, which is a portfolio designed with cells in each of the
three attributes — maturity, coupon and credit risk — containing representative bonds in proportions that match
the market proportions of the bonds in each cell.
Indexed portfolios created by the cellular approach have proven to be very successful in tracking a bond index. To
be effective, the stratification must be fairly detailed and, consequently, a large portfolio must be created in order
to fill each cell appropriately. This method works well in a bond market as large as in the U.S. But, unfortunately, in
Canada, with its smaller and more illiquid market, this approach is difficult to follow.

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The second method of index replication is known as tracking error minimization. This approach uses historical
data to model the tracking error variance for each bond in an index, then minimizes the model’s total tracking
error. A bond’s tracking error is statistically estimated as a function of its cash flows, duration and other sector
characteristics. Quadratic programming is applied to find the optimum index portfolio of minimized tracking
error.

DIVE DEEPER

Cellular Sampling Versus Tracking Error Minimization

On one level, the methods of cellular sampling and tracking error minimization are complementary. The
cell matching of sampling tries to replicate an index’s attributes, while the optimization of the tracking
error minimization model only tries to replicate an index’s return stream.
On another level, there are some definite drawbacks to each method. One problem with cellular
sampling is that matching some cells is more critical than matching others, because the volatility
associated with them is higher. Failure to get a close match results in a higher tracking error in the index
fund. The cellular sampling method also ignores correlations between cells, which results in the risk from
an overweight in one cell to be cancelled with an overweight in another.
The tracking error minimization model relies on historical volatilities and correlations between different
risk factors in the market. Thus, the variance model is limited to the historical experience over the
observation period and may therefore neglect a significant change that has not yet resulted in return
volatility. Furthermore, the quality of the quadratic programming is heavily dependent on the quality of
the historical data. As it is difficult to secure enough data regarding each bond in the index, the tracking
error minimization method is very difficult to implement.

IMMUNIZATION
Immunization can be viewed as a means of protecting a bond portfolio from interest rate risk. For example,
a financial institution may use immunization to shield its statement of financial position against the maturity
mismatch of its assets and liabilities. Regulatory concerns and shareholder responses motivate financial institutions
to minimize these mismatch problems. For example, pension funds use immunization to ensure that an investment
will mature with the exact amount needed on a certain date. This can be achieved by finding a zero-coupon
instrument that matures on the target date. However, there are other more sophisticated approaches, such as the
duration matching procedure that is described below.

MATCHING DURATION
In the previous discussion of a financial institution’s goals, the mismatch between the maturity lengths of the
assets and liabilities was noted. To be precise, it is the difference in the duration of the assets and liabilities that is
of concern. When interest rates rise, banks find that fixed-term, fixed-rate loans, which are financed by floating,
lower-rate deposits, become less profitable. The profit spread narrows until new loans can be issued at higher
market rates. The durations of the loans and deposits must be matched to eliminate the so-called gap that causes
the spreads to narrow and widen. If the portfolios of assets and liabilities have equal durations, then, according
to Property 2 of duration (as described previously), both portfolios will change in value equally and the financial
institution’s net position is immunized. This approach is more flexible and more practical than achieving an absolute
match in maturity between groups of loans and deposits with the same total value.
For the pension industry, the obligation to make a future payout creates a need for a portfolio of fixed income
instruments with a duration that matches the timing of the payout. While a discount bond maturing at that time
will be satisfactory, it may not be available. Instead, a coupon bond with the correct duration will suffice; this means
a bond with a maturity longer than the duration. The consequences are such that the bond must be sold on the

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payout date at a price that, together with the interim interest payments and subsequent earnings on them, equals
the required payout. The bond’s price will fall if interest rates rise (price risk), but the accumulated earnings on the
interest payments will rise (reinvestment rate risk), with the opposite offsetting moves to an interest rate decrease.
It is important to note that this analysis examines the portfolio’s accumulated value as of the payout date, rather
than its present value.
This process is described as target date immunization. The strategy’s success depends in part on the path of
interest rates over the investment horizon. For example, suppose interest rates did not change and interest
payments were reinvested as received at a fixed rate for the period remaining until the payout date. If interest rates
were to increase up to the final date following the last interest payment before payout, the accumulated value
of the interest payments would be unaffected, but the bond’s selling would fall, causing a drop in the portfolio’s
available value.
To be successful, the interim interest payments must be reinvested at the floating rate and at the same rate acting
on the bond. This implies a flat yield curve, which occurs infrequently. In fact, the portfolio needs to be rebalanced
to ensure that its duration remains the same as the payout time over the length of the process. If interest rates
change, rebalancing will be needed, as the portfolio’s duration is inversely related to its yield (Property 4). Even
if interest rates remain the same, the portfolio’s maturity falls over time and, as per Property 5, its duration will
also fall, but at a slower pace. Meanwhile, the duration of the liability is equal to the time remaining, so it is out of
balance with the asset duration.
Contingent immunization is often used as a compromise between passive and active management. In this
case, the manager is willing to risk some of the portfolio’s value in the practice of active management, but at a
certain lower level, they would want to protect themselves against further losses. Assume the manager wishes
to guarantee a certain minimum value for the portfolio by a specified target date. At present, the portfolio’s
value is such that a zero-coupon bond could be purchased to return a value in excess of the desired amount
on the target date. The manager follows an active management strategy until a trigger point occurs, meaning
the point where the portfolio’s value reaches the level at which a zero-coupon bond will mature to the target
amount.

EXAMPLE
Contingent Immunization
Suppose that $100 million is desired in five years and the current market yield is 7%. This means a minimum of
$71.3 million ($100 million ÷ 1.075) invested at the current yield is needed today to attain the desired amount.
The portfolio is currently worth $80 million. The trigger point, which in this case is $71.3 million, is the minimum
value with t years left when a yield of y prevails, such that it equals $100 million ÷ (1 + y)t — we will refer to
this amount as V(y,t). The manager can invest actively, but must monitor the amount [V(y,t)] and compare it
with the portfolio’s value to see if it is triggered. If triggered, the portfolio is immediately rebalanced to create
an immunized position. Note that in Figure 7.2, the trigger point is a rising function of time, although the
smooth diagram represents a constant market yield. The contingent immunization is triggered at point t*. If the
portfolio’s value never falls to the curve V(y,t), it will continue erratically to a higher level at the horizon, rather
than rising smoothly along the curve.

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Figure 7.2 | Contingent Immunization

Portfolio Value

$ (Millions) 100

80
71.3

Trigger point

t* 5 years
Time

Portfolio Value

100
$ (Millions)

80
71.3

Trigger point

5 years
Time

CASH FLOW MATCHING

It was suggested earlier that purchasing zero-coupon bonds — or other pure discount bonds, such as T-bills — that
are due to reach maturity at the time of any cash payout will totally immunize a portfolio against interest rate
changes. Provided the instruments are available, this process, known as a dedication strategy, can be adopted for an
indefinite horizon, though at the risk of some liquidity. Unfortunately, this strategy breaks down when one considers
that pension funds generally have an infinite horizon of payouts. However, it is possible to estimate the duration of
an asset or liability with an infinite life. As such, it appears the standard immunization approach will be part of any
process, even if some dedication is used to match cash flow.

ACTIVE PORTFOLIO MANAGEMENT

Active portfolio management refers to strategies intended to benefit from changes to current interest rates or from
some mispricing in the market for competitive instruments. Active management begins with a prediction about
the direction of interest rates or the relative yields of alternative instruments. Various market participants may see
opportunities to improve their positions by exchanging holdings from one instrument to another. The portfolio
remains invested in fixed income to the same degree — there is no adjustment to asset allocation. Essentially, the
end result of the analysis is to rebalance the portfolio to a preferred allocation within the fixed income sector.

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INTEREST RATE ANTICIPATION

Much of the attention of Wall Street and Bay Street is focused on the actions and predicted actions of the U.S.
Federal Reserve Board or the Bank of Canada. The question is always whether they will raise or lower interest rates,
which is complicated when considering if a change in short-term interest rates will translate to a similar shift in the
remainder of the yield curve. Conceivably, increasing short-term interest rates may reduce inflationary expectations
so that the long rate will not rise. Aside from central bank economists, private sector economists issue forecasts
for inflation, economic growth, and long rates. Based on assorted and often conflicting information, a fixed income
portfolio manager must decide whether to position their portfolio with a longer or shorter duration.
This positioning mechanism is referred to as a rate anticipation swap, where funds are moved from one end of the
yield curve to the other. If interest rates are expected to fall, locking in higher rates for a longer period will be profitable.
Extending the portfolio’s maturities and the duration of the portfolio will result in an increase in its value. Conversely, if
interest rates rise, long-term (or long-duration) bond prices will fall more than short-term (or short-duration) ones and
the portfolio will benefit from a shift to a shorter duration. In the extreme, a rise in interest rates would indicate to those
with perfect foresight that they should move all of the portfolio’s funds into 30-day T-bills, while a fall would indicate
a move to 30-year bonds. Prescient portfolio managers would always invest entirely in either long- or short-duration
bonds unless no change is anticipated. Even in that case, a normal rising yield curve would indicate long-duration
bonds, except for any short-term cash requirements. However, since no one has perfect foresight, a portfolio manager’s
response is to make shifts in average duration at a magnitude that is in proportion to the manager’s convictions.
In determining how to react to a forecast, an analyst uses a technique known as horizon analysis. The analyst
chooses a horizon over which the interest rate change is expected to evolve and at the end of which a new yield
curve is predicted. Swapping two bonds for that period entails a difference in price for the two bonds at the end of
the horizon. During the period, there is also a difference in coupon interest, which is to be reinvested at predicted
rates that are consistent with the yield curve evolution.
If no change in the level of interest rates is expected, investors can ride the yield curve. Since a normal yield curve
is concave and upward sloping, yields get progressively smaller as bond maturities get shorter. A five-year bond
could be priced to yield 4.5%, with four-year bonds yielding 4%. Purchasing a five-year bond priced at par leads to a
capital gain if it is sold one year later and the yield curve has not shifted.
For example, a five-year bond with a semi-annual coupon of 4.5% is worth $1,000 if its yield is 4.5%. One year
later, assuming an unchanged yield curve, it is now a four-year bond yielding 4%, so its price is $1,018.31.* Riding
the yield curve results in a capital gain of almost 2%. This amount is then reinvested in another five-year bond
offering 4.5%, which is again sold after another year elapses. The success of this strategy depends on the absence of
change in the yield curve.

EXAMPLE
Riding The Yield Curve
A portfolio manager of a $10 million fixed income portfolio, consisting of one Government of Canada (GoC)
bond (Bond C) with 10 years to maturity, has recently updated her interest rate forecast and expects little
change in the shape of the GoC yield curve over the next year. She decides that the best interest rate anticipation
strategy involves repositioning the portfolio to ride the yield curve more optionally.
Upon closer inspection of the GoC yield curve, the manager observes a slight kink in the yield curve around the 10-
year mark. She attributes this to the extra demand associated with the highly liquid benchmark 10-year bond issue.
She inputs her no-change scenario for the yield curve into her horizon analysis to evaluate opportunities in the
middle portion of the yield curve. The manager produces the following table of figures pertaining to four GoC bonds.

* The value of $1,018.31 was calculated as: N = 8, I/Y = 2, PMT = 22.50, FV = 1,000, compute PV to arrive at −1,018.31 (rounded to two decimal
places).

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EXAMPLE
(cont'd)

Bond A Bond B Bond C* Bond D

Currently
Time to Maturity 8 years 9 years 10 years 11 years
Yield to Maturity (YTM) 7.0% 7.1% 7.2% 7.5%

One-Year Horizon
Time to Maturity 8 years 9 years 10 years
Expected YTM 7.0% 7.1% 7.2%
Change from Last Year’s YTM −0.1% −0.1% −0.3%
Expected Total One-Year Return 7.7% 7.9% 9.6%

The expected total one-year return includes the coupon payment and the capital gain, assuming all bonds are
currently trading at par, resulting from the declining yields.
In light of her analysis, the manager sells the $10 million position in Bond C and purchases $5 million in market
value for each Bond B and Bond D. The manager estimates that this trade leaves the portfolio’s modified duration
unchanged and increases its convexity marginally. She concludes that the portfolio’s interest rate risk has
changed very little. However, based on her yield curve forecast, the portfolio’s total expected return from riding
the yield curve has increased from 7.9% to 8.65% [(7.7% + 9.6%) ÷ 2]. Of course, if the manager’s no-change
forecast for the yield curve proves to be inaccurate, the portfolio’s realized return over the next year may be
higher or lower than this estimate.
* For Bond C, the expected price of the semi-annual coupon bond in one year is calculated as N = 18, I/Y = 3.55, PMT = 36, FV = 1,000,
compute PV to arrive at −1,006.57.
Next, [(($1,006.57 + $72) / 1000) − 1] = 0.0786. Next, 0.0786 × 100 = 7.86%. Finally, 7.86% was rounded to 7.9%.

BOX TRADES
Before describing the mechanics and rationale of a box trade, it is important to first review the rationale for and
execution of a standard bond swap or trade.

BOND SWAPS
Bond swaps normally involve the purchase of one bond and the simultaneous sale of another related or unrelated
bond. The motivation for a fixed income swap is for the portfolio manager to potentially profit from the correct
analysis of the proper value of the yield spread between the two fixed income securities. The portfolio manager then
structures and executes the trade or swap to capture this assumed market opportunity.
For example, Table 7.3 shows the standard statistical parameters normally considered when a fixed income portfolio
manager determines whether a particular pair of bonds should be swapped. The table shows the summary statistics
for the daily closing yield spread between two particular bonds over a period of two years.

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Table 7.3 | Historic Yield Spread

Government of Canada (Five-Year Maturity) Versus Company X (Five-Year Maturity)

Yield Spread During the Prior Two-Year Period (Basis Points)
+2/−2 Standard Deviations 85/15
+1/−1 Standard Deviation 60/40
Mean 50

In this example, if the current yield spread between the two five-year maturity bonds is, say, 53 basis points, there
would not be a strong argument based on their historic yield spread relationship to support the initiation of a
fixed income swap, since their current yield spread is very close to the historic mean value. This infers that the two
securities are properly valued when compared to one another and thus accordingly, there is no incentive to enter
into a swap.
Alternatively, if the current yield spread between the two bonds is, say, 66 basis points, the Company X bond is
trading more than one standard deviation wider, or cheaper, versus the GoC bond of the same maturity. Stated in
probability terms, the current yield spread is greater than what it was over almost 70% of the time during the past
two years.1 The portfolio manager might decide that the current yield spread is supportive of selling the GoC bond
and to use the proceeds to purchase the Company X bond. Of course, the portfolio manager is anticipating that the
yield spread will decrease or narrow, and a gain on the swap can then be realized.
The fixed income swap will be reversed at a future point in time when either of the following occurs:

• The yield spread for the swap has moved in a favourable direction and has reached the portfolio manager’s
target spread, wherein he decides to reverse the trade and realize the profit; or
• The yield spread has not moved in a favourable direction and the portfolio manager decides to reverse the trade
and take the loss.

EXAMPLE
Reversing a Fixed Income Swap
Reversing a fixed income swap or trade involves the following:

• Selling the fixed income security that was purchased at the initiation of the swap; and
• Purchasing the fixed income security that was sold at the initiation of the swap.

The result is that the swap has been reversed and the portfolio has been returned to the same position it was in
prior to the initiation of the fixed income swap.
Bond Swap
Since the two bonds were issued almost three years ago, a portfolio manager has made several profitable bond
swaps between a Northern Bank Ltd. senior bond (5.75% due 6/30/28) and a U.S. Treasury bond (4.85% due
6/15/28). Assuming a normal distribution, the daily yield spread between the two bonds displays the following
parameters over the past three years.

1
The mean of 50 is a given number in this example. Approximately 68% of all yield spreads for the two five-year maturity bonds lie within 1
standard deviation (above or below) of the mean. The reference to 70% of the time is rounded from “approximately 68% of all yield spreads
for the two five-year maturity bonds lie within 1 standard deviation”. The yield spread of 66 basis points is outside of the 60-basis point yield
spread to 40-basis point yield spread, which has occurred approximately 68% of the time over the last two years.

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EXAMPLE
Bond Swap – (cont'd)
Yield Spread – Northern Bank Ltd. Bond (5.75% due 6/30/28) Versus U.S. Treasury Bond (4.85% due
6/15/28)
Yield Spread (Basis Points)
+2 Standard Deviations +90
+1 Standard Deviations +80
Mean +65
−1 Standard Deviations +50
−2 Standard Deviations +40

The portfolio manager has found the following swaps to be profitable:

• Swap initiation: Sell the U.S Treasury bond and buy the Northern Bank Ltd. bond when the yield spread is
greater than 80 basis points.
• Swap reversal: Sell the Northern Bank Ltd. bond and buy the U.S Treasury bond when the yield spread is near
−50 basis points. (Note this yield spread is negative, since when reversing the swap, the portfolio manager is
selling the higher-yielding bond and buying the lower-yielding bond.)

Currently, the two bonds have the following market yields, prices and yield spreads, respectively.

Yield to Maturity (YTM) and Market Value at Swap Initiation

Bond YTM (%) Market Value (per $100 Bond)
Northern Bank Ltd. Bond (5.75% due 6/30/28) 5.29 103.50
U.S. Treasury Bond (4.85% due 6/15/28) 4.47 103.04
Difference +0.82

The yield spread is greater than 80 basis points, which is the threshold level to initiate the swap, so $1 million of
the U.S. Treasury bond is sold and the proceeds are invested in $1 million of the Northern Bank Ltd. bond.

Forty days later, the bond market has sold off and, accordingly, all yields are higher. Both bonds have suffered
capital losses due to the increase in interest rates; however, the yield give-up between the two bonds is now
51 basis points, which is close to the threshold level to reverse the swap. The two bonds now have the following
YTMs and market prices.
YTM and Market Value at Swap Reversal
Bond YTM (%) Market Value (per $100 Bond)
Northern Bank Ltd. Bond (5.75% due 6/30/28) 5.80 99.62
U.S. Treasury Bond (4.85% due 6/15/28) 5.29 96.62
Difference −0.51

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7 • 18 PORTFOLIO MANAGEMENT TECHNIQUES

EXAMPLE
Bond Swap – (cont'd)
The net profit after reversing the swap is as follows:

• Swap initiation (selling the U.S. Treasury bond minus buying the Northern Bank Ltd. bond): $103.04 − $103.50
= −$0.46 (or a net cost of $0.46 per $100 bond).
• Swap reversal (selling the Northern Bank Ltd. bond minus buying the U.S. Treasury bond): $99.62 − $96.62
= $3.00 (or a net receipt of $3.00 per $100 bond).
• The net profit on the swap: −$0.46 + $3.00 = $2.54 (or a net profit of $2.54 per $100 bond).

Despite the sell-off in the bond market, the bond portfolio has a higher market value of $2.54 per $100 bond,
and the portfolio is invested in the exact same manner it was 40 days earlier. This is the direct result of the
31-basis point narrowing of the yield spread between the two bonds.

DUAL BOND SWAP (BOX TRADE)

With the knowledge of a standard fixed income security trade or swap, it is easier to understand the structure of
a box trade since it involves the simultaneous execution of a pair of related fixed income security swaps. They are
related in that the pair of swaps involves the securities of the same two bond issuers. It is referred to as a box trade
because the pair of bond swaps is commonly depicted as a box on a yield curve diagram. The yield curve in Figure 7.3
depicts a box trade involving the bonds of two issuers — A and B — and immediately below it is a table listing the
four bond transactions that constitute the two bond swaps.

Figure 7.3 | Box Trade – Bonds from Issuers A and B

Transaction 3
Issuer B
Sell Issuer B’s
Y-term bond
Transaction 2
Buy Issuer B’s
X-term bond
YTM (%)

Issuer A

Transaction 4
Buy Issuer A’s
Transaction 1 Y-term bond
Sell Issuer A’s
X-term bond

Term to Maturity (Years)

Swap Transaction
1 Sell Issuer A’s X-term bond
1
2 Buy Issuer B’s X-term bond
3 Sell Issuer B’s Y-term bond
2
4 Buy Issuer A’s Y-term bond

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The objective of a box trade is to profit from the potential market revaluation of the respective yield spreads for
either or preferably both of the two fixed income swaps. In essence, the portfolio manager uses a box trade when
they believe the yield curve for the higher-yielding issuer will either steepen or flatten relative to that of the lower-
yielding issuer.
The portfolio manager employs this type of trade when they believe the yield spreads for each of the two pairs of
fixed income swaps have reached a sufficiently attractive magnitude, which is either too small or too large, so that
both of the swaps should be initiated. Normally, the portfolio manager makes this valuation assessment based
on the statistics of the historic yield spread relationship between the two bonds being traded in each of the two
respective contemplated swaps.
In the example above, the portfolio manager believes Issuer B’s yield curve will steepen relative to that of Issuer
A’s yield curve. Conversely, if the portfolio manager believed Issuer B’s yield curve would flatten relative to that of
Issuer A’s yield curve, the opposite of the four transactions would occur — that is, sells would become buys, and
buys would become sells.
However, in addition, the combination of the pair of swaps that constitute a box trade must also satisfy the
following parameters for or constraints of the total fixed income portfolio:

• No change in the portfolio’s overall duration

• No change in the portfolio’s overall credit risk exposure
• No change in the amount of the portfolio’s assets invested in each of the two credits involved in the box trade

With these additional constraints, a properly structured box trade does not result in any changes to the total
portfolio’s interest rate exposure, overall credit risk exposure and amount of exposure to specific issuers. The
structure of the box trade only provides exposure to the change in the relative yields between the two issuers.
Two of the most popular types of box trades that Canadian institutional fixed income portfolio managers execute
are discussed below.

INTERMARKET DOMESTIC BOX TRADE

An intermarket domestic box trade involves four transactions of four domestically issued fixed income securities
from two Canadian bond issuers. Figure 7.4 shows an example involving the five-year and 10-year maturity bond
issues from ABC Inc. (a Canadian company) and the GoC, respectively. The table at the bottom of Figure 7.4 shows
the four market transactions that would be executed if the portfolio manager believed that ABC Inc.’s yield curve
was going to flatten versus the GoC’s yield curve.

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7 • 20 PORTFOLIO MANAGEMENT TECHNIQUES

Figure 7.4 | Box Trade – GoC and ABC Inc. Bonds

Transaction 3
ABC Inc.
Buy ABC
10-year bond
Transaction 2
Sell ABC
5-year bond
YTM (%)

GoC

Transaction 4
Sell GoC
Transaction 1 10-year bond
Buy GoC
5-year bond

5-year 10-year
Term to Maturity (Years)

Swap Transaction
1 Buy Government of Canada 5-year bond
1
2 Sell ABC 5-year bond
3 Buy ABC 10-year bond
2
4 Sell Government of Canada 10-year bond

If the portfolio manager’s outlook is correct, a gain would be realized on the narrowing of the yield spread between
the two bonds involved in the 10-year swap. Of course, the flattening of the yield curve would also potentially affect
the spread between the two bonds involved in the five-year swap. If the spread between the two five-year bonds
decreases, there would be a loss that would reduce the gain on the 10-year swap. Of course, if the yield spread
increases between the two bonds involved in the five-year swap, a gain would also be realized and added to the gain
on the 10-year swap.

INTRAMARKET BOX TRADE

An intramarket box trade is another popular type of box trade that Canadian institutional fixed income portfolio
managers perform that involves bonds issued by the Canadian and U.S. governments. In this case, the portfolio
manager is speculating on the change in slope or spread between two points on the yield curves of these two
governments, respectively. If the portfolio manager believes the yield curve for GoC bonds is going to flatten versus
the yield curve for U.S. government bonds, the type of trade would appear as in Figure 7.5, and would involve the
four transactions in the table below it.

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 CHAPTER 7 MANAGING FIXED INCOME PORTFOLIOS: TRADING OPERATIONS, MANAGEMENT STYLES, AND BOX TRADES 7 • 21

Figure 7.5 | Box Trade – GoC and U.S. Government Bonds

Transaction 3
GoC
Buy GoC
10-year bond
Transaction 2
Sell GoC
5-year bond
YTM (%)

U.S.

Transaction 4
Sell U.S.
Transaction 1 10-year bond
Buy U.S.
5-year bond

5-year 10-year
Term to Maturity (Years)

Swap Transaction
1 Buy U.S. Government 5-year bond
1
2 Sell Government of Canada 5-year bond
3 Buy Government of Canada 10-year bond
2
4 Sell U.S. Government 10-year bond

The gains and losses from this intramarket box trade would occur in a similar manner as the previously mentioned
box trades.

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SUMMARY
After completing this chapter, you should be able to:
1. Describe a repurchase agreement (repo) transaction.
A sale/repurchase agreement involves selling a fixed income security on a specific day at an agreed upon
price and simultaneously agreeing to buy back the same security at a set price on a future date.

2. Compare buy-side and sell-side fixed income professionals.

There are a number of comparisons that can be made between sell-side (fixed income trader at a broker/
dealer) and buy-side (institutional fixed income portfolio manager) fixed income professionals relating to
primary occupational goal/performance factor, secondary occupational goal/performance factor, tertiary
occupational goal/performance factor, source of assets, regulatory capital charges and limitations, use of
leverage, use of short sales, immediate supervisor, direct staff reports, range of securities managed/traded
and individual compensation.

3. Compare passive and active bond management styles, particularly how their approach to interest rate
risk differs.
There are two bond management styles: passive management, where no attempt is made to predict the
direction or magnitude of interest rates, and active management, which tries to profit from interest rate risk.

4. Discuss and describe the properties of duration in portfolio management.

A bond portfolio’s modified duration has five general properties:
«« A portfolio’s modified duration is the dollar-weighted sum of individual bond modified durations.
«« The proportional change in a bond’s price following a yield change, which is the product of modified
duration and the change in a bond’s yield to maturity.
«« For the same maturity, the higher a bond’s coupon rate, the lower its modified duration.
«« For the same maturity, the higher a bond’s yield to maturity, the lower its modified duration.
«« For the same coupon, the longer a bond’s term to maturity, the greater its modified duration.

5. Describe the main strategies associated with a passive bond management style, including buy-and-hold, using
barbell and laddered portfolios and creating a bond index fund.
Buy-and-hold strategy: This strategy means purchasing bonds with available funds and holding each bond to
its maturity, thereby avoiding the interest rate risk on an early sale.
Barbell portfolio: In a barbell portfolio, bonds are initially purchased at both ends of the term structure —
that is, the portfolio consists of 30-year and one-year bonds.
Laddered portfolio: In a laddered portfolio, bonds are initially purchased with each bond’s maturity being up
to 30 years in equal proportions.
Bond index funds: The intent of a bond index fund is to create a portfolio that mirrors a bond index’s
performance and that requires no active security selection. Two methods can be employed to replicate a
bond index:
«« Cellular or stratified sampling: A portfolio designed with cells in each of three attributes — maturity,
coupon and credit risk — containing representative bonds in proportions that match the market
proportions of the bonds in each cell.
«« Tracking error minimization: This approach uses historical data to model the tracking error variance for
each bond in an index, then minimizes the model’s total tracking error.

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6. Describe the process of target date immunization and contingent immunization.

Target date immunization: The need for a portfolio of fixed income instruments with a duration that
matches the timing of the payout.
Contingent immunization: The manager follows an active management strategy until a trigger point occurs,
meaning the point where the portfolio’s value reaches the level at which a zero-coupon bond will mature to
the target amount.

7. Describe the primary active portfolio management strategies, including interest rate anticipation and
box trades.
Interest rate anticipation: A fixed income portfolio manager must decide whether to position their portfolio
with a longer or shorter duration. This positioning mechanism is referred to as a rate anticipation swap,
where funds are moved from one end of the yield curve to the other.
Box trade: The structure of a box trade involves the simultaneous execution of a pair of related fixed
income security swaps. They are related in that the pair of swaps involves the securities of the same two
bond issuers.
«« Intermarket domestic box trade: Involves four transactions of four domestically issued fixed income
securities from two Canadian bond issuers.
«« Intramarket box trade: Another popular type of box trade that Canadian institutional fixed income
portfolio managers perform involves bonds issued by the Canadian and U.S. governments.

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 Managing Fixed Income
Portfolios: Other Bond Portfolio
Construction Techniques, High 8
Yield Bonds, and ETFs
CONTENT AREAS

Other Bond Portfolio Construction Techniques

High-Yield (Junk) Bonds

Fixed Income Exchange-Traded Funds (ETFs)

LEARNING OBJECTIVES

1 | Discuss the structure of mortgage-backed securities (MBS), asset-backed securities (ABS),

collateralized debt obligations, foreign currency instruments, and real return bonds.

2 | Demonstrate the ways derivatives can be used in fixed income portfolio management.

3 | Discuss high-yield bonds.

4 | Describe fixed income exchange-traded funds (ETFs).

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8•2 PORTFOLIO MANAGEMENT TECHNIQUES

KEY TERMS

Key terms are defined in the Glossary and appear in bold text in the chapter.

asset-backed securities foreign-denominated bonds recovery rate

(ABS)
forward rate agreement securitization
basis risk (FRA)
special purpose vehicle
cash collateralized debt hedge ratio (SPV)
obligation
interest rate futures step-up bond
collateralized debt
obligation (CDO) interest rate swap synthetic collateralized
debt obligation
credit default swap (CDS) mortgage-backed securities
(MBS) tranches
credit derivatives
real return bonds

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INTRODUCTION
Fixed income portfolio management can include more sophisticated instruments that, similar to bonds, have
relatively determined payments, as well as the risk management products that portfolio managers can use to
control bond portfolio volatility.
This chapter begins with a look at alternative instruments, including mortgage- and asset-backed securities
and collateralized debt obligations. Then there is a discussion of the use of derivatives in fixed income
portfolio management. The chapter concludes with a discussion of high yield bonds and fixed income
exchange-traded funds.

OTHER BOND PORTFOLIO CONSTRUCTION TECHNIQUES

In addition to the basic passive and active management approaches discussed in Chapter 7, there are more
modern instruments and techniques used today. These reflect the response of the securities industry to
changing financial conditions. Much of the innovation originates from the drastic increases in interest rates
in the 1970s, when investors looked for better alternatives to bank deposits and government securities.
Today, portfolio choices include many alternatives to conventional bonds. A corporation’s financial assets,
such as mortgages and receivables, can be bundled and sold as short-term instruments with good security.
The process of turning relatively illiquid assets into tradable securities is known as securitization. Also, there
are some well-developed risk management strategies in conventional bond portfolios using derivatives. Some of
the most popular instruments and derivative strategies are presented below.

ASSET-BACKED SECURITIES
Corporations regularly find themselves with current assets, which are classified as receivables, that represent the
debt of customers who purchase goods or services from them. These receivables are likely to be home equity loans;
auto loans; credit card receivables; student loans; home improvement loans; trade receivables; or equipment leasing
on operating assets, such as planes and ships. Corporations and auto dealers regularly finance their inventories by
borrowing from banks and other financial institutions, pledging their inventories as security for repayment. It is also
common for corporations to pledge their accounts receivables to factors that advance cash against the repayment
of the receivables on various terms. Factoring is a profitable, if risky, business.
More recently, the role of the factor has been appropriated by corporations that have their receivables assembled
into packages of loans that are then securitized and sold to investors as asset-backed securities (ABS), which are
a type of bond with cash flows that are supported by the cash flows from a specified pool of underlying assets. The
pooling adds liquidity to otherwise illiquid assets, while also reducing risk by diversifying the underlying portfolio.
An ABS offers competition to T-bills and commercial paper. It provides another vehicle for the placement
of short-term funds with a slightly higher yield, while retaining security and liquidity. It becomes a suitable
alternative for portfolio managers to choose from when designing their fixed income funds.

CREATING AN ABS
The originator of loans can securitize its pool of receivables, rather than issue corporate bonds to finance them.
The first step in creating an ABS is to sell the assets to a legal entity called a special purpose vehicle (SPV). The
originator sets up the SPV, typically as a trust. It is the legal owner of the loans and is separate from the originator.
The SPV buys the loans and sells the securities, which are backed by the loans, to investors in exchange for cash, and
uses this cash to pay the originator. An SPV that is created by a party not related to the originator is called a conduit,
which essentially fills the same role as the SPV set up by the originator.

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The trust’s credit risk is improved using credit enhancement facilities, which are discussed below. The trustee collects
the cash flow generated by the assets, and is responsible for distributing the interest and principal payments to the
investors and the servicing fees to the loan servicer. The loan servicer’s role is to send monthly payment statements,
collect monthly payments, maintain records of payments and balances, collect and pay taxes and insurance, and
follow-up on delinquencies. The basic structure of an ABS is illustrated in Figure 8.1.

Figure 8.1 | Basic Structure of an ABS

Obligors

Servicing Fees Seller/Servicer Liquidity

Cash Flow Credit

Trustee Trust (SPV) Enhancement

Issues ABS
Principal and
Interest Payments
Investors

CREDIT ENHANCEMENT FACILITIES

An ABS needs various forms of internal and external credit enhancements to upgrade the risk-return profile of the
underlying receivables. Credit enhancements reduce the credit risk for investors, thereby increasing the rating on
the investor certificates and lowering the ABS issuer’s funding costs. One or more credit enhancement facilities are
usually required in order to receive a high enough debt rating to make the certificates readily marketable.

EXTERNAL CREDIT ENHANCEMENTS

The credit risk of an ABS can be reduced by using third-party guarantees to provide for first-loss protection (losses
on collateral due to the first defaults) up to a specified level. The most common forms of third-party guarantees
are bond insurance and pool insurance. Bond insurance is a financial guarantee from an insurance company that
guarantees the timely payment of interest and principal if these cannot be satisfied from the pool. Pool insurance
covers losses from defaults and foreclosures. To sufficiently increase the credit rating of an ABS, the third-party
guarantor’s rating must be at least as high as the rating sought. The disadvantage is that if the guarantor’s rating
is downgraded, the securities the insurance guarantees may also be downgraded.
A letter of credit, which is an unfunded commitment by a third party that protects against losses on underlying
assets, is another form of external credit enhancement. Protection is limited to a fixed percentage of collateral.
A bank usually provides a letter of credit in exchange for a fee.

INTERNAL CREDIT ENHANCEMENTS

The credit risk of an ABS can also be reduced internally. A senior/subordinated structure establishes two or more
layers — also known as tranches — of ownership within an ABS. Senior/subordinated classes are structured so that
each position benefits from the credit protection of all of the positions below it. The senior positions get priority

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in the payment of both principal and interest over the junior positions. The junior class absorbs any of the initial
losses on the underlying collateral up to a certain percentage of the total principal. When that is exceeded, the
next level up of seniority will absorb the losses up to a certain percentage, and so on. Senior classes are usually sold
to institutional investors, and the selling bank typically retains the most subordinated piece. As compensation for
absorbing the risk, the yields on the lower classes are much higher than those on the senior ones.
The schedule followed by an ABS that prioritizes the manner in which the interest and principal are paid is known as
the cash flow waterfall. At the top of the waterfall are the senior noteholders and some standard fees and expenses.
At the bottom of the waterfall are the junior classes. The cash flows that remain after all payments are made are
known as the excess spread, which seeds the reserve fund.
Reserve funds are money market deposits held for protection against future losses. Reserve funds are seeded from
either the initial underwriting profits or the excess spread, which is the payment from receivables, net of monthly
coupons, service fees and all other expenses. The excess spread is the first line of defence against collateral losses.
Another internal credit enhancement strategy is overcollateralization, where the principal amount of an issued ABS
is less than the principal amount of the underlying pool of assets backing it.

EXAMPLE
An ABS could be issued for $300 million, but the principal amount of assets backing it is $310 million. The
remaining $10 million of principal provides a cushion in case of default within the original $300 million pool.

MORTGAGE-BACKED SECURITIES
Mortgage pass-through securities were first created in the U.S. in 1970 by the Government National Mortgage
Association, or Ginnie Mae, as it is more commonly known. They were imitated in Canada by the issuance
of mortgage-backed securities (MBS) insured by the Canada Mortgage and Housing Corporation (CMHC)
under the National Housing Act. An MBS is a portfolio of mortgages assembled and sold in tranches to increase
mortgage capital for lenders. It offers secure higher-yielding medium-term investments that are comparable to
government bonds.
To understand an MBS, it is first important to recognize that banks and trust companies no longer wish to lend
funds for individual homes under conventional mortgages. Financial institutions have realized that there is more
profit to be made in issuing and servicing a mortgage — that is, appraising credit, charging fees, advancing the funds,
and collecting and processing monthly payments — than in tying up deposit capital in the loans. It is preferable to
lend $100,000 after the appraisal and collection of initial fees, then sell the mortgage to investors using the CMHC’s
guarantee to get the $100,000 back. At this point, they can lend it again and collect more fees, and then sell it
again, thus leading to a never ending process. The same $100,000 can earn a lot more in initial fees and processing
fees for the monthly payments on each loan.
Most significantly, an MBS adds a lot of liquidity to the market. Investors are happy to buy an MBS, because they
can effectively place money in real estate without facing the risk of default, with the benefit of CMHC’s guarantee,
or the problems related to collections and credit appraisal. The packaging of insured mortgages has the added
benefit of creating a tradable security, the MBS, that comes from nationwide mortgages. The assets are safe
and liquid for investors, and the funds become available for lending to any area without the restriction of local
credit shortages.

PACKAGING AN MBS
The specifics of an MBS program require that financial institutions assemble a portfolio of mortgages that totals
$10 million, for instance, with a common interest rate, term and amortization period. Collectively, this is an MBS,
which is then guaranteed by the CMHC. The MBS is subdivided into individual units; for example, 1,000 units that
are worth $10,000 each with equal claims of 1/1000th of the payment stream from the mortgages contained in

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8•6 PORTFOLIO MANAGEMENT TECHNIQUES

the MBS. The cash flow, as a mortgage payment, is partly interest and partly return of capital. Because mortgages
may have prepayment provisions, which have significant effects on cash flows and yields, an MBS is separately
composed of prepayable and non-prepayable mortgages. Assuming mortgages are more likely to be prepaid when
interest rates are falling, the realized yield on a prepayable MBS will be lower than expected from the interest rates
on component mortgages.
Investors are attracted to the yield on an MBS. Since an MBS is a fixed-payment instrument with the CMHC’s
guarantee, it is comparable to government bonds. The Government of Canada stands behind the CMHC’s guarantee,
making an MBS relatively equal in security to GoC T-bills and bonds. As such, one would expect the yield on an MBS
to be virtually the same as on government bonds. In fact, there is a clear yield premium on an MBS.

ELEMENTS OF PREPAYMENT RISK

When a fixed income portfolio manager evaluates an MBS for inclusion in their portfolio, they need to judge the
prepayment risk. As mentioned earlier, misjudging the prepayment risk can result in a lower yield on the MBS
than the rate on the underlying mortgages. Examined below are the three factors that determine prepayment risk,
as follows:
1. Housing turnover
2. Cash-out refinancing
3. Rate/term financing

Housing turnover Refers to existing home sales. Turnover is positively correlated with prepayment risk.
Home sales are affected by the following:

• Family relocation due to changes in employment or family status (divorce, marriage)

• Trade-up or trade-down activity attributable to changes in rates, income and
home prices

In other words, people are more likely to change housing when it is more affordable.

Cash-out refinancing Refers to the replacement mortgage of a borrower’s first mortgage in order to monetize
the property’s price appreciation. The replacement mortgage is completed for more than
the principal remaining and the borrower pockets the difference.

EXAMPLE
A person whose principal residence is worth $400,000 with a mortgage of $150,000 can refinance it at
$200,000, pocketing the remaining $50,000.

Adding to the incentive for a borrower to monetize their property’s price appreciation is
the tax law regarding gains on a principal residence. The principal residence exemption
allows homeowners to keep the gains tax-free from the sale or cash-out refinancing of
their principal residence.

Rate/term financing Occurs when a borrower obtains a new mortgage on the same property at a lower
interest cost or shorter term to maturity, with no increase in their monthly payment.
The homeowner’s incentive to refinance is based on the projected present value of
the interest savings, net of the cost to refinance. Rate/term financing activity tends to
increase as the prevailing market mortgage rate becomes lower than the borrower’s
current mortgage rate.

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COLLATERALIZED MORTGAGE OBLIGATIONS

A further development from an MBS is a collateralized mortgage obligation (CMO), which exists primarily in the
U.S. In a CMO, the MBS pool is further divided into tranches that make payments based on different segments of
the mortgage cash flows. For example, a fast-pay tranche might receive all of the principal payments from the MBS
until the investment has been recouped, while the other tranches receive only interest payments. Once the fast-pay
tranche is satisfied, the second tranche begins to receive principal payments until it is repaid, and so on, until all
tranches have been repaid. Interest payments are based on each tranche’s outstanding principal. The ordering of the
tranches results in an earlier to later recovery of capital for each class of investor.
An MBS is a portfolio alternative to a coupon bond, with a readily determined duration. Managers may choose to
invest in an MBS to pick up the extra yield while maintaining a target portfolio duration. The market for an MBS is
relatively liquid, making it an attractive alternative for any of the medium-maturity bonds, as they are linked to
mortgages that are typically renegotiable at five-year intervals. In contrast, for the short end, where maturing bonds
and T-bills are usually found, there are securitized instruments based on short-term assets.

COLLATERALIZED DEBT OBLIGATIONS

A collateralized debt obligation (CDO) is a security that repackages a collection of underlying assets and sells
multiple classes (tranches) of the asset pool’s interest to investors. This allows the restructuring of the pool’s credit
risk into new tranches with different risk profiles than the underlying assets. These are debt obligations that are sold
to investors with different risk appetites.
A CDO is very similar to an ABS in structure and operation, except in the type of securitized asset. An ABS is
supported by a discrete pool of receivables, such as home equity loans, student loans, car loans and credit card
receivables. A CDO’s cash flows are supported by MBS, ABS, leveraged bank loans, real estate investment trusts
(REITs), corporate bonds or even other CDOs.
A CDO has three main components that are similar to an ABS, as follows:
1. An originator, which is typically a bank
2. Investors ready to buy the credit risk
3. An SPV

As discussed earlier in relation to an ABS, an SPV, which is also called a special purpose entity (SPE), is a legal
entity created specifically for each individual CDO. An SPV, which is an independent company from the originating
financial institution, takes over the loans from the bank and issues the CDO tranches against them. Thus, the
SPV’s assets are the loans or other risky debt, and its liabilities are the CDO notes. The separation of the SPV
and the originator actually protects investors from the originator’s default under what is known as the SPV’s
default remoteness.
There are two main types of CDOs: cash and synthetic. A discussion of synthetic CDOs will appear later in this
chapter. Under a cash collateralized debt obligation, the originator sells the collateral (assets) to the SPV for cash.
The collateral is now off the originator’s balance sheet and on the SPV’s balance sheet. The SPV pools all of the assets
and sells them in tranches. There are usually three main tranches — senior, mezzanine and equity — and one note is
issued for each tranche, which is ranked by default likelihood and repayment frequency; that is, seniority of debt.
The different tranches have different priority claims on the cash flows from the underlying collateral. These tranches
may be rated by agencies, receiving ratings from very senior (senior tranche) to unrated (equity tranche). The equity
tranche is a residual tranche that will receive payment from the collateral pool after the other tranches have been
paid. If a loss or default occurs, it will first be absorbed by the equity tranche, with any additional losses absorbed by
the mezzanine tranche and so on. Figure 8.2 illustrates a cash CDO’s typical cash flows and structure.

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Figure 8.2 | Typical Structure of a Cash CDO

Originator Collateral sold to SPV SPV

Holds collateral Issues CDO notes
(underlying assets according to different
such as loans or bonds) tranches (different
Payment for purchase
seniorities and coupons)
of collateral

Coupon payment

Investors
Invest in CDO tranches,
for example:
1. Senior tranche
(e.g., AAA)
2. Mezzanine tranche
(e.g., A, BBB)
3. Equity tranche
(not rated)

Principal (returned
by SPV at maturity)

EXAMPLE
Typical Cash CDO
An originator pools loans that are worth $200 million. After selling the loans to an SPV, three tranches are
created, as follows:

Attachment Notional Amount Spread

Tranche Points ($ Million) Credit Rating (Basis Points)
Equity 0%–5% 10 Not Rated 1,200
Mezzanine 5%–15% 20 A 125
Senior 15%–100% 170 AAA 10
Total Portfolio 0%–100% 200 A 81

• The equity tranche is responsible for the first 5% of the portfolio’s losses, with attachment points in the
range of 0% to 5%.
• The mezzanine tranche is responsible for the next 10% of the portfolio’s losses, with attachment points in the
range of 5% to 15%.
• The senior tranche is responsible for the remaining 85% of the portfolio’s losses, with attachment points in
the range of 15% to 100%.

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EXAMPLE
Typical Cash CDO – (cont'd)
What follows are notional amounts that correspond to each of the tranches:

• $10 million for the equity tranche (5% × $200 million)

• $20 million for the mezzanine tranche (10% × $200 million)
• $170 million for the senior tranche (85% × $200 million)

Typically, the equity tranche will not be rated, while the mezzanine tranche will be rated A and the senior tranche
will be rated AAA, for an overall pool rating of A. Commensurately, the equity tranche will generate 1,200 basis
points over U.S. T-bills, the mezzanine tranche will generate 125 basis points and the senior tranche will generate
10 basis points. Overall, the portfolio’s spread over treasuries is 81 basis points, which is the weighted average of
the tranche spreads, calculated as follows:
(0.05 × 1200) + (0.1 × 125) + (0.85 × 10) = 81 bps

Assume there are accumulated credit losses totalling $15 million (7.5%). The equity tranche is the first to absorb
any CDO losses, and does so up to $10 million (5%) of the portfolio. This is why the equity tranche’s yield
(1,200 basis points) is so high — the spread has to compensate investors for the added credit risk of every loan
in the pool. Once the equity tranche is used up, the mezzanine tranche absorbs the remaining $5 million (2.5%).
The mezzanine tranche is now at $15 million — 7.5% of the original portfolio — and continues to absorb any
future credit losses. Investors in the mezzanine tranche are now earning the 125-basis point spread on the new
$15 million balance.

SYNTHETIC COLLATERALIZED DEBT OBLIGATIONS

A synthetic CDO is the credit derivative variant of the cash CDO. In a synthetic CDO, the originator, which is a
financial institution, retains ownership of the underlying assets and buys protection from the SPV using a credit
default swap (CDS), thus swapping the credit risk over to the SPV. This allows the originator to unload the credit risk
while retaining the assets. The SPV inherits the risk structure of the collateral held by the originator and repackages
it into tranches to sell to investors.
It is important to note that the collateral is now a CDS, and the SPV does not buy the underlying assets. Typically, it
uses the proceeds from the CDO tranches to invest in high-quality, low-risk assets, such as treasuries, that generate
the required cash flows for servicing its CDO payment requirements — coupons and the repayment of the principal.
For example, on an interest payment date, the CDO receives the premiums from the CDS, as well as interest on
the high-quality, low-risk assets. The SPV then distributes the interest payments on each tranche according to its
risk level. As with a cash CDO, if a loss or default occurs, the payoff on the CDS is taken from the equity tranche
first (write-down of principal), with additional losses absorbed by the mezzanine tranche, and so on. Figure 8.3
illustrates the cash flows and structure of a standard synthetic CDO.

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Figure 8.3 | Typical Structure of a Synthetic CDO

CDS Coupon
Originator premiums SPV payments High-quality,
Writes CDS Protection/seller in low-risk (e.g., AAA)
with SPV (and the CDS issues CDO assets as collateral
continues to hold notes according to for the SPV
underlying assets) CDS protection different tranches Principal collected
given default (different seniorities from investors
and coupons)

Principal (returned
Coupon payment
by SPV at maturity)

Investors
Invest in CDO tranches,
for example:
1. Senior tranche
(e.g., AAA)
2. Mezzanine tranche
(e.g., A, BBB)
3. Equity tranche
(not rated)

HOW CDOs ARE USED

A financial institution typically initiates a CDO to take certain types of unwanted debt off their statement of
financial position, thus enhancing their on-book debt quality. At the same time, it may repackage some harder-
to-sell debt, making it easier to sell in more investor-specific tranches, thereby increasing the liquidity and market
appeal of the underlying assets. Finally, arbitrage-motivated CDOs may want to benefit from the difference
between the returns on the purchased collateral and the lower weighted-average payments made to the
different tranches.

EXAMPLE
If an SPV makes $50 million a year in returns on the capital received by investors, but needs to pay a total of
$30 million yearly to these same investors across all tranches, it will generate a $20 million profit.

Investors benefit from CDOs by accessing risk-specific tranches that suit their needs. For instance, asset and hedge
fund managers may wish to invest in equity tranches for the high return-risk mix they offer, given appropriate
portfolio design and diversification. Prudent investors, such as institutional pension funds and endowments, may
invest in high-grade tranches with high seniority and security. All these investors benefit from the fact that it may
be difficult or impossible for them to directly invest in a large pool of underlying assets, such as those that support
the CDO in which they invest.

CASH VERSUS SYNTHETIC CDOs

Synthetic CDOs have qualities that make them preferable over their cash counterparts for both issuers and
investors. They can be compiled in the marketplace sooner. The time from inception to finish can be as few as four
weeks or, on average, six to eight weeks. On the other hand, cash CDOs usually take three to four months from

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inception to finish. Synthetic CDOs take less time to assemble than cash ones, because it is quicker to find and settle
a CDS, and there is no need to find cash assets in the market first.
With regard to most credit names, a CDS is cheaper than a similar underlying bond. A CDS is a derivative and,
like most derivatives, is cheaper to deal with than an underlying asset. A CDO’s sponsor will pay only a handful of
basis points for a CDS. A cash bond would cost the benchmark yield plus the credit spread, which is a considerably
higher cost.
Banking relationships can be maintained with clients whose loans do not need to be physically sold off of the
sponsor’s balance sheet. To enact the actual sale of a bank loan, the bank’s client has to grant permission. This
would not create a favourable impression with the client, whose confidence in the bank would depart along with
all of the potential fees from the relationship.
Finally, the range of reference assets that can be used in a synthetic CDO is vast and includes illiquid cash
instruments, such as undrawn lines of credit and bank guarantees, that would give rise to true sale issues in a
cash CDO.
Cash CDOs still have some advantages over synthetic ones, such as the originating entity’s lower exposure to
counterparty risk. In a synthetic CDO, the default of a counterparty would stop payments of the premium payments
or, worse, culminate in a credit event payment and the termination of the CDO. No equivalent counterparty risk
exists in a cash CDO, though default risk still lies with the reference assets. Cash CDOs also have a larger investor
base, because certain potential clients have limits on the use of credit derivatives.
For example, on an interest payment date, the CDO receives the premiums from the CDS, as well as the interest on
the high-quality, low-risk assets. The SPV then distributes the interest payments on each tranche according to its
risk level. Like a cash CDO, if a loss or default occurs, the payoff on the CDS is taken from the equity tranche first
(write-down of principal), with additional losses absorbed by the mezzanine tranche, and so on.

OTHER FIXED INCOME SECURITIES

Modern portfolios should also consider the benefits of recent or increasingly plentiful securities intended to help
reduce the risks that are present in the financial system. These risks include general economic cycle risk, currency
risk and interest rate risk due to inflation. Two opportunities that present themselves are investing in bonds issued
by foreign companies and governments or by domestic companies in foreign currencies, and in bonds whose returns
are linked to inflation.

FOREIGN CURRENCY INSTRUMENTS

The efficient frontier for fixed income securities is greatly improved in a mean-variance context by expanding the
universe of investable assets to include foreign securities. This can occur in a number of ways, but the real choice
depends on the portfolio’s goals. Given an imperfect correlation with international economic cycles, bonds of
foreign corporations will help diversify a portfolio to reduce total risk. Many foreign corporations will choose to issue
U.S. dollar–denominated bonds, while foreign-denominated bond issues abound. This raises the question of whether
such an investment adds to risk due to exchange rate risk.
There are two aspects to exchange rate risk. If the intent is for a bond portfolio to be part of a total portfolio that
includes equities, which these days are more than likely to have a foreign component, then foreign-denominated
bonds — or bonds issued by domestic or foreign corporations, or by governments offering diversification from
interest rate and currency risk — can help offset the equity portfolio’s risk. A detailed analysis of the correlations
between foreign returns, both before and after currency adjustments, is required to determine weights in both
the portfolio’s equity and fixed income components. If the portfolio owner is a corporation whose earnings were
affected by foreign sales or expenses, which is a less likely situation, then the bond portfolio could be used to hedge
those results. The other possibility is to use currency futures to hedge the payments from foreign-pay bonds.

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It should be noted that even for international bond portfolios, the question of currency risk hedging remains open.
There are proponents of currency risk hedging and those who maintain the opposite view. The latter feel that
currency risk is largely diversified in a broad portfolio of international bonds, and that hedging is a time-consuming
and costly process that is consequently not warranted. In fact, the opponents of hedging insist that currency risk is
desirable because it eventually hedges against the consumption effects of import prices.
Investing in foreign fixed income securities involves consideration of short-term vehicles denominated in different
currencies and locations, as well as in Eurobonds and their equivalents. In addition, more innovative instruments,
such as dual currency bonds, which offer the holder the option to receive payment in either of two currencies,
create more possibilities that a bond portfolio manager must appraise. When a portfolio manager is considering the
purchase of more complicated instruments, they must consider not only the issue of diversification and hedging of
payment streams, but also the valuation of derivatives.

INFLATION HEDGING
Inflation has subsided from the double-digit annual rates of the 1970s. However, inflation exists and affects
investment choices. One consequence has been the issue of real return bonds, which are bonds that promise to
pay interest based on inflation levels. (Real return bonds and their calculations were discussed in greater detail in
previous CSI courses, including Investment Management Techniques and Wealth Management Essentials). These
bonds, effectively guarantee the preservation of purchasing power to the holder. Both the interest payments and
principal are linked to the change in the CPI. In considering these bonds, a portfolio manager has to determine how
the liabilities, if any, that are tied to the portfolio are affected by inflation. There has been increasing criticism of the
definition of the CPI as a measure of true inflation, which is particularly relevant over a long time span.

USING DERIVATIVES IN FIXED INCOME MANAGEMENT

Futures on currencies, stock indexes and government bonds are standard instruments for the risk management of
foreign currency exposure and a portfolio’s inherent systematic risk. Swaps are a popular and effective means of
controlling the risk of holding or issuing debt. Interest rate futures and swaps are now essential tools in fixed income
portfolio management.

FORWARD RATE AGREEMENTS

A largely interbank market exists for forward rate agreements (FRAs), which are over-the-counter contracts
for hedging interest rates. The majority of these contracts are for six- to 12-month periods, with two years as the
longest life. Like many other financial derivatives, FRAs are settled by an exchange of cash to satisfy the closing
position with respect to the interest rate agreed on. Also, as FRAs strictly trade over the counter, no margin is
required between the parties.

EXAMPLE
For a bond portfolio manager, a bank might agree to fix an interest rate of 5.25% on a six-month deposit starting
in three months on a stated principal amount of $10 million. The party agreeing to fix the interest rate, which in
this case is the bank, is known as the FRA’s buyer. The bond portfolio, which is the party that wishes the interest
rate to be fixed, is known as the FRA’s seller. If in three months the going rate for six-month deposits is 5.5%,
the bond portfolio will settle the FRA by paying the differential of 0.25% × $10 million × 0.5 years to the bank.
The bond portfolio’s $10 million is then invested short term as desired at the current rate of 5.5%. The overall
effect is that the portfolio locks in a rate of 5.25%, having given up the chance to earn the higher rate by selling
the FRA. On the other hand, if the going rate in three months is 4.5%, the bank would settle the FRA by paying
the differential of 0.75% × $10 million × 0.5 years to the bond portfolio. Again, the bond portfolio’s $10 million
is invested as desired at the current rate of 4.5%, but the settlement of the FRA has the effect of increasing the
portfolio’s return to the locked-in rate of 5.25%.

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INTEREST RATE FUTURES

Interest rate futures, which are contracts used by banks, corporations and individuals to hedge interest rate risk for
future payments, are an alternative to using swaps.
Today, Canadian investors can hedge through the Bourse de Montréal (the Bourse) using one-month or three-month
Canadian Overnight Repo Rate Average (CORRA) futures or two-year, five-year, 10-year and 30-year GoC bond
futures. U.S. futures exist for treasury notes (medium-term bonds) and treasury bonds (long-term bonds). Futures
also exist for short-term Euro currency deposits based on the Euro Interbank Offered Rate (EURIBOR), and longer-
term German and U.K. government bonds. Canadian bond portfolio managers wanting to effectively hedge their
portfolios can use the Bourse’s instruments, but generally there will be much more liquidity on the U.S. exchanges.
U.S. futures will probably be needed, especially if a portfolio has any U.S. components, and European futures may be
used for European exposures.
The quotation, settlement and trading practices for individual instruments are likely to differ, and a familiarity with
the details is crucial to an understanding of futures strategies in bond hedging. The pricing of futures implicitly
determines the interest rate for the period covered. Naturally, the pricing is actually determined by the market’s
expectation of interest rates. For instance, the Bourse’s CORRA futures are priced on an index basis, as follows:
Futures price = 100 − the annualized rate (expressed in percentage form) (8.1)

EXAMPLE
A three-month CORRA futures price of 94.60 means the futures are trading with an implied rate of 5.40%.
The calculation is: 94.60 = 100 − the annualized rate. In other words, the annualized rate = 100 − 94.60 = 5.40.

CORRA futures are settled in cash.

Bond futures on U.S. and GoC bonds are based on notional bonds whose prices depend on changing rates for their
maturities. For the GoC 10-year bond futures contract, the reference bond is a 10-year 6% coupon bond. Both
Canadian and U.S. bond and note futures are settled by delivery of one of a range of acceptable bonds at a chosen
date, with both uncertainties determined by the party that is short the contract. The bond portfolio manager’s
recognition of these and other issues, such as conversion factors and the cheapest-to-deliver bond, which are beyond
the scope of this course, is essential when engaging in a hedge portfolio using these futures. Also, marking to market 1
has only a minor effect on cash flows, but the cash must be available as needed for possible margin calls.
The more common problem is to hedge the value of a portfolio or an individual bond against long-term rate
increases. The sale of bond futures will cause gains on the futures position through a rate increase to compensate
for the portfolio’s resulting loss, and vice versa. There are two aspects to the risk, with one being volatility in the
portfolio value and the other being loss of value.
The first problem is solved by setting as an objective the minimization of the variance in the portfolio’s value, as
hedged by the futures position. The important detail about using futures as a hedging technique is determining the
hedge ratio, which is the relative number of derivative contracts per underlying asset necessary to protect against
changes in the portfolio’s value. This can be determined by regressing the changes in cash prices against those in
futures prices. A simple linear regression would reveal the hedge ratio as the slope. Since linear regression minimizes
the sum of the squares of the error term, it effects a variance minimization. The input data are historical bond
prices and the chosen futures contract, where the bonds should be chosen to represent the portfolio’s holdings.
Multiplying the hedge ratio times the face value of the portfolio and dividing by the face value of the contract yields
the number of contracts to use in the hedge.

1
The process in a futures market in which the daily price changes are paid by the parties incurring losses to the parties earning profits.

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The alternative approach is to hedge the portfolio’s value by considering its modified duration. Essentially, the
modified duration, price and face value of the contract and portfolio are compared to determine the hedge ratio.
The formula is as follows:
MVp DP (8.2)
Hedge Ratio = ×
MVF DF

Where:
MVP = The portfolio’s market value
MVF = The futures contract’s market value
DP = The portfolio’s modified duration
DF = The futures contract’s modified duration

Hedging with the number of contracts calculated using formula 8.2 effectively changes a portfolio’s duration to
zero, thereby insulating it from any changes in the interest rate — good or bad.

EXAMPLE
Consider a portfolio with a market value of $110 million and a modified duration of 9.55 that is hedged with 10-
year GoC bond futures with a market value of $104,000 and a modified duration of 5.85. The portfolio manager
would sell the following:
$110,000,000 9.55
Hedge Ratio = × = 1,727 contracts
$104,000 5.85

Note that in the example above, the portfolio can also be hedged by a combination of longer and shorter futures
contracts for which separate hedge ratios would be needed, determined by the proportion of the portfolio to be
hedged by each futures position.
Hedging with futures still entails risk. The basis refers to the difference between the futures price and the spot
price, which is the actual price of a commodity or underlying asset to a futures contract on the current day. At the
maturity of a futures contract, the basis must equal zero. If the basis is not zero, arbitrage profits are possible.
Basis risk is the risk that the basis will not behave as expected over the life of the hedge. If a hedge needs to be
lifted prior to the maturity of the futures contract, any unexpected shift in the basis has the potential to reduce the
effectiveness of the hedge. The more the notional bond underlying the futures contract differs from the portfolio’s
bonds, the more the basis risk affects the hedge. Also, as the contract matures and the spot and futures prices
converge, the hedge position will change in value more directly with interest rate changes.
The hedge ratio formula shown in the example above can be rearranged to provide the number of contracts needed
to adjust a portfolio to any duration. The rearranged formula is as follows:

MVp (DT − DI )
Hedge Ratio = × (8.3)
MVF DF

Where:
DT = The portfolio’s target modified duration
DI = The portfolio’s initial modified duration

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EXAMPLE
Hedging a Bond Portfolio Against Interest Rate Risk
A fixed income manager is anticipating a sharp increase in interest rates immediately following the next U.S.
inflation report. As a temporary strategic measure, the manager intends to reduce her portfolio’s modified
duration to one-half of its current level. Further, she notes that the portfolio’s duration will be readjusted back to
normal levels one week after the inflation report.
The portfolio is a $50 million corporate bond portfolio consisting of 50 investment-grade bond issues. The
manager calculates that the portfolio’s modified duration is currently five. She estimates that she would have
to switch approximately $25 million of her mid- to long-term bonds for T-bills in order to meet the portfolio’s
modified duration target of 2.5. Using an average bid-ask spread estimate of 0.25% of market value for corporate
bonds, the manager estimates that her expected round-trip transaction costs for these duration adjustments
would be 0.25% of $25 million, or approximately $62,500.
The manager is concerned with the high transaction cost and the fact that these trades temporarily lower
the portfolio’s corporate credit risk exposure. If corporate bonds perform well in the interim, the manager’s
performance will lag fully invested corporate bond portfolios. As an alternative, the manager considers selling
GoC bond futures to lower the portfolio’s overall modified duration by fully hedging exactly half of its market
value. The manager calculates the modified duration and market value of the 10-year GoC bond futures
contract to be 6.4 and $95,000, respectively, and uses these figures to determine the number of contracts
required to lower the portfolio’s total modified duration to 2.5. Using Equation 8.3, she makes the following
calculation (note that the result is rounded from −205.59 to −206):

$50,000,000 (2.5 − 5)
× = −206
$95,000 6.4
The number of futures contracts the manager will have to sell, then buy back again later, is 206.
Finally, the manager estimates that the round-trip bid-ask spread is $100 dollars per contract and round-
trip brokerage commissions are $25 per contract. This implies that the total expected transaction costs from
implementing these duration adjustments using futures would be $25,750 [206 × ($100 + $25)]. The manager
decides to reduce the portfolio’s duration by selling 206 10-year GoC futures contracts. She recognizes that while
this minimizes the expected transaction costs and maintains full corporate credit risk exposure, it also introduces
basis risk into the portfolio.

INTEREST RATE SWAPS

Interest rate swaps are agreements made between two parties to exchange interest payments on loans for the
same amount. Each party guarantees to pay the other’s interest for a stated period, allowing portfolio managers
to react to anticipated rate changes without having to perform a major and costly restructuring of their portfolio
through the sale of its various components and the substitution of others. In dealing with swaps, there are two
established assumptions. First, the short-term rate used in U.S.-dollar swaps is conventionally the Secured Overnight
Financing Rate (SOFR) used for European market interest rates and as a base for many international lending
contracts. The rate conventionally used in Canadian-dollar swaps is CORRA. The SOFR is a floating rate, unlike U.S.
or Canadian T-bill rates, which are fixed. Second, the underlying principal to which rates apply is a notional principal
only — that is, it is not actually exchanged.

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EXAMPLE
Plain Vanilla Swap
The plain vanilla swap is the most common and basic swap. One side pays a fixed-rate cash flow and the other
side pays a floating-rate cash flow. To illustrate, consider a bond portfolio with a duration of 10, designed in
response to a portfolio manager’s expectation of stable rates. At this point, the manager has decided that rates
will finally rise and wishes to guard against this by shifting $50 million out of 20-year 6.5% T-bonds, which
are currently trading at par, into 364-day T-bills with a 5% yield. Instead of selling the T-bonds and buying the
T-bills, the manager enters the swap market and offers to swap interest payments at 6.5% for receipt of interest
payments at the SOFR, based on the notional principal of $50 million. The portfolio will then receive an annual
rate of the SOFR × $50 million in exchange for paying 6.5% × $50 million, or $3.25 million, while continuing to
receive interest at 6.5% on the T-bonds owned by the portfolio. If the SOFR for this swap is calculated as the T-bill
rate plus 1%, and the T-bill yields are either of 5%, 5.5% or 6%, the portfolio’s net cash flow will be as follows:
T-Bill Rate
Cash Flow ($ Million) 5% 5.5% 6%
T-Bond Interest $3.25 $3.25 $3.25
Swap Cash Flow
6.5% T-Bonds ($3.25) ($3.25) ($3.25)
SOFR* $3.00 $3.25 $3.50
Net Cash Flow** $3.00 $3.25 $3.50

* For example, for the 5% T-bill rate scenario, the SOFR is calculated as the T-bill rate + 1%, which is 5% + 1% = 6%. Continuing with this
example, the SOFR swap cash flow of $3.00 million is calculated as 0.06 × $50 million.
** For example, for the 5% T-bill rate scenario, the portfolio receives $3.25 million in interest from the T-bonds it owns. It pays $3.25 million
as part of the swap. In addition, the portfolio receives $3 million as part of the swap. By adding up these three numbers, we arrive at a
net cash flow of $3 million, which is an inflow of $3 million and therefore a positive number.

The swap agreement commits to an exchange of payments on the notional principal over a period of time. Instead
of purchasing and rolling over the T-bills every year, the SOFR is received at an anticipated rising yield. Assume that
the swap has been taken for three years. Over that time, the portfolio will continue to hold the T-bonds and use
their coupon to make the swap payments against the SOFR. The terms of the swap are likely to be that SOFR, as of
the beginning of each annual period, will be the rate at which interest is determined for the period. This will then
closely track the T-bill rate that could have been gained.
The example above illustrates the substitution of a variable flow of $3 to $3.5 million for a fixed rate of $3.25 million.
In reality, the SOFR is likely to be closer to the T-bill rate, so the cash flow may be worse by comparison.
Swap markets are not really composed of individual participants searching for others to take the other side. Usually,
swaps are brokered by a dealer who maintains a swap book with potential rates for fixed- and floating-rate loans.
Individual swaps are arranged through the dealer, who charges a fee based on the interest rate differentials going
either or both ways, as illustrated2 in Figure 8.4. At times, the dealer may take one side of the swap, expecting to
re-swap the other side in the near future.

2
The dealer receives 6.5% from Counterparty B and pays 6.25% to Counterparty A thus earning a fee of 0.25%.

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Figure 8.4 | Interest Rate Swap with a Dealer

Floating Rate
(SOFR) SOFR SOFR
Counterparty Dealer Counterparty
A B
6.25% 6.5% 6.5%
Fixed Rate

Although generally bond futures are a more effective instrument for hedging a portfolio’s holdings, for bond
portfolios, the major advantage of a swap arrangement is the ability to modify the lending terms in response to
anticipated interest rate changes, without having to incur the transaction costs of buying and selling securities. The
market is extremely liquid, with volumes in the trillions of dollars, matching portfolio holders and borrowers that
choose to swap their borrowing terms to more suitable ones versus their corporate cash flows. Swaps are usually
illustrated with examples of borrowers that are seeking more favourable terms.
The question always arises as to why borrowers choose to swap instead of arranging more suitable loans in the first
place. The standard answer is that they have greater capacity to borrow short or long, in one market or another,
than they do to borrow the alternative that they prefer. This refers to reputation and credit risk. The conclusion is
that either the credit market is inefficient in determining risk due to a lack of information, or the swap market is
inefficient and is exposing participants to more risk than they realize. It is crucial to realize that swaps are a binding
agreement on both parties, but that defaults can occur. In such cases, it is more often the beneficiary of an ex-post
favourable swap who finds the loser in default than the reverse.

CREDIT DERIVATIVES
Credit derivatives are financial instruments that derive their value from an underlying credit asset or pool of credit
assets, such as bonds or mortgages, and are designed to transfer and manage credit risk. The underlying asset being
protected is the reference asset, which is issued by the reference entity. The payouts are a function of an issuer’s
creditworthiness. In essence, credit derivatives offer credit holders or speculators a way to make an investment
decision based on an issuer’s credit risk that is separate from the investment decisions they make based on other
risks, such as duration and currency.
Credit derivatives allow market participants to fine-tune the credit risk exposures associated with their credit
portfolios. Credit assets represent a sizeable proportion of the portfolios held by banks, portfolio management
companies, insurance firms and hedge funds. In a context of significantly increased credit market volatility, credit
derivatives have become extremely popular. In fact, they are the fastest-growing segment of the market.

THE ROLE OF CREDIT DERIVATIVES

The basic objective of credit derivatives is to transfer credit risk between the protection buyer, the party wishing
to reduce credit risk, and the protection seller, the party wishing to acquire credit risk. It is understood that the
protection seller has gone long the credit and the protection buyer has gone short the credit.
Credit derivatives transfer credit risk in the following two ways:
1. By diversifying a bond portfolio: A bank or fixed income portfolio manager may want to assume credit risk
by providing credit protection in return for a fee. Doing so increases a portfolio’s yield and also enables the
bank or fixed income manager to gain credit exposure for clients who are unwilling or unable to purchase the
bonds directly.
2. By reducing credit risk: A bank or fixed income portfolio manager may want to reduce credit risk for a single
reference asset or an entire sector by buying a credit derivative.

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Credit derivatives have certain inherent advantages that allow portfolio managers to accomplish this objective
more efficiently than with physical fixed income assets. First, credit derivatives separate the credit risk decision from
the duration and liquidity decisions. Typically, all the risks inherent in a physical bond are bundled and cannot be
separated on purchase. With credit derivatives, the manager can take credit risk without assuming the liquidity and
duration risks of holding the reference asset. This feature also allows the manager of the reference asset to keep
a portfolio’s holdings intact. Without credit derivatives, a manager who is worried about a portfolio’s short-term
credit would be forced to sell their assets, thereby incurring a tax liability.
Second, a credit can be sold short easily using a credit derivative. In the physical bond market, it is extremely
difficult, if not impossible, to sell short a bond or bank loan in the same manner as a stock. Economically, the credit
derivative accomplishes the same effect synthetically.
Finally, when embedded in structured products, such as CDOs, credit derivatives give investors synthetic exposure
to certain assets without the stress of administering them. For example, a bank could bundle its industrial loans and
sell off the credit risk using credit derivatives. The investor benefits from the higher-than-average yield and the bank
benefits by reducing the credit risk on its loan portfolio.
Different institutional investors have different uses for credit derivatives, as shown in Table 8.1.

Table 8.1 | Purpose of Credit Derivatives

Holder Buy Sell

Banks They use credit derivatives to hedge and They also sell protection to diversify their
therefore buy protection from counterparties. loan portfolios — changing their return-
They do so for the following reasons: risk profiles — and enhance yields with
respect to lending. The credit derivatives
• To enhance their credit risk management
add income to the returns generated by
by decoupling the credit positions from
the portfolios themselves, a situation
their risk profile
that is somewhat analogous to covered
• To retain ownership of loans, given their call writing with equities.
increased risk level
• To reduce regulatory capital requirements
by reducing the risk budget proportion
attributable to the portfolio’s credit
component

Insurance Similar to banks, they buy and sell protection, They may sell protection to increase
Companies depending on circumstances and their yields, which is once again analogous
portfolio make-up. They typically buy to covered call selling with equities,
protection to diversify and mitigate liability and to help match assets to liabilities,
concentrations, in effect selling away the particularly to match cash flows from
risks associated with concentrated liability one to the other.
commitments, rather than reconfiguring their
liability portfolios, which may prove difficult.

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Table 8.1 | Purpose of Credit Derivatives

Holder Buy Sell

Asset Managers They buy protection to manage negative As other market participants do, they sell
and Hedge Fund expectations on positions for macroeconomic protection for the following reasons:
Managers or sectoral reasons. They may also establish
forward long or short trades to access these
• To increase yield and diversification,
given a positive credit outlook
markets, mainly as hedgers.
• To generate leverage on existing
portfolios
• To establish forward trades — long or
short — mainly as speculators

Securities Dealers They buy protection to cover their exposure They sell protection to increase yield,
as market makers and, more generally, to better diversify their loan and asset
manage the credit risk on their books. portfolio, and help offset hedging costs
for other credits.

Source: Celent Communications, Asset Counsel Inc.

THE STRUCTURE OF CREDIT DEFAULT SWAPS

Of the several forms of credit derivatives in the marketplace, the most basic form is the credit default swap (CDS).
A CDS is the exchange of two cash flows: a fee payment and a conditional payment, which are only made if a credit
event occurs. A credit event is defined as:

• A downgrade in credit rating below a specified level

• Financial or debt restructuring
• Bankruptcy or insolvency of the reference asset obligor
• A default on a payment obligation, such as a bond coupon, and continued non-payment for a specified period
• A technical default, which is a non-payment of coupon or interest when due

Even if only one of these conditions is met, a CDS will have value for the protection buyer, whereas the protection
seller will keep the predetermined fee regardless of the outcome — positive or negative — for the obligor.
A CDS is analogous to a specific type of insurance option in which the default of an asset triggers payment. One
party buys the protection and insures itself against the risk of default or other credit impairment on an underlying
credit instrument, whereas the other party accepts the risk of an uncertain event in exchange for a fee. The
protection buyer holds a risky asset and pays a reasonable fee (premium) to reduce the severity of possible adverse
outcomes. The protection seller values the premium’s cash flows against the risk of adverse outcomes and possible
payouts. Figure 8.5 shows the structure of a single-name (or single-asset) CDS.

Figure 8.5 | Cash Flows of a Single-Name CDS

Protection fee (premium)

Protection
buyer/owner of Protection
underlying asset seller
Payment made only if credit event
on underlying asset occurs

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If a credit event occurs, the CDS is activated and terminates with the payment according to the contract’s
predetermined conditions. The payment can be 100% of the face value or a percentage of the total (nominal) CDS
commitment, depending on the importance of the loss triggered by the credit event. There are two payment modes,
as follows:

• Physical settlement: The protection buyer remits the asset to the protection seller against the full-face
value payment.
• Cash settlement: The protection buyer retains the asset and receives the difference between the face value and
recovery value.

Based on Figure 8.5, consider the following situation: On August 15, 2022, two parties enter into a CDS. The terms
of the contract are a five-year CDS, with the protection buyer paying 120 basis points (bps) annually for protection
on a $100 million bond position (reference asset). The contract’s payment schedule calls for semi-annual payments
with physical delivery of the bonds in the event of default. The protection buyer pays $600,000 every six months
to the seller [(120 bps × $100 million) ÷ 2] beginning on February 15, 2023, until the end of the contract or until the
credit event (default) occurs. The buyer will only receive a payout if the reference entity defaults, thus triggering the
credit event. If this happens, the protection seller must buy the bonds for $100 million.
If this situation called for cash settlement rather than physical settlement, the recovery value would be determined
by an independent assessor using the recovery rate, which is the realizable rate of recovery upon default. If the
bonds’ recovery rate is $200 per $1,000 of par value (20%) after the default, the cash payout the protection seller
must make is $80 million ($100 million − $20 million recovery value).
Each payment method offers certain advantages. Physical settlement is preferable for the protection seller if the
fortunes of the asset’s issuer improve. Physical settlement also permits the protection seller to take part in creditor
negotiations with the reference asset’s issuers, which may result in improved terms for them. Cash settlement is
administratively simpler than physical settlement and preferable when the credit derivative is part of a synthetic
structured product. Also, cash settlement does not expose the protection buyer to shortages of the underlying
deliverable asset.

ADVANTAGES AND DISADVANTAGES OF SECURITIZATION

Securitization — cash CDOs, synthetic CDOs or ABS — gives a loan originator certain advantages, as follows:
1. The potential for reduced funding costs: Through securitization, a company can issue debt that is de-linked
from its own credit ratings, and can therefore often achieve a lower cost of funds for its operations.
2. The protection of underlying assets: If the loan originator that issued the bonds using the assets as collateral
later goes bankrupt, creditors can go after the receivables for recourse. For example, under an SPV structure
of a cash CDO or ABS, the SPV owns the receivables and creditors cannot go after the assets because the SPV
legally owns them.
3. The diversification of funding sources: Loan originators can construct a more cost-efficient capital structure by
employing securitization instead of more conventional funding sources, such as bank loans or corporate debt.
Securitization also typically lacks restrictive covenants that often accompany bank loans or corporate debt.
4. The acceleration of earnings for financial reporting purposes: The loan originators can immediately book
the proceeds from the sale of the receivables as income, less the servicing costs and coupon payments to
investors. The proceeds can go straight to the bottom line instead of as a figure on the asset side of the
statement of financial position.

The two biggest disadvantages to securitization are the following:

1. The lack of transparency of the underlying assets
2. The pricing of the securitization

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First, the lack of transparency of the underlying assets makes it difficult for credit analysts to gauge a proper
credit rating on the securitization. Bad credit risks could easily hide in a pool of assets. Creating a large pool is
supposed to mitigate the risk through diversification, but a pool containing a large number of credit risks could
easily be overlooked.
Second, at the best of times, a CDO and ABS are extremely difficult to price. As the credit crisis of 2007 revealed,
money market funds that held these instruments had a great deal of trouble valuing them. The assets that
supported the cash flows were often mortgages granted to individuals with poor credit who were buying overvalued
homes in the U.S. As the underlying cash flows dried up, the value of the securitized instruments suddenly came into
question. No one knew how to place a definitive value on the securities. Investor demand for new paper disappeared
because of the pricing uncertainty, and holders of the paper could not find buyers.

HIGH-YIELD (JUNK) BONDS

A high-yield bond, which is commonly known as a junk bond, is a bond that currently has a non-investment-grade
credit quality rating from one or more bond credit-rating agencies. Non-investment-grade bonds have credit ratings
of Ba1/BB+ or lower. Conversely, investment-grade bonds have current credit ratings of Baa3/BBB- or higher.
The origin of the term junk bond is unclear, but it likely surfaced when the high-yield bond market was in its infancy.
The prevailing view was that a bond with a non-investment-grade credit rating was likely doomed to fail because of
its issuer’s insolvency. Therefore, market observers considered them to be fit only for the garbage bin, thus the term
junk bond.

HIGH-YIELD BOND ISSUERS

The two major issuers of high-yield bonds are original issuers and so-called fallen angels, as described below:

• An original issuer is a bond issuer with a non-investment-grade credit rating at the time of underwriting. A non-
investment grade is typically assigned to new issue bonds for one or more of the following reasons:
• The issuer is highly leveraged relative to its immediate competitors or typically for its industry.
• The issuer has no demonstrable operating track record, but has above average growth and profitability
prospects. For example, it may be a start-up company in an emerging and potentially profitable industry.
• The issuer is currently experiencing financial difficulties, but does not have any bonds presently outstanding.
• A so-called fallen angel is a bond issuer that once had an investment-grade credit rating on its bonds
outstanding, but has recently fallen into financial difficulty. As a result, the issuer’s bonds outstanding have
been downgraded to a non-investment-grade rating. Fallen angels can be either in or on a path to bankruptcy.
Certain institutional investors in high-yield bonds specifically target fallen angels for their potential investment
value. They purchase downgraded securities that are in either reorganization or liquidation, depending on
whether the issuer is near bankruptcy or in bankruptcy court protection.

Some industry commentators believe a third source of high-yield bonds exists: those issued by either the acquiring
entity or the target company of a leveraged buyout (LBO). In an LBO, the target company, which is either
public or private, is bought out by a limited group of investors. If the investors are the target company’s current
management, the transaction is called a management buyout (MBO). If the investors are a firm specializing in LBOs,
the transaction is called a leveraged buyout. The name is derived from the fact that the firm must typically issue a
large number of bonds to finance the purchase of the current shareholders’ holdings. Firms that specialize in LBOs
do so in the hope of reorganizing the target firm and eventually selling it at a profit. In many cases, the degree of
leverage is so high that the newly issued bonds can only garner a non-investment-grade credit rating at the time
of underwriting.

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HIGH-YIELD BOND INVESTORS

Individuals rarely invest directly in high-yield bonds. Instead, they gain indirect exposure to them by investing in
managed financial products.
The clear majority of outstanding high-yield bond issues are held by institutional investors. Because of the inherent
credit risk and complexity of high-yield bonds, there are at least two factors for successfully investing in them:

• Investors must conduct a proper and detailed fundamental analysis on high-yield bonds and their
respective issuers.
• Investors must diversify their holdings to compensate for the risks associated with individual bond issues.

Understandably, institutional investors are in the best position to deal with the requisite success factors.

HIGH-YIELD BOND MARKET INDEXES

Like all well-developed financial markets and investment sectors, the U.S. high-yield bond market has several well-
designed indexes, which are useful tools for measuring the performance of a fund or fund manager. These indexes
also support fund design, regulatory oversight and academic research, all of which, in turn, support the growing
interest and investment in the high-yield bond sector.
Although they are related, each index has a unique construction methodology. These indexes attempt to mimic the
overall U.S. high-yield bond market with respect to the following parameters:

• Market value weighting exposure of an economic/industry sector

• Maximum percentage index weighting exposure per chosen issuer
• Average credit rating for the market, and credit rating distribution by economic/industry sector
• Average term to maturity for the market, and term-to-maturity profile
• Average coupon rate for the market and for an economic/industry sector
• Structure profile (convertible, step-up, fixed/floating, payment-in-kind, etc.)

Indexes are also available for certain credit rating sub-sectors of the high-yield bond market. For example, some
investors may wish to direct or restrict their high-yield investment allocation funds to the higher-quality portion of
the high-yield bond market. These investors will likely select a high-yield bond market index that limits its exposure
to only BB-rated and B-rated securities. Likewise, investors who seek a higher amount of credit risk might choose
high-yield bond market sub-indexes for CCC/Caa- or lower-rated securities.

CREDIT RATING METHODOLOGY

The three main global bond credit-rating agencies are Moody’s Investors Service (Moody’s), S&P Global Ratings
(S&P), and Fitch Ratings Inc. (Fitch). Collectively, they currently have a nearly 95% global market share.
The bond credit-rating agencies assign a unique grade or credit rating to a bond based on their respective assessment
of the issuer’s ability to make timely interest and principal payments during the life of the bond. Essentially, bond
credit ratings attempt to provide objective, consistent and simple measures of a bond issuer’s creditworthiness. These
credit ratings are opinions of a bond issuer’s future creditworthiness relative to other issuers.

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Credit-rating agencies employ fundamental credit analysis to develop their credit ratings. In the case of Moody’s,
its fundamental credit analysis focuses on four main aspects of both the bond issuer and the bond issue under
examination, as follows:
1. Fundamental analysis – Moody’s fundamental analysis of a bond issuer focuses on four main traditional groups
of financial statement analysis:
• Leverage
• Asset/collateral coverage
• Liquidity
• Profitability
Moody’s analysis also includes the following factors:
• Industry trends
• Regulatory environment
• Competitive position
• Access to liquidity (capital markets, bank lines)
• Issuer structure (priority of claim, structural subordination, support agreements)
• Special event risk
2. Covenants – Analysis in this area focuses on the following:
• Restrictions on an issuer’s activities
• Affirmative covenants and negative covenants
• Appropriateness and applicability to an issuer’s industry
• “Need to be tight, but not too tight”
3. Franchise/collateral value – Moody’s estimates a bond issuer’s franchise value on a going concern basis. This
calculation depends heavily on an issuer’s competitiveness ranking within its industry. It also depends on
an issuer’s ability to both grow profitably at a faster rate than its competitors and, conversely, its ability to
survive during periods of economic or industry downturn. The estimate of an issuer’s franchise value also
drives the calculation of asset/collateral coverage. In the event of an issuer’s bankruptcy, this calculation aids
bondholders that may need to sell some or all of an issuer’s assets to recover amounts due to them as lenders.
4. Management quality – Analysis in this area focuses on an issuer’s operating philosophy, operating track record,
strategic planning and ability to react successfully to unexpected changes.

Essentially, the credit-rating process focuses on forming views regarding the likelihood of plausible future outcomes.
It does not forecast scenarios; instead, it places some weight on their likely occurrence and on the potential credit
consequences.

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Bond credit ratings for the three main bond credit-rating agencies are compared and briefly described in Table 8.2.

Table 8.2 | Bond Credit Ratings

Rating Grade Description

Fitch S&P Moody’s (Moody’s)
AAA AAA Aaa Minimal credit risk
AA+ AA+ Aa1
AA AA Aa2 Very low credit risk

Investment grade
AA− AA− Aa3
A+ A+ A1
A A A2 Low credit risk
A− A− A3
BBB+ BBB+ Baa1
BBB BBB Baa2 Moderate credit risk
BBB− BBB− Baa3
BB+ BB+ Ba1
BB BB Ba2 Substantial credit risk
BB− BB− Ba3
B+ B+ B1
B B B2 High credit risk

(non-investment grade)
Speculative grade
B− B− B3
CCC+ CCC+ Caa1
CCC CCC Caa2 Very high credit risk
CCC− CCC− Caa3
CC CC Ca In or near default, with
C C – possibility of recovery

DDD SD C
In default, with little
DD D –
chance of recovery
D – –

DEFAULT RISK AND DEFAULT RATES

A key metric for estimating default risk in the high-yield bond market is the default rate over various time periods.
Defaults are defined as bond issues where one of the following events has occurred:

• A missed payment of interest and/or principal due has not been paid within the normal 30-day grace period
• The issuer has filed for bankruptcy protection or liquidation
• A corporate restructuring has been announced

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There are two main types of default rates, as follows:

• Dollar-denominated default rate, which is based on the dollar amount of bonds that have defaulted
• Issuer-denominated default rate, which is based on the number of issuers that have defaulted

Both types exhibit a high correlation over long periods, but can greatly diverge over short periods. The dollar-
denominated default rate is more popular, but there are specific instances or types of analysis where the issuer-
denominated default rate is more applicable.

RECOVERY RATES
When the default rate is used to measure credit risk, it is calculated at the time of the credit event. If calculated on
a dollar-denominated basis, it reveals the amount of a lender’s funds that are at risk of non-repayment given the
worst-case scenario.
However, only in a limited number of situations does the actual monetary loss equate to the original default
amount. In most situations, lenders recover some of their security’s value. The amount of value/funds eventually
realized by creditors as a percentage of the bond’s face or default amount is called the recovery rate.

EXAMPLE
ABC Company defaulted on $80 million face value of their bonds. If the amount realized by creditors is $36
million, then the recovery rate is 45%, calculated as ($36 million ÷ $80 million) × 100.

Of course, lenders attempt to maximize the recovery rate on their defaulted bonds. This goal dictates the
negotiating strategy they employ with the borrower prior to bankruptcy proceedings. The amount eventually
recovered — and therefore the recovery rate — depends on several factors, including the issuer’s collateral value and
the general state of its industry and of capital markets.
Depending on the issuer’s size and complexity, as well as the factors noted above, it can often take a year or two for
bondholders to reach a final resolution of their claims.

CREDIT SPREAD
As compensation for assuming credit risk, lenders require an incentive to purchase corporate bonds, both at the
time of bond underwriting and in secondary market trading, in the form of a higher yield. This so-called credit
premium is calculated as the difference between the yield to maturity (YTM) of the corporate bond minus the YTM
of a federal government bond of the same maturity.
All else being equal, the lower the bond’s perceived credit risk, the higher its credit rating and the smaller, or tighter,
the yield spread will be.
Primarily because of their inherent higher degree of leverage, the credit spreads of high-yield bonds will generally
react quickly to credit-rating upgrades or downgrades and to corporate announcements that suggest a change in
the issuer’s creditworthiness.

UNIQUE COUPON STRUCTURES

Similar to investment grade-bonds, most high-yield bonds have fixed coupon payments over the life of the security.
However, the high-yield bond market has a higher percentage of bonds outstanding with call features, when
compared to the percentage share of the investment-grade bond market. High-yield bond issuers generally want
the flexibility to call coupon debt outstanding should bond market conditions improve and permit lower-cost
refunding.

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In addition, the high-yield bond market has some unique coupon structures that are seldom used when
underwriting investment-grade bonds. These structures are primarily driven by the need for the issuer to conserve
cash, especially during the immediate years after the bonds are issued.
These coupon structures are often considered when underwriting high-yield bonds to finance two types of
transactions, as follows:
1. LBOs and MBOs: These types of merger and acquisition (M&A) transactions often involve the assumption of a
very high degree of leverage by the target company. In turn, high leverage puts a high strain on the company’s
cash flow, especially shortly after its acquisition. In buyout situations, the cash flow from operations is likely to
be insufficient to cover coupon payments in the short term.
2. Start-ups: A bond issuer looking to fund either a start-up facility or an incremental capital expansion requires a
substantial amount of capital. Without having a current at-scale operating facility, the issuer is unlikely to have
the cash flow available to pay cash coupons until the plant is fully operational.

The suitable debt financing solution for these types of transactions is to pay little or no cash coupons on the bonds
in the short term. Then, at some point in the intermediate future, the bonds begin to pay a cash coupon that is
higher than current market yield. In both cases, the lenders want the debt financing to be consistent with their
business plans. This usually involves the implementation of an efficiency program and/or an incremental capacity
expansion program that results in sufficient positive free cash flows at a set point in the future — often two to three
years — to service the debt.
The coupon structures most frequently used by high-yield bond issuers with the goal of short-term cash
conservation are deferred coupon bonds, extendible reset bonds and payment-in-kind (PIK) bonds:

Deferred Coupon The issuer pays no interest for a set number of years — usually two to four years —
Bonds immediately after the issuance, then pays cash coupons until maturity at an agreed
upon interest rate at the time of underwriting. The cash coupon is deliberately
negotiated at an above-market interest rate to compensate the lender for the
both the value of the initial coupon deferment and the credit risks associated
with the issuer.
An iteration of a deferred coupon bond is a step-up bond, which is underwritten with
pre-defined (varying) coupon rates for each year until maturity. The coupon rate is set
below market for the first few years, but then crosses to above-market rates for the
remainder of the bond’s term.

Extendable Reset These bonds permit the issuer to reset the coupon rate at a fixed date in the future so
Bonds that the bond will then trade at a set market price, which is usually at par. With some
issues, rates can be reset quarterly or annually, but most issues permit only one coupon
reset date during the life of the bond.

Payment-in-Kind (PIK) These bonds provide the issuer with the option to pay coupons on their payment date in
Bonds one of the following two methods:

• Cash
• An identical bond to the original PIK issue in an amount equal to the coupon’s value
The issuer normally has this option for approximately the first half of the original PIK
bond’s life. After that point, the coupon can only be paid in cash.

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FIXED INCOME EXCHANGE-TRADED FUNDS (ETFs)

Consistent with the overall Canadian exchange-traded fund (ETF) market, Canadian fixed income-related ETFs have
experienced phenomenal growth over the past decade.
Industry monitors3 report that Canadian fixed income ETFs had $76.49 billion in AUM as of September 30, 2022.
This amount corresponds to 24.5% of the total Canadian ETF industry’s assets.

INVESTMENT MANDATES FOR FIXED INCOME ETFs

The Canadian fixed income ETF market offers investors customized exposures to many types of fixed income
securities that are traded on domestic and international bond and money markets. This well-developed market
allows investors and their investment advisors to structure their fixed income ETF portfolios precisely to meet their
needs and risk profile.
Like other types of ETFs, fixed income ETFs are normally structured to track or replicate a passive investment
benchmark. This benchmark is usually chosen from one of two main forms, as follows:
1. A standardized fixed income benchmark that is often quoted in the financial press and that many investors are
familiar with.
2. A customized benchmark that includes a unique passive fixed income portfolio designed by an ETF manager.

After selecting a performance benchmark, an ETF manager’s next step is to create a set of unique investment
guidelines and restrictions. This step ensures that the ETF’s assets are invested and managed in a manner that allows
the fund to meet its respective performance benchmark.
The performance benchmark of an ETF and its respective investment guidelines and restrictions are chosen with the
following three main factors in mind:
1. Interest rate risk (also called market risk)
This is generally the single largest risk to a fixed income portfolio, as it is directly related to the ETF’s weighted
average term to maturity or, more appropriately, its duration. Therefore, the ETF’s investment guidelines and
restrictions stipulate how far its weighted average term to maturity or duration can vary from those of its
performance benchmark.
Acknowledging the importance of interest rate risk, government bond-based ETFs are generally offered with
one of four weighted average term-to-maturity targets:
• Short-term government bond ETFs: The weighted average term to maturity is equal to that of a
short-term federal government bond index. It is usually restricted to one- to five-year term-to-maturity
holdings.
• Mid-term government bond ETFs: The weighted average term to maturity is equal to that of a mid-term
federal government bond index. It is usually restricted to six- to 10-year term-to-maturity holdings.
• Long-term government bond index ETFs: The weighted average term to maturity is equal to that of a
long-term federal government bond index. It is usually restricted to 10- to 30-year term-to-maturity
holdings.
• Aggregate government bond ETFs: The weighted average term to maturity is equal to that of a federal
government aggregate bond index, with investments covering the entire bond’s term-to-maturity range,
which is one to 30 years.

3
Canadian ETF Association, Canadian ETF Assets as of September 30, 2022 report dated October 19, 2022.

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2. Credit risk
Investment in non-government guaranteed fixed income securities entails the assumption of some degree of
credit risk by a fund. This risk often rivals interest rate risk for funds that invest in non-government guaranteed
fixed income securities.
With respect to credit risk exposure, fixed income ETFs are generally offered with one of three broad mandates:
corporate bond ETFs, investment-grade corporate bond ETFs and high-yield bond ETFs. The corporate bond
ETF mandate is the broadest mandate and it has two broad sub-categories: investment-grade corporate bond
ETFs and high-yield bond ETFs. These sub-categories are based primarily on credit ratings.
Corporate bond ETFs: Investments in these ETFs are restricted to fixed income securities issued by domestic
corporations.
Investment-grade corporate bond ETFs: Investments in these ETFs are restricted to corporate bond issues with
an investment-grade credit rating — that is, a minimum credit rating of Baa3 and/or BBB−.
High-yield bond ETFs: Investments in these ETFs are restricted to corporate bond issues with a non-investment-grade
or high-yield credit rating — that is, a credit rating of Ba1 and/or BB+, or lower.
It should be noted that investment guidelines and restrictions pertaining to the amount of credit risk that a
fund can assume is often stated in terms of the minimum credit quality that is acceptable, as well as the fund’s
minimum overall weighted average credit quality.

3. Currency risk
Fixed income ETFs with international or global investment mandates invest in fixed income securities issued
by both foreign governments and corporations. The issues are normally denominated in the bond issuer’s
respective domestic currency, which differs from the currency in which the ETF is priced. If the fund is
managed in a non-hedged manner, it is exposed to potential adverse currency movements. The ETF manager
must decide whether to minimize or eliminate potential currency risk by hedging part or all of the fund’s
currency risk.

INVESTMENT MANAGEMENT TECHNIQUES FOR FIXED INCOME ETFs

The primary objective of an ETF’s investment management is to track, or replicate, the fund’s performance
benchmark as closely as possible over time.
The ETF manager’s success at attaining this performance objective is usually measured in terms of tracking error.
The smaller the tracking error, the more successful the ETF is at attaining its stated return objective. (An ETF’s
tracking error is discussed in Chapter 6.)
The extent to which the fund attains a smaller tracking error is dependent on the following two factors, both of
which are within an ETF manager’s control:
1. Management fees: An ETF’s management fee is established by the fund’s manager, and due to its nature, will
always cause a fund’s rate of return to be lower than the benchmark’s rate of return by at least that amount
over time. Accordingly, the higher the management fee, the larger the tracking error will be, which makes the
fund less attractive to investors and their investment advisors. The management fee decision is essentially
a trade-off between the ETF manager’s business goals and the acknowledgment that an ETF with a larger
tracking error generally does not compare well to a competitor’s ETFs with lower tracking errors.

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2. Investment management techniques: ETF managers use one of three main passive investment strategies to
minimize the tracking error for a fixed income ETF, as follows:
• Replication: With this technique, an ETF’s holdings exactly replicate the securities that comprise its
performance benchmark. Replication has the benefit of having the lowest tracking error of all ETF passive
investment management techniques, but it is only practical and effective for ETFs that have customized
performance benchmarks with a limited number of securities holdings. Accordingly, it is generally only used
for fixed income ETFs that have very narrow investment mandates — typically, industry sector funds.
• Statistical sampling (also called representative sampling): This investment management strategy uses
statistical techniques to create a passive fixed income portfolio that minimizes a fund’s tracking error in
comparison to a specific bond market index. It uses the smallest possible number of securities to achieve this
result. This investment management technique is the most popular for fixed income ETFs that attempt to
track the performance of a well-known bond index. Such an index normally contains a very large number of
securities because of the absolute number of bond issues outstanding.
• Synthetic replication: This strategy uses a popular ETF investment technique, whereby the ETF enters a total
return swap (TRS) with an approved derivative counterparty, which is generally a large commercial bank
or investment dealer. The ETF holds its investors’ funds in cash and short-term securities, and pays the
realized short-term rate of return daily to the swap counterparty. In return, the TRS counterparty pays a
daily rate of return to the ETF equal to rate of return on the ETF’s performance benchmark, less an agreed
upon spread (fee).

A TRS has become a mainstay in the ETF universe in recent years for two main reasons:

• It is completely customizable, which can be very attractive from a marketing and investor standpoint. A TRS
allows an ETF to offer a rate of return based on a customized performance benchmark. Alternatively, it can offer
the rate of return on a popular fixed income market index without incurring the potential performance-related
drawbacks associated with replication and statistical sampling techniques.
• It allows an ETF’s tracking error to be known in advance. Besides an ETF’s management fee, the only possible
source of tracking error is the counterparty’s swap-related fee, which is typically fixed over the term of the TRS.
From a risk standpoint, it is important to note that a TRS involves the assumption of counterparty credit risk.
Investors must be aware that, should the swap counterparty fail financially at any point, the TRS requires that a
payment be made to the ETF. The ETF will have to attempt to recover the amount of money due in bankruptcy
proceedings with the swap counterparty.

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8 • 30 PORTFOLIO MANAGEMENT TECHNIQUES

SUMMARY
After completing this chapter, you should be able to:
1. Discuss the structure of mortgage-backed securities (MBS), asset-backed securities (ABS), collateralized debt
obligations, foreign currency instruments, and real return bonds.
• Mortgage-backed securities (MBS): These are portfolios of mortgages assembled and sold in tranches to
increase mortgage capital for lenders. They offer secure higher-yielding medium-term investments that are
comparable to government bonds.
• Asset-backed securities (ABS): These are a type of bond with cash flows that are supported by the cash flows
from a specified pool of underlying assets. The underlying assets could be home equity loans, auto loans,
credit card receivables or student loans.
• Collateralized debt obligations (CDOs): These are securities that repackage a collection of underlying
assets and sell multiple classes (tranches) of the asset pool’s interest to investors. A CDO’s cash flows are
supported by MBS, ABS, leveraged bank loans, real estate investment trusts (REITs), corporate bonds or even
other CDOs.
• Foreign currency instruments: These are bonds issued by foreign companies and governments or by domestic
companies in foreign currencies.
• Real return bonds: These are bonds with payments that are based on inflation levels.
2. Demonstrate the ways derivatives can be used in fixed income portfolio management.
• Forward rate agreements (FRAs): Over-the-counter contracts for hedging interest rates that are settled by an
exchange of cash.
• Interest rate futures: Exchange-traded contracts used by banks, corporations and individuals to hedge
interest rate risk for future payments.
• Interest rate swaps: Agreements made between two parties to exchange interest payments on loans for the
same amount, with each party guaranteeing to pay the other’s interest for a stated period.
• Credit derivatives: Financial instruments that derive their value from an underlying credit asset or pool of
credit assets, such as bonds or mortgages, and are designed to transfer and manage credit risk. The most
basic form is the credit default swap (CDS).
• Synthetic collateralized debt obligations (CDOs): The credit derivative variant of the cash CDO. In a synthetic
CDO, the originator, which is a bank, retains ownership of the underlying assets and buys protection from
the special purpose vehicle (SPV) using a CDS.

3. Discuss high-yield bonds.

• A high yield bond is a bond that currently has a non-investment-grade credit quality rating from one or more
bond credit-rating agencies.
• There are several well-designed U.S. high-yield bond indexes in existence.
• Bond credit-rating agencies assign a credit rating to a bond.
• The most frequently used coupon structures for high-yield bond issuers that need to conserve cash in the
near term are deferred coupon bonds, extendable reset bonds, and payment-in-kind (PIK) bonds.

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4. Describe fixed income exchange-traded funds (ETFs).

• Fixed income exchange-traded funds (ETFs) are normally structured to track or replicate a passive
investment benchmark.
• The choice of an ETF’s performance benchmark incorporates three main factors: interest rate risk, credit risk,
and currency risk.
• Fixed income ETFs use one of three main passive investment strategies to minimize tracking error:
replication, statistical sampling, and synthetic replication.

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 The Permitted Uses of
Derivatives by Mutual Funds 9

CONTENT AREAS

The Types of Mutual Funds that Use Derivatives

Mutual Fund Regulations

How Mutual Funds Use Derivatives

The Advantages of Derivatives

The Potential Risks of Derivatives

LEARNING OBJECTIVES

1 | Identify the types of mutual funds that use derivatives.

2 | Describe the regulations that impact how a mutual fund can use derivatives.

3 | Describe the necessary disclosures for a mutual fund to use derivatives.

4 | Distinguish between hedging and non-hedging purposes.

5 | Explain the ways in which mutual funds use derivatives.

6 | Identify the advantages and disadvantages of using derivatives in mutual funds.

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9•2 PORTFOLIO MANAGEMENT TECHNIQUES

KEY TERMS

Key terms are defined in the Glossary and appear in bold text in the chapter.

cash-secured put option derivatives

covered call option execution slippage

currency cross-hedge National Instrument (NI) 81-102

delta sale of options

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 CHAPTER 9 THE PERMITTED USES OF DERIVATIVES BY MUTUAL FUNDS 9•3

INTRODUCTION
Due to the leverage and volatility associated with derivatives, mutual funds have been restricted from using them
extensively. However, competitive pressure for higher returns and investor dollars is slowly translating into the use
of more derivatives in mutual funds. Thus, it is important to fully comprehend the particular circumstances under
which mutual fund managers are allowed to use derivatives.
This chapter starts with a review of the mutual funds that typically include the use of derivatives, as well as the
regulations that govern their use. We then provide some examples of how derivatives are used in mutual funds,
then conclude with a description of the potential advantages and disadvantages for investors.

THE TYPES OF MUTUAL FUNDS THAT USE DERIVATIVES

Many mutual funds purchase individual securities, such as equity and fixed income issues, and earn their returns
through returns on the securities within the portfolio. However, many mutual funds also use derivatives.
A derivative is a financial contract whose value is derived from, or depends on, the value of some other asset. The
other asset, which is known as the underlying asset, can be a financial asset, such as a stock or bond, a currency, an
interest rate or an equity index. It can also be a commodity, such as crude oil, gold or wheat. Certain mutual funds,
particularly index funds, are more likely to use derivatives than others.
In Chapter 6, we discussed how index funds try to replicate the return on a market index, such as the S&P/TSX
Composite Index in Canada or the S&P 500 Index in the U.S. Many index funds buy all or a substantial portion of
the constituent securities. Most index funds also use derivatives based on the target index to manage cash balances.
Liquidity and low transaction costs allow derivatives to meet any net redemptions. They also provide quick access to
index returns when a fund receives net contributions.
As noted, other types of mutual funds may also use derivatives. In all cases, the fund’s prospectus must state
whether the fund has the latitude to use derivatives.

MUTUAL FUND REGULATIONS

Canadian mutual fund regulations fall under the jurisdiction of the Securities Acts of each province or territory.
Securities administrators control the activities of mutual funds and their managers and distributors through
National Instruments (NIs), particularly NI 81-102.
NI 81-102 applies to mutual funds in Canada and outlines the permitted derivative activities that these funds can
undertake. The following sections of NI 81-102 apply to the use of derivatives in mutual funds:

• 2.7 Transactions in Specified Derivatives for Hedging and Non-hedging Purposes

• 2.8 Transactions in Specified Derivatives for Purposes Other Than Hedging
• 2.9 Transactions in Specified Derivatives for Hedging Purposes

Mutual fund managers are permitted to use derivatives within specific parameters. NI 81-102 permits mutual funds
to use derivatives to reduce risk. In addition, NI 81-102 ensures conventional mutual fund managers do not use
derivatives to speculate to any great degree. Within the allowable uses, mutual fund managers may employ a range
of derivatives, including options, futures, forwards and swaps. NI 81-102 includes specific details that apply to all
derivative positions, such as the following:

• A minimum credit rating for counterparties to over-the-counter (OTC) derivatives contracts. An A rating from
DBRS Morningstar or the equivalent from Fitch Ratings Inc., Moody’s Canada Inc., or S&P Global Ratings.

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9•4 PORTFOLIO MANAGEMENT TECHNIQUES

• A maximum exposure to an individual OTC derivative counterparty of 10% of a fund’s net assets.
• Calculating the exposure to an individual OTC derivative counterparty based on daily mark-to-market exposure.

TRANSACTIONS FOR HEDGING PURPOSES

Under NI 81-102, mutual funds may use derivatives for hedging or risk reduction. To qualify as a hedge, the
derivative that is used must:

• Be intended to offset or reduce a specific risk associated with all or part of a position or positions in the fund;
• Have a value with a high degree of negative correlation to the value of the position being hedged; and
• Not be expected to offset more than the changes in the value of the position being hedged.

According to the guidelines in NI 81-102, the easiest way for a mutual fund manager to establish a hedge is to take
a position in a derivatives contract with a payoff that is opposite to, or offset by, that of the position or exposure
to be hedged. By definition, a position that has a payoff opposite to that of the position or exposure to be hedged
will reduce the risk of that position and will have a high negative correlation with it. Using an appropriately sized
derivatives contract will ensure that the derivatives position does not offset more than the changes in the value of
the position being hedged.
Because conventional mutual funds are only allowed to take limited short positions in securities,1 the majority of
securities positions they will be hedging are long ones. Derivatives positions that have payoffs opposite those of
long positions include the following:
• Short forward, futures and swap contracts
• Long put option contracts
• Short call option contracts

In addition, NI 81-102 allows currency cross-hedges to qualify as hedge transactions. A currency cross-hedge is a
transaction in which a mutual fund substitutes its exposure to one currency risk for exposure to risk from another
currency, as long as neither is the currency in which the mutual fund’s NAV is determined and the aggregate
amount of currency risk to which the mutual fund is exposed is not increased by the substitution.

TRANSACTIONS FOR NON-HEDGING PURPOSES

Mutual fund managers frequently need to shift funds from one market segment to another, from one type of market
to another and from one country to another. Derivatives allow mutual fund managers to make these switches
quickly, minimizing transaction and market impact costs.
Under NI 81-102, mutual funds may use derivatives for non-hedging purposes within specific guidelines. The most
common use of derivatives for non-hedging purposes is to gain exposure to a market without having to own the
underlying securities.

EXAMPLE
Index derivatives are often used to gain exposure to a market index without having to buy the index’s constituents.

In some cases, derivatives may be used to provide additional portfolio income or the opportunity to buy an
underlying asset at a lower price than it is currently trading at.
Additional regulations in NI 81-102 that relate specifically to the use of derivatives for non-hedging purposes
include details such as the appropriate portfolio holdings to ensure that leverage is not being used.

1
PMT chapter 4 mentioned that short sales are not allowed to be more than 20% of a conventional mutual fund’s net asset value.

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 CHAPTER 9 THE PERMITTED USES OF DERIVATIVES BY MUTUAL FUNDS 9•5

Exhibit 9.1 | Prospectus Disclosure

The use of derivatives must be disclosed and described in a mutual fund’s simplified prospectus. The prospectus
must also explain how derivatives will be used to achieve the mutual fund’s investment and risk objectives, and the
limits of and risks involved with their use.
The following quote from a recent TD Mutual Funds prospectus illustrates the use of derivatives by a mutual fund
for hedging purposes:
When using derivatives for hedging purposes, a Fund seeks to offset or reduce a specific risk associated with all, or
a portion, of an existing investment position, or group of investments or positions. A Fund’s hedging activity may
therefore involve the use of derivatives to manage certain risks such as interest rate risk or to manage the Fund’s
exposure to underlying interests such as securities, indices and currencies.
This next quote, which is from the same prospectus, illustrates the use of derivatives by a mutual fund for non-
hedging purposes:
A Fund may also use derivatives for non-hedging purposes to gain exposure to underlying interests, such as
individual securities, asset classes, indices, currencies, market sectors and markets without having to invest
directly in such underlying interests; to reduce transaction costs; and to expedite changes to the Fund’s
investment portfolio. While derivatives are being used by a Fund for non-hedging purposes, the Fund must
generally hold cash or cash equivalents, the interest underlying the derivative and/or a right or obligation to
acquire such underlying interest in sufficient quantities to permit the Fund to meet its obligations under the
derivative contract without recourse to the other assets of the Fund.*

* TD Mutual Funds Simplified Prospectus; p. 97. Available online at

https://www.td.com/ca/en/asset-management/documents/fund-document/pdf/Prospectus/TD-Mutual-Funds/TD_MF_SP_Final_E.pdf

HOW MUTUAL FUNDS USE DERIVATIVES

HEDGING USES
Canadian mutual funds use derivatives primarily to reduce exchange rate exposure resulting from holding foreign
currency–denominated securities.

EXAMPLE
Using Derivatives for Hedging Exposure to Exchange Rates
A Canadian equity mutual fund manager holds mostly Canadian equities, with a small allocation to multinational
equities. About 10% of the portfolio is in U.S. equities and 5% is in Japanese equities. This mutual fund is exposed
not only to the price of the equities that make up the U.S. and Japanese positions, but also to the U.S. dollar and
Japanese yen. The fund manager wants to remove the currency risk associated with owning the non-Canadian
equities.
The fund manager sells a U.S. dollar forward contract against the Canadian dollar, which locks in an exchange
rate for the U.S. dollar exposure. The fund manager also sells a Japanese yen forward contract against the
Canadian dollar, which locks in a rate for the Japanese yen exposure. The forward contracts enable the mutual
fund to maintain market exposure to the U.S. and Japanese equities, but they do not carry the currency risk
associated with them.

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EXAMPLE
(cont’d)
If the value of the foreign currencies declines over the term of the forward contracts, it will be offset by the gains
on the forward contracts. If the value of the foreign currencies increases over the term of the forward contracts,
it will be offset by the losses on the forward contracts. As the forward contracts approach their maturity, the
manager will likely roll them over — buy them back at a profit or loss and sell new forward contracts — to
maintain the hedges. As long as the hedges are in place, the portfolio’s returns will come only from the changes
in the value of the underlying equities.

NON-HEDGING USES
Mutual fund managers may use derivatives to create or increase exposure to a market or sector, earn additional
income for a fund or provide an additional opportunity for gains. Common uses of derivatives for non-hedging
purposes in fund management fall into the following categories:

• The sale of call or put options to earn additional income;

• The purchase of options, forwards, futures or swaps to gain exposure; and
• The sale of forwards, futures or swaps to reduce exposure.

THE SALE OF OPTIONS

Some mutual fund managers sell options to take advantage of current or desired portfolio holdings and earn
additional income. Although not without risk, the sale of options that are covered (offset) by another exposure or
by cash is considered less risky than the sale of uncovered options.
Canadian conventional mutual fund managers are permitted to sell options, provided they have an offsetting position
in the underlying asset; the right to buy or sell the underlying asset such as purchased call or put options; the cash to
cover the exercise of the sold options; or an adequate combination of all three. These rules are detailed in NI 81-102.

WRITING COVERED CALL OPTIONS

A mutual fund manager can sell a covered call option with a strike price that represents an attractive selling price.
A covered call option is a call that is sold with the underlying asset already owned in the portfolio. The manager
receives the option premium and, in exchange, agrees to sell the underlying security at the strike price if the
option is exercised. The manager must be comfortable keeping the security if the option is not exercised. The call
option buyer obtains the right to buy the underlying asset at the strike price, and will do so only if the price of the
underlying asset rallies past the strike price. Writing covered call options is a defensive strategy that is designed to
offset losses in long stock positions with income from call option premiums.

EXAMPLE
Selling a Covered Call Option
A Canadian equity fund manager holds shares of Medium Bank. The manager believes the share price will move
very little over the next few months and would like to sell the shares if the price reaches $70. The manager sells a
call option on the shares with a strike price of $70, for which the fund gains a $2 per share option premium. If the
option buyer exercises the call option, the manager has the obligation to sell the shares at $70.
If the share price drops to $50, the buyer will not exercise the call option. The fund retains the Medium Bank
shares and the $2 per share option premium, but owns shares that have declined in value. If the share price rises
to $90, the buyer will exercise the option and the manager will sell the shares at $70. The manager’s effective
selling price for the shares will be $72 ($70 strike price + $2 premium received).

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 CHAPTER 9 THE PERMITTED USES OF DERIVATIVES BY MUTUAL FUNDS 9•7

WRITING CASH-SECURED PUT OPTIONS

A mutual fund manager can sell a put option with a strike price that represents an attractive entry price for buying
an underlying security. The put option buyer gets the right to sell the underlying security at the strike price. In
exchange, the manager receives an option premium for agreeing to buy the underlying asset at the strike price if the
put option is exercised. The option premium reduces the manager’s cost of acquiring the underlying security if the
option is exercised. Writing cash-secured put options is a bullish strategy designed to add income if an underlying
asset rallies in value. However, the manager must be comfortable with having no position on an attractive asset if
the option is not exercised.

EXAMPLE
Writing a Put Option
A mutual fund manager would like to buy additional shares of Medium Oil, which are currently trading at $28.
The manager believes the shares will appreciate over the long term, but would like to take advantage of any
short-term dips to add to the fund’s position. To do so, the manager writes a put option with a $25 strike price.
For the sale of the put option, the manager earns $3 per share in option premiums. The fund manager now has
the obligation to buy the shares at $25 should the put option buyer decide to exercise the option.
If the price of Medium Oil’s shares rallies to $35, the put option will not be exercised by the option buyer and the
fund will retain the $3 option premium. If the price of Medium Oil’s shares declines to $15, the put option will be
exercised by the option buyer and the manager will buy the shares at $25. The manager’s effective purchase price
will be $22 ($25 strike price – $3 option premium received).

According to NI 81-102, the conventional mutual fund manager is not allowed to write a put option without having
the cash to buy the shares. Since the fund must have adequate cash to purchase the shares if the put option is
exercised, it is considered to be a cash-secured put option. If the fund does not have the cash to purchase the
shares, it could be at risk should the put option be exercised. Furthermore, since the manager must buy the shares if
the put option is exercised, the stock must be acceptable to the fund.

APPLICATION OF BOND FUTURES AND FIXED INCOME OTC DERIVATIVES

TO MUTUAL FUNDS
Bond futures and fixed income-related OTC derivatives are used in the management and risk control of fixed income
mutual funds and in the fixed income component of multi-asset class diversified funds, such as balanced funds.
When compared to equity fund derivative applications, one major distinction is that equity-related futures and OTC
derivatives are typically used to either gain or hedge out exposure to entire equity markets generally using equity
index-related derivatives. However, the application of fixed income-related futures and OTC derivatives are more
specifically focused on increasing or decreasing a fund’s exposure to interest rate risk. Equity fund managers tend
to use derivatives to manage a fund’s beta, whereas fixed income portfolio managers generally use derivatives to
manage a fund’s duration.
The two most popular applications of bond futures and fixed income-related OTC derivatives to manage a mutual
fund’s duration are as follows:

• To increase the duration of a fixed income mutual fund, a manager would buy U.S Treasury bill futures
(90-day term to maturity), U.S. Treasury note futures (10-year term to maturity), and U.S Treasury bond
futures (30-year term to maturity). To decrease the duration, the manager would short U.S. Treasury
bill futures, U.S Treasury note futures, and U.S. Treasury bond futures. U.S. Treasury futures are used for
modifying a bond portfolio’s duration since they have high liquidity, very low transaction costs, and ease
of execution.

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9•8 PORTFOLIO MANAGEMENT TECHNIQUES

A manager would determine the required respective amounts of a combination (linear sum) of the three
futures contracts noted above to attain the bond fund’s targeted duration. It should be noted that there are
only a limited number of Canadian government bond futures contracts. Canadian bond portfolio managers
often use the U.S Treasury bond futures contracts to attain the desired duration result for their domestic bond
funds. They will generally not hedge the U.S. dollar currency exposure that accompanies the U.S. dollar bond
futures position. However, the manager will hedge if it is anticipated that the futures position will be held for
a medium- to longer-term time horizon where currency movements could be detrimental to the bond fund’s
overall rate of return.
• Short selling a longer-term fixed-for-floating interest rate swap reduces the bond fund’s duration more than
if a short-term interest rate swap was shorted. The impact on the bond fund’s duration is very similar to that
realized when shorting a 30-year U.S. Treasury bond future. Conversely, going long a longer-term fixed-for-
floating interest rate swap will lengthen the bond fund’s duration.

INDEX DERIVATIVES
Another common use of derivatives for non-hedging purposes is the creation of index funds. A fund manager can
create an index fund by purchasing all (or most) of the assets in an index in their same (or approximate) weightings.
Alternatively, the manager can use a derivatives contract to get synthetic exposure.
Index derivatives, which are typically forwards and futures, give fund managers exposure to broad market price
movements without having to own each of the securities in an index. Depending on the needs of the fund,
exchange-traded or OTC derivatives can be used. Since OTC derivatives are customized, their attributes can be
tailored to a mutual fund’s specific requirements.
Swaps are also sometimes used to replicate an index’s returns. An index fund might use a swap as an alternative to
an exchange-traded derivative, if no listed derivatives are available. Alternatively, it might be attractive to a fund
manager to use a swap that is customized for a fund’s specific requirements.

EXAMPLE
A Total Return Index Swap
The manager of a fixed income index mutual fund holds most of the securities that make up the index. For new
inflows into the fund, the manager decides to buy Treasury bills (T-bills) instead of the index’s fixed income
securities and use a swap to gain exposure to the return on the index. The manager enters into a swap based on
$10 million that calls for a quarterly exchange of return based on the T-bills and the index.
Although the manager continues to own the T-bills, their return will be paid to the swap counterparty, while
the return on the fixed income index will be paid by the swap counterparty to the fund. The result is that the
fund’s returns will be that of the fixed income index, net of any costs that are incurred in undertaking the swap.
Figure 9.1 is a graphical depiction of the cash flows in this scenario.

Figure 9.1 | Swaps and the Return on an Index Fund

Return on T-Bills
Index Fund Swap Counterparty
Return on Index

Return on T-Bills

Treasury Bills

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 CHAPTER 9 THE PERMITTED USES OF DERIVATIVES BY MUTUAL FUNDS 9•9

EXAMPLE
(cont’d)
If during the first quarter, the return on the T-bills was 0.75% and the return on the index was 2%, the terms
of the swap require the mutual fund to pay the swap counterparty $75,000 ($10 million × 0.0075) and the
swap counterparty to pay the mutual fund $200,000 ($10 million × 0.02). Like most swaps, there is likely
a clause that requires only a net payment by the party that owes the larger of the two payments — that is,
the principal is not exchanged in an interest rate swap. In this case, the swap counterparty pays the mutual
fund $125,000. This quarterly calculation and exchange of payments would continue until the end of the
swap’s term.

THE ADVANTAGES OF DERIVATIVES

The use of derivatives by mutual fund managers benefits investors by offering opportunities to obtain exposure
to certain assets and by mitigating certain kinds of risk. The advantages that derivatives provide to mutual fund
managers include the following:

• Risk reduction
• Ease of execution
• Lower costs
• Greater asset selection
• More portfolio income

RISK REDUCTION
One of the most important uses of derivatives for mutual fund managers is the ability to reduce risk. For example,
derivatives are often used to reduce the currency exposure otherwise associated with foreign currency–denominated
investments, enabling investors to own foreign securities without worrying about exchange rate fluctuations. Call
options are also sold on existing stock positions to reduce losses during flat or down markets.

EASE OF EXECUTION
Derivatives contracts permit a fund manager to purchase a large number of diverse securities in a single transaction,
which could be difficult, time-consuming and costly if each security in the index was purchased individually.
In addition, derivatives can help avoid execution slippage, which occurs when the execution of a transaction causes
subsequent prices to worsen. A manager benefits from the ease and low cost with which a derivatives transaction
can be executed.
Stock index forwards can also be used in asset allocation strategies. Suppose the manager of a balanced mutual
fund receives new cash of $10 million. The manager’s allocation to the equities index is currently 30%. Rather than
purchase individual stocks to mirror the index in small and odd amounts, and pay the slippage, the manager buys
stock index forward contracts with a notional value of $3 million (30% of $10 million). This provides a proxy for
owning the equities in the index, and the manager can implement the asset allocation quickly and cheaply.

LOWER COSTS
One of the major benefits of using derivatives as a proxy for owning individual securities is lower transaction and
administration costs. This is particularly true for international funds, which face potentially higher costs for analysis,
custodians, and slippage. As a result, some international funds, particularly index funds, use derivatives contracts
to gain exposure to foreign markets, rather than buying foreign securities directly. If the fund manager can obtain

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exposure to the market at a lower cost than owning the securities outright, cost savings can be passed along to
investors in the form of lower fees and management expenses.

GREATER ASSET SELECTION

Mutual fund managers may be able to use derivatives to gain access to markets that would otherwise be difficult
or impossible to enter. For instance, a manager could easily gain exposure to the emerging markets asset class
by buying futures based on the MSCI Emerging Markets Index, which represents over 1,300 securities in over
20 countries. The availability of specialty and foreign derivatives increases the variety of assets available to investors.

MORE PORTFOLIO INCOME

Derivatives can be used to increase returns in mutual fund portfolios when markets are stagnant or falling. The sale
of covered call options can increase portfolio income from underlying securities. However, if the underlying securities
are sold and subsequently rally, there is a risk that the manager will have missed potentially greater returns.

THE POTENTIAL RISKS OF DERIVATIVES

Not all mutual fund managers use derivatives. There are disadvantages and risks associated with their use in mutual
fund management, including the following:

• Income considerations
• Management of expiration dates
• Portfolio attributes
• Limited gains
• Transparency
• Tax considerations
• Costs
• Credit and counterparty risk

INCOME CONSIDERATIONS
In the use of derivatives in mutual funds, portfolio income is both a potential advantage and disadvantage. Although
options can be written to earn income, the fund manager using forwards and futures as a proxy for securities does
not collect dividend or interest income that would otherwise be earned by security holders. The pricing of a futures
or forward contract already takes into account the effect of dividends or interest income payable on the underlying
asset, but there are no explicit payments related to dividends or interest to the owner of the derivatives contract.

THE MANAGEMENT OF EXPIRATION DATES

Derivatives contracts have an expiration date, at which point the contracts must be rolled over or renewed to
maintain the exposure. The associated costs and administration of expiry may be an issue.

PORTFOLIO ATTRIBUTES
Using derivatives for hedging purposes may not provide adequate protection against market risk if there is a weak
correlation between the portfolio’s securities and the derivatives contracts used for hedging.

EXAMPLE
Government bond futures contracts provide an inadequate hedge for corporate bond holdings, because the
futures do not provide protection against the credit spread risk of corporate bond holdings.

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When an option is used, the price sensitivity of the option (delta) will help determine the effectiveness of the hedge
or position taken. An option with little value and a strike price that is substantially above or below the asset’s current
price will not change much in value, even for relatively significant changes in the underlying asset’s market value.

LIMITED GAINS
Derivatives are often used to hedge the risk associated with foreign currency investments or interest rates. While
the purpose of hedging is to reduce risk, if the fund manager forecasts incorrectly, hedging may result in a loss or a
smaller gain for the fund than would otherwise be the case.

EXAMPLE
A fund manager hedges against the decline in a currency’s value using a forward contract, and the hedged currency
subsequently rises in value. As a result, the fund’s returns may suffer in comparison with peer funds or indexes.

The sale of call options may also limit gains, because it obliges the fund manager to sell the underlying security at
the strike price. If a written call option is exercised, the fund may lose opportunities for future gains that it would
otherwise accrue from owning an appreciating security.
Similarly, a fund manager can write a put option to acquire an attractive security for the portfolio. The sale of a put
option obliges the manager to buy the underlying security at the strike price, but provides the fund with income
from the option premium. The written put option will only be exercised by its owner if the security’s price declines
below the put option’s strike price. If the put option is exercised, the manager must buy the security at the strike
price. And if the price of the security continues to decline, the fund will suffer losses.

TRANSPARENCY
Canadian mutual fund regulations require that the use of derivatives be disclosed in a fund’s prospectus — see
Exhibit 9.1 entitled Prospectus Disclosure. Details of derivatives contracts are disclosed in the financial statements
that accompany the fund’s prospectus. In some cases, the time lag associated with the publication of the financial
statements and the complexity of the contracts involved may make it difficult for an average investor to understand
the true exposure offered by a mutual fund.

TAX CONSIDERATIONS
One commonly enjoyed benefit of investing is that capital gains and dividends receive preferential tax treatment.
However, the income that typically accrues to fund holders as a result of futures and forward contracts is taxed as
income and therefore does not normally receive any preferential treatment.
Tax considerations are very important outside tax-sheltered plans, because the return to the investor is an after-tax
return. Within registered savings plans, such as RRSPs, there is no preferential benefit to earning returns as capital
gains over ordinary income. Therefore, depending on the investor’s perspective, there may or may not be a tax
consideration for mutual funds that use derivatives.

COSTS
Not all mutual funds that use derivatives have lower costs than those that do not use them. Extra administrative
and management costs are associated with the use of derivatives.

CREDIT AND COUNTERPARTY RISK

A mutual fund using derivatives contracts is exposed to the counterparty’s creditworthiness. In the case of an
exchange-traded contract, this means exposure to the derivatives clearinghouse, which is the entity that provides
clearing and settlement services for the derivatives contracts. This risk is minimal. However, the use of one or two
financial institutions as counterparties for a fund’s OTC derivatives contracts, whether used for hedging or non-
hedging purposes, concentrates a mutual fund’s counterparty exposure.

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SUMMARY
After completing this chapter, you should be able to:
1. Identify the types of mutual funds that use derivatives.
• Certain mutual funds are more likely to use derivatives than others, particularly index funds.
2. Describe the regulations that impact how a mutual fund can use derivatives.
• NI 81-102 applies to mutual funds in Canada and outlines the permitted derivative activities that these funds
can undertake.
3. Describe the necessary disclosures for a mutual fund to use derivatives.
• The use of derivatives must be disclosed and described in a mutual fund’s simplified prospectus. The
prospectus must also explain how derivatives will be used to achieve the mutual fund’s investment and risk
objectives, and the limits of and risks involved with their use.

4. Distinguish between hedging and non-hedging purposes.

• NI 81-102 specifies the conditions under which a mutual fund can use derivatives in hedging and non-hedging
positions.
• To qualify as a hedge, the derivative that is used must:
« Be intended to offset or reduce a specific risk associated with all or part of a position or positions in
the fund;
« Have a value with a high degree of negative correlation to the value of the position being hedged; and
« Not be expected to offset more than the changes in the value of the position being hedged.
• The most common use of derivatives for non-hedging purposes is to gain exposure to a market without
having to own the underlying securities.

5. Explain the ways in which mutual funds use derivatives.

• Hedging: Canadian mutual funds use derivatives primarily to reduce exchange rate exposure resulting from
holding foreign currency–denominated securities.
• Non-hedging: Common uses of derivatives for non-hedging purposes in fund management fall into the
following categories:
« The sale of call or put options to earn additional income;
« The purchase of options, forwards, futures or swaps to gain exposure; and
« The sale of forwards, futures or swaps to reduce exposure.

6. Identify the advantages and disadvantages of using derivatives in mutual funds.

• The advantages of using derivatives by mutual fund managers include risk reduction, ease of execution,
lower costs, greater asset selection and more portfolio income.
• The disadvantages of using derivatives by mutual fund managers include income considerations, the
management of expiration dates, portfolio attributes, limited gains, transparency, tax considerations, costs,
and credit and counterparty risk.

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 Creating New Portfolio
Management Mandates 10

CONTENT AREAS

New Investment Product Development Process

Investment Guidelines and Restrictions

LEARNING OBJECTIVES

1 | Describe the key steps for analyzing the potential for investment products and developing new ones.

2 | Discuss the importance of a thorough assessment for a new investment product’s potential market
size and the challenges of developing that assessment.

3 | Describe the various legal and regulatory issues when considering the development of a new
investment product.

4 | Identify the key information requirements for preparing a financial forecast for a new investment
product.

5 | Explain the steps to follow after project approval has been granted for a new investment product.

6 | Describe the purpose of an investment product’s investment guidelines and restrictions, and the
critical importance of a well-defined investment policy.

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KEY TERMS

Key terms are defined in the Glossary and appear in bold text in the chapter.

backtesting new product development committee

final go/no-go decision performance benchmark

investment-grade credit rating pro forma financial projection

management expense ratio (MER) product management team

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INTRODUCTION
The primary purpose of this chapter is to explain how an investment management firm assesses and develops new
investment funds and other products and services. The products and services provided by these firms range from
traditional mutual funds and institutional pooled funds to separately and unified managed accounts, exchange-
traded funds (ETFs), and alternative mutual funds. Investment management firms with the appropriate skill sets
have an ever-growing number of distribution channels through which they can sell their expertise to a range of
investors.
The chapter starts with a description of the typical development process of a new product and the key steps
involved. We also explain each major step in the assessment process, as well as the information and assumptions
that must be in place to bring the project to a final go or no-go decision.
Finally, we discuss why it is important to have well-developed investment guidelines and restrictions for each new
fund or product, and we describe the key factors to consider when developing investment guidelines and restrictions
for equity, fixed income, and balanced fund mandates.

NEW INVESTMENT PRODUCT DEVELOPMENT PROCESS

The investment management industry is well-known for its ingenuity and ability to develop products that connect
both new and existing investors with perceived opportunities in capital markets. However, like with all new
business opportunities, there is risk involved in creating new products and services. As such, it is prudent to have a
well-designed new product development process in place to lower risk and lead to better decisions regarding new
products.
There are eight key steps in assessing and developing new investment products, as follows:
1. Identifying potential market opportunities
2. Determining the required portfolio management skills, and if external investment management skills will be
needed
3. Assessing the market
4. Determining legal and regulatory restrictions
5. Developing a marketing and distribution strategy
6. Preparing a financial forecast, including pro forma financial statements
7. Obtaining approval from the investment management firm’s senior management team
8. Developing and launching the product

Each of these steps will be covered in detail in the following sections (see Figure 10.1).

Figure 10.1 | The New Product Development Process

1. Identifying Potential • Originating new product ideas from inside the investment management
Market Opportunities firm or outside of it from investors or competitors.

2. Determining the Required • Assessing if the investment firm has the portfolio management skills
Portfolio Management required for the new product. If not, a decision will need to be made to
Skills consider an outside sub-advisor.
• Backtesting the process if an internal track record does not exist.

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Figure 10.1 | The New Product Development Process

3. Assessing the Market • Analyzing potential investor interest in the new product.
• Using competitors’ products if entering an existing product market, which is
more difficult to assess if the new product is a completely novel concept.

4. Determining Legal and • Confirming and integrating all applicable legal and regulatory guidelines
Regulatory Restrictions and restrictions into the new product’s design.

5. Developing a Marketing • Developing a marketing and distribution strategy that is most suitable and
and Distribution Strategy appropriate for the new product.

6. Preparing a Financial • Preparing a detailed financial forecast for the new product, including details
Forecast regarding investment management fees and the sales and marketing
budget.
• Forecasting usually involves numerous sales growth scenarios with
associated probability weights.

7. Obtaining Approval • Presenting the new product proposal to the firm’s senior management team
from the Investment for approvals.
Management Firm’s
Senior Management
Team

8. Developing and • If the product is approved, implementing key steps to bring the product to
Launching the Product market.

STEP ONE: IDENTIFYING POTENTIAL MARKET OPPORTUNITIES

New investment products or fund concepts generally arise when they are either “pulled” or “pushed” to market.
A product market pull occurs when a new investment fund or product idea originates from within the investment
fund or product market. Typically, current investors or product distributors are the sources of new fund ideas. In
other words, the investment management firm is being pulled towards a potential new investment fund or product
opportunity.
When a new product concept originates from within an investment management firm, it is commonly referred to as
a product push because it is pushed to distributors and investors as a new product.
The investment management firm promotes a new investment fund or product concept for one or both of two
reasons:

• To identify an internal portfolio management skill that appears to be competitive, performance-wise, in relation
to what is already in the marketplace (if there is any competition at all).
• To identify an emerging or underdeveloped market sector, sub-sector, product structure, or regulatory initiative
that could form the basis for a new, specialized investment mandate.

PRODUCT MANAGEMENT TEAM AND THE NEW PRODUCT DEVELOPMENT COMMITTEE

Most large investment management firms, especially those with products targeting retail investors and their
advisors, have a product management team. This team is responsible for not only managing the day-to-day and
project-related business of the firm’s existing products, but also taking the lead in the development and launch
of new products. Although anyone within a firm can decide to investigate new product ideas, it is the product

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management team’s role to research and analyze them. If necessary, they coordinate the work of the various
functional teams in the back, middle, and front offices to bring the new products to market.
In smaller firms, as well as those that are focused solely on the institutional market, a dedicated product
management team may not exist. In that case, the responsibility for managing the firm’s existing products is shared
by the various functional teams in the back, middle, and front offices. When new product ideas are identified
for potential development, an ad hoc new product development committee may be struck to vet and assess
the opportunities. A properly constituted committee consists of a multidisciplinary group of individuals with the
requisite expertise in the creation, launch, and management of new investment fund products. External consultants
may also be used as needed.
Whether a product management team exists or a new product development committee is struck, the goal of the
investment management firm should be to create a product development process with the following characteristics:

• Tailored to the development of investment funds or mandates

• Thorough and comprehensive
• Has a well-designed decision-making process
• Supplies data needs
• Includes an analysis process
• Uses an estimating methodology

STEP TWO: DETERMINING THE REQUIRED PORTFOLIO

MANAGEMENT SKILLS
Fundamental to their nature, all active investment products and services are built on portfolio management skills.
Once a market opportunity has been identified, a firm needs to determine if it has the necessary in-house portfolio
management skills or if it needs to hire external investment managers. Any potential opportunity can only be
accessed through the services of a portfolio manager who hopefully has the skills and abilities to earn competitive
rates of return in a particular part of the capital markets.
Passive investment products, including many index-tracking or rules-based ETFs, are built on the ability to manage
a pool of assets so that their performance before fees mirrors that of a target benchmark index or rules-based
strategy. Whether the index represents a broad basket of large-cap, domestic equity securities or a narrow slice of a
foreign country’s bond market, the investment management firm requires two things:

• In-house expertise in passive replication techniques

• Operational efficiency to manage the fund’s cash flows while minimizing cash drag and trading expenses

The fees generated from passive management are almost always less than those from active management, so the
investment management firm must focus on cost control as it builds scale in a particular mandate.
In general, investment management firms that focus on the institutional or high-net-worth markets (or both) offer
investment funds that solely use internal portfolio managers, including teams that manage index-replication and
rules-based strategies. On the other hand, at firms that create and manage products such as traditional mutual
funds and ETFs that cater to individual investors and their advisors, the use of external, third-party portfolio
managers (in addition to internal portfolio managers) is quite common.
Nowadays, the need to outsource portfolio management skills is seen as prudent, especially for investment
products that have global investment mandates. It is generally more cost and time effective to hire third-party
managers than try to acquire all the necessary skills in-house. However, remember from Chapter 4 that from
a regulatory and business perspective, a fund manager is responsible for all the activities of the sub-advisors it
employs. Therefore, the fund manager must conduct detailed due diligence of potential third-party managers.

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DIVE DEEPER

Backtesting
To determine whether an investment management firm’s team has the requisite skills to manage a new
product, it will perform a backtest. As the name implies, backtesting involves the retrospective analysis
of a potential investment product. Of course, backtesting is not required if the firm already has a fund
with a sufficiently long performance record that meets the new fund’s investment objectives, as well an
investment strategy that is consistent with it. If such an internally managed fund does not exist — and
if hiring another investment manager with an appropriate track record on a sub-advisory basis is not
feasible — then backtesting will form an integral part of the analysis.
Backtesting is typically fraught with a number of inherent biases and weaknesses, and must be used and
analyzed carefully to ensure the results are useful. Essentially, the investment team is being asked the
following:
“If you had been given this fund mandate three years ago, how would you have managed it and what
would your results have been?”
Given that the firm knows exactly how the market performed over the last three years, the answer to
this question is inevitably biased. This is one reason why regulators have concerns about the inclusion
of backtesting results in sales and marketing literature, advertising and presentations by investment
managers. The regulators’ concerns centre on the potential misrepresentation that occurs if the
backtesting results are not clearly noted and described as such within these materials. Backtesting
results are often appended to actual performance data, but are not clearly identified. It is quite likely
that new regulations will be approved regarding the use and presentation of backtested results in sales
and marketing materials.*

* For more information on the Ontario Securities Commission’s comments about back-testing, go to
https://www.osc.gov.on.ca/documents/en/Securities-Category3/csa_20110705_31-325_marketing-practices.pdf

STEP THREE: ASSESSING THE MARKET

Assessing the market for a new investment fund or product is a matter of conducting a proper assessment of the
demand for it. It is a difficult and challenging activity to gauge investor demand given its dependence on the
following factors, among others:

• The general tone of the economy and the markets, particularly the equity market
• The recent performance of the particular market sector if the new mandate is especially focused
• In the case of an actively managed product, the firm’s investment performance in both absolute return and its
performance relative to the market sector the new fund is focused on
• In the case of a passively managed product, the firm’s expertise in managing to replicate an index or follow a
rules-based strategy
• The adequacy of a firm’s distribution capabilities relative to the product type and structure

The market assessment must incorporate the various investor needs, including income and growth of capital. Does
the new product offer one of these needs or both? Assessing investor needs is very important and can result in an
incredibly large market opportunity if they are assessed properly and the product’s design accommodates them.

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 CHAPTER 10 CREATING NEW PORTFOLIO MANAGEMENT MANDATES 10 • 7

EXAMPLE
New Investment Products that Meet Investor Needs
Some examples of new investment products that meet a number of investor needs are as follows:

• Products that offer exposure to an industry theme, such as alternative energy.

• Exchange-traded funds (ETFs) have grown substantially during the past 15 years because they provide
investors with a myriad of funds that meet numerous investment mandates. These mandates range from
funds that attempt to replicate the return of popular market indexes, such as the S&P 500 Index, to funds
that specialize in very narrow parts of the equity market, such as biotechnology stocks. ETF investment
mandates are often not original, but their unique difference is that they offer investors exposure to equity
markets by purchasing stock exchange–listed securities, rather than by purchasing a mutual fund with a
similar mandate. Unlike conventional mutual funds, ETFs can be traded very easily throughout the day. In
addition, the fees and commissions associated with ETFs tend to be much lower than those associated with
most mutual funds.

Another major factor in the market assessment of a new investment product is whether it is entirely new or an
imitation of an existing product. Of course, assessing the market for a novel product is difficult, because there are no
other products in the marketplace that can be used as a benchmark or proxy for market assessment. When the new
product that is being analyzed is entering an existing market sector, the investment firm must be confident that the
product will offer comparable or better results than its existing competitors’ funds.

POTENTIAL BENEFITS OF BEING FIRST TO MARKET

Unfortunately, financial innovations are not patentable. As such, the firms that are first to market with an innovative
fund or investment product do not generally enjoy the financial advantages associated with market exclusivity.
Investment firms recognize this fact and attempt to bring new funds to the market as quickly as possible and with
the greatest distribution they can provide. Industry participants fully expect that the successful launch of a new
fund will bring competitors into the market. Usually, the more successful the new product launch is, the quicker and
more profound the competitive response will be.
Some of the potential benefits of being first to market include the following:

An Increase in Assets Unless the new product launch is a total failure, the firm has accumulated additional
Under Management assets to manage and therefore earns additional investment management fees.

Market Share A successful launch, combined with good investment results and effective sales and
Leadership marketing efforts, frequently results in the opportunity to obtain and maintain a
respectable market share. Often, particularly with mutual funds, the firm that enters
the market first with a new fund can also benefit from additional investor awareness of
the fund. The firm can entrench itself in the lead as competitors spend more resources
to make investors aware of their “follow-on” investment products.

Innovator Status The firm that is first to market will often be recognized as an innovator in the
market and will attract the attention of the financial press and of financial product
distributors. This recognition makes it potentially easier for the firm to find and
negotiate better and broader distribution relationships for future product launches.

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STEP FOUR: DETERMINING LEGAL AND REGULATORY RESTRICTIONS

As discussed in Chapter 3, securities regulations apply to both investment management firms and investment
products that are managed or distributed in Canada, and they can vary for different types of products.
These restrictions must be considered when developing a new investment product. Table 10.1 compares the legal
and regulatory restrictions that apply to different groups of Canadian investment products and funds.

Table 10.1 | Canadian Investment Products and Regulatory Agencies

Product Primary Offering Document Investor Type

Conventional mutual fund Short-form prospectus All
Alternative mutual fund Short-form prospectus All
Closed-end fund Long-form prospectus All
Pooled fund or hedge fund Offering memorandum Exempt/accredited

MUTUAL FUNDS
From a regulatory perspective, mutual funds are the most regulated of all Canadian investment products. They
are usually structured legally as unit trusts, although a few are structured as corporations. The appropriate legal
structure must be created and registered with the various provincial or federal authorities.
After it is completed by the mutual fund manager’s legal counsel, the fund’s prospectus must be filed for approval
with each of the provincial securities regulators where it will be distributed. The time to obtain approval for the
prospectus from the various provincial securities regulators is usually in the range of four to eight weeks after the
filing date. This timing is dependent on the following three major factors:

The Time of Year Many mutual fund companies bring new funds to market late in the calendar year
to help attract investors who are making RRSP contributions during January and
February. Accordingly, securities regulators are often inundated with prospectus filings
during the late third quarter or early fourth quarter of the year. This flood of filings
often extends the product review time for newly submitted mutual fund prospectuses.

A “Clean” Prospectus It goes without saying that it is critical that a firm have competent legal and
accounting counsel when it is creating a prospectus for approval. Prospectuses receive
critical review by the securities commission staff responsible for the registration of
new mutual funds. A poorly crafted prospectus will result in a greater number of
deficiencies identified by the regulators. These deficiencies are noted in a deficiency
letter and sent to the mutual fund manager. Each and every deficiency in the filed
prospectus must be corrected and resolved to the satisfaction of the securities
regulator before the prospectus approval will be granted. The greater or the more
severe the deficiencies are, the longer it will take for the firm to finally obtain
complete securities regulator approval.

Exemptions Often, for competitive advantage, prospectuses that are filed for regulatory approval
will contain requests for a particular exemption or exemptions from regulations.
Depending on the number and magnitude of each requested exemption, the length of
time to obtain regulatory approval will be extended.

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INVESTMENT PRODUCTS FOR EXEMPT OR ACCREDITED INVESTOR MARKETS

A number of investment products and funds are designed explicitly for investors who meet the definition of exempt
or accredited investors. These include investment products such as hedge funds, private equity funds, leveraged
buyout funds, infrastructure funds. These investment products are usually legally structured as limited partnerships.
In Canada, investment products that are only designed for and distributed to exempt or accredited investors do
not require an approved prospectus. These products are generally distributed with an offering memorandum or a
partnership agreement, or both. These offering and subscription documents must be filed with securities regulators
prior to the product’s sale and distribution. However, these documents do not require the approval of securities
regulators. Therefore, there is no timeline for regulatory approval.

ONSHORE VERSUS OFFSHORE REGISTRATION

Onshore versus offshore refers to where an investment fund or product is registered. As such, it is a product design
feature and is often associated with income tax and other related potential benefits. Offshore funds can bring along
other types of risks for investors, as the legal and regulatory requirements that govern the offshore legal entity
that is holding the investments might be quite different from those that exist in the investor’s country of domicile.
However, the choice of a fund’s registration and domicile does not tend to affect its investment strategy per se.

STEP FIVE: DEVELOPING A MARKETING AND DISTRIBUTION STRATEGY

An excellent marketing and distribution strategy is required for the successful launch of a new investment fund,
especially when there is no performance track record to use in sales and marketing materials.

THE MARKETING “STORY”

The launch of a new investment fund requires a new or unique “story” to create investor interest. Product features
per se will usually not be sufficient to create interest. Generally, the marketing theme for a new actively managed
fund is built around the investment manager’s skills and abilities. For example, does the new fund’s manager have
a unique investment management process or skill? Invariably, the answer is yes, but the marketing challenge is
to explain the new fund’s investment attributes, then further explain how its particular investment strategy will
capitalize on this market opportunity.
When the new product is a passively managed product, like many new ETF products, the story likely revolves around
a previously unexplored segment of the market or a cheaper way to access an existing market. The explosive growth
in ETFs has increased the challenges investment management firms have to define and market their products in a
way that will lead to real traction and scalability with investors.
The marketing challenge is also typically impacted by whether the new fund under development is innovative and
first to market, or if it is entering an area of the market that has been opened up by other investment firms. Each
situation has its own unique marketing challenges.
When a new investment product is entering a market where competitive products currently exist, the marketing
story has to depend heavily on the portfolio manager’s abilities. The benefit of entering an existing market is that
the competition has already spent resources to educate the public about the benefits of investing in a particular
type of fund or part of the capital markets. The challenge in this case is to develop a marketing story that is
sufficiently unique to set apart the new fund or product from existing funds.
Not surprisingly, the marketing challenges for an innovative investment fund or product are the opposite of those
involved in entering an existing sector of the marketplace. A new product’s marketing story does not have to deal
with comparisons to competitors’ products. However, it does have to focus on explaining the benefits of investing in
a new type of fund and on why the portfolio manager is appropriate.

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DISTRIBUTION CHANNELS
A distribution channel is a route through which a fund gets to investors so they can buy it. A major marketing
challenge is to decide which distribution channels and distributors to use. Sometimes, the channel is dictated by the
product’s structure. For example, as an exchange-traded product, an ETF can be purchased by any investor holding
an account with either an investment dealer or a mutual fund dealer. In many instances, the choice of distribution
channels and distributors is very straightforward. In the example of a new mutual fund product, these decisions
have already been made as a matter of overall corporate strategy. As a result, the new investment fund or product
will be marketed under the mutual fund’s corporate brand by the same distributors that currently have agreements
in place. However, new distributors might be considered if they have some unique distribution capabilities that are
very well-suited to the new investment fund or product.

STEP SIX: PREPARING A FINANCIAL FORECAST

One key step in the product development process is to bring together all the assumptions into a financial forecast or
model for the new product under consideration and for the investment management firm. Generally, this includes
communicating all the new product’s financial or monetary aspects. The forecast integrates the firm’s assumptions
about the following key variables:

• Net sales
• Market growth
• Investment management fees
• Distributor compensation, including upfront commissions and trailer fees
• Third-party expenses

Usually, the ideas for a new investment fund start with a back-of-the-envelope version of the fund’s financial model,
which becomes more refined as the product development process continues.

NET SALES
The key variable in the financial analysis of a new investment product is the sales estimate. Net sales equal the
total value of new sales into an investment product minus the total value of redemptions or withdrawals out of the
product. The amount of net sales leads directly to the amount of assets under management (AUM), which, in turn,
leads to the gross revenue — or investment management fees — assumption for the firm. This is the case because
investment management fees are usually a fixed percentage of a fund’s AUM.
The net sales estimate for a new product requires the greatest amount of effort to forecast. It is a difficult task for
new products that are entering an established sector, but it is a particularly daunting task for the development of
innovative product launches. Of course, in the latter case, there is no competitor comparison that can be used as a
basis or benchmark to assist the firm in preparing a net sales estimate for the new product.
To create a sales forecast for an innovative product, a firm would first look at related products to see what amount
of sales success each has had. The sales estimate resulting from such a comparison introduces lots of risk, since
the new product, which is innovative, has no direct comparison in the market. Nevertheless, though the related
products are certainly not valid as head-to-head comparisons, their performance can be used as reference points
during the development of the new product’s sales plan and volume targets.
Finally, and often most important, is the tone of the overall equity market. Market tone at the time of a
new product launch can tremendously affect the initial net sales results. It is not uncommon for investment
management firms to pause or even cancel outright a new product launch if the financial markets turn “sour” just
before the planned launch date.

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MARKET GROWTH
A firm’s AUM increases not only with net sales but also with positive investment performance. All else being equal,
the better the performance of the firm’s portfolio managers and sub-advisors, the greater the level of AUM, which in
turn will lead to higher gross revenue for the investment management firm.
Forecasting growth in AUM due to market growth is a function of three factors:

• The market in which the new product will be invested

• The firm’s historical or backtested performance in the market
• Any structural product feature that may reasonably be expected to impact performance relative to the first two
factors

An example of the third factor is leverage. If a product is using leverage as part of its investment strategy, the firm’s
estimate of the product’s market growth should allow for the estimated amount of leverage.

INVESTMENT MANAGEMENT FEES

Once the AUM has been estimated from net sales and market growth, the firm can estimate the level of investment
management fees paid by the product’s investors to the investment management firm for portfolio management, as
well as any other administrative fees payable to the firm that are not included in the third-party fees-and-expenses
category. Essentially, investment management fees represent the fund manager’s gross revenue for managing that
particular product. This revenue attempts to compensate the firm for setting up the product, providing investment
management, paying any ongoing trailer fees, paying for marketing and advertising, and (hopefully) earning a profit
for all of its efforts.
These fees are identified and quantified in the fund’s offering documents or prospectus. They are calculated on the
basis of a fixed percentage of the fund’s daily net asset value (NAV). Since the fees are charged directly to the fund
on a daily basis, they reduce the fund’s NAV by a similar amount. The fees can only be changed by a vote from the
fund’s current investors.
Investment management fees tend to be quite competitive between firms, though they do vary based on the type
of mandate a fund manages. Money market funds have the lowest investment management fees, bond funds have
the next-highest fees and equities have the highest fees of all three asset classes. Investment management fees are
highest for specialty mandate equity funds and those that invest in foreign markets.

DISTRIBUTOR COMPENSATION
Distributor compensation generally takes two forms: upfront commissions and trailer fees. Commission fee scales
which tend to be quite similar for the majority of distribution firms, are negotiated between the fund manager and
its respective distribution firms. In the case of mutual funds, the prospectus must include the maximum commission
that can be charged by any of the fund’s distributors.
Most mutual funds offer a selection of options with regard to sales commissions. For example, investors can pay
a one-time upfront commission they negotiate with the distributor’s agent, which is the investment advisor or
mutual fund salesperson.

THIRD-PARTY FEES AND EXPENSES

The operation of most types of investment funds and products includes the use of many different services. While
many larger investment management firms offering mutual funds act as the trustee for their mutual fund trusts,
most of these services are provided by third parties — that is, some party other than the fund manager. The primary
services are as follows:

• Custodial/safekeeping
• Trustee

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• Unitholder record-keeping
• Fund administrator
• Audit
• Legal
• Fund director fees (for those funds that have an independent board of trustees providing fund oversight)

Investment advisory and sub-advisory services are also performed by a third party. The fund’s investment advisor
is an independent legal entity, and its legal relationship with the fund is defined by the terms set forth in the
investment management agreement between the fund and the investment manager.
In most Canadian mutual fund companies, the fund manager and the fund’s investment manager, or portfolio
manager, are separate legal entities, but they are under the same control. On behalf of the mutual fund entity,
the fund manager must have a contract with the investment manager to obtain its services for the benefit of the
investors who own shares or units in the mutual fund entity.

PRO FORMA FINANCIAL PROJECTIONS

At this point, a pro forma financial projection is created for the new fund or product under consideration. It has
three key inputs or assumptions, as follows:
1. AUM (revenue)
2. Fees charged to investors (revenue)
3. All fees and expenses to be charged to the fund and, accordingly, to investors

These projections are prepared on an annual basis and they are normally made for five or more years. The fund’s
economics are usually based on two analyses, as follows:

Investor or Unitholder This analysis examines the total amount of fees and expenses that the fund will charge
annually. This is an important analysis, since investors have become more aware and
sensitive about the amount of money they are paying in fees and expenses. These
annual fees and the expenses associated with each Canadian mutual fund are readily
available. The information is usually expressed as a management expense ratio
(MER). The MER is charged to the fund by the fund manager before any returns are
paid out to investors. It includes the fund manager’s compensation and other expenses
associated with operating the fund. It is calculated as follows:
MER = (Management Fee + Fund Expenses) / Fund’s Daily NAV (10.1)

The MER is accessible from a number of sources since, by regulation, it must be

included in the fund’s routine financial reports. It is also published frequently by the
fund manager and is often included in publications that focus on the mutual fund
industry. The size of a fund’s MER is often part of a potential investor’s decision as to
which mutual fund to invest in.

Fund Manager This analysis examines the amount of fees the fund manager will earn from the fund
annually. In essence, this is the amount of money the fund manager will earn for
creating and managing the fund.

Although the amount of fees and expenses charged to a fund’s investors has become more important over
time, most fund managers attempt to launch a new fund with a competitive MER so that it is sold based on its
investment return potential and the fund manager’s expertise.

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As mentioned earlier, the key variable in the analysis of a fund’s pro forma financial projection is the amount of
AUM. Accordingly, the projection is normally prepared with a number of scenarios for sales or AUM. These scenarios
typically consider a series of different sales estimates.
A pro forma projection is essentially the final step in a new investment fund’s analysis before it goes for approval.

STEP SEVEN: OBTAINING APPROVAL FROM THE INVESTMENT

MANAGEMENT FIRM’S SENIOR MANAGEMENT TEAM
Once the analysis of the proposed new fund has been completed, the pro forma financial projection and all other
related materials are brought to the firm’s senior management team, which is responsible for approving and
committing the resources required to take the final steps associated with creating and launching a new fund or
product.
The new product review will take the following key factors into consideration:

The Pro Forma The main focus will centre on the fees that are generated for the fund manager in each
Financial Projection of the scenarios for sales and AUM. The senior management team will agree to the
expected or probability-weighted sales scenario.

The Fund’s or Product’s The new fund’s sales prospects will be examined by considering its uniqueness or
Competitiveness competitiveness, or both, and in terms of its investment manager’s capabilities.

The Marketing Strategy The senior management team will also examine whether the marketing strategy fits
well with the fund’s competitive aspects. If the fund has a unique investment strategy
and mandate, the senior management team will discuss the marketing message and
how the market must be educated about the fund. In the case of a “follow-on” fund,
the senior management team will consider how the market is likely to respond to one
more fund in a sector that is already well-developed.

Distribution The senior management team must be comfortable with the new fund’s distribution
strategy. Does the new fund sell itself, thereby making it appropriate for many
different distribution channels — that is, direct or advisory? Alternatively, is the
new fund unique or very specialized? Does the firm plan on using distributors that
can effectively explain the new fund to its investor base? The choice of distribution
channels and partners is critical to the new fund’s eventual sales success.

FINAL GO/NO-GO DECISION

The senior management team’s review of the materials and information noted above leads to a final go/no-go
decision.
Often, the decision not to proceed any further with the development of a product is made because of concerns
that it will not garner enough AUM to make it economical to create and manage. A new product may be cancelled
if equity markets take a very bearish tone during the development process. It may also be cancelled or postponed
even after approval has been obtained and the firm has spent money on third-party services to register the product
and prepare marketing materials. This seldom happens, but it can occur if equity markets are particularly weak,
which is not a favourable environment for any type of new product launch. In this situation, depending on the
amount of money and resources expended, the fund manager may decide to complete all of the necessary steps,
such as prospectus completion, then resume the process once equity market conditions have improved sufficiently.

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The decision to proceed with the new fund results in the development process moving forward to the next step.
Depending on the firm’s size or focus (i.e., if they are focused solely on the institutional market), the product
management team or an ad hoc new product development committee might remain in charge of executing the
project up to and including the fund’s launch.

DID YOU KNOW?

The Costs of Failure

Of course, not all new funds brought to market are considered a success. A number of factors can
hamper sales results, but weak market conditions in general, or weak conditions in the sector or
geographic areas that a new fund plans to invest in, can dampen potential investor interest if these
conditions are present around the timing of the new fund’s launch.
In these instances, the fund manager can experience two types of losses, as follows:
1. Direct financial loss, when the fund’s assets do not provide a return that covers the costs associated
with its launch.
2. Loss of marketplace stature, since market participants — competitors, independent distributors and
investors — are aware of the fund manager’s failure to create sufficient investor interest.
For large fund managers, the failure of a new fund launch does not have substantial consequences.
However, for small- to medium-sized firms, the potential risks associated with a new fund launch can be
of some concern. The failure of a new fund launch can make it potentially more difficult and expensive
for the small to medium-sized fund manager to launch a new fund in the future. Depending on the
reasons for the failure, fund distributors may be more reticent to join distribution syndicates for a small
to medium-sized firm’s future fund launches.

STEP EIGHT: DEVELOPING AND LAUNCHING THE PRODUCT

When a decision to proceed with the launch of a new fund or product is made, the focus shifts from research and
analysis to bringing the product to market. This effort is led by the product management team, where one is in
place, or by an ad hoc new product development committee.
Depending on the novelty or uniqueness of the new product, the period from when the final go/no-go decision
is made to the product launch will typically be in the range of three to four months for a mutual fund or ETF. As
mentioned, it typically takes four to eight weeks for the regulators to review a mutual fund prospectus and its
related distribution documents.
In the case of products intended for the exempt or accredited investor markets, the process is generally somewhat
easier and takes less time to complete. The primary reason for this difference is that these investment products do
not require the preparation and filing of a prospectus, as well as the additional time associated with the necessary
regulatory review. Products that target these types of investors can often be ready for sale in less than two months.
The following sections outline the steps required to develop and launch a new investment product.

INTERNAL PREPARATIONS
As discussed in chapter 5, investment management firms require numerous internal and external information flows
in order to sell and manage their products. This is a straightforward process when the new product is an addition
to an existing platform. However, modifications to existing processes and procedures are often necessary if the
new product’s mandate includes securities transactions in capital markets, or investment dealers or custodians the
firm is not currently dealing with. Existing procedures and processes must be appropriately modified and adapted
if the new product’s mandate involves the services of a sub-advisor with whom the firm does not currently have a
business relationship.

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LEGAL STRUCTURE
One of the first steps is to establish the product’s legal structure if it is required. This step is fairly straightforward
and is done quickly, since almost all of the other steps in the product development process depend on the existence
of the product’s legal entity.

THIRD-PARTY SERVICE PROVIDERS

As mentioned, the development and launch of most new products involves several services, many of which are
provided by third parties with expertise in various areas. Normally, established firms will retain their existing third-
party service providers to provide the necessary services for the new product. Hiring established contractors can
shorten the time required to seek, interview, and negotiate contracts with new third-party service providers.
Also, many service providers will offer their services at competitive fees because of their existing relationship with
the manager of the new product. These competitive fees also help make the fund’s expense load or MER more
competitive. This puts new firms at a disadvantage, since they will likely spend more time and resources finding and
negotiating with third-party service providers. They will not likely negotiate a fee structure as low as the one an
established firm would receive for its products.

DISTRIBUTION AGREEMENTS
Distribution agreements are required for most new investment funds or products. The only exception would be
investment management firms that distribute directly to exempt or accredited investors. Again, this process is very
straightforward and quick for established fund managers that have existing relationships with various third-party
distributors, as existing agreements usually only require straightforward amendments that accommodate the
addition of the new fund. Again, new managers are at a slight disadvantage time-wise, since they will have to source
and negotiate all of these agreements from scratch.

REGULATORY FILINGS
Most investment firms use the services of an external legal counsel for the preparation of all of the documents and
applications associated with filing a new investment fund or product offering. It is generally wise to use competent
external legal counsel, since prospectus filings can contain many nuances that are most effectively and efficiently
addressed by lawyers who are very familiar with securities regulations and the regulatory review process and
standards.

SALES AND MARKETING

Appropriate sales and marketing materials must be developed, prepared and published prior to a new fund launch.
Sales and marketing materials are prepared simultaneously for two audiences. The first audience is the distributors
that are contracted to sell the new fund. Specific materials are prepared to help them understand both the fund’s
mandate and the investment manager’s skills and abilities at managing such a mandate. The materials help them
prepare for how they will market the new fund to their respective clients or investors. In essence, these materials
help “script” the sales approach and discussion about the fund with prospective investors. These materials are
developed specifically for the appropriately licensed distributors and are not intended for distribution to investors.
The second audience is the prospective investors themselves. The materials normally take the form of glossy
sales and marketing brochures that fund managers, retail investment advisors or registered mutual fund sales
representatives send to individual investors. These brochures are an important and necessary part of the fund’s sales
process, particularly with individual investors — both mutual fund and exempt high-net-worth investors.
Print and media advertising is often part of the new fund launch and sales efforts. Sufficient time and resources
must be provided to arrange for advertising and to allow all preparations to be in place for the new product launch.
The distributors also want and need to be aware of the advertising strategy.

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INVESTMENT GUIDELINES AND RESTRICTIONS

Industry best practices require that each investment fund or product has its own unique set of approved investment
guidelines and restrictions that govern all aspects of the fund’s investment management. These guidelines and
restrictions are prepared during the new product development process and are essentially agreed to when the
development of a new investment fund or product is approved.
The investment guidelines and restrictions must be consistent with the fund’s stated investment objectives and
accommodate all regulatory restrictions that pertain to the fund’s investment activity. Though they are not
intended to be modified on a frequent basis, the investment guidelines and restrictions pertaining to each fund
should be reviewed on an annual basis. All changes to the investment guidelines and restrictions must be approved
by the parties with the fiduciary duty for the fund. In many cases, including those that constitute a material change
to the fund’s regulatory or constating documents, the changes will have to be approved by the investors in the fund.
When the fund is a mutual fund or ETF, approval may be granted or withheld through a unitholder vote.
Investment guidelines and restrictions are intended to ensure the fund meets its long-term objectives. It is wise for
the firm that is launching a new product or fund to employ agreed-upon restrictions that govern the investment
manager’s actions regarding the fund. These guidelines and restrictions permit the investment manager to use
their skills and abilities to manage the fund, but only within the parameters that are considered appropriate by the
fiduciaries responsible for the fund’s operation and management.
Consistent with industry best practices, investment guidelines and restrictions are typically monitored on a
near-real- or real-time basis by personnel who do not report to the investment manager or front office staff.
The compliance staff, who are part of the firm’s middle office operations, perform this monitoring function (see
Chapter 5).
Numerous benefits can accrue from having a well-defined investment policy for each investment fund. Some of the
primary benefits are as follows:

Improves Portfolio Well-developed investment guidelines and restrictions help to minimize the frequency
Return Consistency and amount of deviation between the fund’s return and the periodic rate of return of
its peers and competition. The fund’s significant underperformance in relation to the
performance of its peers should be reduced. (Unfortunately, when the guidelines and
restrictions are well-developed, they will also reduce the frequency and amount of
outperformance for the fund relative to its peers). Any reduction in the volatility of the
fund’s returns should result in higher and more favourable risk-return statistics for the
fund.

Higher Fund Sales and Normally, investment funds with the most favourable risk-return statistics are able to
AUM garner greater market share over time. Of course, a higher AUM leads to a higher level
of investment management fee income for the fund’s investment manager.

Reduces Potential For two reasons, the potential volatility reduction in the fund’s periodic returns should
Litigation be accompanied by a reduction in the potential for litigation from investors during
periods of very poor market returns. First, the fund experiences a decrease in its NAV
to a lesser degree than its peers, who manage similar mandates but with wider and
higher-risk investment guidelines and restrictions. Second, investment funds that are
managed within prudent investment guidelines and actions do represent industry
best practices, providing less opportunity for successful claims against the fund or
investment manager.

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COMMON DESIGN FACTORS FOR INVESTMENT GUIDELINES AND

RESTRICTIONS
Several factors are taken into consideration when designing a set of investment guidelines and restrictions that
govern the investment management of a new fund or product.
By their nature, equity funds will, of course, have some unique guidelines and restrictions, as will fixed income and
money market funds. Balanced fund mandates will have investment guidelines and restrictions that specifically
pertain to overall equity and fixed income portions, and to specific equity and fixed income security allotments.
Discussed below are several design factors that are common for both equity and fixed income investment
mandates.

INVESTMENT OBJECTIVES
All investment funds and products should have a concise statement of their investment objectives. This statement is
important and useful for both fund distributors and investors, because it helps to assess the degree of risk associated
with investing in a fund. Investment objectives tend to be some combination of capital preservation, income, and
capital appreciation. Generally, funds that seek only capital appreciation tend to have greater investment risk than
those that also pursue income.
Sometimes, capital appreciation is more specifically described as short-term or long-term capital appreciation to
distinguish between funds that plan to engage in active trading versus ones that will likely buy and hold investments
for the longer term. Likewise, a fund that intends to pay regular distributions to investors may describe its
investment as one that provides, for example, monthly income.
By defining a fund’s investment objectives, it is easier to make a proper comparison with its competitors.

DOMESTIC VERSUS GLOBAL FOCUS

The various capital markets around the world offer different investment opportunities and carry different risks. As a
result, a fund’s geographic focus and the countries it is permitted to invest in are of great importance to investors.
It is common for a mutual fund manager or a large institutional investment manager to offer funds with a complete
domestic focus, funds with a complete international focus, and funds with a global focus. Many fund companies
offer country- and region-specific mandates as well. Most common are funds that invest only in the U.S., Europe,
Asia, or emerging markets. As a result, the manager hopes to have access to more investors since it is, in essence,
offering the entire range of investment products from a geographic perspective.
Properly structured investment guidelines and restrictions will normally stipulate the minimum and maximum
amount of the fund’s assets that can be invested in each country or region. These restrictions ensure that the fund
will be managed according to its stated mandate and that it does not become overexposed to any country’s or
region’s financial markets due to the relative outperformance of those particular markets. In equity markets, these
diversification guidelines are typically built around the equity market indexes for global capital markets that are
prepared by companies such as Standard & Poor’s.

CURRENCY HEDGING
For a mandate that permits a portion or all of the fund’s assets to be invested in securities issued in non-domestic
markets, there will be foreign currency risk exposure. This is the case because the fund’s NAV is generally calculated
in Canadian dollars, while some or all of its securities are trading and priced in other currencies.
The decision as to whether the portfolio manager will employ currency hedging or partial currency hedging is part of
the product design. However, the fund’s investment guidelines and restrictions must be consistent with the selected
currency hedging strategy.

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In Canada, most fixed income funds only invest in fixed income securities issued by domestic issuers. Accordingly,
there is seldom any foreign currency exposure for these types of funds. To the extent that a fixed income fund is
allowed to invest a maximum percentage of its NAV in foreign securities, the investment guidelines and restrictions
will be developed in a manner that is consistent with the currency risk stipulated in the fund’s design.

BENCHMARK SELECTION
It is critical that the appropriate performance benchmark is selected for a new fund. The performance benchmark
is used to explain a fund’s performance, and it can be embarrassing or rather difficult to explain a change in a fund’s
benchmark after it has been launched. Investment management performance is measured in three basic ways, as
discussed below.
First, the use of peer or competitive performance results, which was discussed in detail in Chapter 5, is very common
in the institutional investment management marketplace. An investment manager’s quantifiable performance
ranking is a key determinant for both winning and losing new investment mandates from institutional investors.
These results are also the major factor that institutional investors use when terminating existing investment
management contracts.
The second most popular performance benchmarks are market indexes, such as the Dow Jones Industrial Average
(DJIA), the S&P 500 Index, and the S&P/TSX 60 Index. While these market-based indexes are also used by
institutional investors, they tend to be treated as secondary or supplemental to an investment manager’s peer
survey ranking. Institutions tend to use market-based indexes for asset mix analysis and changes.
However, in the individual investor marketplace, the roles of the two types of performance benchmarks are
reversed. Mutual funds tend to use market-based indexes when presenting the results and performance of their
investment funds. Peer performance comparisons, such as quartile rankings, are used much less often in sales and
marketing materials and in reports to individual retail investors.
The third performance benchmark is a fund’s absolute return, which is the primary performance benchmark
for exempt market products, such as hedge funds, private equities, and other partnerships. With these types of
investment funds, a manager’s fee income is primarily in the form of a performance-based fee that is based on a
fund’s absolute rate of return, with no reference whatsoever to peer performance ranking or market-based indexes.

PORTFOLIO REBALANCING FREQUENCY

Due to the nature of the capital markets and the different performance of securities, an investment fund’s actual
investment exposure changes constantly and, depending on the markets, can result in material changes to the
fund’s investment exposures. This typically occurs when a particular sector of the market for a small group of
securities had a substantially different performance than the market or the rest of the fund’s securities.
On a real-time basis, the investment manager constantly monitors the fund’s exposure, typically as a percentage
of its total market value. As the market value weighting of individual securities, market sectors or even entire
asset classes, as in the case of balanced funds, approach their respective predetermined limits, the manager must
rebalance the fund’s holdings. Rebalancing must be done in order for the fund’s investments to be closer to the
manager’s “target” portfolio and also to remain within the fund’s investment guidelines and restrictions.
Rebalancing processes and procedures are driven by the competing forces of trying to keep a fund’s risk profile as
similar to the selected benchmark or index as possible, and trying to keep the rebalancing activities themselves to
a minimum. This is the case because every rebalancing transaction incurs additional transaction costs of brokerage
and custodial fees.
When rebalancing, all investment managers use proprietary investment models, which attempt to obtain the
optimal financial result for the fund given the two competing factors. Depending on their optimization models,
every manager will use different rebalancing frequencies and drift ranges from the benchmark.

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SECTOR RESTRICTIONS
Sector guidelines stipulate the minimum and maximum weight exposure that a fund can have, as compared to the
market value weighting of the respective sectors in the fund’s performance benchmark.

EXAMPLE
Assume that a particular industry sector currently has a 15% market value weighting on the S&P/TSX 60 Index,
which is Fund A’s performance benchmark. Fund A’s investment guidelines state this sector’s maximum market
value variation from the 15% weighting established by the performance benchmark. Suppose the guidelines
state that the sector could not vary by more than plus or minus 3% from the performance benchmark’s sector
weighting. Fund A’s sector weighting would have to be rebalanced if its respective market value percentage
breached 12% on the low side or 18% on the upside.

This risk control tool helps ensure that the fund does not become over- or underexposed on any sector weighting
versus the weighting of the same sector in the fund’s performance benchmark or index.

ISSUER RESTRICTIONS
Sector restrictions manage risk by controlling the amount of money that may be invested in a particular sector in a
fund. Similarly, there are diversification guidelines to control the amount invested in a specific security issuer. Issuer
restrictions add one more level of refinement to risk control for the entire portfolio.
There are two primary types of issuer-based guidelines. One type restricts the number of issuers that a fund can
hold at any time, while the other specifies the maximum percentage of a fund’s NAV that can be invested in any one
issuer. These guidelines are generally set as either:

• A maximum percentage variation from an issuer’s market value weight in a fund’s benchmark; or
• A market value percentage weight for an issuer in terms of its market value percentage weight in a fund.

Issuer guidelines are established in a similar method as sector guidelines.

EXAMPLE
Suppose that Company B currently represents a 3% weighting on a market value basis of the S&P/TSX 60 Index,
which is the fund’s performance benchmark. Also, assume that the fund’s investment guidelines and restrictions
state that a specific issuer’s market value weighting cannot be greater than 150% of the company’s current
weighting in the index. This means that the maximum allowed weighting of Company B’s value in the fund
would be 4.5%.

Issuer restrictions are normally set in terms of maximum allowable investments to control the maximum amount
of the fund that can be invested in any one issuer. However, though investment managers normally do not include
minimum investment restrictions pertaining to individual issuers, there are indirect guidelines contained within the
investment restrictions pertaining to the minimum allowable investment in an industry sector.
Some investment guidelines and restrictions also include a requirement that there is a cap on the fund’s investment
as a fixed percentage of the fund’s assets in any one issuer, regardless of that particular issuer’s market value
weighting in the index.
It is important to note that some investment guidelines and restrictions stipulate that a fund must hold a minimum
number of issuers at all times. This stipulation is intended to complement the maximum issuer restrictions
discussed above.

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CASH AND SHORT-TERM INVESTMENTS

Investing guidelines and restrictions for an equity mandate often include restrictions on the amount of cash that the
fund can hold. The percentage of cash allowed depends on the fund’s investment objectives. If the fund seeks high
absolute returns, it may be allowed to hold 10%, 20% or more in cash. A liberal restriction on cash holdings gives
the manager room to tactically allocate assets. If the fund is more sensitive to a stock’s benchmark weight, cash
may be restricted to no more than 1% to 2% of the fund’s total value.

PERFORMANCE BENCHMARKS
An investment manager’s performance is measured by two standard methods. For an institutional investment
manager in particular, their performance is primarily assessed relative to other active managers who are managing
a similar investment mandate. These managers and their institutional clients are focused on the investment
manager’s percentile ranking.
For mutual funds, market-based indexes are often used as a performance benchmark. It is important that the
correct market index or indexes be used when explaining a fund’s performance. The market index that is selected
should be representative of the fund’s investment objectives, investment strategy, and investment guidelines and
restrictions.
Occasionally, a fund will rely on a custom-made index for its mandate — if such an index is more appropriate than a
standard benchmark. The investment firm should carefully explain the methodology behind the construction of the
custom index so that the fund’s distributors and investors will better understand the fund’s investment objectives
and investment strategy.
Numerous market-based indexes exist for domestic and global fixed income markets. These indexes are also further
broken down into bond market sector indexes, and even bond market sub-sector indexes. They help measure the
performance of fixed income investment managers, providing information about the industry’s characteristics, such
as term to maturity, credit quality, and coupon. But, most importantly, the rates of return, which are divided into
capital appreciation and interest income, are available for these indexes.

UNIQUE FACTORS IN EQUITY MANDATE DESIGN

Due to the nature of equities versus other asset classes, such as fixed income, investment guidelines and restrictions
for equity mandates contain a number of unique factors.

MARKET CAPITALIZATION
Equity mandates are normally designed and examined in terms of the allowable capitalization issuers included in
a fund. Equities are normally segmented into large-, mid- and small-capitalization categories. These categories are
important since investors and investment advisors need to understand the amount of risk that a particular equity
mandate is likely to incur due to the size of the companies the fund invests in. However, the precise definition of
these categories and the market value ranges allowed for each are not generally agreed upon in the investment
marketplace.
As a result, it is important that a fund’s investment guidelines and restrictions clearly define, numerically, the
allowable ranges of capitalization for its individual issuers. One rule of thumb is that small-capitalization equities
and some foreign equities offer greater potential returns over time, but they are normally accompanied by greater
risk because a fund’s NAV will become more volatile.

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 CHAPTER 10 CREATING NEW PORTFOLIO MANAGEMENT MANDATES 10 • 21

PORTFOLIO MANAGEMENT STYLE

Equity investment managers tend to focus on one investment management style. The most popular investment
management styles are as follows:

• Growth
• Value
• Momentum
• Growth at a reasonable price (GARP)
• Technical

Although, strictly speaking, investment management style is not part of the investment guidelines and restrictions,
it is a critical aspect of an investor’s decision to invest in a particular fund. Investment management style is usually
one of the key attributes used to describe a fund’s investment management approach. Style provides a broad-brush
description of the investment management approach. However, a description of style is usually accompanied by a
more detailed explanation of how an investment manager actually executes a fund’s investment strategy and makes
investment decisions. The detailed explanation is meant to let the investor know how a manager is different — and
hopefully better — than competing managers who are grouped under the same investment style.
Investment management style is important because many investors and their advisors have definite preferences
for a particular style. This preference is often a starting point when making a decision to invest with a new fund
manager.
In response to this style preference, some fund managers offer an investment fund or product with a blended style
approach that makes use of a number of external investment managers on a sub-advisory basis, with each of them
managing a predetermined portion of the fund.

SECTOR- OR INDUSTRY-SPECIFIC MANDATES

In the case of a sector- or industry-focused equity mandate, only the accepted and conventional industry categories
are used in the design of its mandate and in the construction of its investment guidelines and restrictions. Also,
the investment guidelines and restrictions for an industry-focused equity fund must include a restriction on the
maximum allowable proportion of the fund that can be invested in equity securities that do not form part of the
sector index. Of course, the firm must also set restrictions regarding the maximum allowable exposure to any one
issuer in the sector or industry index that pertains to the fund.

NON-COMMON STOCK INVESTMENTS

Depending on an equity mandate’s design, its investment guidelines and restrictions may allow for investments
in securities other than common stocks, cash and short-term instruments. Some of the more common types of
allowable securities for equity funds are warrants, options and convertible bonds.
Many equity mandates allow investments only in the common stocks of equity market issuers. Some equity
mandates do permit investments in related securities, but they are typically restricted to a maximum market value
percentage of the fund. In turn, each type of non-equity security will have a maximum allowable investment for
that type of security. Finally, each type of non-equity security will also have investment guidelines and restrictions
that stipulate a minimum amount of diversification of the issuers within each type of non-equity security.

COVERED CALL WRITING

One strategy that is used to increase a fund’s income or risk profile is covered call writing. Covered call writing
involves the writing or sale of call options against some of the long positions or underlying common stock held
by a fund. In this type of transaction, the investment manager is seeking to increase the fund’s income by earning

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10 • 22 PORTFOLIO MANAGEMENT TECHNIQUES

premiums related to the sale of the call options, while accepting the risk that the common stock held by the fund
might be called away at a fixed price to the call option’s buyer.
The additional income the fund earns by selling the call options is considered in light of the trade-off that would
occur if the common stock were to achieve a sufficiently high enough price in the future that it would be called
away at the option strike price. In that scenario, the fund would lose an opportunity to earn the amount above the
strike price at which the securities were sold to the call option’s owner. Investment guidelines and restrictions on
many equity mandates do permit a limited amount of covered call writing when the investment manager deems
it appropriate. It is not uncommon for funds with this type of flexibility not to use covered call writing strategies
during strong bull markets.
It is extremely important to note that in the case of Canadian conventional mutual funds, call writing must be done
only on a covered basis.

SHORT SALES
Regulations pertaining to Canadian mutual funds permit a fund to sell securities short. Short selling is limited
to 20% of a conventional mutual fund’s NAV.

UNIQUE FACTORS IN FIXED INCOME MANDATE DESIGN

Due to the unique features of fixed income securities, investment guidelines and restrictions for fixed income
mandates contain a number of unique factors.

SECTOR-SPECIFIC MANDATES
While many fixed income mandates offer broad exposure to the fixed income market, there is also demand for fixed
income funds with sector-specific mandates. The most popular sector-specific fixed income funds are those that only
invest in the following securities:

• Government securities (federal, provincial, and municipal)

• Corporate securities
• Specialty securities (mortgage-backed securities and asset-backed securities — see Chapter 8)

Sector-specific fixed income mandates are very popular, particularly in the United States. Canadian investors,
particularly institutional investors, are becoming more comfortable with investing in sector-specific funds, usually
as a supplement to the bulk of their fixed income assets that are invested in funds based on broad fixed income
market mandates.

CREDIT QUALITY
Fixed income mandates are also defined by the lowest allowable credit rating of the issuers of the fixed income
securities in which the funds can invest. Most broad market and specialty fixed income mandates only permit
investments in issuers with an investment-grade credit rating. An investment-grade credit rating means that the
issuers of the securities have, at a minimum, a BBB credit rating (or equivalent) from at least one of the popular
fixed income credit rating agencies.
Fixed income securities with a credit rating below investment grade are often referred to as high yield bonds.
As noted above, the investment guidelines and restrictions for broad market fixed income mandates do not
normally permit investments in high yield bonds. There is market interest in well-designed and diversified fixed
income portfolios that only invest in securities that are below investment grade. These fixed income mandates are
commonly referred to as high yield bond funds.

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 CHAPTER 10 CREATING NEW PORTFOLIO MANAGEMENT MANDATES 10 • 23

Regardless of whether a fixed income mandate is restricted to investment-grade issuers, investment guidelines
generally include restrictions on the entire fund’s minimum average credit rating, as well as on the maximum
percentage of the fund’s assets that can be invested in securities with various credit ratings.

EXAMPLE
For an investment-grade fixed income fund, the credit quality restrictions might stipulate that a minimum
of 60% of its NAV be invested in securities with an AAA credit rating, a maximum of 20% of its NAV be invested
in securities with an A credit quality rating and a maximum of 10% of its NAV be invested in securities with
a BBB credit quality rating. Of course, in addition, the investment guidelines and restrictions would prohibit
investments in fixed income securities that carry a credit rating below BBB.

TERM TO MATURITY AND DURATION

Even fixed income funds that are completely invested in AAA government-issued securities can expose investors
to significant capital risk, particularly if interest rates rise substantially from the time of the original investment.
By their nature, fixed income securities have varying amounts of interest rate risk, which increases as the term to
maturity, or duration, of the securities increases.
Accordingly, the investment guidelines and restrictions must restrict a fixed income fund’s minimum and maximum
average term to maturity or average duration, or both. This is particularly important in the case of broad market
fixed income funds, where the term to maturity for investments can range from as short as one to two weeks (for
money market investments) to as long as 30 years (for securities issued by federal and provincial governments).
Some fixed income mandates are designed specifically around term-to-maturity restrictions and attempt to provide
investments that are centred on the short-, mid- or long-term sectors of the broad fixed income market. For this
type of fixed income fund, the investment guidelines and restrictions also limit the amount by which the fund’s
average term to maturity may deviate from the representative term to maturity for the sector of the broad fixed
income market in which it is investing.

UNIQUE FACTORS IN BALANCED FUND MANDATES

Balanced funds form a significant portion of the total amount of AUM for both individual and institutional investors.
Virtually all mutual fund managers and institutional investment managers offer a balanced fund mandate in
addition to the various other equity and fixed income funds they manage and offer.
Normally, a balanced fund’s equity and fixed income portions are invested in a manner identical to that in which
the fund manager’s or institutional investment manager’s diversified equity funds and diversified bond funds are
invested. A balanced fund will accomplish this in one of two ways. It will hold individual securities in the balanced
fund in the same proportion as they are held in the equity and bond funds, or simply invest in units of the entire
equity and bond funds.

TARGET ASSET MIX POLICY

In offering a balanced fund to investors, a fund manager is also offering their expertise in determining the fund’s
appropriate asset mix. For balanced funds, asset mix decisions are substantially different than those for equity
funds and fixed income funds, as the investment manager uses different skills and abilities when determining the
appropriate mix between equities, fixed income securities and cash.
The investment guidelines and restrictions for a balanced fund’s equity and fixed income portions are invariably
the same as the ones that apply to equity and fixed income funds. However, additional investment guidelines and
restrictions are required to limit the entire fund’s asset mix policy. Specifically, they stipulate the minimum and
maximum amount of the balanced fund’s NAV that can be invested in the three major asset classes — namely,
equities, bonds, and cash.

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10 • 24 PORTFOLIO MANAGEMENT TECHNIQUES

An investment manager typically manages a balanced fund relative to a target asset mix policy, which represents
the fund’s average or long-term asset mix.
For a typical Canadian balanced fund, the target asset mix policy is as follows:

• 60% Canadian equities

• 30% Canadian bonds
• 10% Canadian short-term money market investments

The target asset mix is unique to each balanced fund. Balanced fund mandates can have a target equity mix
from 50% to 70% of the fund’s assets. The remainder of the fund’s assets is normally invested in Canadian fixed
income securities.

STRATEGIC VERSUS TACTICAL ASSET MIX STRATEGY

For a balanced fund, the target asset mix is often also described as the strategic asset mix policy. An investment
manager attempts to add value to a fund over time by adjusting its strategic asset mix in order to capture perceived
opportunities in one asset class versus another. These adjustments, which are based on analysis and models that
the investment manager develops, typically indicate when one asset class is cheap or expensive relative to the other
asset classes the balanced fund can invest in.
This active management strategy, which is applied to managing balanced funds, is commonly referred to as the
tactical asset mix strategy. Investment guidelines and restrictions limit the degree to which a balanced fund’s
tactical asset mix strategy can change the market value weightings of various asset classes from the weightings
established in the target asset mix policy for these asset classes.

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 CHAPTER 10 CREATING NEW PORTFOLIO MANAGEMENT MANDATES 10 • 25

SUMMARY
After completing this chapter, you should be able to:
1. Describe the key steps for analyzing the potential for investment products and developing new ones.
There are eight key steps in assessing and developing new investment products:
1. Identifying potential market opportunities
2. Determining the required portfolio management skills, and if external investment management skills will
be needed
3. Assessing the market
4. Determining legal and regulatory restrictions
5. Developing a marketing and distribution strategy
6. Preparing a financial forecast, including pro forma financial statements
7. Obtaining approval from the investment management firm’s senior management team
8. Developing and launching the product

2. Discuss the importance of a thorough assessment for a new investment product’s potential market size and
the challenges of developing that assessment.
Assessing investor needs is very important and can result in an incredibly large market opportunity if they
are assessed properly and the product’s design accommodates them.
It is a very difficult and challenging activity to gauge or assess investor demand, since the demand is
dependent on a number of factors. Some of the more important factors are as follows:
«« The general tone of the economy and the markets, particularly the equity market.
«« The recent performance of the particular market sector if the new mandate is especially focused.
«« In the case of an actively managed product, the firm’s investment performance in both absolute return and
its performance relative to the capital market sector the new fund is focused on.
«« In the case of a passively managed product, the firm’s expertise in managing to replicate an index or follow
a rules-based strategy.
«« The adequacy of a firm’s distribution capabilities relative to the product type and structure.

3. Describe the various legal and regulatory issues when considering the development of a new investment
product.
A prospectus must be filed with each of the provincial securities regulators where the conventional mutual
fund will be distributed.
In Canada, investment products, such as hedge funds, private equity funds and leveraged buyout funds,
that are only designed for and distributed to exempt or accredited investors do not require an approved
prospectus. They are generally distributed with an offering memorandum or a partnership agreement, or
both.

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4. Identify the key information requirements for preparing a financial forecast for a new investment product.
The financial forecast integrates the product development team’s assumptions about the following key
variables:
«« Net sales
«« Market growth
«« Investment management fees
«« Distributor compensation, including upfront commissions and trailer fees
«« Third-party expenses

The pro forma financial projection has three key inputs or assumptions, as follows:
1. AUM (revenue)
2. Fees charged to investors (revenue)
3. All fees and expenses to be charged to the fund and, accordingly, to investors

5. Explain the steps to follow after project approval has been granted for a new investment product.
Step seven is obtaining project approval from the investment management firm’s senior management team.
If the project is approved, it moves forward to the next step, which is step 8.
Step eight: Developing and launching the product
«« Establish internal and external information flows in order to sell and manage the product.
«« Establish the new fund’s legal structure.
«« Negotiate with and contract different third-party service providers.
«« Establish distribution agreements.
«« Complete regulatory filings.
«« Appropriate sales and marketing materials must be developed, prepared and published prior to the
product launch.

6. Describe the purpose of an investment product’s investment guidelines and restrictions, and the critical
importance of having a well-defined investment policy.
Investment guidelines and restrictions are intended to ensure the fund meets its long-term objectives.
These guidelines and restrictions permit the investment manager to use their skills and abilities to manage
the fund, but only within the parameters that are considered appropriate by the fiduciaries responsible for
the fund’s operation and management.
Some of the primary benefits of having a well-defined investment policy are improved return consistency,
higher fund sales and assets under management (AUM), and reduced potential litigation.

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 Alternative Investments 11

CONTENT AREAS

Definition of Alternative Investments

Reasons to Invest in Alternative Investments

Issues and Challenges with Alternative Investments

Performance Attribution

The Unique Risks of Alternative Investments

Due Diligence

Current Trends and Developments in Alternative Investing

LEARNING OBJECTIVES

1 | List the primary characteristics and attributes of alternative investments.

2 | Explain the main factors for the continued and growing interest in alternative investments.

3 | Describe some of the major issues and challenges an alternative investment manager must deal with
and why they must be dealt with properly.

4 | Describe how the asset allocation process is used and modified when alternative investments are
included in a portfolio’s asset mix.

5 | Identify some of the main problems and issues that arise when doing performance attribution for
alternative investments.

6 | List and describe some of the unique key risks of alternative investments and why they must be
considered prior to investing in them.

7 | Describe the due diligence process when thinking about investing in an alternative investment.

8 | Discuss the primary trends and developments in the alternative investment management industry
and their potential impact on its development.

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KEY TERMS

Key terms are defined in the Glossary and appear in bold text in the chapter.

alternative investments lockup

commodities managed futures fund

due diligence modern portfolio theory (MPT)

efficient frontier real estate

hedge funds transparency risk

liquidity dates

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 CHAPTER 11 ALTERNATIVE INVESTMENTS 11 • 3

INTRODUCTION
Traditionally, an investment fund’s board of trustees would have focused their investment efforts on publicly traded
securities, such as equities and bonds. However, with uncertain equity market returns and lower prospective bond
market returns, many institutional investors have shifted their attention from the public investment markets to
alternative investment markets.

DEFINITION OF ALTERNATIVE INVESTMENTS

An investment is generally considered alternative if it meets the following criteria:

• Has different performance characteristics from traditional assets, such as stocks and bonds — that is,
alternative investments do not conform to the normal or bell-shaped return distribution that is typical of
traditional investments
• Is rarely traded in public capital markets
• Is relatively illiquid, when compared to marketable securities
• Is relatively uncommon in investment portfolios
• Has a relatively limited investment history
• Requires unconventional investment skills on the part of an investment manager

By comparison, traditional investments have historically comprised equities, bonds and money market investments
that are traded in public capital markets and invested on a long-only basis. Traditional investments can be easily
benchmarked for performance measurement and are managed by strategies that do not involve short selling,
leverage or the use of derivatives.
Alternative investments cover a wide range of investment opportunities. The major categories include hedge funds,
private markets, real estate and commodities (see Figure 11.1).

Figure 11.1 | Major Alternative Investment Categories

Alternative
Investments

Hedge Funds Private Markets Real Estate Commodities

Arbitrage Private Equity Private Real Estate Physical Commodities

Event-Driven Private Credit Public Real Estate Managed Futures
Long-Short Equity
Multi-Strategy Funds
(Funds of Hedge Funds)

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HEDGE FUNDS
Hedge funds are lightly regulated pools of capital whose managers have great flexibility in their investment
strategies. These strategies are often referred to as alternative investment strategies. However, this term may also
be used to describe investments in private markets, real estate, commodities or managed futures. Hedge fund
managers are not constrained by the rules that apply to conventional mutual funds. They have no restrictions on
short positions, use derivatives for leverage and speculation, perform arbitrage transactions and invest in almost
any situation in any market where they see an opportunity to achieve positive returns.
Because hedge fund managers have tremendous flexibility in the types of strategies they can employ, the manager’s
skills, including the ability to select superior investments within the targeted strategy and relevant markets, is more
important for hedge funds than for almost any other managed product.
Some hedge funds are conservative, while others are more aggressive. Despite the name, some funds do not hedge
their positions at all. Therefore, it is best to think of a hedge fund as a type of fund structure, rather than as a
particular investment strategy.

COMPARING HEDGE FUNDS TO CONVENTIONAL MUTUAL FUNDS

Like mutual funds, hedge funds have the following characteristics:

• They are pooled investments that may have front-end sales commissions;
• They charge management fees; and
• They can be bought and sold through an investment dealer.

Despite these similarities, there are many differences between conventional mutual funds and hedge funds, as
summarized in Table 11.1 below.
Table 11.1 | Comparing Conventional Mutual Funds to Hedge Funds

Conventional Mutual Funds Hedge Funds

Can take limited short positions Have no restrictions on short positions

Can use derivatives only in a limited way Can use derivatives in any way

Are usually liquid May have liquidity restrictions

Are sold by prospectus to the general public Are generally sold by offering memorandum to
accredited investors only

Are subject to considerable regulatory oversight As private offerings, are subject to less regulations

Charge management fees, but usually have no Charge management fees and, in most cases,
performance fees performance fees

Have a “relative” return objective — that is, Have an “absolute” return objective — that is, the
performance is usually measured against a fund is expected to make a profit under all market
particular benchmark conditions

Most are valued daily Most are valued monthly

Performance is disclosed quarterly or annually to Performance is disclosed annually to unitholders

unitholders

Cannot take concentrated positions in a single Can take concentrated positions

issuer’s securities

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COMMODITIES
Commodities are another class of alternative investments. Investments in commodities can be made in two
primary ways:
1. Directly: By buying and selling commodities
2. Indirectly: Through commodity derivatives — that is, futures, forwards or swaps

Although it is less direct, exposure to commodities can be had by investing in the securities of companies that
produce commodities.
Commodities are considered a separate asset class, since they can offer diversification benefits when combined
with a traditional portfolio that contains equities and bonds. They often display high volatility, as well as a negative
correlation with equity and bond returns, and a positive correlation with inflation.
In portfolios where income is a high priority, a direct investment in commodities is generally not suitable, since
they do not provide any interim cash flows, unlike bonds, which provide interest income, or some common equities,
which provide dividends. The only return on a commodity investment comes from changes in the commodity’s
price.
One form of indirect investment in commodities is through a structured product design commonly referred to as a
commodity-linked note. This type of note generally offers a small amount of periodic income. However, these notes
do not have a large market share. The most popular method of commodity investment is through a pooled fund
vehicle called a managed futures fund.

MANAGED FUTURES FUNDS

A managed futures fund invests in listed financial and commodity futures markets and currency markets around
the world. Fund managers are usually called commodity trading advisors (CTAs).
Most managers of managed futures funds apply a systematic approach to trading, using technical and statistical
analyses of price and volume information to determine investment decisions. Once the manager has developed the
system, trading decisions are largely mechanical and little or no discretion is involved. Other fund managers make
discretionary decisions according to current economic and political fundamentals.

PRIVATE MARKET INVESTMENTS

The structure of a private market fund is an important consideration when making an allocation to the asset class.
The structure will determine the amount of risk assumed by the investor and the amount of hands-on monitoring
the investor must do in the post-closing period.

STRUCTURE OF PRIVATE MARKET FUNDS

Private market funds are typically structured as limited partnerships.

Limited Partnerships

What is a limited partnership? • An agreement that outlines the structure, management, and
operation of the private market fund

Who runs a limited partnership? • A general partner, which is usually a private market firm

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Limited Partnerships
What does the general partner do? • Solicits limited partners for investment funds
• Takes management and operational responsibility
• Manages the partnership’s investments
• Contributes a very small proportion of the partnership’s capital
(most often 1%)

What does a limited partner do? • Provides the balance of the funds beyond the general partner’s
contribution
• Is a passive investor

A partnership typically invests in between 10 and 50 portfolio companies during its three- to five-year investment
phase. Most private market partnerships have 10 to 30 limited partners, though some have as few as one and others
more than 50. The minimum monetary commitment is typically $1 million.
Most partnership management firms have between six and 12 senior managers who serve as general partners,
although many new firms are started by two or three general partners, and a few large firms have 20 or more.
The partnership managers typically raise funds for a new partnership when the investment phase for an existing
partnership has been completed so approximately every three to five years. At any given time, they may be
managing several funds, each in a different phase of its life. Each partnership is legally separate and is managed
independently of the others.
As their name implies, limited partners hold limited liability, much as in a limited liability corporation, limited
liability partnership, or, more generally, a corporate environment. The general partner, however, holds full liability.
Because of this constraint, the general partner is itself a corporation, the shareholders of which are the private
market managers.
Another distinguishing feature of private market funds is that investments are not marketed under a prospectus.
Limited partnerships are marketed under an offering memorandum. Therefore, private market investments, like
other investments based on offering memorandum such as hedge funds, require a greater level of due diligence by
the investor.

INVESTMENT LIFE CYCLE OF A LIMITED PARTNERSHIP

A partnership’s investment activities are divided into four stages: selecting, structuring, monitoring, and exiting the
partnership’s investments.

Investment Life Cycle of a Limited Partnership

Stage Description

1. Selecting Investments • Includes obtaining access to high-quality deals.

• Large amounts of information are sorted and evaluated during selection.

2. Structuring Investments • Deciding the type and number of securities issued as equity by the
portfolio company.
• Determining the provisions of investment agreements.

3. Monitoring Investments • The phase of active participation in the management of portfolio

companies.

4. Exiting Investments • Involves taking portfolio companies public or selling them privately.

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 CHAPTER 11 ALTERNATIVE INVESTMENTS 11 • 7

SELECTING INVESTMENTS
A private market partnership survives on its deal flow and access to information about high-quality investment
opportunities.
To be successful, private market firms must be able to select the handful of investments they invest in each year
from among hundreds of proposals. Success relies heavily on the acumen and experience of the general partners.
Investment proposals must meet the partnership’s initial criteria. Private market partnerships typically specialize by
three characteristics:

• Type of investment
• Industry
• Geographic location

Securities that pass initial scrutiny are subjected to a second review, which may take several days. Critical
information is verified, and the major assumptions of the business plan are examined. Proposals that survive this
review become the subject of a more comprehensive due diligence process that can last up to six weeks.
Extensive due diligence in the private markets is needed because publicly available information about issuers is
scarce, and in most cases the partnership has had no prior relationship with the issuer.

STRUCTURING INVESTMENTS
If, after due diligence, the portfolio candidate remains a suitable investment, the partnership and the firm begin
negotiating an investment agreement that sets forth the structure of the deal. The main aspects of the agreement
are the share of ownership the partnership will acquire, the managerial incentives in place at the portfolio company,
and the partnership’s ability to exert control over the company, especially if it underperforms.

PARTNERSHIP’S OWNERSHIP SHARE

The partnership’s ownership share is determined by estimating the company’s value on some future date and
deciding the proportion that provides the partnership with a sufficient rate of return on its investment.
The value is typically based on multiples of projected after-tax earnings, earnings before interest and taxes, and cash
flow. Required rates of return vary by investment type. Venture capital partnerships typically require returns of 50%
on early-stage investments and 25% on later-stage investments, whereas required returns on most non-venture
investments are 15% to 25%. Riskier investments generally require more attention and monitoring, so the general
partner requires a higher rate of return to compensate for their time and effort.

MANAGERIAL INCENTIVES
To prevent management from pursuing its own interests at the expense of investors, private market partnerships
rely on the following techniques to align the interests of managers and investors:

• Managerial stock ownership

Senior managers of companies in which private market partnerships invest typically own a significant share
of their company’s stock. Equity ownership in many cases accounts for a large part of a manager’s total
compensation. A common provision in both venture and non-venture financing is an equity earn-out. This
arrangement allows management to increase its ownership share (at the expense of investors) if certain
performance goals are achieved.
Performance goals can be defined as earnings, the market value of the firm, or a combination of the two.
• Type of equity issued to Investors
Different types of private equity are issued to different investors. Convertible preferred stock is the security of
choice for partnerships issuing equity to investors. In the event of liquidation, holders of convertible preferred
stock are paid before holders of common stock but after subordinate debt holders.

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From the partnership’s standpoint, the issuance of convertible preferred stock offers two advantages. First,
it reduces the partnership’s investment risk in that it expands the equity pool. Second, it provides stronger
performance incentives to the company’s management than does conventional equity.
Management typically holds common stock or warrants to purchase common stock, which are worth relatively
little even if the company is only marginally successful. With convertible preferred stock, management gets a
liquidation preference plus a rich dividend in addition to equity participation.

• Terms of management employment contracts

In theory, management’s equity position could encourage excessive risk-taking; however, management
compensation can be structured to offset incentives for such behaviour. Provisions in this regard often take the
form of employment contracts and buyback provisions. Employment contracts specify the conditions under
which management can be dismissed, and buyback provisions allow the firm to repurchase a manager’s shares
at cost if the manager is replaced.

MECHANISMS OF CONTROL
A private investment partnership protects its interests through its ability to exercise control over the firm.
Mechanisms of control must be appropriate and robust. These include:

Board Representation There are few things general partners can do that influence the outcome of their
investment more than representing the partnership on the company’s board of
directors. In many cases, private equity partnerships dominate the boards of their
portfolio companies. Even if it holds only a minority stake, a private equity partnership
at least is able to participate actively in a company’s management and have timely
access to information.

Greater Allocation of A partnership’s investment is usually large enough to bestow majority (and
Voting Rights controlling) ownership in early-stage ventures, leveraged buyouts, and financially
distressed firms. The partnership may still obtain voting control if it has less than a
majority of votes but holds the largest block among shareholders.
Even if the partnership lacks voting control, it is generally the largest non-
management shareholder. Thus, it has a disproportionate degree of influence on
matters that come to a shareholder vote.

Access to Additional Financial capital is the lifeblood of any firm. A partnership’s ability to provide access
Financing to funds places the partnership in a powerful position, especially with development-
stage companies. Venture capital funding is typically provided to portfolio companies
in several rounds, with each allotment just large enough for the firm to advance to the
next stage of development.
Even if diversification provisions in the partnership agreement prevent the partnership
from providing additional financing, the general partners have extensive contacts to
bring in other investors.
To a lesser extent, non-venture capital is also provided in stages. For example, mid-
life-cycle firms with acquisition strategies periodically require capital infusions to
finance growth.

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MONITORING INVESTMENTS
In the period after the investment closes, general partners not only monitor and govern their portfolio companies
but also provide consulting services. General partners are involved with the following types of company activities:

• Design of compensation packages for senior managers

• Replacement of senior managers as necessary
• Help with arranging additional financing
• Recruiting knowledgeable board members

General partners may become involved with these activities:

• Solving major operational problems

• Evaluating capital expenditures
• Developing the company’s long-term strategy

Partnership involvement is greatest in new ventures and in some non-venture situations (such as leveraged
buyouts) in which improving managerial performance is one of the primary reasons for investment.
For these two types of investments, private equity investors typically are also majority owners, so they have an even
greater incentive to become involved in the company’s decision-making process.

EXITING INVESTMENTS
A limited partnership has a finite life, and the limited partners must be paid within a specified period. The exit
strategy is therefore an important consideration. There are three possible exit strategies: public offering, private
sale, or share purchase by the company. Each exit strategy has different ramifications for the limited partners, the
general partners, and the company’s management.

Public Offering A public offering is an attractive offering for the partnership. It usually results in the
highest valuation of the company and is often the preferred exit route. Company
management usually favours a public offering as well because it preserves the firm’s
independence and provides it with future access to capital by creating a liquid market
for the firm’s securities.
A public offering, however, usually does not end the partnership’s involvement with
the firm. The partnership may be restricted from selling any or a portion of its shares
in the offering by security regulations that may require an initial holding period. The
partnership may also be restricted from selling its shares by agreement with the
underwriter of the offering.

Private Sale A private sale can be an equally attractive option for the partnership. It provides
payment in cash or marketable securities and ends the partnership’s involvement
with the firm.
For the company’s management, however, a private sale is potentially unwelcome
because the company becomes merged with or acquired by a larger company and
cannot remain independent.

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Share Repurchase by Share repurchase involves the sale back to the firm of common stock or a mandatory
the Company redemption of preferred shares. With a sale of common stock, a valuation formula is
agreed to in advance.
For minority investments, a guaranteed buyout provision is essential because it is the
only means by which the partnership can be assured of liquidity.
For many investments, however, buybacks by the firm are considered a backup exit
route and are used primarily when the investment has been unsuccessful.

PARTNERSHIP AGREEMENT
The provisions of the partnership agreement offer additional protection for limited partners. The agreement
sets forth the broad terms of the general partners’ share of the profits and details how management fees and
profit shares are calculated. These provisions can significantly reduce the general partners’ incentive to engage in
behaviour that does not maximize value for investors.
The partnership agreement also includes covenants that restrict the general partners from engaging in activities
such as the overuse of leverage. Finally, it provides the limited partners with some oversight of the general partners.

GENERAL PARTNER COMPENSATION

General partners earn a management fee and a share of the partnership’s profits known as carried interest. For a
partnership that yields average returns, carried interest may be several times larger than the management fees.

MANAGEMENT FEES
General and limited partners must agree on both the fee percentage and the base on which the fee is assessed.
Management fees are frequently set at a fixed percentage of committed capital, and they stay at that level over
the partnership’s life. Typical fee percentages range from 1% to 3%. Most venture funds charge 2% to 2.5%, but
some larger venture partnerships, as well as many non-venture partnerships, can charge less if the firm sees a large
deal flow.
Fees during the investment period should also be quoted as a percentage of invested capital rather than
committed capital. This practice results in lower fees for the limited partners and encourages the general partners
to invest committed capital as quickly as possible. It also lessens the general partners’ temptation to gather
more commitments than can be profitably invested because excess commitments will not result in higher
management fees.

CARRIED INTEREST
The general partners’ share of a partnership’s profits is often set at 20% of the partnership’s net return. The rules for
calculating net return have varied over the years, but they have recently evolved to favour the limited partners.
Previously, especially for leveraged buyout partnerships, carried interest was based on the returns on individual
investments. Now, carried interest is typically based on the return on the partnership’s entire portfolio. This
change favours the limited partners because general partners are now motivated to increase the value of the entire
partnership portfolio, not just the value of a single successful investment.

PARTNERSHIP COVENANTS AND CLAUSES

Partnership agreements also protect the interests of the limited partners through covenants that place restrictions
on a partnership’s investments and on certain other activities of the general partners.
Partnership covenants usually set limits on the percentage of the partnership’s capital that may be invested in a
single company or on the aggregate size of the partnership’s two or three largest investments.

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Covenants may also specifically exclude investments in publicly traded or foreign securities, derivatives or other
private equity funds, and private market investments that deviate significantly from the partnership’s primary focus.
Finally, covenants usually restrict the fund’s use of debt and, in many cases, require that cash from the sale of
portfolio assets be distributed to investors immediately.
Each of these restrictions is intended primarily to limit the general partners’ ability to undertake greater risk in ways
that benefit themselves at the expense of the limited partners.
General partners can also use the following methods to further their interests at the expense of investors:

• Making investments simply to generate fee income for themselves or their affiliates
• Investing in companies in which other partnerships they manage have equity stakes to boost the valuation of
those companies
• Using personal funds to co-invest in only the partnership’s most attractive investments

Partnership agreements address these potential problems as follows:

• Putting limits on deal fees (i.e., fees paid to general partners on completion of individual investments)
• Requiring that deal fees be offset against management fees by restricting co-investment with the general
partners and by restricting the ability of general partners and their associates to co-invest selectively in the
partnership’s deals

CLAWBACKS
Clawback clauses became part of financial nomenclature as a result of public disaffection after the financial crisis of
2008. Pressure for accountability led a number of financial institutions to set up or reinforce management clawback
clauses to ensure that the interests of management were aligned with the interests of stakeholders.
Clawback clauses in private market funds are used to ensure that general partners do not receive payments in excess
of what was agreed upon.
This is notable in private market funds that have structured the general partners carried interest on a deal-by-deal
basis. In such cases, a general partner could have completed a number of profitable deals early in the fund’s life, but
then the fund experienced a long period of underperformance. Without a clawback clause, this situation could lead
to the limited partners earning less than the agreed-upon amounts when the fund is wrapped-up.
Among the many different forms of clawback clauses, an example is the placement of a portion of the general
partner’s carried interest in an escrow account that can be subsequently altered, depending on the performance of
future deals within the fund.

GOOD LEAVER / BAD LEAVER CLAUSES

Good and bad leaver clauses are structured to incentivize general partners and key executives for good behaviour,
but also to deter them from decisions that could damage stakeholder value. These clauses are more subjective
in nature given that private market funds can have exceptionally long investment periods over which many
unforeseen changes can occur. Good and bad leaver clauses address some of the reasons for which general
partners leave a fund.

Good Leaver Triggers Bad Leaver Triggers

Retirement Underperformance

Disability Bankruptcy

Death Fraud

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A major component of good and bad leaver clauses address the value of the fund shares held by the exiting party.
Those exiting the fund under good leaver terms may be able to sell all of their shares at fair market value. Those
deemed bad leavers under the terms of the fund may receive only a portion of their shares or may only be able to
sell their shares at a discount to fair market value.

GATE PROVISIONS
Gate provisions are used by fund managers to limit fund redemptions if they think servicing these redemptions
could create undo loss of value in the fund. If a manager does not enact a gate provision during a period of high
redemptions from the fund, then the manager may be forced to quickly sell assets below market value, which would
result in a sharp decline in the fund’s net asset value (NAV) and the value of the limited partners’ initial investment.
Large enough withdrawals can cause funds to liquidate entirely, especially if a large portion of the underlying assets
are highly illiquid.
The following situations could cause mass redemptions:

• Extreme market volatility

Recessions or large economic events can cause investors to panic and sell investments, such as during the
aftermath of the 2008 financial crisis or the Brexit Referendum in 2016.
• Loss of public image
The fund or fund manager may be found not to be acting in the interests of the investors or committing
fraudulent acts.
• Asset valuation
Changes in public opinion regarding underlying assets such as oil, guns, or chemical products. Additionally, there
may be political, environmental, or economic risk associated with the fund’s underlying assets, depending on
where in the world they are domiciled.

The two common forms of gate provisions are investor-level and fund-level, as follows:

• Investor-level gate
The investor-level gate limits redemptions to a maximum fixed percentage of an investor’s total investment in
a fund every year (or every redemption period). For example, if the investor-level gate was limited to 10% per
year, then it would take ten years for the investor to redeem their investment, and if it was 25% per year, then it
would take only four years.
• Fund-level gate
The fund-level gate limits redemptions to a percentage of the outstanding investment in the fund at each
redemption period.

The following example shows how the two different gate provisions (investor level and fund level) affect the
capitalization of the fund over a period of sustained redemptions. In both cases, the investor has submitted a
maximum redemption request for their $200 million investment, and both funds have a 25% redemption gate.
It is assumed that each fund only offers one redemption period per year.

EXAMPLE
First Second Third Fourth Remaining
Redemption Redemption Redemption Redemption investment
Period ($M) Period ($M) Period ($M) Period ($M) ($M)

Fund 1:
50 50 50 50 0
Investor-level gate

Fund 2:
50 37.5 28.13 21.09 63.28
Fund-level gate

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For example, for Fund 2, the fund starts with $200 million in investment. The first redemption is 25% of
$200 million which is $50 million. Therefore, the second redemption will be based on 25% of ($200 million −
$50 million). And 25% of $150 million equals $37.5 million.
As the example shows, the fund-level gate works in favour of the fund manager and remaining investors in that it
slows the rate of redemptions and, in turn, decreases the risk that the fund manager will need to sell illiquid assets
into markets at depressed prices.
Additional clauses may be in place to protect specific investors, such as institutional investors or investors that
invested in the first round of financing for the fund. A commonly used clause in this regard is a side letter clause, in
which a separate agreement is made between the investor and the fund stating that their investment is not subject
to the conditions of a gating provision.

REAL ESTATE
Real estate is considered an alternative investment even though it has been an important investment for
countless investors over thousands of years. However, from the point of view of financial markets and the portfolio
management industry, real estate is seen as an alternative to traditional investments, such as stocks and bonds.
Investment in real estate equity tends to take two forms: private and public (also referred to as real estate
securities). With the private form, investments are made in real, tangible assets that usually generate steady cash
flow from rental income. Generally, investors access real assets through pooled investment vehicles or some other
type of commingled fund. The real estate market is segmented into commercial, industrial and residential sectors.
Equity real estate, both private and public, can offer favourable risk-return characteristics and low correlations
with traditional investments. Beyond low correlations with other types of asset classes, real estate also offers
diversification benefits across geographic regions and types of real estate properties. Many investors hold physical
real estate in the form of primary or secondary residences, or as investment properties.
Physical real estate has several distinguishing features, as follows:

• The average retail investor will feel comfortable leveraging real estate, as opposed to shorting or margining
investments. Real estate is arguably the single most important collateralized asset owned by investors. Other
types of property can be leveraged as well.
• Similar to other investment fees, real estate investment costs can be high.
• Appraisal, due diligence, maintenance and repair costs all reduce an investment’s return and need to be factored
into the potential net returns that property can generate.
• Tax liabilities can be significant with real estate. In particular, municipal taxes, water taxes, school taxes and
other taxes levied on the value of property or at disposition need to be considered.
• Real estate may represent a significant portion of an investor’s total net worth. Because of this, when
completing asset allocation, an advisor should, whenever possible, include real estate holdings in their analysis.
• Real estate market returns compete with other asset market returns. At the same time, real estate provides
current consumption value, which other investments may not. The implicit rental value of property needs to be
taken into account, as it represents an opportunity cost of holding and occupying physical real estate.
• Real estate is positively correlated with inflation and tends to protect a client’s net worth from the erosion
of inflation.
• With potentially long holding periods, real estate — depending on the type and purpose of the investment —
can stabilize overall portfolio returns, although it can be highly volatile. Real estate markets are subject to
boom-and-bust cycles.
• Overall, real estate can be considered a bond substitute with an added inflation protection feature.

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Real estate holdings are not interchangeable; are expensive per unit; and require significant management, care and
maintenance. For these reasons, many investors will not physically hold real estate beyond a principal residence
and perhaps a secondary one. Real estate has been structured into investment vehicles that pool property holdings
under one sponsorship and management, and then resell shares of the pool to investors. Investors hold claim to the
net returns generated by the pool, pro rata to their share proportion. This is called securitization, which has proven
popular in the form of real estate investment trusts (REITs).
Real estate takes a public form when it is securitized — that is, when a pool of real estate assets is resold to investors
as shares, as in the case of REITs. Real estate securities can provide exposure to good property expertise and a
diversified set of properties, and are considerably more liquid and divisible than actual real estate holdings.
REITs have been successful in the recent past. The following are some of their main features:

• REITs are publicly traded, with most of them listed on the Toronto Stock Exchange. Hence, they are liquid and
can be traded much more readily than their physical counterparts.
• REITs have shown a high and stable average rate of return, which has made them attractive to many investors.
• REITs offer tax efficiency, because they flow profits back to investors to be taxed in their hands (under their
individual tax conditions).
• REITs tend to be more correlated to equities than to bonds, as their sensitivity to macroeconomic factors and
overall economic health is similar to stocks.
• From an asset allocation point of view, REITs tend to be construed as a high-yield bond or equity substitute.
Their liquidity makes them less stable than physical real estate and contributes to making their market value
significantly more volatile.

Exhibit 11.1 | Summary of Alternative Investment Features

Although each alternative asset class offers unique benefits and drawbacks, the broader group shares a number of
common features, including the following:

• The potential for higher risk-adjusted returns than traditional asset classes
• A relatively low correlation to traditional investments
• Less liquidity than traditional investments
• Limited performance history and benchmark availability
• No trading in transparent public markets across most alternative sectors
• Relatively infrequent transactions, and returns that are dependent on private valuation
• Less regulation than traditional investments
• The ability to use leverage, short securities and derivatives
• Higher investment management–related fees
• A longer capital lockup period and investment horizon
• Narrow (as yet) availability to individual investors

Some of these characteristics clearly do not apply to all alternative asset classes. For example, many hedge funds
generally invest exclusively in publicly traded securities that are priced daily. Real estate investment will not involve
the shorting of a stock. However, in general, the above features hold for most alternative asset classes.

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REASONS TO INVEST IN ALTERNATIVE INVESTMENTS

Since the 1990s, both individual and institutional investors have become more interested in alternative
investments. However, the level of interest and investment in alternative investments has particularly grown in
momentum since the turn of the new millennium. The sharp technology-led sell-off in the global equity markets
in 2000, coupled with the low yields available on bond investments at the time, encouraged many investors to shift
a portion of their investments in traditional asset classes, such as public equities and bonds, into different forms of
alternative investments.
Why is there so much interest in alternative investments? By their nature, alternative investments offer a number of
potential benefits that are neither characteristic of nor present in traditional investments. The following summarizes
these potential benefits:

Table 11.2 | The Potential Benefits of Alternative Investments

Benefit Description
They Offer Improved The return characteristics of alternative investments differ from those of
Portfolio Diversification traditional asset classes, and vary widely within the group of alternative
investments. Since their periodic returns are uncorrelated with traditional equity
and fixed income, alternative investments can diminish overall portfolio risk.

They Can Realize Through short sales, some alternative investment strategies, such as
Profit in Any Economic hedge funds, can realize profits even in weak economic or financial market
Environment environments when securities are declining in price.

They Reduce Portfolio An overall investment portfolio’s volatility can be reduced when alternative
Volatility investments are properly combined with traditional assets or other types of
alternative investments. The volatility of a traditional portfolio comprised of only
equities and bonds can be reduced by the addition of alternative investments.
Accordingly, the portfolio’s current equity and bond holdings can be maintained.

They Enhance Long-term Often, alternative investments are added to a portfolio to potentially increase
Total Risk-Adjusted its risk-adjusted return over the long term. Many investment managers use
Returns alternative investments even if doing so means a lower potential rate of return.
This is the case as long as the lower rate of return will be accompanied by an
even greater reduction in the portfolio’s potential risk, which is usually measured
in terms of the standard deviation of returns.

Investors Gain Access to Many investors have the majority of their investment portfolios invested in
Investment Managers traditional assets. These portfolios are managed by investment managers
(and Investment who have expertise investing in publicly traded securities. Furthermore,
Strategies) That Are Not these portfolios are invested in a long-only manner. Investing in alternative
Generally Available to the investments exposes investors to managers with very different skills and
Public investment strategies. It is hoped that this access provides better investment
results over the long term.

They Preserve Capital in A unique feature of alternative investments, particularly hedge funds, is they can
Volatile Markets be used in a number of trading strategies, such as short selling and the use of
derivatives. These particular investment strategies are seldom used in traditional
long-only portfolios, but have the benefit of producing positive returns,
regardless of the direction of the overall financial markets.

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Table 11.2 | The Potential Benefits of Alternative Investments

Benefit Description
They Provide Access Some alternative investment strategies focus on global markets and securities
to Global Markets that a traditional equity and bond portfolio would not normally invest in.
Investments in these markets would likely only occur through alternative
investments.

They Align with Investors’ The managers of alternative investment funds receive a large portion of
Interests Through Variable their variable compensation from a standard performance fee calculation
Performance Fees that is based on the amount of returns or gains their fund earns or realizes.
Accordingly, the investment manager receives a performance fee only if their
alternative investment fund earns a positive rate of return. Intuitively, the
performance-fee basis of variable compensation has a closer alignment with
investors’ interests. This is the case because the manager of an alternative
investment only receives a performance fee if they actually increase the value
of the investor’s fund holdings.

They Align the Interests The managers of alternative investment portfolios often have a significant
of Investors with Those of portion of their personal wealth invested in the funds they manage, which more
Investment Managers closely aligns their interests with those of investors. In contrast, those who
manage traditional portfolios might have little, if any, of their personal wealth
invested in the equity, bond or money market portfolio they are responsible for.

ISSUES AND CHALLENGES WITH ALTERNATIVE INVESTMENTS

There are a number of issues and challenges associated with investing in alternative investments. There are
well-accepted processes and procedures developed to deal effectively with each of these issues, but they
nonetheless represent a potential operational challenge and risk, particularly to those start-up alternative
investment managers whose previous experience primarily involved managing and investing in traditional
investments on a long-only basis.

ASSET ALLOCATION PROCESS

One of the major challenges institutional investors face when evaluating alternative investments is determining the
appropriate asset allocation policy, including which alternative investments to include in the policy portfolio and in
what proportions.
Typically, the analysis of policy mix alternatives is based on historic periodic return data for each asset class under
examination. It is tempting to use historical pricing data for the analysis of an asset mix policy simply because
the data is available. This approach is acceptable for conventional assets, which are frequently traded and have
observable market price data, and for which it is correctly assumed that the forward-looking period is adequately
represented by historical pricing and the rate of return data set. However, there are a number of considerations that
limit their use in determining asset mix policy allocations.
In order to have an appropriate and accurate analysis, it is imperative that the risk and rate of return data and
assumptions used in the analysis of the asset mix policy across traditional and alternative investments be forward-
looking and consistent in reflecting the true underlying economic exposure of the assets. Historical data can be
biased on both accounts and therefore may affect — in some cases, perhaps severely — the validity of the asset mix
policy analysis.

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MEAN-VARIANCE OPTIMIZATION
For the purposes of determining the asset mix policy allocation, whether for traditional or alternative investments,
it is appropriate to use long-term risk and return characteristics. These estimates should never be conditional on the
current or near-term market and business cycle situation, but must instead focus on the characteristics relevant to
the portfolio over a long time horizon.
The distinct performance characteristics of various alternative investments provide a rationale for including them in
a multi-asset portfolio. However, it is hard to quantitatively gauge the optimal share of such alternative investments.
Across many of the liquid and publicly traded asset classes, the use of quantitative mean-variance models has
become routine, with the most widely used being based on Markowitz’s modern portfolio theory (MPT).1 The basic
theory behind MPT contends that a portfolio’s diversification across different asset classes with low or negative
correlation characteristics will minimize risk. The quantitatively derived asset allocation parameters seem to provide
investors with a method of constructing optimal and efficient portfolios.
However, investment managers who use MPT or other quantitative asset allocation methods in alternative
investment sectors face considerable hurdles. These types of asset allocation models make strong assumptions
about market structure, statistical pricing dynamics, the use and dispersion of pricing data, and investor behaviour.
These assumptions generally imply that mean variance optimization should result in risk-minimizing portfolios for
rational investors.
This theory works surprisingly well for portfolios constructed of highly liquid public markets, such as common
stocks and bonds. However, alternative investments are another matter. Alternative investments do not conform
well to many of the key assumptions underlying standard mean-variance optimization. First, one of the strongest
assumptions is that the asset returns are normally distributed, which is certainly not the case for most alternative
asset classes. Most alternative assets do not follow a symmetric bell-shaped distribution, such as a normal
distribution. Indeed, most alternative asset classes tend to be skewed and characterized by significant kurtosis.
Skewness and kurtosis are two statistical measures of the variation of the asset class returns from a normal
distribution. They essentially attempt to quantify how far the asset class rate of return distribution varies from a
normal distribution.
Often, MPT performs poorly when asset returns are skewed, resulting in an efficient frontier — a set of optimal
portfolios that match an investor’s expected returns with their risk profile — that systematically includes smaller
allocations to negatively skewed assets for a given level of returns than is optimal. Second, the implied symmetry
of the covariance-based measure of risk ignores investor risk aversion. The usual mean-variance approach treats
return deviations from the mean (expected return) in a symmetrical fashion — that is, unexpectedly high returns
are considered just as sub-optimal as unexpectedly low returns. In reality, investors are undeniably more averse to
volatility on the downside than to volatility on the upside.
These limitations, and others, result in the limited validity of using pure mean-variance models, such as MPT, to
determine the optimal portfolio asset allocation to alternative investments. Unfortunately, the available data sets
on alternative investments are generally not yet sufficiently robust or precise to support highly targeted asset
allocation decisions.
Pioneering research done by professors in the U.K. has resulted in a solution to this asset mix policy conundrum
when alternative asset classes are considered in a portfolio’s asset mix. Their analysis concludes that MPT-type
quantitative models can be used, but with modification, so that the optimization algorithm includes the skewness
measure and the kurtosis measure for each asset class under consideration. So, in essence, they attempt to preserve

1
Harry M. Markowitz, “Portfolio Selection,” The Journal of Finance 7, No. 1 (March 1952): 77–91.

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MPT and its strong theoretical underpinnings, and adjust it to accommodate the abnormal aspects of the return
distributions for non-traditional asset classes, such as alternative investments.2, 3, 4

SECURITY PRICING AND VALUATION

Security pricing is very straightforward for funds that invest solely in publicly traded securities. It is generally as
simple as obtaining a daily end-of-day data feed from the stock exchange or exchanges on which a fund’s securities
are traded.
However, for the vast majority of investments made by alternative investment managers, there is no equivalent
independent and accurate source of security pricing. In fact, security pricing for unlisted and non-marketable
securities and assets is often a mix of art and science, and sometimes the art component can lead to serious issues
for a fund and its investors. Alternative investment managers should ensure they have developed and instituted
a security pricing process that is sound, reasonable and appropriate for the specific types of securities and
investments their fund will invest in.
Furthermore, investment managers should strive to ensure that a fund’s investors also have a clear understanding of
the pricing risks generally associated with the periodic valuation of the types of securities and investments included
in the fund.

SHORT SALES
Some start-up hedge fund managers and their administrative staff have limited experience executing and settling
security short sale transactions. In the case of a long sale, the fund actually owns the stock that is being sold.
However, in the case of a short sale, the manager must make arrangements for a broker to borrow the stock that
the fund has sold short, so that this particular stock can be “lent” to the fund, then delivered to the party that
purchased it from the fund. These arrangements can introduce an operational risk for the investment management
firm, as well as for the fund and its investors.
Care must be taken to ensure that the firm’s front, middle and back office staff fully understand the execution,
settlement and accounting of securities that the fund has sold short. Most investment dealers and prime brokers
have daily processes and procedures to ensure that all of their clients — that is, investors and fund managers — have
properly settled their short-sale transactions on a timely and daily basis.
It is imperative that all of an investment manager’s fund accounting reports identify all of a fund’s long and short
positions accurately and on a daily basis.

ACCOUNTING FOR LEVERAGE

Financing, or the use of financial leverage, is key in many types of alternative investment strategies, especially
hedge fund strategies. As will be discussed in detail later in this chapter, most hedge fund financing is short term, at
variable rates and can be called in on one day’s notice. The investment management firm must always be aware of
the amount of leverage in each of its funds. This information should ideally be available on a real-time basis, since
the amount of leverage in many hedge funds changes throughout the day as trading occurs. In addition to knowing
exactly how much leverage they are currently using, the manager must also be sure that the amount of leverage
being used in the management of each individual fund is within the bounds allowed by investment guidelines and

2
Harry M. Kat, “Managed Futures and Hedge Funds: A Match Made in Heaven,” Alternative Investments Research Centre Working Paper Series,
Working Paper #0014, London, UK.
3
Gaurav S. Amin and Harry M. Kat, “Stocks, Bonds and Hedge Funds: Not a Free Lunch!” Alternative Investments Research Centre Working
Paper Series, Working Paper #0009, London, UK.
4
Chris Brooks and Harry M. Kat, “The Statistical Properties of Hedge Fund Index Returns and Their Implications for Investors,” Alternative
Investments Research Centre Working Paper Series, Working Paper #0004, London, UK.

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restrictions. In addition, the manager must also be aware of how much leverage the prime broker or brokers allow
for each particular fund the manager oversees.
It is also critical for the manager to have real-time information about the margin balances for each of the funds
they manage. Margin balances are a measure of the amount of financing or credit available for each fund. These are
calculated by prime brokers and investment dealers on a daily basis for all of the accounts they have with margin
agreements in place. Accounting for margin balances can become an exercise in consolidation, since a fund might
have more than one source of margin credit available and active at any one time.

PERFORMANCE ATTRIBUTION
Performance attribution is the process whereby a fund’s periodic performance results are analyzed to determine
its various “sources” of return. Numerous commercially available performance attribution models exist and many
investment managers supplement them with some of their own additional refinements. Performance attribution
is relatively straightforward for funds that contain only traditional investments, such as publicly traded stocks
and bonds.
However, the performance attribution process becomes much more difficult when analyzing alternative
investment funds. As noted earlier in this chapter, many alternative investment funds contain primarily
investments or securities that are not publicly traded and for which there are no available realistic and
independently sourced values or prices. Therefore, the valuation and pricing of a fund’s investments are left to the
abilities and judgement of its investment manager. The validity of the performance attribution exercise can be
severely affected by this subjective security pricing process. Although generally well-meaning, the manager has no
way of determining whether the pricing of the portfolio’s securities are realistic or not. Unrealistic security pricing
leads to an inaccurate valuation of the fund’s net asset value (NAV), and an inaccurate valuation of the NAV leads
to inaccurate rate of return calculations, which means the performance attribution will also be inaccurate. The
end result is that the fund’s valuation, performance measurement and reporting, and performance attribution
processes are rendered meaningless.

LACK OF SUITABLE PERFORMANCE BENCHMARKS

For investment products that invest solely in publicly traded securities, such as mutual funds, there is a plethora
of suitable performance benchmarks available to help investors assess the success and capabilities of a mutual
fund manager. Unfortunately, this is not necessarily the case in the alternative investment management industry.
However, third-party performance index providers do exist for alternative investment mandates. For example, in
the hedge fund industry, there are more than 10 firms that provide hedge fund performance indexes and associated
information. Most of these firms provide monthly performance data series to the public on either a free or
fee-for-service basis. However, these firms have their own unique assumptions and standards for developing and
maintaining their databases and performance data series. Those who consult these performance data series must
be cognizant of the assumptions and procedures that are used to develop and maintain this information.
One of the biggest challenges for performance index providers is that fund universe participants — that is, fund
managers — provide their respective fund and return information on a voluntary basis, so anyone and everyone
can participate. Most of the performance index providers do not have filters or processes to ensure that only the
appropriate investment funds are being included in their respective performance universes and sub-universes.
Also, performance data for most alternative investment funds is not audited or verified by an independent party
or auditor. Accordingly, there is no assurance that the data investment managers submit to performance index
providers is accurate and truthful.

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LACK OF MANDATE DEFINITION AND STANDARDIZATION

Another significant challenge for performance index providers, as well as investors, is that there are no industry-
wide agreed-upon standards with respect to the definition and standardization of alternative investment funds and
their investment strategies. In the mutual fund sphere, it is likely a very good assumption that a Canadian large-
capitalization equity fund invests the vast majority of its assets in large-capitalization equities based in Canada
and listed on Canadian stock exchanges. This makes the performance comparison valid when comparing it to other
mutual funds with the exact same investment strategy.
However, an investor does not have this level of comfort when using performance index data covering the
alternative investment industry. There are no standards or controls over which investment strategy universe or
sub-universe an individual alternative investment manager decides to be included in. For example, say a hedge fund
manager decides to have a fund included in the convertible bond arbitrage sub-universe of hedge fund managers.
Then suppose that over 40% of that particular fund’s assets were invested in merger arbitrage investments during
the performance reporting time period. Should that fund be included in the convertible bond arbitrage sub-universe,
the merger arbitrage sub-universe, both sub-universes or neither sub-universe? Unfortunately, there is no standard
in the alternative investment management industry to help answer this question in an appropriate manner.

LACK OF INVESTMENT STRATEGY TRANSPARENCY

The lack of transparency of an alternative investment manager’s strategy also affects an investor’s ability to verify
that a specific fund and its manager are being included in the appropriate peer group for performance evaluation
and assessment. Some hedge fund strategies, particularly global macro, have very wide latitude as to what types
of investments and strategies an investment manager can employ over time. This latitude makes performance
comparisons with peers very difficult, if not impossible.

THE UNIQUE RISKS OF ALTERNATIVE INVESTMENTS

All asset classes have risks associated with them. In the case of most traditional asset classes, these risks are
well understood and measured. However, there are a number of additional unique risks that must be considered
when thinking about investing in alternative asset classes. Some of these risks emanate from the unique return
characteristics of the asset class itself, while other risks arise from the investment management strategies that are
typically used in the management of these alternative asset classes. A number of these risks are discussed below.

LESS REGULATORY OVERSIGHT

As most alternative investments are offered as private placements, they are not required by securities laws to
provide the comprehensive initial and ongoing information that is associated with securities offered through a
prospectus. This lack of transparency can mean that investors in some alternative investment vehicles may not
always know how their money is being invested.
For example, it is possible that an unscrupulous alternative investment manager could be covering up losses by
reporting inflated earnings. This type of fraud might not be identified until it is too late for investors to recover any
of their initial investment. Also, the alternative investment manager may stray from the fund’s stated investment
strategy, thereby engaging in a practice known as style drift. Once again, because of the lack of ongoing reporting
requirements, investors may not find out about this until long after the fact.
To avoid these types of situations, the onus is on investors and their advisors to conduct thorough due diligence on
alternative investment managers and their funds prior to and while investing in them. Due diligence checks should
include a review of the fund’s audited financial statements to support the representation of historical performance
and a detailed review of its offering memorandum. There is more on due diligence later in this chapter.

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TRANSPARENCY RISK
Transparency risk refers to the risk incurred by investors’ limited access to information about their alternative
investments, including the fund’s operation, as well as its holdings and performance. As discussed earlier, this
information is not available or presented to investors in a fully transparent manner, as would be the case with
mutual funds. The degree and amount of fund or product transparency is stipulated in the alternative investment’s
offering documents or partnership agreement. Many alternative investment managers do not want information
about their fund’s operation or its holdings leaking into the financial markets and to competing investment
managers. However, depending on the particular fund, this might be very appropriate and certainly in the best
interests of the fund’s investment manager and its investors.

MANAGER AND MARKET RISK

The management of mutual funds has evolved to the point where an investor’s performance expectations are
usually defined by the benchmark a manager is measured against. In other words, the manager’s performance is
measured against a particular index. Alternative investment funds do not seek to produce returns relative to a
particular index, but strive to generate positive returns, regardless of market direction. Therefore, the risk-return
characteristics of the strategies alternative investment managers use, and whether they are focused on hedging
strategies or strategies exposed to significant market risks, become important.
A mutual fund manager’s performance is more likely to reflect the general performance of the markets they are
trading in, whereas an alternative investment manager’s performance largely depends on the manager’s investment
skills and abilities. In light of this, it is more important to clearly understand the manager’s risk and return metrics,
including expected return, expected risk (as measured by the standard deviation), the Sharpe ratio, the overall
percentage of positive months, and so on. These metrics provide a more objective measure of the manager’s
performance than an index that is unrelated to the underlying strategies.

COMPLEX INVESTMENT STRATEGIES

Many alternative investments involve different and often bigger risks than are normally associated with traditional
investments. Frequently, the assumption of new risks — or even ones associated with traditional investments —
is coupled with leverage in the investment strategy’s execution, thus increasing, sometimes substantially, the
potential for an investor to incur significant losses. Even if alternative investment managers try to mitigate risk, the
investment techniques and strategies they employ may be difficult to understand. As a result, investors may not
fully understand them. Investors should try to understand the investment manager’s strategies and techniques as
much as possible, and ask them questions to ensure they are not participating in an investment strategy they are
uncomfortable with.

LIQUIDITY RISK
In the case of private market and real estate alternative investments, liquidity risk is very obvious. However, it can
also be a factor in hedge funds that focus on very thinly traded public securities. A lack of liquidity for an extended
period of time can lead to sustained losses for a fund if its manager is unable to trade into or out of particular
securities.

PRODUCT LIQUIDITY CONSTRAINTS

Unlike mutual funds, alternative investment funds are typically not able to liquidate their portfolios on short notice.
Holding less liquid investments often produces some of the excess returns generated by hedge funds. This liquidity
premium is part of the trade-off against traditional investments. In light of this, there are often various forms of
liquidity constraints imposed on hedge fund investors. It is important to note that the liquidity risk discussed in
the previous section refers to the amount of liquidity in the investments themselves, whereas product liquidity
constraints are the terms and conditions under which investors can redeem their investments in an alternative
investment fund or product. Product liquidity constraints are explained in the alternative investment fund’s offering
documents, and are therefore agreed upon by investors at the time of their initial investment.

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A lockup refers to the time period when an initial investment cannot be redeemed from an alternative investment
fund or product. Some alternative investment funds require lockups of three years or more. While lockups of
this duration are not common for alternative investment funds that are offered on a continuous basis in Canada,
some alternative investment funds do have initial lockup periods or charge an early redemption fee if the initial
investment is redeemed within the first three months to one year. Once the lockup period is over, the investor is free
to redeem shares on any liquidity date specified in the offering memorandum. Longer-term lockup periods tend to
be more often associated with real estate and private market funds.
Liquidity dates refer to pre-specified times of the year when investors may be allowed to redeem units in an
alternative investment fund. Some alternative investment funds can be liquidated only on a quarterly or annual
basis. If they wish to redeem their units, investors often need to give alternative investment funds advance notice,
such as 30 days or more before the actual redemption. As is the case with traditional mutual fund managers,
alternative investment fund managers can refuse redemptions if there are unusually poor conditions in the markets
that prevent the orderly liquidation of a fund’s investments.
For an alternative investment manager, the length of the lockup period represents a cushion, which is particularly
useful to a new manager. If the alternative investment fund experiences a sharp drawdown — a sharp reduction in
NAV, which is defined as the peak-to-trough decline in the fund’s NAV — after its launch, the lockup period forces
investors to stay in the fund rather than bail out. An alternative investment fund’s ability to demand a long lockup
period and still raise a significant amount of money depends on its manager’s quality and reputation, as well as the
shrewdness of its marketers.

LIMITATIONS ON TRANSFERABILITY
Another type of liquidity risk often associated with alternative investments is the difficulty — or outright inability —
for investors to transfer their security interest in an alternative investment fund or product to other parties. Many
types of alternative investment vehicles, such as limited partnerships, generally have clear and limited restrictions
as to the limited partners’ ability to sell or transfer partnership interest to another party. Many of these types of
funds are only seeking investors who will remain in the investment over an extended, and often set, period of time.
This could create liquidity problems in an investor’s own financial affairs, even if the investment in the partnership is
performing well. Many partnership agreements have some limited facility for partners to be able to sell all or part of
their partnership units to other limited partners.

INCOME TAX IMPLICATIONS

The income taxation of alternative investment funds is as varied as the structures used to offer them. Some
alternative investment funds, such as limited partnerships and domestic trusts, are subject to full taxation on an
annual basis. Others offer full tax deferral by using offshore structures to defer tax until disposition. In addition,
some portion of the returns may be taxed as income, while other portions are considered capital gains for
tax purposes.
Investors must assess whether a fund’s investment strategies will primarily generate income or capital gains, or a
combination of the two, and how its investment and trading policies might increase their own tax obligations. Prior
to their initial investment, investors should seek the assistance of tax professionals to clarify the tax implications of
an alternative investment fund or product.

PRICING RISK
Many alternative investment funds hold securities or other types of assets for which it is very difficult to obtain valid
and realistic market prices. In particular, pricing is a risk in real estate funds and private market funds where certain
assets or properties might trade only once every few years. However, pricing risk can also be a factor in hedge funds
that invest in publicly traded securities, especially if they trade in very illiquid sectors and securities and have, in
relation to the market, large positions in them. In such cases, the prices that are based on market-sourced data
might not be representative of the actual prices that would be realized if most, or all, of the hedge fund manager’s

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position had to be sold quickly. These price discrepancies can be very large and depend on the liquidity associated
with the security itself and the overall tone of the market in which the security trades.
Sometimes pricing is left to the hedge fund manager. These situations can result in the hedge fund manager
manipulating the market price, which can lead to overstated values for particular securities and the overall fund’s
NAV. Some alternative investment managers who price their own non-publicly traded securities use proprietary
algorithms. These algorithms are referred to as “black box models”, since only very few individuals who work with
the managers are permitted to have knowledge of the models’ bases and assumptions. Accordingly, these models
have not been reviewed and assessed by industry academics and other participants as to their validity, application
and accuracy. A manager’s use of such models introduces “black box pricing risk” to the securities priced or valued
using them. A number of these models have failed during periods of extreme shifts and high volatility in the capital
markets, when the models’ assumptions were discovered — after the fact — to be severely limited and inaccurate.

SHORT SQUEEZE RISK

Hedge fund managers, in particular, must be very skilled at assessing the difficulty and cost to cover or buy back
the securities they have previously sold short. With less liquid securities, a hedge fund manager might have a lot
of difficulty finding parties who are willing to sell an amount of securities at quoted market prices to enable the
manager to cover a short position. This is known as short squeeze risk, which generally increases during periods of
extreme bullishness in financial markets.

COUNTERPARTY RISK
This is the risk that the party on the other side of the security trade, often referred to as the counterparty, will be
unable to honour its commitments under the terms of the trade. Counterparty risk arises when the counterparty
slips into financial distress or failure prior to honouring all of its outstanding financial commitments, such as security
transactions. If the counterparty is an investment dealer, the alternative investment manager and fund might end
up in a position where they are not able to complete the sale or purchase transaction that was entered into with the
dealer. Such a scenario can have financial costs for the fund, since the investment manager must try to complete
the sale transaction with another investment dealer at a new and possibly lower market price, or they must try
to purchase the original securities from another dealer at a new and possibly higher market price. In this example,
the investment dealer counterparty was acting as an agent in the purchase or sale transaction, but is nonetheless
responsible for the security transaction’s effective completion.

FINANCING RISK
Many alternative investment managers use borrowed capital or financing in their investment strategy’s execution.
Most hedge fund managers use some degree of leverage when managing their fund. The amount of leverage used is
unique and varies depending on the hedge fund’s strategy and the fund manager’s own strategy. However, one thing
hedge fund managers have in common is that their financing tends to be short term in nature and obtained from
the investment dealers or brokers with which they are trading securities. Hedge fund managers face a real challenge
if investment dealers increase the cost of a hedge fund’s short-term financing or, worse, reduce the amount of
financing available.
The cost and availability of an investment dealer’s short-term financing can change very quickly, because it is
affected by both financial market conditions and the dealer’s own financial situation. Investment dealer–sourced
financing can be amended or called on with as little as one day’s notice to the hedge fund. This type of situation
could have an extremely negative impact on the hedge fund and its value if it forces a liquidation or purchase at
greatly disadvantageous prices.
Though it tends to be lower, financing risk also often arises for real estate and private market funds, where financing
for a fund’s investments and transactions — if and when required — is carefully matched to the nature of the asset
being financed. This is a prudent financing strategy that can effectively reduce the refinancing risk for an alternative
investment fund or product.

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BUSINESS RISK
When it comes to alternative investments, one of the biggest and most overlooked risks is the business risk
associated with the fund or product’s manager. Unlike large, well-capitalized mutual fund organizations, many
alternative investment management firms are often start-up businesses or very small organizations with limited
amounts of capital. A new firm tends to be undercapitalized and the manager tends to be inexperienced at running
this type of business. An alternative investment manager may be a competent investment manager but lack the
skills or abilities to run a business.
Furthermore, most alternative investment funds are often highly dependent on the skills and investment abilities
of the investment manager, who is frequently the general partner if the alternative investment vehicle is structured
as a limited partnership. Investment decisions are often made by relatively few staff — sometimes by only one
individual. For this reason, the inability of one or more of the key personnel to carry out their investment and
business-related duties could have an adverse effect on the investment or partnership. Although business risk can
also play a role in traditional investments, it affects alternative investments differently, because it may prove very
costly or even impossible to exit these types of investments due to liquidity issues, as explained earlier.

DUE DILIGENCE
Due diligence is a reasonable investigation of a proposed investment and its principals. The goal of due diligence is
to ascertain an investment’s worthiness and appropriateness for particular types of investors. What follows are the
primary objectives and purpose of performing due diligence on an investment fund:

• To properly determine the risk profile of an investment; and

• To address as many of the risks as possible.

When investing in any type of investment fund, whether it involves traditional or alternative investments, the
investor is essentially buying into four main factors:
1. The expertise and capabilities of the investment manager’s principal officers
2. The investment manager’s specific investment strategies, processes and systems
3. The fund’s historic performance
4. The fund’s corporate, tax, regulatory and custodial structure

The proper assessment of these four factors can be quite involved, particularly when performing a due diligence
analysis on an alternative investment fund or product. The unregulated nature of the alternative investment
management industry, and the fact it is essentially comprised of unique investment firms with unique investment
strategies and processes, complicates the process.
The due diligence process is often divided into four steps or stages, as follows:
1. Screening potential investment funds and products
2. Identifying potential investment opportunities through performance reviews and presentations from
investment managers
3. Conducting full due diligence reviews and analysis
4. Continuously monitoring the fund and its investment manager after the investment has been made

A comprehensive due diligence process for investment funds, both traditional and alternative ones, should address
the following eight main areas:
1. Structure of the investment management organization
2. Investment management information (personnel and experience)

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3. Fund or product risk analysis

4. Operations and an assessment of operational risks
5. Fund or product structure (or both)
6. Investment performance and attribution analysis
7. Investment manager’s account structure and composition
8. Compensation and fee structure

The limited information provided by most alternative investment funds makes the due diligence process a more
difficult and drawn-out process than with conventional investment funds.
Advisors typically have more access to information about the alternative investment fund industry than clients
do. For example, they can participate in conference calls with alternative investment fund managers, and attend
seminars and conferences featuring presentations by the managers. Most alternative investment managers allow
advisors to phone them and ask questions about their funds. Advisors should contact alternative investment
fund managers not only before investing in a fund, but also routinely, as part of an ongoing due diligence process,
because alternative investment funds can change over time.

ASSESSING AN ALTERNATIVE INVESTMENT FUND’S RISK PROFILE

Advisors could develop a scoring system to assess an alternative investment fund’s risk profile, which is similar to a
client’s risk profile. The following questions should be addressed when assessing any alternative investment fund’s
risk profile. Please note that this list is not exhaustive; rather, it provides information about the main areas that
should be addressed during a due diligence review.

INVESTMENT MANAGER’S INVESTMENT PROCESS AND STRATEGY

• What is the alternative investment fund’s investment process, philosophy and style?
• Is leverage used and, if so, how much? How is it employed?
• Does the fund use hedging strategies?
• Are derivatives used to hedge or speculate?
• What hedging strategies are used and why?
• What risk controls does the fund have in place?
• Have profits been made evenly across investments/strategies, or by a handful of winning positions?
• Have losses come from a high number of trades, high expenses, a small number of bad trades or positions, or for
other market reasons?
• Does the fund have foreign exchange risk?
• Are there capacity constraints for the fund’s investment strategy?
• At the initiation of a position, does the manager have a maximum loss tolerance and, if so, do they use a stop-
loss rule (a predetermined price below the current market value where a security will automatically be sold)?
• What type of market environment is required for the manager’s investment strategy to work? Is there
something currently happening in the markets that makes this investment strategy more or less attractive?
• What is the worst type of market environment that could negatively affect the manager’s investment or trading
strategy, or both?

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FUND DETAILS
• Are audited financial statements available for the fund?
• Are the fund’s historical returns actual returns or simulated returns?
• How long is the fund’s lockup period?
• What is the fund’s liquidity risk?
• How does the fund’s high water mark work (a stipulation that the fund’s value must be greater than its previous
greatest value for the manager to receive a performance fee)?
• What are the fund’s or product’s subscription and redemption policies?

INVESTORS’ LEGAL AND TAXATION ISSUES

• What are the legal and taxation issues for the fund’s investors?
• Where is the fund domiciled and how is its income treated for tax purposes?
• Is the fund registered with, or subject to regulation by, any securities regulators?
• What is the fund’s legal structure and does it create any risk of personal liability to investors?
• Is the fund structured as a limited partnership or trust?

BUSINESS ISSUES
• Does the current manager have a long-term track record for the fund’s strategies?
• How much capital has the manager personally invested in the fund?
• Is the investment management company profitable at its current level of assets under management?
• How stable and well-financed is the investment management company?

HYPOTHETICAL QUESTIONS
• How do changes in market factors, such as prices, volatilities and correlations, affect the fund?
• How do declines in the creditworthiness of the entities in which the fund invests affect the fund?
• How does a decline in market liquidity affect the value of the fund’s investments?

CURRENT TRENDS AND DEVELOPMENTS IN ALTERNATIVE INVESTING

Financial markets are always changing and evolving, and the alternative investment sector of the global investment
management industry is no different. Some of the major events and trends are worth discussing.

INCREASED GOVERNMENT REGULATION

Due to a number of factors, not the least of which is the failure of a few high-profile hedge funds, there has been
an increasing call from many individuals and politicians for more regulatory oversight of the hedge fund industry
in particular, especially in the U.S. As mentioned earlier, the hedge fund and alternative investment industry is the
least regulated of all major investment sectors, including mutual funds and securities underwriting.

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INSTITUTIONALIZATION
The alternative investment industry in general, and the hedge fund industry in particular, are quickly becoming
institutionalized — that is, as institutional investors become bigger players in the area of alternative investing, they
are able to change industry practices and standards somewhat over time. Institutionalization might turn out to be
the key factor that propels the alternative investment industry to a higher level of investor interest.
Many large institutional investors that are investing in alternative investments have, over time, invested in the
people and technology they felt they needed to allow them to participate in the alternative investment industry
on a basis they deemed prudent. Working alone or in concert, these large institutional investors are standardizing
a number of the unique processes and procedures involved in the creation, investment and management of various
types of alternative investments. Most investment managers must operate their businesses and funds at the level of
proficiency and professionalism mandated by the large institutional investors if they hope to ever get an investment
allocation from them.
Most large institutional investors are regulated and must conduct their business and investing affairs according
to the regulatory standards emanating from, say, banking and insurance industry regulators, and from their own
industry best practices. These standards are directly and indirectly working their way into the investment practices
and standards of these large institutional investors. It seems this trend is sure to accelerate over the near term.

CONTINUED INNOVATION
One thing is for sure — the alternative investment industry can never be accused of lacking innovation. In reality, it
is likely the most innovative sector of the global financial and capital markets. New alternative investment products
appear overnight and often catch even the most seasoned industry veterans in awe.
In some regards, the alternative investment management industry is still in its infancy, having only really been
recognized as a serious contender in the global investment arena over the past few decades. However, despite all
of the well-publicized hedge fund industry disasters and the increasing volatility of financial markets in general, the
alternative investment industry continues to grow rapidly.

DIGITAL ASSETS
Generally speaking, a digital asset is a non-tangible asset that is created, traded, and stored in a digital format.
Within the broad category of digital assets, there are two general sub-categories: crypto assets and non-crypto
assets. Many crypto assets are considered currencies (i.e., cryptocurrencies), but not all, so we prefer to use the
more general crypto asset categorization. And although all crypto assets are considered digital assets, not all
digital assets are crypto assets. An example of a digital asset that is not a crypto asset is a non-fungible token
(NFT), which is a digital ownership recording of, for example, a piece of art, a sports memorabilia item, or another
type of digital file.
Less than a decade ago, most market participants would not have come anywhere close to seeing digital assets as
an asset class. For example, bitcoin was viewed more as a technology tool (Bitcoin the protocol) and as digital cash
(bitcoin the token), rather than as an investment asset class. The digital assets market has matured since then, and
an increasing number of institutional investors are coming around to viewing it as a legitimate and separate asset
class (despite the CFTC classifying bitcoin as a commodity).
The pandemic drove a new level of institutional adoption of bitcoin and cryptocurrencies by corporate treasuries.
The justification for investing corporate treasury assets in bitcoin is to maintain the purchasing power of the
treasury in the current economic environment. Inflation pressures have increased through fiscal and monetary
policy expansion, and returns on interest rates and fixed-income securities are historically low.

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As more corporate treasuries and high-net-worth clients move towards crypto investments, the need for
institutional support has increased. Fidelity has built out their enterprise-grade bitcoin custody and other crypto
investment services for several years. This effort requires sophisticated tools to manage the investment and
mechanisms for custody, which can be challenging to build in an environment where there is active trading.
The availability of several different types of funds, trusts, and ETFs makes it easier for investors that are not capable
of providing safe self-custody or managing the complexities of buying, trading, and storing cryptocurrencies. It also
makes it easier to fold cryptocurrency-related securities into a traditional portfolio management infrastructure.
It seems clear that digital assets have now evolved to the point where a significant number of investors view it as a
new institutional asset class, albeit a young one that still must overcome some investor and regulatory concerns.

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SUMMARY
After completing this chapter, you should be able to:
1. List the primary characteristics and attributes of alternative investments.
• Alternative investments cover a wide range of investment opportunities. The major categories include hedge
funds, private markets, real estate and commodities.
• Hedge funds are lightly regulated pools of capital whose managers have great flexibility in their
investment strategies.
• Commodities are another class of alternative investments. Investments in commodities can be made in two
primary ways:
« Directly: By buying and selling commodities
« Indirectly: Through commodity derivatives — that is, futures, forwards or swaps

• Managed futures funds: They invest in listed financial and commodity futures markets and currency markets
around the world.
• Private market funds are typically structured as limited partnerships.
« A partnership’s investment activities are divided into four stages: selecting, structuring, monitoring, and
exiting the partnership’s investments.
« The provisions of the partnership agreement offer additional protection for limited partners.

• Real estate: From the point of view of the financial markets and portfolio management industry, real estate
is seen as an alternative to traditional investments, such as stocks and bonds.

2. Explain the main factors for the continued and growing interest in alternative investments.
• Alternative investments offer a number of potential benefits that are neither characteristic of nor present in
traditional investments. The following summarizes these potential benefits:
« They offer improved portfolio diversification
« They can realize profit in any economic environment
« They reduce portfolio volatility
« They enhance long-term total risk-adjusted return
« Investors gain access to investment managers (and investment strategies) that are not generally available
to the public
« They preserve capital in volatile markets
« They provide access to global markets
« They align interest with investors through variable performance fees
« They align the interests of investors with those of investment managers

3. Describe some of the major issues and challenges an alternative investment manager must deal with and why
they must be dealt with properly.
• Asset allocation process: At issue are which alternative investments to include in the policy portfolio and in
what proportions.
• Security pricing and valuation: There is no independent and accurate source of security pricing for the vast
majority of investments made by alternative investment managers.

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• Short sales: Some start-up hedge fund investment managers and their administrative staff have limited
experience in executing and settling security short sale transactions.
• Accounting for leverage: The investment management firm must always be aware of the amount of leverage
in each of its funds. This information should ideally be available on a real-time basis, since the amount of
leverage in many hedge funds changes throughout the day as trading occurs.

4. Describe how the asset allocation process is used and modified when alternative investments are included in a
portfolio’s asset mix.
• Alternative investments do not conform well to many of the key assumptions underlying standard
mean-variance optimization. Most alternative asset classes tend to be skewed and characterized by
significant kurtosis.
• A modification to models can be made to include the skewness and kurtosis measures for each asset class
under consideration.

5. Identify some of the main problems and issues that arise when doing performance attribution for alternative
investments.
• Lack of suitable performance benchmarks
• Lack of mandate definition and standardization
• Lack of investment strategy transparency
6. List and describe some of the unique key risks of alternative investments and why they must be considered
prior to investing in them.
• Less regulatory oversight: Most alternative investments are not required by securities laws to provide
comprehensive and ongoing information.
• Transparency risk: Refers to the risk incurred by investors’ limited access to information about their
alternative investments, including the fund’s operation, as well as its holdings and performance.
• Manager and market risk: An alternative investment manager’s performance largely depends on their
investment skills and abilities.
• Complex investment strategies: They can lead to an increased potential for significant losses.
• Liquidity risk: It can lead to losses if the manager is unable to trade into or out of particular securities.
• Product liquidity constraints: They are the terms and conditions under which investors can redeem their
investments in an alternative investment fund or product.
• Limitations on transferability: The difficulty — or outright inability — for investors to transfer their security
interest in an alternative investment fund or product to other parties.
• Income tax implications: The income taxation of alternative investment funds is as varied as the structures
used to offer them.
• Pricing risk: Many alternative investment funds hold securities or other types of assets for which it is very
difficult to obtain valid and realistic market prices.
• Short squeeze risk: Hedge fund managers, in particular, must be very skilled at assessing the difficulty and
cost to cover or buy back the securities they have previously sold short.
• Counterparty risk: This is the risk that the party on the other side of the security trade, often referred to as
the counterparty, will be unable to honour its commitments under the terms of the trade.

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 CHAPTER 11 ALTERNATIVE INVESTMENTS 11 • 31

• Financing risk: One thing hedge fund managers have in common is that their financing tends to be short
term in nature and obtained from the investment dealers or brokers with which they are trading securities.
Hedge fund managers face a real challenge if investment dealers increase the cost of a hedge fund’s short-
term financing or, worse, reduce the amount of financing available.
• Business risk: Many alternative investment management firms are often start-up businesses or very small
organizations with limited amounts of capital. Most alternative investment funds are often highly dependent
on the skills and investment abilities of the investment manager.

7. Describe the due diligence process when thinking about investing in an alternative investment.
• The primary objectives and purpose of an investment fund due diligence is to properly determine the risk
profile of an investment and address as many of the risks as possible.
• The due diligence process has four steps or stages: screening potential investment funds and products,
identifying potential investment opportunities through performance reviews and presentations from
investment managers, conducting a full due diligence review and analysis, and continuously monitoring the
fund and its investment manager.
• A comprehensive due diligence process involves eight main areas of enquiry: structure of the investment
management organization, investment management information (personnel and experience), fund or
product risk analysis, operations and an assessment of operational risks, fund or product structure (or both),
investment performance and attribution analysis, investment manager’s account structure and composition,
compensation and fee structure.

8. Discuss the primary trends and developments in the alternative investment management industry and their
potential impact on its development.
• Increased government regulation: An increasing call from many individuals for more regulatory oversight of
the alternative investment industry, particularly the hedge fund industry.
• Institutionalization: Increased investment in alternative investments by institutional investors.
• Continued innovation: New alternative investment products appear overnight.
• Digital assets: an increasing number of institutional investors are coming around to viewing it as a legitimate
and separate asset class.

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Performance Attribution 12

CONTENT AREAS

Client Portfolio Reporting

Portfolio Management Reports

Performance Attribution

LEARNING OBJECTIVES

1 | Describe the Global Investment Performance Standards (GIPS) and why most institutional
investment management firms are in compliance with them.

2 | Describe a typical portfolio management report and highlight the type of information included in it.

3 | Explain why both book and market prices are included in portfolio management reports.

4 | Know the difference between performance reporting and attribution.

5 | Apply performance attribution analysis to evaluate a portfolio manager’s skills.

6 | Explain style drift.

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KEY TERMS

Key terms are defined in the Glossary and appear in bold text in the chapter.

clearing portfolio management report

Global Investment Performance Standards returns-based style analysis

(GIPS)
settlement
holdings-based style analysis
style analysis
market prices
style drift
performance attribution

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 CHAPTER 12 CLIENT PORTFOLIO REPORTING AND PERFORMANCE ATTRIBUTION 12 • 3

INTRODUCTION
This chapter briefly examines the Global Investment Performance Standards (GIPS). It also examines what is
contained in a basic portfolio management report. Because the actual settlement process is vulnerable to errors,
we explain how a portfolio management report is constructed. Lastly, we touch upon aspects of performance
attribution, how the analysis is performed and, finally, what it provides in terms of evaluating a portfolio
manager’s skill.

CLIENT PORTFOLIO REPORTING

GLOBAL INVESTMENT PERFORMANCE STANDARDS

The investment management industry is becoming more global in scope. However, performance measurement
and reporting standards have varied considerably from country to country. Some countries have established
guidelines, while others have few standards. These varied practices limit the comparability of performance results
between firms from different countries and have hindered those wishing to increase global business. The Global
Investment Performance Standards (GIPS) present investment performance fairly and ethically to current and
potential clients.
The CFA GIPS standards have evolved over the last two decades. Since they are standards, not laws, firms do not
necessarily have to be compliant with GIPS standards. In fact, adopting the GIPS standards is voluntary. However,
there are benefits for institutional investment management firms and their clients to comply with the GIPS
standards, as follows:

• Standardized performance presentation guidelines assure investors that performance information is complete
and fairly presented. The guidelines also give investors a common yardstick with which to compare investment
management firms, even if the firms are located in different countries with different laws and protocols.
• By knowing that an investment management firm complies with the GIPS standards, prospective and existing
clients will have a greater degree of confidence in the firm’s performance numbers. Performance standards that
are accepted across all countries enable firms to measure and present their performance so that clients can
easily compare performance among various managers. In fact, firms that choose not to comply with the GIPS
standards may be at a competitive disadvantage. Some institutional investors will not consider an investment
manager whose firm is not compliant with the GIPS standards.

To date, over 40 countries, including Canada and the U.S., have adopted the GIPS standards.

KEY ASPECTS OF THE GIPS STANDARDS

There are many GIPS standards on performance and presentation that a firm is required to follow to be compliant,
and other standards that a firm is only recommended to abide by. This chapter will touch upon only the most salient
requirements. Some of the key aspects of the GIPS standards that will be briefly discussed in the following sections
are as follows:

• Information about a firm

• Composite requirements
• Data used to determine performance calculations
• Calculation methodologies
• Presentation and reporting guidelines
• Information about a firm’s responsibilities

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A FIRM
To begin the compliance process with the GIPS standards, a firm must specifically define the legal entity that
encompasses it. A firm is a distinct business entity that is presented to clients as a group that performs investment
management, whether it is a division, a department or a unit. In defining a firm, it is important to avoid presenting
its performance on too narrow a basis. At the same time, it is important not to define a firm’s performance so
broadly that it includes other parts whose returns could materially misrepresent the performance of the firm’s
investment process.
In addition, for periods beginning January 1, 2011, a firm’s total assets must be the aggregate of the fair value of all
of its discretionary and nondiscretionary assets under management (AUM) within the defined firm. A firm must
also include the performance of assets assigned to a sub-advisor, provided the firm has control over the selection of
the sub-advisor. Finally, changes in a firm’s organization may not be used as a reason to alter historical composite
results. Composites are the firm’s discretionary, fee-paying portfolios amalgamated along a particular investment
strategy, such as emerging markets, small-capitalization funds and so on. This rule exists to prevent firms from
reorganizing and thereby dropping unfavourable return data from their presentation.

COMPOSITES
In order to disclose their performance clearly with respect to specific strategies, firms must include all actual, fee-
paying, discretionary portfolios in at least one composite. Non-fee-paying discretionary portfolios, such as a model
portfolio, may be included in a composite as long as there are appropriate disclosures. Non-discretionary portfolios
are not permitted in a firm’s composite because the firm needs to distinguish its skill on its discretionary strategies.
Furthermore, if any portfolios were discontinued, they must be included in the historical returns of their appropriate
composites, up until the last full measurement period that the portfolio was in existence. Also, portfolios cannot be
freely switched between composites, unless a firm has documented proof of changes in client guidelines or changes
in the composite’s definition.

DATA
A firm must maintain and capture all of the data it deems necessary to support and perform the required
performance calculations and presentations. Valuations must be based on fair values.
Portfolios are to be valued at a minimum frequency, depending on their inception date. For portfolios established
prior to January 1, 2001, valuations must be performed at least quarterly. For portfolios established on or after
January 1, 2001, valuations must be performed at least monthly. For periods beginning January 1, 2010, firms must
value portfolios on the date of all large external cash flows. Lastly, firms must use trade date accounting — data on
the date of trade — for periods beginning January 1, 2005.

CALCULATION METHODOLOGIES
The GIPS standards are quite specific regarding the types of calculation methodologies permitted in composites.
For instance, total return, which includes realized and unrealized gains and losses plus income, must be used.
Money-weighted returns are permitted where the firm has control over external cash flows and a specific
characteristic also applies. Otherwise, time-weighted returns are used. Periodic returns must be geometrically
linked. External cash flows should be treated in a manner consistent with the policies associated with the
specific composite. The returns from cash and cash equivalents in portfolios must be included in the total
return calculations.

PRESENTATION AND REPORTING

To provide investors with a sufficient idea of a firm’s investment skills, the GIPS standards require that each
composite show at least five years of performance data. If a firm or the composite has been in existence for less
than five years, the data should start from the inception date of the firm or composite.

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 CHAPTER 12 CLIENT PORTFOLIO REPORTING AND PERFORMANCE ATTRIBUTION 12 • 5

After presenting five years of performance, a firm has to provide additional performance of up to 10 years.
Therefore, if the firm has been doing business for seven years, its composites would have, at a minimum, five- and
seven-year performance records. On the firm’s 10th anniversary and every year thereafter, the firm would present
five- and 10-year performance records.
Each year of a composite’s performance record must show annual returns. Each composite must disclose the
number of underlying portfolios and the amount of assets. If a composite contains five portfolios or less, a firm does
not have to report the number. Also, each composite must disclose the amount of total firm assets at the end of
each annual period.

A FIRM’S RESPONSIBILITIES
A firm cannot be selective with regard to who they want to be able to see composite performance. It must make
every reasonable effort to provide a compliant presentation to any prospective client. This information should
include a description of the composites, a list of the discontinued composites and a full list of the composites that
are available. A firm that is compliant with GIPS standards that jointly markets its services with another firm that is
non-compliant with GIPS standards must ensure that only it claims to be compliant.

PORTFOLIO MANAGEMENT REPORTS

A portfolio management report is a document of record that an institutional client refers to for information on a
firm’s holdings and performance. Investment managers prepare these reports for institutional investors that invest
in their pooled funds, segregated funds and limited partnerships. Portfolio management reports can provide data on
either a trade date or settlement date basis.
A portfolio management report focuses on a fund’s particulars. On a monthly basis, detailed portfolio accounting
information is included for each security holding. This information could cover facts such as:

• The issuer’s name

• The number of shares held
• The market value per share, either as the closing price on valuation day, the last traded price, the bid price on
valuation day or an average of the bid and ask prices
• The total market value for each issuer based on the per share price
• The maturity date, call date, retraction date and coupon (for bonds)
• The market value of each issuer as a percentage of the total portfolio’s market value
• The total book value of each holding — the cost of purchase, including commissions — on a per share and
issuer basis
• The unrealized gain or loss of each holding — the market value less the book value
• The annual yield, dividend or coupon interest, and payments in kind

Issuer information is grouped by industry sector. Holdings are further grouped by asset class — for example,
short-term securities, Canadian equities, foreign/U.S. equities and fixed income. These reports have the look and
feel of a fund’s financial statements. Portfolio management reports pertain to an entire fund, with no reference to
its unitholders.
On a quarterly or yearly basis, portfolio management reports tend to have much more portfolio management
information and details on a portfolio’s trading activities and performance for the reporting time period. The reports
typically include a detailed explanation of the portfolio manager’s investment strategy, performance attribution,

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outlook for the market and major industry sectors, plus any planned changes in investment strategy. They also
include details such as the number of security transactions (portfolio turnover) and a statement of the portfolio’s
realized gains and losses. Some of the features of quarterly and yearly portfolio management reports are as follows:

• The changes in the portfolio’s sector or industry holdings on a quarter-over-quarter basis.

• A list of the portfolio’s five to 10 largest security holdings at quarter end by portfolio weighting and by the
change in portfolio weighting versus the previous quarter end.
• The portfolio’s total rate of return on both a time-weighted and dollar-weighted basis.
• The portfolio’s total rate of return divided between trading gains and income.
• The relative ranking of the portfolio’s performance against the appropriate institutional investment manager
peer survey, and also against any appropriate market performance benchmarks — for example, the S&P 500
Index and S&P/TSX Composite Index.
• The portfolio’s rate of return statistics.
• The detailed performance attribution report, which shows the major sources of under and overperformance for
the quarter — that is, cash holdings, sector and security over or underweighting versus the appropriate capital
market index weighting.
• The current portfolio’s value at risk.
• A report, which is typically a half to a full page in length, that discusses the major events that affected the
economy and capital markets during the quarter.
• An analysis of how the investment strategy performed versus the market and its competition.
• A summary of the portfolio manager’s outlook for the economy and the capital markets for the next one or
two quarters.
• A summary of how the portfolio is positioned to capitalize on the portfolio manager’s capital market outlook.

Portfolio management reports are not typically circulated among a firm’s mutual fund unitholders, and often form
the basis for the quarterly performance stewardship reports and presentations that institutional portfolio managers
present internally to the mutual fund manager. These reports often form the basis for the regular quarterly
presentations by portfolio managers to the mutual fund’s sponsor or manager.
Mutual fund unitholders receive a report that has less extensive information about each of the portfolio’s particular
holdings. For example, compared to a portfolio management report, a unitholder report, which is published on a
monthly or quarterly basis, does not include as much detailed information about each security holding’s position.
The unitholder report only includes a list of the top 10 to 20 security holdings by weight and their respective
proportionate weightings in the portfolio.
This report is often posted on the mutual fund manager’s website and is therefore accessible to all current
investors and the public. However, mutual fund security regulations require that the annual reports to unitholders
contain the portfolio’s detailed security holdings and other information that is included in a typical portfolio
management report.

BOOK VERSUS MARKET PRICES

In portfolio management reports, security values are available at both book (cost) and market prices. For
strictly economic purposes, such as risk management and portfolio performance, market price–based reporting
is fine. However, because tax liabilities are based on a security’s costs, both formats are used in portfolio
management reports.

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 CHAPTER 12 CLIENT PORTFOLIO REPORTING AND PERFORMANCE ATTRIBUTION 12 • 7

MARKET PRICES
For risk management and performance measurement, market prices are more useful than historical costs. However,
sometimes the notion of market prices can be interpreted in different ways.
For instance, stock market prices are usually taken as the last trade of the day. This makes sense, because they
represent an actual trade. On the other hand, the last trade of the day may have occurred earlier in the trading
session. But, for some securities, the last trade may have occurred several days ago. So what would reflect the actual
market price? In certain cases, the actual bid price may be a better proxy than the price of the last transaction. For
over-the-counter securities, average bid prices or the average midpoint between bid and ask prices can be used.
For rarely traded securities, some institutions will use a marked-to-model approach for reporting purposes. Once a
pricing model is accepted as being a good proxy to value a security, it can be used for reporting. The main problem is
that the assumptions that existed when the model was established may not hold when it comes time to report.

TAX IMPLICATIONS
Each time a security is sold, a tax treatment is done. Provided their income is taxable, the owner has to determine
if the sale created a capital gain or loss. The security’s cost is its book value. This book value is determined by
dividing the total cost of buying all identical securities, including transaction costs, by the number of securities the
investor owns.
For foreign investments held by Canadians, the historical cost of a position needs to be measured in Canadian
dollars for tax purposes. Therefore, even for accounts in U.S. dollars, the investment manager still needs to know
what the exchange rate was each time a transaction took place or a dividend was received, as these events have to
be recorded in Canadian dollars.
For non-taxable accounts, one might assume that it is not necessary to keep track of the historical cost because
no taxes have to be paid on the accounts. However, the historical cost does need to be tracked, as performance
measurement rules still require that realized gains or losses be distinguished from unrealized ones.

COMPARING PORTFOLIO MANAGER AND CUSTODIAN REPORTS

When an institutional portfolio management firm makes trades, it will make note of them in its internal records
and update the portfolio as of the trade date. However, the clearing and settlement of trades is a lengthy and
time-consuming process. Clearing is the process of confirming and matching security trade details, and settlement
is the moment of irrevocable exchange of cash and securities.
A custodian, who is a firm’s official record-keeper, records information about a portfolio on the settlement date,
which is usually no more than two business days after the trade date. (In Canada, effective May 27, 2024, the
proposed settlement date change is to one business day after the trade date.) This time is needed to clear and
settle the trades. The process is prone to errors, because there are several parties other than the buyer and seller
who need to complete the process. As a result, there could be discrepancies between the manager’s and the
custodian’s records.

PERFORMANCE ATTRIBUTION
Portfolio performance attribution, which is the evaluation of a manager’s performance by attributing a
portfolio’s success or failure to specific decisions, is an important component of the investment process for the
following reasons:

• It ensures a portfolio’s investment objectives are being satisfied.

• It is an important statistic used to monitor a portfolio manager’s performance.
• It is used to calculate the value added of the investment strategy.

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12 • 8 PORTFOLIO MANAGEMENT TECHNIQUES

Performance attribution is not the same as portfolio reporting. In creating a portfolio, the portfolio manager must
decide which asset classes to include, and how much weight to assign to each asset class in the managed portfolio.
Furthermore, the manager needs to decide the sub-composition of each asset class — that is, which particular
stocks or bonds to pick within those broad asset classes. As such, there are many decisions that go into a portfolio’s
composition. Portfolio reporting gives a sense of how a portfolio has performed at an overall level, but it does not
indicate which of the manager’s decisions were particularly beneficial, and which ones could have been improved.
Performance attribution attempts to answer these questions.
Performance attribution takes a managed portfolio’s overall return and breaks it down into various decision
components. It is a tool used to evaluate a portfolio manager’s investment talent and skills. The overriding objective
of the attribution process is to separate out the skills component from the luck component — that is, was the
managed portfolio’s return earned due to competent investment decisions the manager made, or was it simply
earned due to chance?

AN EXAMPLE OF PERFORMANCE ATTRIBUTION ANALYSIS

Performance attribution analysis can be done in multiple ways, with the evaluation of various portfolio manager
decisions. For example, some performance attribution analysis separates out a portfolio’s overall return into
industry selection, security choice, and up and down markets, while others may include style allocation and
market timing.
The example provided in this section will look at the following two components of an overall portfolio’s return:
1. Asset allocation
2. Security selection

The first component refers to the broad allocation of investable wealth into fixed income, equity and cash. The second
component involves deciding which individual securities to include in each asset class. In this example, in order to
understand why the managed portfolio behaved the way it did, it will be compared to an appropriate benchmark.
That is, the investment management decisions affecting this portfolio will be compared to those of the benchmark
portfolio — also called the bogey portfolio — in order to evaluate the efficacy of the portfolio manager’s choices.
Portfolio performance attribution involves four steps, as follows:

• Step 1: Calculating the managed portfolio’s return.

• Step 2: Calculating the benchmark portfolio’s return.
• Step 3: Calculating the managed portfolio’s excess return.
• Step 4: Explaining the difference in returns based on asset/component allocation and security selection.

The example that follows uses just two components to break down the overall return; however, once the attribution
analysis process is understood, it can be extended to include other decision components, such as industry selection,
style and so on.
Consider a managed portfolio that comprises equity, bonds and cash. The investment allocated to each of these
three broad categories is 75%, 12% and 13%, respectively. Assume that the appropriate benchmark portfolio has a
composition of 65% equity, 25% bonds and 10% cash.
The exercise breaks down the managed portfolio’s excess return into two components — asset allocation and
security selection — then compares these components to the benchmark portfolio. The example computes how
much of the managed portfolio’s excess return arose due to the manager’s broad allocation across asset classes, and
how much came about because he was accurately able to select the individual securities within each asset class.

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 CHAPTER 12 CLIENT PORTFOLIO REPORTING AND PERFORMANCE ATTRIBUTION 12 • 9

STEP 1: CALCULATE THE MANAGED PORTFOLIO’S RETURN

Table 12.1 illustrates the managed portfolio’s calculated return.

Table 12.1 | Managed Portfolio’s Return

Asset Class Weight (%) Return of Asset Class (%)

Equity 75 6.94
Bonds 12 1.43
Cash 13 0.42

Based on these values, the managed portfolio’s return is 5.4312%, which is calculated as follows: (0.75 × 0.0694) +
(0.12 × 0.0143) + (0.13 × 0.0042) = 0.054312.

STEP 2: CALCULATE THE BENCHMARK PORTFOLIO’S RETURN

For comparison purposes, the benchmark portfolio’s return is calculated in Table 12.2 below.

Table 12.2 | Benchmark Portfolio’s Return

Asset Class Weight (%) Return of Asset Class (%)

Equity 65 5.42
Bonds 25 1.20
Cash 10 0.42

The overall return is calculated in the same way as the managed portfolio. In this case, the benchmark portfolio’s
return is 3.8650%, which is calculated as follows: (0.65 × 0.0542) + (0.25 × 0.0120) + (0.10 × 0.0042) = 0.03865.

STEP 3: CALCULATE THE MANAGED PORTFOLIO’S EXCESS RETURN

In order to accurately compare the managed portfolio against the benchmark portfolio, the excess return must first
be calculated, as follows:
Excess return = Managed portfolio’s return − Benchmark portfolio’s return
= 5.4312% − 3.8650%
= 1.5662%

STEP 4: EXPLAIN THE DIFFERENCE IN RETURNS

Now that we know the managed portfolio’s excess return is 1.5662%, we need to attempt to break down this
number by the portfolio manager’s asset allocation and security selection decisions. Table 12.3 represents the asset
allocation contribution to the managed portfolio’s excess return.

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Table 12.3 | Asset Allocation Contribution to the Managed Portfolio’s Excess Return

Managed Benchmark Contribution of

Portfolio Portfolio Excess Weight Asset Class Asset Class to
Weights (%) Weights (%) (%) Return (%) Performance (%)
(1) (2) (3) = (1) − (2) (4) (5) = (3) × (4)

Equity 75 65 10 5.42 0.5420

Bonds 12 25 −13 1.20 −0.1560
Cash 13 10 3 0.42 0.0126
Total Portfolio 100 0.3986

In Table 12.3, column 3 calculates the difference between the asset allocation weights assigned in the managed
portfolio to those of the benchmark portfolio. Column 4 lists the market return for each asset class and column
5 calculates the contribution of each asset allocation to overall performance. Thus, 0.3986% of the managed
portfolio’s excess return can be explained by the manager’s asset allocation decision.
From Step 3, recall that the managed portfolio earned an excess return of 1.5662% over the benchmark portfolio.
Of this excess return, 0.3986% can be attributed to the portfolio manager’s prudent asset allocation decisions.
Thus, the remaining 1.1676% must be due to security selection. However, the portfolio manager made two security
selection decisions, namely, which securities to include in the managed portfolio’s equity component and which
bonds to include in its fixed income component. The next step breaks down the 1.1676% into security selection for
both equities and bonds, as illustrated in Table 12.4.

Table 12.4 | Security Selection Contribution to the Managed Portfolio’s Excess Return

Managed Asset Class Asset Class Contribution

Portfolio Return – Managed Return – Bogey Excess Return to Performance
Weights (%) Portfolio (%) (%) (%) (%)
(1) (2) (3) (4) = (2) − (3) (5) = (1) × (4)
Equity 75 6.94 5.42 1.52 1.1400
Bonds 12 1.43 1.20 0.23 0.0276
Total 1.1676

In Table 12.4, column 1 specifies the weights allocated to each asset class in the managed portfolio. Columns 2 and
3 give the returns for each asset class for the managed portfolio and the benchmark portfolio, respectively. For each
asset class, column 4 calculates the managed portfolio’s excess return as compared to the benchmark portfolio. The
contribution of asset allocation is the weighted average of the excess returns for each asset class, with the weights
being the percentage of total investable wealth allocated to each asset class in the managed portfolio. Note that
the total contribution of security selection decisions across both asset classes is 1.1676%. When this figure is added
to the 0.3986% attributable to the portfolio manager’s asset allocation decisions, the excess return of the managed
portfolio over that of the benchmark portfolio is 1.5662%.
To summarize, the managed portfolio earned 5.4312%, while the benchmark portfolio earned 3.8650%. Of
the managed portfolio’s excess return of 1.5662%, 0.3986% can be allocated to the portfolio manager’s asset
allocation decisions and 1.1676% can be allocated to their security selection decisions. Of the excess return of
1.1676% return due to security selection decisions, 1.14% was due to the portfolio manager’s equity picks, while
0.0276% was due to their bonds picks.

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The above performance attribution analysis reveals that the portfolio manager seems to have security selection skills
— at least during the time frame in question. The manager’s security selection had a greater effect on equities than
on bonds. Making this differentiation in skills — security selection versus asset selection, stock selection versus bond
selection — is important in determining whether a manager has the skills they claim to have. For instance, using the
example above, a client who invested with the manager would be reassured if they had claimed to be a stock picker,
where there was a value-add of 1.14%. The client would be less assured if the manager was specifically hired to select
bonds or rotate among asset classes, where the value-add was only 0.0276% and 0.3986%, respectively).

SECTOR ATTRIBUTION
Performance attribution can be done along any dimension through which a portfolio manager can add active
returns. The previous section highlighted performance attribution along asset timing choices. This section will
highlight attribution along sector choices in both an equity and a bond portfolio.

SECTOR ATTRIBUTION OF AN EQUITY PORTFOLIO

Consider an equity manager whose portfolio returned 12.55% over the previous calendar year. On a relative basis,
the manager did well, because their benchmark index returned 11.27% over the same period. What dimension of
active skills did this manager display during the year? Did they demonstrate sector selection skills or stock-picking
skills? It is not apparent by looking at the raw overall returns. Both the managed portfolio and the benchmark index
need to be broken down into their respective sector weights and returns, which is shown in Table 12.5 below.

Table 12.5 | Sector Weights of the Managed Portfolio and Benchmark Index

Portfolio Weight Portfolio Sector Index Weight Index Sector

(%) Return (%) (%) Return (%)
Energy 33 15.2 29 23.8
Materials 13 20.7 9 12.3
Industrials 3 4 7 1.7
Consumer Discretionary 5 7.8 6 2.2
Consumer Staples 1 3.9 5 6.8
Health Care 1 −9.5 3 −5.1
Financials 36 11.4 32 8.1
Information Technology 0 0 2 −5.6
Telecommunication Services 2 −1.4 4 1.7
Utilities 6 5.2 3 9.3
Total Weighted Portfolio/
Index Return 12.549 11.274

The process of finding allocation and selection effects is similar to that of the previous section. The results are
illustrated in basis points in Table 12.6 below. Using the energy sector as an example, let’s first calculate the
allocation effect. Energy had a portfolio sector weight of 33%; the index sector weight was 29%; and the index
sector return was 23.8%. Using the asset allocation contribution to excess return process described in Table 12.3, the
excess weight is 4% (calculated as the portfolio’s sector weight minus the index sector weight, or 33% − 29% = 4%).
Next, the allocation effect is 95.2 (calculated as the excess weight multiplied by the index sector return, or 4% ×
23.8% = 95.2).

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To calculate the selection effect, we use the security selection contribution to excess return process described in
Table 12.4. Energy had a portfolio sector return of 15.2%; the index sector return was 23.8%; and the portfolio
sector weight was 33%. The energy excess return is −8.6% (calculated as the portfolio sector return minus the index
sector return, or 15.2% − 23.8% = −8.6%).
Next, the selection effect is −283.8 (calculated as the excess return multiplied by the portfolio sector weight, or
−8.6% × 33% = −283.8).

Table 12.6 | Asset Allocation and Security Selection Returns in Basis Points

Portfolio Portfolio Index Index Allocation Selection

Sector Sector Sector Sector Effect Effect
Weight (%) Return (%) Weight (%) Return (%) (Basis Points) (Basis Points)

Energy 33 15.2 29 23.8 95.2 −283.8

Materials 13 20.7 9 12.3 49.2 109.2

Industrials 3 4 7 1.7 −6.8 6.9

Consumer Discretionary 5 7.8 6 2.2 −2.2 28

Consumer Staples 1 3.9 5 6.8 −27.2 −2.9

Health Care 1 −9.5 3 −5.1 10.2 −4.4

Financials 36 11.4 32 8.1 32.4 118.8

Information Technology 0 0 2 −5.6 11.2 0

Telecommunication Services 2 −1.4 4 1.7 −3.4 −6.2

Utilities 6 5.2 3 9.3 27.9 −24.6

Total Weighted Portfolio/

Index Return 12.549 11.274 186.50 −59

The attribution analysis reveals that the portfolio manager demonstrated skills during the calendar year when
selecting industry sectors by adding 186.5 basis points to the portfolio over the benchmark, but detracted from the
portfolio’s overall return through poor stock selection by losing 59 basis points. The sum of allocation and selection
effects, which is 127.5 basis points, is the total value added to the portfolio — 12.549% less 11.274%.
In general, the manager did not have poor stock selection skills. Poor stock selection seemed to be concentrated
in only two sectors: Energy and Utilities. Strong stock selection skills were evident in the Materials and Financial
sectors. The manager did not have good uniform sector selection skills, as some value was lost in their allocations to
the Consumer Staples, Consumer Discretionary and Industrials sectors.

SECTOR ATTRIBUTION OF A BOND PORTFOLIO

The mathematics of a bond portfolio’s attribution is not as straightforward a process as an equity portfolio’s
attribution. It is far more rigorous — and beyond the scope of this course — and requires the use of specialized
software. However, it is still useful to know what the attribution factors are, as defined below:

Income Effect For bonds with no embedded options and for mortgage-backed securities (MBS), this
effect is equal to the coupon interest. For other securities, such as a collateralized
mortgage obligation (CMO), the income effect incorporates amortization toward par.

Pay-Down Effect For MBS bonds, CMOs and asset-backed securities backed by home equity loans, this
effect accounts for principal prepayments or amortization at par.

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 CHAPTER 12 CLIENT PORTFOLIO REPORTING AND PERFORMANCE ATTRIBUTION 12 • 13

Amortization/ This is the percentage change in a bond’s price as it moves closer to maturity and rolls
Roll Effect (moves) along the slope of the yield curve. The amortization component is based on the
change in amortized price from the beginning to the end of the period.

Duration Effect This reflects the impact of the change in the general level of interest rates. It is defined
as the percentage change in a security’s price that would occur if the yield curve shifted
in a parallel fashion equal to the change in the 10-year Treasury price.

Convexity Effect This reflects the impact of embedded options on returns from callable securities, MBS or
other structured securities that may be in a portfolio.

Curve Effect This reflects the return due to the actual change in the underlying yield curve’s shape
in excess of the hypothetical parallel shift described in the duration effect above. This
category captures the change in the yield curve’s shape over the period.

Sector/Quality Effect This is the percentage change in a bond’s price attributable to the widening or
tightening of option-adjusted spreads (OAS) that was observed for a bond’s peer
group. OAS measures the yield spread that is not directly attributable to a bond’s
characteristics. A larger OAS means a greater return for greater risks. A peer group is
the combination of the primary sector, quality rating, effective duration and currency;
for example, the Industrials sector, a single A quality rating, an effective duration
of 2.0–3.0 and currency in U.S. dollars. The effect observes the excess return over
Treasuries realized by each peer group.

Security Selection This is the portion of the actual price return that is not explained by the term structure
(duration, roll and yield curve) and sector/quality effects. This effect isolates the return
due to a change in the bond’s OAS that is greater or less than the change in the average
OAS of the bond’s peer group.

Residual Factor This is the portion of the reported return that is not entirely explained by the other
effects. The most common source is pricing noise, where the portfolio’s actual reported
return is computed using prices from a source that is different than the prices used in the
attribution analysis.

PERFORMANCE ATTRIBUTION STYLES

Performance attribution styles refer to the dimensions of risk and return that exist in the market. Styles are
systematic approaches to investing that are shared by large groups of investors. Style analysis matters because
different styles are rewarded differently by the market.
Style analysis is the study of style drift in a fund’s holdings or returns over time. Style drift, which is given
important consideration in performance analysis for several reasons, occurs when a manager’s portfolio strays
from a specific investment management style. A small-capitalization manager who invests in large-capitalization
stocks during a period when small-capitalization stocks are underperforming cannot be viewed as a skillful
small-capitalization manager. Generally, the relative performance of a portfolio with a significant style bias will
depend largely on whether or not the specific style has performed well. The style differences may dominate the
portfolio’s relative returns even if the manager has strong stock selection skills. The more style drift that exists
in a manager’s investment approach, the more difficult it becomes to separate the manager’s skills from sheer
coincidence. Furthermore, style drift makes it more difficult to ascertain a fund’s appropriate risk level. Without a
grasp of the risk, it is impossible to set an ideal asset allocation ratio.

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12 • 14 PORTFOLIO MANAGEMENT TECHNIQUES

However, style analysis is not easy, as some portfolios represent a blend of styles, thus style classification becomes
a matter of subjective judgment. It is not always easy to classify a managed portfolio into one particular style.
Furthermore, portfolio compositions and manager styles may change over time. This could be true of either
the managed portfolio or the benchmark portfolio. As a result, comparing the returns of these portfolios over a
measurement period may not be entirely accurate. Finally, style analysis may be difficult to apply in an international
context because of the varying definitions of style categories across countries and markets. However, there are
generally two methodologies used to do a style analysis: returns and holdings.
The foundation for returns-based style analysis was developed by Nobel Prize-winning economist William Sharpe
in a 1988 article entitled “Determining a Fund’s Effective Asset Mix.”1 Sharpe suggests that a fund’s investment
style may be determined by comparing the fund’s returns — usually 36 to 60 months of data — to the returns of a
number of selected passive style indexes. These style indexes represent different investment styles or asset classes,
such as large-capitalization value, large-capitalization growth, small-capitalization growth, small-capitalization
value, government bonds and cash-equivalent asset classes.
Sharpe considered investment styles to be broken down into 12 broad categories, as follows:2
1. Treasury Bills
2. Intermediate bonds
3. Long-term bonds
4. Corporate bonds
5. Mortgage-related securities
6. Large-capitalization value stocks
7. Large-capitalization growth stocks
8. Mid-capitalization stocks
9. Small-capitalization stocks
10. Non-U.S. bonds
11. European stocks
12. Japanese stocks

A quadratic minimization procedure is applied to minimize the difference in monthly return performance between a
fund’s performance and a set of portfolio weights for the style indexes under consideration. Returns-based analysis
then constructs a set of portfolio weights for the style indexes such that the composite index’s return maximizes the
correlation to the fund’s return.

EXAMPLE
Quadratic minimization may indicate that a small-capitalization value fund’s composite benchmark could be
17% cash, 17% large-capitalization value, 11% small-capitalization growth and merely 55% small-capitalization
value.

Each of the 12 investment style categories represents a strategy that can be replicated using a low-cost index fund.
Thus, the benchmark not only provides a standard to which style composition can be compared, but also a passive
strategy that provides a return stream with which returns from style drift can be judged.

1
William F. Sharpe, “Determining a Fund’s Effective Asset Mix,” Investment Management Review (December 1988): 59–69.
2
William F. Sharpe, “Asset Allocation Management Style and Performance Measurement,” Journal of Portfolio Management (Winter 1992):
7–19.

© CANADIAN SECURITIES INSTITUTE

 CHAPTER 12 CLIENT PORTFOLIO REPORTING AND PERFORMANCE ATTRIBUTION 12 • 15

Holdings-based style analysis examines each stock in a portfolio and maps it to a style at a specific point in time,
in effect creating a history in the form of snapshots. Style can be determined by looking at capitalization, price-to-
book ratios, price-to-earnings ratios or dividend yield. Once a large enough history has been collected, a profile of
the fund’s average style can be developed and used as the custom benchmark.
There are merits and drawbacks to each of these methods. The trade-off is between ease of use and accuracy.
Returns-based analysis is the easiest to use, as it only requires monthly returns. Holdings-based analysis requires
detailed portfolio data that is neither easy nor inexpensive to obtain. In addition, the holdings-based method has
no way to account for any derivatives that may be in a portfolio. However, holdings-based analysis is the most
transparent and accurate method, because every stock can be tracked and correctly categorized by style.
Results from returns-based analysis may be inaccurate if the style indexes used in the quadratic minimization have
overlapping membership, meaning they are highly correlated. Also, for portfolios with less than two years of history,
holdings-based analysis is the only methodology to use. There are commercially available software packages that
can conduct either type of analysis.

ATTRIBUTING FOR STYLE DRIFT

Attributing for style drift in a portfolio is markedly different from attributing for sector or security selection. The
analyst must account for style drift over time, rather than look at a snapshot of a moment in time. For example,
to track an equity manager’s style drift, an analyst must plot the portfolio’s large-capitalization value, large-
capitalization growth, small-capitalization growth and small-capitalization value proportions according to the
results from returns- or holdings-based analysis and compare them over several years or quarters.
A small-capitalization growth manager with 80% small-capitalization growth, 5% small-capitalization value and
15% large-capitalization growth could be suspected of style drift if the proportions over a year became 60%, 10%
and 30%, respectively. This style drift might be the result of small-capitalization growth migration into the large-
capitalization growth category, or it could be a conscious effort on the manager’s part to increase the portfolio’s
overall returns with a large-capitalization growth allotment. To find a definitive answer, a client or advisor would
need to question the manager on their current investment practices.

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12 • 16 PORTFOLIO MANAGEMENT TECHNIQUES

SUMMARY
After completing this chapter, you should be able to:
1. Describe the Global Investment Performance Standards (GIPS) and why most institutional investment
management firms are in compliance with them.
• GIPS standards are an effort to present investment performance fairly and ethically to current and
potential clients.
• Compliance with GIPS standards is not mandatory, but non-compliance can put a firm at a competitive
disadvantage.

2. Describe a typical portfolio management report and highlight the type of information included in it.
• Portfolio management reports provide information on a firm’s holdings and performance to an institutional
investment client.
• On a monthly basis, a portfolio management report contains detailed information for each security holding.
On a quarterly or yearly basis, the report contains additional information, as well as details on a portfolio’s
trading activities and performance for the reporting period.

3. Explain why both book and market prices are included in portfolio management reports.
• Security values in portfolio management reports are available at both book (cost) and market prices. Market
prices are more useful in risk management and performance measurement, but book prices are required for
tax purposes.

4. Know the difference between performance reporting and attribution.

• Portfolio reporting gives a sense of how a portfolio has performed at an overall level, but it does not
indicate which of the portfolio manager’s decisions were particularly beneficial, and which ones could have
been improved.
• Performance attribution takes a managed portfolio’s overall return and breaks it down into various decision
components. It is a tool used to evaluate a portfolio manager’s investment talent and skills.

5. Apply performance attribution analysis to evaluate a portfolio manager’s skills.

• There are four steps in a portfolio performance attribution analysis:
« Step 1: Calculate the managed portfolio’s return.
« Step 2: Calculate the benchmark portfolio’s return.
« Step 3: Calculate the managed portfolio’s excess return.
« Step 4: Explain the difference in returns based on asset allocation and security selection.

6. Explain style drift.

• Style drift occurs when a manager’s portfolio strays from a specific investment management style.
• The more style drift that exists in a manager’s investment approach, the more difficult it becomes to
separate the manager’s skills from sheer coincidence.
• Style drift makes it more difficult to ascertain a fund’s appropriate risk level.

© CANADIAN SECURITIES INSTITUTE

Glossary
audit bottom-up approach
A
Verifying that all of the firm’s functions An investing style that focuses on
are conducting their affairs and the merits of an individual security.
active bond management activities in conformance with its It can take the form of either a
A bond management style that tries established operational procedures value-oriented or a growth-oriented
to profit from interest rate risk by — basically, that the rules established approach.
predicting the direction or magnitude by the firm’s compliance and legal
of interest rate changes. functions are being followed. box trade
Involves the simultaneous execution of
active portfolio management a pair of related fixed income security
A portfolio management style that swaps.
recognizes that securities markets are B
not efficient and adjusts a portfolio buy-and-hold strategy
through sector rotation, timing or backtesting Purchasing bonds with available funds
momentum strategies, or by the and holding each bond to its maturity,
The retrospective analysis of a
search for undervalued stocks. thereby avoiding the interest rate risk
potential investment product.
on an early sale.
alpha
barbell portfolio
The measure of a manager’s skills in
In a barbell portfolio, bonds are
adding value by taking active risk.
initially purchased at both ends of the
term structure — that is, the portfolio C
alternative investments
consists of 30-year and one-year
Investments that have different bonds. Canadian Securities Administrators
performance characteristics from (CSA)
traditional assets, such as stocks basis risk The CSA, which is a working group of
and bonds; that are rarely traded in
The risk that the basis — the price regulators from each provincial and
the public capital markets; that are
difference between an asset and territorial regulator, is charged with
relatively illiquid; that are relatively
its derivative — will not behave as forging uniformity in regulation where
uncommon in investment portfolios;
expected over the life of a hedge. possible.
that have a relatively limited
investment history; and that require
unconventional investment skills on beneficiary cash collateralized debt obligation
the part of the manager. In a fiduciary relationship, the A specific type of asset-backed security
beneficiary is the person to whom a in which the originator sells the
asset mix committee fiduciary owes a fiduciary duty. collateral (assets) for cash to a special
purpose vehicle (SPV). The collateral
A committee, usually composed of
beta can consist of mortgage-backed
the chief investment officer and heads
The systematic risk or the extent to securities, corporate bonds, other ABSs
of various asset class groups, which
which an investment moves with the or CDOs.
establishes the target asset mix for the
various balanced fund portfolios a firm overall market.
manages. cash-secured put option
board of trustees Where the fund has adequate cash to
asset-backed securities (ABS) An independent committee purchase the shares if the put option is
established to oversee a pension plan’s exercised.
A type of bond whose cash flows are
supported by the cash flows from a operation.
specified pool of discrete assets.
bond swap
Normally involves the purchase of one
bond and the simultaneous sale of
another related or unrelated bond.

© CANADIAN SECURITIES INSTITUTE

G•2 PORTFOLIO MANAGEMENT TECHNIQUES

cellular sampling collective investment vehicles currency cross-hedge

A strategy used to recreate a fixed See pooled investment vehicles. A transaction in which the mutual
income index portfolio where each fund substitutes its exposure to one
of a bond’s three dimensions — commodities currency risk for exposure to risk from
maturity, coupon and credit risk — is An alternative investment class that another currency, as long as neither
applied to the fund’s total capital and offers diversification benefits when is the currency in which the mutual
representatives of each cell are bought combined with a traditional portfolio fund’s net asset value is determined.
in proportion to the total index. containing equities and bonds.

chief compliance officer (CCO) compliance

The person who is responsible for Ensuring the firm is operating in such D
designing and implementing a a way that it is abiding by the rules
supervision system that will provide and regulations set by the securities dealers
the firm’s board of directors with regulators, the terms set out in the Individuals or companies that actually
reasonable assurance that compliance firm’s investment management trade securities.
standards are being met. agreements with investors and its own
established best practices. defined benefit (DB) plan
chief investment officer
A pension plan where entitlements are
The person within an investment contingent immunization typically calculated on the basis of the
management firm who has overall Where a manager is willing to risk employee’s salary profile and tenure
responsibility for the firm’s portfolio some of the portfolio’s value in the of employment. These entitlements
management activities. practice of active management, but at represent the sponsor’s liabilities.
a certain lower level wants to protect
clearing themselves against further losses. It is defined contribution (DC) plan
The process of confirming and often used as a compromise between A pension plan where the beneficiary
matching security trade details. passive and active bond management. is typically provided with a menu of
investment choices, including mutual
client services corporate governance funds, among which to allocate regular
Services offered by an investment The set of processes, customs, policies, contributions. The investment risk is
management firm that provide current laws and institutions affecting the way borne entirely by the beneficiary.
investors with timely and relevant an investment management firm is
information about their portfolios directed, administered or controlled. delta
under management. The price sensitivity of an option to
covered call option changes in the underlying asset’s price.
closet indexing A call that is sold with the underlying
The tendency of active managers to asset already owned in the portfolio. derivatives
build a portfolio that is close enough A financial contract whose value is
to a performance benchmark so that credit default swap derived from, or depends on, some
the portfolio neither underperforms A type of credit derivative where an other asset’s value.
nor outperforms the benchmark by exchange of two cash flows occurs: a
very much. fee payment made by the buyer and due diligence
a conditional payment made by the The reasonable investigation of
code of ethics seller, made only if a credit event is a proposed investment and its
An integral part of ensuring that a triggered. principals with the goal of ascertaining
discretionary portfolio manager’s the investment’s worthiness and
fiduciary duty is performed and that all credit derivatives appropriateness for particular types of
clients and investors are treated fairly Financial instruments that derive their investors.
and appropriately. value from an underlying credit asset
or pool of credit assets, such as bonds
collateralized debt obligation (CDO) or mortgages, and are designed to
A security that repackages a collection transfer and manage credit risk.
of underlying assets and sells multiple
classes (tranches) of the asset pool’s
interest to investors. A CDO can take a
cash or synthetic form.

© CANADIAN SECURITIES INSTITUTE

 GLOSSARY G•3

exempt investors Financial Transactions and Reports

E Analysis Centre of Canada
Investors who do not require a firm to
sell them securities via a prospectus. (FINTRAC)
efficient frontier A federal agency created to gather
A set of optimal portfolios that match exempt market dealer financial information under the
a client’s expected returns with their A dealer who trades or advises in Proceeds of Crime (Money Laundering)
risk profile. the exempt market, such as private and Terrorist Financing Act.
placements.
end values foreign-denominated bonds
Represents the ends toward which Bonds issued by domestic or foreign
a person strives and influences corporations or governments offering
how a person acts today to achieve F diversification from interest rate and
tomorrow’s goals. currency risk.
fairness policy
endowment funds forward rate agreements (FRAs)
A policy that all investment
Portfolios that are managed to Over-the-counter contracts for
management firms should have
produce income for a beneficiary hedging interest rates.
outlining the way employees will deal
organization.
with clients in matters of making
and providing investment analysis, fund accounting
enhanced active equity investing The proper accounting of the fund’s
recommendations or trade services.
An active portfolio management The policy ensures that all clients are asset values.
technique where the manager treated fairly by a firm’s employees.
overweights the securities that fundamental indexing
are expected to outperform the fiduciary A methodology where each stock’s
benchmark and underweights the index weighting is determined by four
In a fiduciary relationship, the person
securities that are expected to fundamental measures, thus diluting
in whom trust has been placed.
underperform, using short selling if weighting errors and erasing the link
necessary. between portfolio weight and over or
fiduciary duty
The duty of a person in a position of undervaluation.
enhanced indexing
trust to act solely in the beneficiary’s
An indexing technique that results in
interest.
portfolios that are designed to provide
index-like performance with some G
excess return net of costs. final go/no-go decision
A decision made by an investment
management firm’s senior general partner
ethical dilemma
management team about whether or Under a limited partnership, the
Exists when two or more of the
not to proceed any further with the institutional investment manager.
possible choices pit different values
development of a product.
against each other.
Global Investment Performance
financial intermediaries Standards (GIPS)
ethical principles
The various companies and Standards that attempt to present
Help guide behaviour in situations
organizations that connect and move investment performance from firms of
where no regulation exists or applies.
capital between suppliers and users of different countries fairly and ethically
capital. to current and potential clients. GIPS
ethics
standards are the product of the CFA
A set of consistent values that guide financial intermediation Institute’s Investment Performance
individual behaviour. Council, and although not mandatory,
The movement of funds from suppliers
of capital to users of capital. most investment management firms
execution slippage are in compliance with them.
Occurs when the execution of a
transaction causes subsequent prices growth-oriented approach
to worsen. A bottom-up approach to investing
that focuses on the individual stock,
specifically on earnings.

© CANADIAN SECURITIES INSTITUTE

G•4 PORTFOLIO MANAGEMENT TECHNIQUES

investment management agreement

H I
The contract that governs the
relationship between an institutional
head of equities immunization investment manager (the “Advisor”)
The person within an investment A means of protecting a bond portfolio and its institutional investor client
management firm who has overall from interest rate risk. (the “Client”).
responsibility for the portfolio
management of all of the equities the index funds investment policy statement
firm manages. A fund that uses a passive portfolio A statement developed by the
construction technique in order to investment committee for a fund’s
head of fixed income track a target portfolio’s performance. investment program that outlines the
The person within an investment investment aspects of the fund.
management firm who has overall index tracking
responsibility for the portfolio A passive investment strategy where
management of all of the fixed income the manager constructs a subset of the
and money market securities the firm benchmark that faithfully mimics the K
manages. index.
Know Your Client (KYC) rule
hedge funds institutional investor
An industry best practice stipulating
Lightly regulated pools of capital Any non-retail investor; also known as that an investment professional should
whose managers have great flexibility financial intermediaries, they include give appropriate cautionary advice to
in their investment strategies. pension plans, mutual funds, insurance and perform appropriate action for a
companies, endowments, charitable client based on the client’s investment
hedge ratio foundations, family trusts/estates and objectives and needs.
The relative number of derivatives corporate treasuries.
contracts per underlying asset
necessary to insure against portfolio interest rate futures
value changes. Contracts used by banks, corporations L
and individuals to hedge interest rate
hedged portfolio risk for future payments.
laddered portfolio
A portfolio with no exposure to a
specific risk. interest rate risk In a laddered portfolio, bonds are
initially purchased with each maturity
The variation in bond values due to
high closing up to 30 years in equal proportions.
changes in market yields.
An illegal activity where a portfolio
late trading
manager enters a higher bid price interest rate swaps
for a security at closing to artificially An illegal activity where a mutual fund
Agreements made between two
increase the net asset value of the fund company allows a trader to enter an
parties to exchange interest payments
to which the security belongs. order, either to purchase or sell, after
on loans for the same amount, with
the established cut-off time.
each guaranteeing to pay the other’s
holdings-based style analysis interest for a stated period.
leverage
An analysis of a manager’s style that
examines each stock in the portfolio investment committee The use of borrowed money to extend
and maps it to a style at a specific a fund’s buying power.
A committee populated by a subset
point in time, in effect creating a of individuals who serve on an
history in the form of snapshots. limited partnerships (LPs)
investment management firm’s
board of directors that focuses on the A common form of business
horizon analysis investment management aspects of a organization with one or more general
A technique used by analysts to react fund’s operations. partners who manage the business and
to financial forecasts, where the assume legal debts and obligations,
analyst chooses a horizon over which investment consultants and one or more limited partners who
the rate change is expected to evolve, are liable only to the extent of their
See pension consultants.
and at the end of which a new yield investment.
curve is predicted. investment-grade credit rating
liquidity date
When a fixed income security’s issuer
Pre-specified times of the year when
has at least a BBB credit rating from at
investors may be allowed to redeem
least one of the popular fixed income
units in an alternative investment fund.
credit-rating agencies.

© CANADIAN SECURITIES INSTITUTE

 GLOSSARY G•5

lockup modern portfolio theory (MPT)

O
The time period when initial A theory developed by Harry
investments cannot be redeemed from Markowitz contending that a
an alternative investment fund or portfolio’s diversification across Office of the Superintendent of
product. different asset classes with low or Financial Institutions (OSFI)
negative correlation characteristics will An independent agency of the
minimize risk. Government of Canada that
supervises, monitors and regulates the
M mortgage-backed securities (MBS) investment industry.
A portfolio of mortgages assembled
and sold in tranches to increase Ontario Securities Commission
managed futures fund
mortgage capital for lenders and offer (OSC)
A fund that invests in listed financial
secure higher-yielding medium-term An example of a Canadian securities
and commodity futures markets and
investments that are comparable to regulator. The OSC’s mandate, as set
currency markets around the world.
government bonds. by the Government of Ontario, is “to
provide protection to investors from
management expense ratio (MER) unfair, improper or fraudulent practices
The amount charged to a fund by the and to foster fair and efficient capital
fund manager before any returns are markets and confidence in capital
paid out to investors. The MER includes
N
markets.”
the fund manager’s compensation
and other expenses associated with National Instruments
operating the fund. A series of regulations developed by
the Canadian Securities Administrators
P
management styles (CSA) that are applicable across the
The term used to describe an equity country and serve to harmonize rules
and regulations in each jurisdiction. passive bond management
portfolio manager’s investment
strategy, which generally falls into two A bond management style where
categories: active or passive. new product development no attempt is made to predict the
committee direction or magnitude of interest
In smaller investment management rates, thereby minimizing the effects of
market depth
firms, as well as those focused interest rate risk on a bond portfolio.
The number of shares available at the
bid price and offer price. solely on the institutional market, a
committee put together to assess passive portfolio management
new investment fund or product A portfolio management style that
market price
opportunities. is consistent with the view that
The price that a security will fetch on
securities markets are efficient — that
open bidding in the market. Depending
National Instrument (NI) 81-102 is, at all times, securities prices reflect
on the type of security, market prices
This NI applies to mutual funds in all relevant information concerning
can be interpreted in different ways.
Canada and outlines the permitted expected return and risk.

market timing derivative activities that these funds

can undertake. peer investment manager
Buying or selling global securities after performance surveys
global markets have closed — but still
non-exempt investors Surveys that are produced by a number
remain open in North America because
Small individual retail investors. of the larger pension consulting firms
of time zone differences — to take
Non-exempt refers to the fact that and contain sufficient information
advantage of information that will
investment dealers must sell securities to evaluate the effectiveness and
affect the securities when the markets
to these investors via a prospectus that competitiveness of an individual firm’s
reopen the next day.
discloses the fund’s full information, investment process.

means values including its background and essential

data about its securities. pension consultants
The actions taken in the present to
People who advise institutional asset
achieve a future goal.
holders on the choice of external
investment managers. They are also
known as investment consultants.

© CANADIAN SECURITIES INSTITUTE

G•6 PORTFOLIO MANAGEMENT TECHNIQUES

performance attribution portfolio management report provincial and territorial securities

Evaluating an investment manager’s The document of record that an commissions
performance by attributing the institutional client refers to for The governing securities regulators
portfolio’s success or failure to specific information on a firm’s holdings and in Canada that are charged with
decisions the manager made. performance. enforcing and helping to frame the
various securities acts of the provinces.
performance benchmark portfolio manager
A benchmark against which a new An individual, or a team of individuals,
investment product will be measured who advises clients on investments
to explain the fund’s performance. appropriate to the clients’ individual R
circumstances and investment
Personal Information Protection and objectives. The portfolio manager is rate anticipation swap
Electronic Documents Act (PIPEDA) also responsible for making the day-to- A portfolio management technique
A federal law that regulates how day investment management decisions where the bond portfolio manager
businesses, including investment affecting the portfolios for which they decides to position the portfolio with
management firms, handle and secure are responsible. a longer or shorter duration based on
personal and private data. market information.
portfolio turnover
plan sponsor A way to measure the degree or real estate
In the case of a private pension plan, amount of active management, An alternative investment that tends
the employer offering the pension plan specifically trading activity. It is to take two forms: private and public.
to its employees. calculated by dividing the annual With the private form, investments
market value of securities trades by the are made in real, tangible assets that
pooled fund market value of the portfolio. usually generate steady cash flow
An open-ended trust in which investors from rental income. Real estate takes
contribute funds that are then invested pre-trade compliance testing a public form when it is securitized
or managed by the institutional A process to ensure that all security — that is, when a pool of real estate
investment manager. trades are compliant with all security assets is resold to investors as shares.
regulations pertaining to both capital
pooled investment vehicles market conduct and the particular real return bonds
fund, as well as all of the investment Bonds promising to pay interest based
Portfolios in which investors place
guidelines and restrictions that are on inflation levels.
their money to achieve diversification
agreed upon with the investors prior to
at lower costs. Some examples are
the execution of the trade.
mutual funds, hedge funds and private recovery rate
investment partnerships. The amount of value/funds eventually
prime brokerage structures
realized by creditors as a percentage of
portable alpha Structures that allow managers to the bond’s face or default amount.
establish a stock loan account with a
The process of using derivatives or
broker.
short selling to separate the alpha replicating an index
and beta return decisions and to apply A passive investment strategy where
the alpha to portfolios of other asset pro forma financial projection
the manager selects an appropriate
classes. Financial projections prepared for index to replicate in a fund, holding
a new fund that include three key each stock within the fund’s portfolio
portfolio accounting information inputs or assumptions: assets under in exact proportion to its weighting
management (revenue), fees charged within the index.
Information provided to an
to investors (revenue), and all fees and
institutional investor in the portfolio
expenses to be charged to the fund.
management report that includes repo transaction
detailed portfolio holdings, a report on Essentially a sale and repurchase
all security transactions and an income product management team
agreement where a broker/dealer sells
report. Within a large investment a fixed income security to a third party
management firm, a team responsible at an agreed upon price today and
portfolio management information for not only managing the day-to-day simultaneously agrees to buy back the
and project-related business of a firm’s same security from the third party at a
Information provided to an
existing product but also taking the set price on a future date.
institutional investor in an investment
lead in the development and launch of
management firm’s quarterly report
new products.
to clients that includes return data,
holdings data, attribution analysis and
market commentary.

© CANADIAN SECURITIES INSTITUTE

 GLOSSARY G•7

returns-based style analysis soft dollar arrangement

T
An analysis of a manager’s style An arrangement where an investment
developed by William Sharpe. It is firm purchases services via commission
performed by comparing the fund’s dollars rather than via an invoice for target asset mix
returns — usually 36 to 60 months of the goods or services. The desired market value weighting
data — to the returns of a number of for the major asset classes that are
selected passive style indexes. special purpose vehicle (SPV) included in the management of the
A legal entity that is set up by a loan’s firm’s various balanced fund portfolios.
risk budgeting originator, typically as a trust. It is
A process that limits the deviations of the legal owner of the loans and is target date immunization
a portfolio’s return from a benchmark. separate from the originator. In the pension industry, a means of
It is the most common technique used protecting a bond portfolio from
to create an enhanced index portfolio. standards of conduct interest rate risk, where there is an
Standards to which fiduciaries are held obligation to make a future payout on
accountable. a target date.

S step-up bond top-down approach

A bond that is underwritten with An approach to investing that begins
sale of options pre-defined (varying) coupon rates for with a macro and microeconomic
each year until maturity. The coupon analysis of trends and market forecasts
Selling options to take advantage of
rate is set below market for the first in the global, North American and
current or desired portfolio holdings
few years, but then crosses to above Canadian economies. The manager
and to earn additional income.
market rates for the remainder of the then selects the sectors that they
bond’s term. expect will outperform other sectors
sector rotation within the expected economic outlook.
The attempt by an active portfolio
manager to pick the best sectors. stratified sampling
tracking error
See cellular sampling.
The standard deviation of the return
securitization difference between the portfolio
The process of turning relatively illiquid style analysis
and the index when a manager is
assets into tradable securities. The study of style drift in a fund’s
responsible for an index product.
holdings or returns over time.
segregated account tracking error minimization
An investment account that is owned style drift
An approach that uses historical data
by an institutional investor and Occurs when a manager’s portfolio
to model the tracking error variance for
managed by a third-party portfolio strays from a specific investment
each bond in the index, then minimizes
manager. management style.
the total tracking error in that model.

self-regulatory organizations (SROs) sub-advisor

traders
Organizations that have been given A person or entity that the firm
Those employees who execute trades
regulatory supervision by various managing an investment fund will hire
within an investment management
provincial and territorial securities because the sub-advisor has expertise
firm.
commissions by way of monitoring the that is deemed appropriate and
activities of their member firms. beneficial to the fund.
trading philosophy
The role that active security trading
separation of duties principle synthetic collateralized debt
plays in executing a particular fund’s
A principle that is incorporated into obligation
investment management strategy.
a firm’s organizational structure to The credit derivative variant of the
minimize the potential for employee cash collateralized debt obligation
tranches
self-dealing via collusion with another (CDO), where the originator (the bank)
retains ownership of the underlying Layers of ownership within an ABS.
individual in the firm.
assets and buys protection from the Each layer has a different level of
special purpose vehicle (SPV) using a credit risk and hence a different level
settlement of return.
The moment of irrevocable exchange credit default swap, thus swapping the
of cash and securities. credit risk over to the SPV.

© CANADIAN SECURITIES INSTITUTE

G•8 PORTFOLIO MANAGEMENT TECHNIQUES

transparency risk
U V
The risk incurred by investors’ limited
access to information about their
alternative investments, including the ultimate designated person (UDP) value-oriented approach
fund’s operation, as well as its holdings The person within an investment A bottom-up approach to investing
and performance. management firm who is responsible that looks for undervalued securities,
to the self-regulatory organizations for with little focus on overall economic
trust the firm’s conduct and the supervision and market conditions.
Is a belief that those people on of its employees.
whom we depend, whether by choice values
or circumstance, will meet the Beliefs that are long-lasting and guide
expectations we have placed on them. individual and corporate behaviours
and goals.
trustee
A person or entity that holds the value system
title to the property (the cash and A system in which the end and means
securities) of a mutual fund on behalf values mutually reinforce and support
of the mutual fund’s unitholders. each other.

© CANADIAN SECURITIES INSTITUTE

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