PORTFOLIO MANAGEMENT

Portfolio Management: An Overview

What is the portfolio approach to investing?
The portfolio perspective evaluates individual investments on the basis of how they impact the
entire portfolio’s risk and return profile. The key is to understand that diversification will reduce
the risk (standard deviation) of a portfolio.
It is built on modern portfolio theory, in which the extra risk associated with holding a single stock
does not correspond with higher expected returns.
Note during financial crises correlation tends to increase and diversification benefits tend to
decrease.

What is the diversification ratio? How is it calculated?

The diversification ratio gives a quick measure of the potential benefits of diversification. It is
calculated as the standard deviation of an equally weighted portfolio of n securities divided by the
standard deviation of one of those securities selected at random:

Diversification ratio
This is not necessarily the most risk-reducing portfolio however. The equation is very in the weeds.

Describe the major types of investors & their risk tolerance, time horizon, & liquidity needs…

Define defined contribution and defined benefit plans

A defined benefit plan is a retirement plan where the firm promises to make periodic payments to its
retired employees. The liability rests with the firm, and the company is responsible for investment returns.

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From the perspective of an employee, a DB plan has zero investment risk and guarantees retirement
income (but increases dependence on the firm).
In a defined contribution plan, the firm’s sole liability happens at the beginning where they match the
dollar contributions of employees. Afterwards there is zero investment risk for the company and none of
the costs or risks associated with running a pension plan. DC plans shift 100% of investment risk to an
individual which requires them to monitor and reallocate their portfolio themselves. On the positive side,
DC plans allow an individual to own all of their assets, are more transferable and portable, lets individuals
diversify their portfolio how they wish, and lowers taxable income.

What are the 3 Major Steps of the Portfolio Planning Process?

1. Planning – Create Investment Policy Statement (IPS) detailing an investor’s risk tolerance, return
objectives, time horizon, tax circumstances, liquidity needs, income, & unique circumstances
2. Execution – Analyze risk and return characteristics of different asset classes and construct the portfolio
weights. Select individual investments. Top-down or bottoms-up approaches can both be used
3. Feedback – Evaluate investment performance over time as well as investor circumstances which may
change. Monitor and rebalance the portfolio periodically

What are mutual funds? Describe the Difference between open and close-end funds
Mutual funds are pooled investmentsin that they invest a single portfolio containing contributions from
multiple investors. The net asset value (NAV) of a fund is its total value divided by its number of shares.
Mutual funds charge a fee for managing the funds. No-load funds don’t charge upfront fees for buying or
selling shares, whereas load funds do.
Open-ended funds are funds where investors can buy new shares at NAV (or sell/redeem their shares).
Close-end funds do not take new investments into the fund (there are a finite # of shares). These shares
trade on the market just like any other equity. Close-end funds can trade at a premium or discount to NAV.

List the types of mutual funds

1. Money market funds – Invest in short-term debt securities to provide some income and extremely low
risk. Funds are differentiated by type and average duration of the securities they buy
2. Bond mutual funds– Invest in fixed income. Differentiated by bond maturity, credit rating, issuer, and
type.
3. Index funds – Passively managed stock fund designed to replicate performance of an underlying
benchmark, e.g. S&P 500
4. Actively managed funds – Managers select individual securities with the goal of generating alpha. Higher
security turnover causes this to have higher tax liabilities relative to passive funds

Compare ETFs to mutual funds

ETFS: Exchange traded funds are similar to close-end mutual funds, however, they are passively managed
to an index and redemption provisions mean they trade close to NAV at all times.
• Compared to mutual funds, ETFs have lower costs. This is because they have lower record keeping
requirements and pay lower licensing fees to the S&P. For long term holdings they thus have lower
brokerage costs.
• ETFs are more tax efficient because they tend to have lower turnover and fewer redemptions.
• ETFs trade throughout the day, meaning they are constantly marked-to-market. Index funds are priced at
the end of each trading

What are the major types of Hedge Funds (by strategy)?

• Hedge funds are skill-based strategies that can offer both higher absolute and risk-adjusted returns
depending on the choice of strategy. A long-short strategy will take both short and long positions in a
market by buying undervalued securities and selling overvalued securities. Generally long-only strategies
have fewer diversification benefits than long-short strategies (because beta is closer to 1 than 0). Hedge
funds are typically only available and suitable for high-net worth individuals.

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Compare and contrast Private Equity and Venture Capital

Private equity (PE) involves ownership in a non-publically traded private company. Buyout funds typically
purchase a public company and take it private, often financed with a significant amount of debt (leveraged
buyout). The goal is to restructure, improve operating efficiency, increase cash flow, pay down debt, issue
dividends, and then resell for a higher value.
Venture Capital funds typically invest in earlier stage companies and take a minority position. The goal is
the eventual IPO or sale of the business. Compared to PE this is an even higher risk/higher reward strategy.
Both VC and PE typically require a great deal of industry-specific expertise

Risk Management

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Portfolio Risk and Return: Part I

Define and calculate:
Holding Period Return
Average Return
Geometric Mean Return

The percentage increase in the value of an investment over a period of time:

Define and calculate the Money Weighted Rate of Return

The money weighted rate of return (MWRR), or dollar-weighted return, is the IRR on all funds
invested during a period. If you do have to calculate MWRR, enter each cash flow into your
calculator, the final value, and CPT the IRR.
You are unlikely to need the equation:

What are the basic General Return Measures

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(gross/net)?
Gross return is the total return before deducting any management and admin fees.
Net return is the return after all fees have been deducted
*Both fees account for (deduct) trade commissions
Pretax nominal return is the return before paying taxes.
After-tax nominal return is the return after paying taxes.
Real return is the nominal return adjusted for inflation. (subtract inflation)
Leveraged return is the gain or loss on investment as a % of the cash invested

List the major stock and bond asset classes…

• Small-cap stocks
• Large-cap stocks
• Long-term corporate bonds
• Long-term Treasury bonds
• Treasury bills
Asset classes should have correlated returns, whereas returns between asset classes should be largely
uncorrelated.

What does positive, negative, or no covariance indicate?

Formula is covered in the Quantitative methods section. Recall that covariance is an absolute measure (not
in units)
• Positive covariance indicates variables move together
• Negative covariance are variables that move in opposite directions
• Zero covariance means there is no linearrelationship
• Know the equations relating covariance, correlation, and beta.
•
Calculate correlation, What are the key properties of correlation?

Define Risk aversion, risk seeking, and risk neutral behavior

• A risk averse investor is an investor that prefers less risk over more risk given the same level of expected
return (they may still choose higher risk for a higher E(r). (concave)
• A risk seeking investor prefers MORE risk to less risk for the same level of E(r). This is irrational
behavior. (linear)
• A risk-neutral investor is indifferent between more or less risk (convex)
•

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Calculate the portfolio standard deviation for a 2 asset portfolio…

σportfolio
Key on exam is being able to navigate between beta, covariance, correlation (ρ_(a,b))
Where:

How is correlation related to risk in a portfolio context?

The benefits of diversification stem from investing in assets that are not perfectly correlated.
• The LOWER the correlation, the GREATER the diversification benefit
• If two assets have perfect negative correlation (one moves up 10% the other moves down 10%) we would
eliminate all portfolio risk
You can think about this algebraically using the portfolio standard deviation equation, where the last term
demonstrates the impact of changing correlations. So if assets were perfectly correlated (ρa,b=1) we’d get
the max std dev.

σportfolio
What is a minimum variance portfolio and a minimum variance frontier?
Where does the global minimum variance portfolio lie?

For any given E(r) we can vary the weights of the portfolio to find the portfolio that has the least amount
of risk (lowest standard deviation). This portfolio is known as the minimum variance portfolio.
The graph of all of the portfolios that have the lowest standard deviation for each level of expected return
make up the minimum variance frontier.
The furthest left point on the graph below is the global minimum variance portfolio.

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What is the Capital Asset allocation line (CAL)? Calculate its slope and standard deviation…
The capital asset allocation line (CAL) represents all of the possible combinations (weights) of a risk free
asset and optimal risky-asset portfolios.
It is the set of all possible efficient portfolios. The line begins at the intercept with the minimum return of
the risk-free asset (and no risk) and runs to the point where the entire portfolio is invested in the risky
portfolio.

In other words, you put X% of your portfolio into risky assets (A) and the rest into a risk free asset (B).

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How do you select an optimal portfolio given CAL

Every investor has their own utility function representing their risk and return preferences (i.e. degree of
risk aversion). These utility curves are upward sloping reflecting that more risk will only be taken in
exchange for more return. The steeper the slope the more risk averse the investor.
We can map these indifference curves against the capital asset allocation line (CAL), which is the set of
all efficient portfolios. The point of tangency is the utility maximizing, or optimal portfolio. Flatter ICs =
less risk aversion = higher risk/e(r) at tangency

Portfolio Risk and Return: Part II

Describe the Capital Asset Allocation Line vs. the Capital Market Line

The Capital market line (CML) is the specific instance

The CAL is the line plotting the possible
where we define the risky portfolio as the market
combinations of the risk free asset and a
portfolio. In this case investors can combine the risky
portfolio of risky assets. If investors have
market portfolio and the risk-free asset portfolios in-line
different expectations of e(r), σ, or ρ they will
with their risk preferences to build superior risk-return
each have a different CAL
portfolios.

What is the equation for the Capital Market Line? Market Risk Premium
The CML shows expected portfolio return as a linear function of portfolio risk, σ p

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The y-intercept is the risk free rate and the slope is the market risk premium.
With the CML we assume that every investor can both invest and borrow at the risk-free rate. If investors
are borrowing that means they are investing in the market portfolio using margin and the weight of their
risky portfolio will be > 100%

When do investors follow an active vs. passive strategy?

• Investors that believe markets are informationally efficient will tend to follow a lower-cost passive strategy
(i.e. pursue Beta)
• Investors that believe markets are NOT informationally efficient will tend to follow a higher-cost active
strategy in the pursuit of Alpha. Most commonly this means adjusting the weights of assets to overweight
undervalued securities and underweight or short overvalued ones.
•
Compare and contrast systematic and unsystematic risk.
• Systematic risk is market-level risk (beta) that cannot be diversified away. It is caused by things like GDP
growth and interest rate changes that affect the value of all risky securities. The higher a company’s beta
the greater its systematic risk.
• Unsystematic risk, or company-specific risk, is risk that can be diversified away in a portfolio (i.e.
through diversification)
•

Total risk=systematic risk+unsystematic risk

What is the role of systematic risk in a portfolio context?

One of the assumptions of MPT is that stock/portfolio returns depend on the level of systematic risk, NOT
total risk. The riskiest stock does not necessarily have the highest expected return.
Put differently, diversification is free,and thus you will not be rewarded for taking on high levels of
unsystematic risk

What are return generating models? How do you calculate E\left(r\right)E(r) in a multifactor model?
Return generating models are models used to look at expected return for risky firms with high specific
risk. In general they model the sensitivity of returns against specific factors.
The most common form is a multifactor model. Note the left-hand side of the equation we usually solve for
is equity risk premium or excess market return.

Each Beta measures the factor sensitivity for Asset i relative to the expected value of that factor

What is the Fama & French Model?

The Fama & French model is a multifactor return model that uses three variables:
• Firm size
• Firm Book Value/Market Value ratio
• Excess market return

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• The Carhat model adds price momentum using price period returns to this model

What is the Market Model?

• The market model is a simplified single-factor model which is used to estimate a security’s (or
portfolio) beta and its expected return. From there we can see if there are any abnormal returns relative to
our expected value.
• Mathematically:

•
(r_m-r_f)
We estimate the intercept and slope using historical return data.

Calculate and Interpret Beta.

Beta measures the sensitivity of an asset’s return to the return on a market index.

β=
• Overall market has a beta = 1
• Higher Beta = higher sensitivity to systematic/market factors
• Beta often measured using least squares regression line

What is the Security Market Line (SML)?

The SML models the tradeoff between systematic risk (Beta) and expected return. The difference between
the SML and CML is that we use the SML when we are not talking about the market portfolio. We could
use it to graph individual assets or portfolios.

What is the Capital Asset Pricing Model (CAPM)?

The CAPM is the most common representation of the SML. It represents a single efficient market frontier
on which investors create their portfolio using expected returns, standard deviations, and co-variances of
their investments. At its core the CAPM models the explicit tradeoff between beta (systematic risk) and
expected return. Be able to use the CAPM to calculate expected return or answer whether securities
are over/under valued.

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What are the key assumptions of the CAPM Model?

• Investors are risk averse
• Investors are utility maximizing
• Markets are frictionless – no taxes, transaction costs (it is free to diversify)
• All investors have the same single period time horizon
• All investors have homogenous expectations for e(r), σ, and correlation
• All investments are infinitely divisible
• Markets are competitive – Investors take price as given & no investor has the ability to impact that market
price
•
Compare and contrast the CML and SML…
• The CML uses total risk on the x-axis.That is, it represents only efficient combinations of the risk
free asset and the market portfolio along its length (& borrowing is allowed)
• The SML uses systematic risk, or Beta, on the x-axis. It is the graphical representation of the
CAPM model.
• Be able to graphically ID portfolios that are inefficient according to CML
• Be able to ID high and low beta portfolios on the SML
• Understand the types of risk being shown on the SML/CML

•
How do you identify undervalued and overvalued securities on a graph of the SML?
• If the forecasted return > required return the security is undervalued
• If the forecasted return < required return the security is overvalued
• If the forecasted return = required return the security is fairly valued

What are the two primary TOTAL risk adjusted return measures? How do you calculate them?
The Sharpe ratio is a total risk ratio that measures portfolio returns per unit of excess risk. The higher the
Sharpe ratio the better the risk-adjusted performance.

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M2 is a total risk measure that uses the CML to compare the portfolio’s actual returns against market
returns. Basically, M2 measures the value-add or lost relative to the market if the portfolio has the same
risk as the market. Because it also uses excess return in the numerator and standard deviation in the
denominator it is similar to the Sharpe ratio:

What are the two Systematic risk adjusted return measures? How do you calculate them?
The Treynor measure is a SYSTEMATIC risk measure that will give you the same result as Jensen’s ex-
post alpha. Treynor compares excess returns relative to systematic risk (i.e. using beta). A portfolio with
positive alpha will have a treynor > market:

Ex post alpha is a SYSTEMATIC risk measure. It measures the difference between a

portfolio’s actual return and its expected return relative to the SML. If the difference is positive your alpha
is positive, meaning the portfolio would plot above the SML graphically. If you have negative alpha it
would plot below the SML, and zero alpha would be on the SML. Mathematically:

To recap: (1) Calculate the expected return using the CAPM, (2) subtract that from the actual return, and
you’ve got your alpha.

Summarize and calculate the Total and Systematic Risk Measures.

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When do you use total risk and when do you use systematic risk to measure risk?

• If the portfolio is fully diversified systematic risk measures are more appropriate
• If a fund uses a single manager then total risk is likely to be more relevant
• If a fund invests across multiple managers than systematic risk is better

Basics of Portfolio Planning and Construction

Who are the main types of financial Intermediaries?
• Brokers – Help clients buy/sell securities by finding counterparties
• Dealers – Buy & Sell from their own inventory/holdings, earn the spread
• Broker-Dealers – Combine the two services, may have conflict of interest
• Investment banks – Help companies sell common stock/debt/preferred shares to investors. Assist with
mergers and acquisitions & capital raising
• Exchanges – Like NYSE, these are venues (electronic now) where traders meet. Exchanges regulate
members and require timely disclosure from companies trading on the exchange
• Alternative Trading Systems (ATS) – Alternative, less regulated type of exchange. A dark pool is an
ATS where buyer/seller identities not revealed
• Clearinghouses – Intermediaries between buyers/sellers and provide escrow, guarantees, margin trade
regulation, trade limits
•
Define a long and a short position…

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What does hedging in the futures market lok like?
A current or future ownership (right or obligation to buy) represents a long position. A right or obligation
to sell/deliver an asset means you have a short position, generally done via borrowing an asset and selling
it
• Long positions benefit from a rise in the price of the asset
• Short positions benefit from a fall in price
Hedgers use a short position to hedge an existing risk in a long position, e.g. a soybean farmer selling
soybean futures. A hedger will “do in the futures market what they must do in the future.” So the farmer
selling soybeans in the future should sell soybeans in the futures market.

What is the leverage ratio? How is it calculated for an investment made on margin?
The leverage ratio is the value of the asset divided by the value of the equity position (remember leverage
uses debt to increase the total quantity of assets held). Higher leverage indicates more risk:

In practice this is often the share price divided by the initial margin requirement.

Define Margin calls & the maintenance margin requirement. How do you calculate the margin call price?
The margin maintenance requirement is the minimum equity percentage an investor must maintain in
their position.
A margin call occurs when the investor receives a request to contribute more capital to maintain the
margin requirement.

Calculate the return on margin.

The return on margin is an increase in the value of a position after subtracting out commissions, interest
payments on the margin divided by the amount of funds initially invested (including the purchase
commission)

Return on margin=

What are market &limit orders?

When buying and selling in the financial markets there are two types of execution orders.
• Market orders are executed at the stated market price no matter what that price is. Thus a trader placing a
market order values speed and certainty of execution over price control.
• Limit orders are where the trader sets the desired price and waits for the market to hit that price (or not).
Limit orders value price control but sacrifice certainty of execution as a result.
Validity rules define when a trade, or order, should even be executed.

What is a bid, what is a spread, and what is a Bid-Ask Spread?

• Bid➜Is the price a dealer will BUY (and you can sell). It is lower than the ask
• Ask➜Is the price a dealer will SELL (and you can buy). It is higher than the bid
Bid-ask spreads are the difference between what you buy and sell for. The spread represents slippage or
trading costs. Always remember that the price you get is the one that is WORSE for you

Distinguish between Primary and Secondary markets..

Primary markets are the markets for newly issued securities. This can be an IPO or a new share issuance
by an already trading company.

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Secondary markets are where securities trade once they have been issued. A regular investor buying or
selling on the NYSE/LSE is trading on the secondary market. Secondary markets provide liquidity and
price information.

What are the 3 main types of market structures (based on how trades are driven)?
Markets can be either:
1. Quote driven: Where investors trade with dealers (OTC). These tend to have high liquidity.
2. Order-driven: Where investors trade with other investors. More competition leads to better prices
3. Brokered-Markets: Where Investors use brokers to find counter-parties. Most valuable for illiquid
securities (think art)

What are the Characteristics of a well-functioning financial system?

• Investors can save for the future and earn a fair rate of return
• Creditworthy borrowers can obtain funds
• Hedgers can manage their risks
• Traders can obtain the assets they need
If markets are informationally efficient they will also tend to allocate capital efficiently, providing
tremendous value to the economy.

What are the main objectives of market regulators?

• Protect unsophisticated investors
• Help investors evaluate performance
• Prevent insiders from exploiting their informational advantage
• Establish minimum standards of competency
• Promote common reporting standards to facilitate comparison
• Require minimum levels of capital to ensure proper risk-management

Why do we create an Investment Policy Statement (IPS)?

• The IPS is a living document that defines the client/advisor relationship and sets clear objectives
and constraints on the portfolio in order to develop a strategic asset allocation (SAA) that is unique to each
investor. The IPS should be reviewed annually or changed whenever a major change in circumstances
could affect risk-return objectives or portfolio constraints.
• Basically the IPS helps:
• State the goals of the client and evaluate them in a risk/reward context
• Establish the grounds for a strong working relationship
• Better understand the client

What are the major sections of an IPS?

• Describe the client
• State the purpose of the IPS
• State the responsibilities of financial managers and client
• Articulate procedures to update the IPS going forward
• Create the investment objectives -
• Develop the investment constraints – time, taxes, legal, liquidity, unique
• Create the investment guidelines
• Set how performance will be evaluated
• Attach appendices for any other strategic considerations – asset allocation, permitted deviations etc

Describe the risk and return objectives of the IPS…

• Risk can be measured on a relative basis against a benchmark or on an absolute basis.
• Risk tolerance depends on both your willingness to take risk and your abilityto take risk.
• Willingness and Ability are different.
a. Willingness is about your attitude & beliefs about asset types (subjective)

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b. Ability is financially driven—do you low liquidity needs, longer time horizon, a secure job, more assets
saved? If yes, that indicates higher ability

• If there is a conflict between the two always go for the most conservative option.

List the main Portfolio Constraints in an IPS… (RR−TTLLU)

Risk and return (R&R) are the first component of the IPS but are not constraints. Return is usually set
against a desire to meet a future goal. The constraints are TTLLU:
• Taxes – Investors tax rate, taxable/retirement accounts, and specific asset taxes
• Time horizon – Longer time horizon, more ability to take risk
• Liquidity – Lower liquidity/spending needs, more ability to take risk
• Legal – Any legal issues/constraints, e.g. can’t buy particular type of asset
• Unique constraints – Catch all for preferences. Can include ethical considerations, religious ones
•
What is Strategic Asset Allocation? How does it compare to tactical asset allocation?
• Strategic asset allocation is the process of defining a mix of portfolio asset classes that meet the
client’s return and risk parameters while also staying consistent with their constraints. It’s all about
setting long term target percentages of each asset class to invest in to set the basic structure of the
portfolio.
• Correlation within each asset class should be relatively high
• Correlation between each asset class should be low (diversification)
• Tactical asset allocation is the attempt to capitalize on short-term opportunities by deviating from the SAA
/ selecting individual securities

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